Friday, January 16, 2015

Financial Management (Chapter 16: Dividend Policy)

16.1   Do Firms Distribute Cash to Their Shareholders?

1) In response to a temporary decline in earnings per share, most companies would
A) decrease their cash dividend.
B) not decrease their cash dividend.
C) suspend their cash dividend.
D) substitute a stock dividend for the cash dividend.

2) The ex-dividend date is ________ the holder of record date.
A) five days before
B) two weeks before
C) two days before
D) three days after

3) Assume that Home Depot's annual dividend is $1.60 per share. This dividend would most likely be paid as
A) $0.80 twice a year.
B) $1.60 once a year.
C) whenever the company had extra cash.
D) $0.40 four times per year.


4) ZZZ Corporation has declared a stock dividend that pays one share of stock for every 10 shares owned. What will happen to EPS immediately upon the distribution of the stock dividend?
A) There is not enough information to know.
B) EPS will increase by 10%.
C) EPS will not be affected by the stock dividend.
D) EPS will decrease by 10%.

5) Which of the following describes the effect of a stock dividend?
A) A stock dividend immediately increases the market price of a share of stock.
B) A stock dividend immediately decreases the paid-in capital account.
C) A stock dividend immediately increases the number of shares outstanding.
D) A stock dividend indicates that the company must be short on cash.

6) Trendy Corp. recently declared a 10% stock dividend. As of the date of the announcement, Trendy had 10 million shares outstanding which were selling on the NYSE for $50 per share. An accounting entry is required on the balance sheet in order to transfer an amount from retained earnings to the common stock and additional paid-in capital accounts. What is the dollar amount of retained earnings that will be transferred from retained earnings to the common stock account as the result of the stock dividend? Assume that the par value of Trendy is $2 per share.
A) $2 million
B) $50 million
C) $45.45 million
D) $12.5 million


7) A stock dividend will cause changes in the dollar value of which of the below capital accounts?
A) Common stock
B) Additional paid-in capital
C) Retained earnings
D) All of the above

8) Which of the following is the most likely reason for a corporation to cut its dividend?
A) To keep the firm's price within its optimal range.
B) Because the company believes that existing dividend levels are no longer sustainable.
C) To make the firm more attractive to growth oriented investors.
D) To shelter the shareholders from double taxation.

9) Which of the following motivates corporations to split their common stock?
A) To keep the price of the firm's common stock within an optimum price range
B) To increase retained earnings
C) To reallocate capital to shareholders
D) To narrow ownership of the firm


10) If a firm's EPS are $8.33, and the firm is paying a dividend of $1.25 per share, what is the firm's dividend payout ratio?
A) 33%
B) 6%
C) 15%
D) 25%
E) 66%

11) Most stock splits
A) increase the number of shares outstanding.
B) increase the value of the company.
C) tend to raise the price of the stock.
D) all of the above.

12) A stock split will cause changes in the dollar value of which of the following?
A) The par value of the stock
B) The book value of common equity
C) The market value of common equity
D) The per share price of the stock


13) Assume that on January 1 a firm announces that on June 30 they will pay a dividend of $2.50 per share to holders of record on March 30. When does the stock sell ex-dividend?
A) January 5
B) April 5
C) March 28
D) July 5
E) June 25

14) For accounting purposes, a stock split has been defined as a stock dividend exceeding
A) 25%.
B) 35%.
C) 45%.
D) 55%.

15) The final approval of a dividend payment comes from the
A) controller.
B) president of the company.
C) board of directors.
D) Chief Financial Officer.


16) The only definite result from a stock dividend or a stock split is
A) an increase in the P/E ratio.
B) an increase in the common stock's market value.
C) an increase in the number of shares outstanding.
D) cannot be determined from the above.

17) Five years ago, Mr. Martinez purchased 1000 shares of JPM stock at $50 per share. If Mr. Martinez ' tax rate is 25%, would he prefer that the company pay a $5.00 per share dividend or offer to repurchase 100 shares at $50 per share?
A) Pay the dividend because he would have no transaction costs.
B) It would make no difference because he would receive $5,000 either way.
C) Repurchase the stock because he would owe no taxes.
D) It would make no difference because the tax rate on dividends is the same as the tax rate on capital gains.

18) The ________ designates the date on which the stock transfer books are closed in regard to a dividend payment.
A) declaration date
B) ex-dividend date
C) date of record
D) payment date


Use the following information to answer the following question(s).

Your firm is planning to pay a 15% stock dividend. The market price for the stock has been $84. The table below presents the equity portion of your firm's balance sheet before the dividend.

                Common stock
        Par value
        (1 million shares
        outstanding; $4 par value)                                               $ 4,000,000
        Paid-in capital                                                                      16,000,000
        Retained earnings                                                                30,000,000
        Total equity                                                                          $50,000,000

19) Which of the following would result from payment of the stock dividend?
A) Total equity would remain at $50,000,000.
B) Total equity would increase to $57,500,000.
C) Total equity would decrease to $43,478,261.
D) The effect on the equity account would depend on the market's reaction to the dividend.

20) If instead of a stock dividend, your firm decided to split the stock 2-1, then the number of shares outstanding and their par value per share would be
A) 1 million; $4.
B) 1 million; $8.
C) 2 million; $2.
D) 2 million; $4.


21) Five years ago, Mr. Martinez purchased 1000 shares of JPM stock at $50 per share.  The market price of the stock is now $55.  If Mr. Martinez ' tax rate is 25%, would he prefer that the company pay a $5.00 per share dividend or offer to repurchase 100 shares at the market price?  Assume that after the ex-dividend date, the price would return to $50 per share.
A) Pay the dividend because he would have no transaction costs.
B) As long as the tax rate on capital gains and dividends is the same, Martinez' wealth is the same under either alternative.
C) Repurchase the stock because he would owe less taxes.
D) He would be better off to sell the stock in the open market.

22) EG's board of directors announced a quarterly dividend of 25 cents. The ex-dividend date is November 3. On November 2, EG's stock closed at $40.00 per share. What is the most likely opening price on November 3?
A) $40.25
B) $39.75
C) $41.00
D) $39.00


Use the following information to answer the following question(s).

Your firm is planning a 2 for 1 stock split. The market price for the stock has been $84. The table below presents the equity portion of your firm's balance sheet before the split.

                Common stock
        Par value
        (1 million shares
        outstanding; $4 par value)                                               $ 4,000,000
        Paid-in capital                                                                      16,000,000
        Retained earnings                                                                30,000,000
        Total equity                                                                          $50,000,000

23) After the stock split, the number of shares outstanding, their par value and the total common stock account will stand at
A) 2,000,000; $4.00; $8,000,000.
B) 500,000; $8.00; $4,000,000.
C) 2,000,000; $2.00; $4,000,000.
D) 500,000; $2.00, $2,000,000.

24) Immediately after the stock split, the stock price will be approximately
A) $42.
B) $84.
C) $2.00.
D) $8.00.

25) Immediately after the stock split, an investor who owned 100 share before the split will own
A) 100 shares worth a total of $4200.
B) 200 shares worth a total of $8400.
C) 200 shares worth a total of $16,800.
D) 200 shares with a par value of $8.00 each.

26) A firm's payout is calculated as the ratio of retained earnings to earnings before interest and taxes (EBIT).
Answer:  FALSE

27) If a firm were to unexpectedly omit payment of its quarterly dividend, that firm's stock price would probably drop.
Answer:  TRUE

28) The dividend declaration date is the date at which the stock transfer books are to be closed for determining the investor to receive the next dividend payment.
Answer:  FALSE

29) There is absolutely no difference on an economic basis between a stock dividend and a stock split.
Answer:  TRUE

30) Firms can use stock repurchases as a dividend substitute.
Answer:  TRUE


31) The ex-dividend date occurs prior to the declaration date.
Answer:  FALSE

32) Dividends tend to be higher for firms with stable earnings.
Answer:  TRUE

33) Dividend payout ratios are generally much lower for small or newly established firms than for large, publicly owned firms.
Answer:  TRUE

34) After a stock split of 2-1, each investor will have one-half of the percentage ownership in the firm that he had before the split.
Answer:  FALSE

35) A reverse stock split, 1 for 10 for example, should result in a higher price per share.
Answer:  TRUE


36) Managers avoid cutting dividends even in response to short-term fluctuations in earnings.
Answer:  TRUE

37) A reasonable conclusion about dividend policy is that management should avoid surprising investors when it comes to the firm's dividend decision.
Answer:  TRUE

38) Due to the strengthening of the stock market over the past 50 years, stock splits and stock dividends are more common than cash dividends.
Answer:  FALSE

39) The financial crisis of 2008-2009 caused an unusually large number of companies to cut their dividends.
Answer:  TRUE

40) A stock dividend increases a firm's retained earnings.
Answer:  FALSE


41) Kelly owns 10,000 shares in McCormick Spices, which currently has 500,000 shares outstanding. The stock sells for $86 on the open market. McCormick's management has decided on a 2-1 split.
a.    Will Kelly's financial position alter after the split, assuming that the stocks will fall proportionately?
b.    Assuming only a 35% fall on each stock, what will be Kelly's value after the split?

Answer: 
McCormick Spices Corporation - Stock Split
Market price                        $86.00
Split multiple                      2
Shares outstanding           500,000

a.
Investor's shares                        = 10,000
Position before split                  $860,000 = 10,000 shares × $86 per share
Price after split $43.00              = $86/2
Kelly's shares after split          20,000 = 10,000 × 2
Position after split                     $860,000 = 20,000 shares × $43 per share
Net gain                                       $0

b.
Price fall                                       0.35
Price after split                           $55.90 = $86.00(1 - .35)
Position after split                     $1,118,000 = 20,000 shares × $55.90 per share
Net gain                                       $258,000 = $1,118,000 - $860,000

42) Why has the popularity of stock repurchases been growing faster than the cash dividends as a method for companies to distribute cash to their stockholders.

Answer:  Stock repurchases allow investors to tailor the timing of cash flows to their individual needs and tax situations. An investor with high current income can refuse the distribution, thereby "reinvesting" the money, postponing taxes, and avoiding transaction fees. An investor who wants or needs the income can sell shares back to the firm with no or very low transaction fees and often at a price that is slightly higher than the market value.

From the firm's point of view, the effect on stock price of omitting a dividend is often devastating, while there seems to be no equivalent penalty for not offering to repurchase shares.


43) Explain the significance of each of the following:
a.    announcement date
b.    ex-dividend date
c.    record date
d.   payment date

Answer: 
a.    announcement date: Date at which the Board of Directors announces that a dividend will be paid.
b.    ex-dividend: date Date after which the stock trades ex-dividend. Investors who buy the stock on or after the ex-dividend date do not receive the dividend. The previous owner does.
c.     record date: Date on which the company examines its records to determine who is entitled to the dividend.
d.    payment date: The date at which cash is actually distributed to eligible shareholders (those who purchased before the ex-dividend date.)

44) What are the effects of stock splits and stock dividends? Why are they popular?

Answer:  Economically, the only effect of a stock split or stock dividend is to increase the number of shares in existence. Since these shares bring no additional cash into the firm, it is obvious that neither book equity nor market equity increase as a result. Of necessity, the price per share must fall to adjust for the number of additional shares.

A company whose shares sell for a relatively high price, say $200, might decide to split the shares 4 for 1 creating 4 shares valued at $50 for every 1 share in existence. This action is based on the belief that investors will prefer the lower price because a typical 100 share "round lot" would then be more affordable. 

It also assumes that the price of a stock is influenced by supply and demand for the stock rather than just future cash flows. In view of the importance of large institutional investors who are not concerned with whether they buy 100,000 $50 shares or 50,000 $100 shares, this argument seems dubious.

It is also possible that managers use stock splits to hint at future good news concerning the company's cash flows.


45) XYZ Corporation has 400,000 shares of common stock outstanding, a P/E ratio of 8, and $500,000 available for common stockholders. The board of directors has just voted a 3-2 stock split.
a.    If you had 100 shares of stock before the split, how many shares will you have after the split?
b.    What was the total value of your investment in XYZ stock before the split?
c.     What should be the total value of your investment in XYZ stock after the split?
d.    In view of your answers to (b) and (c) above, why would a firm's management want to have a stock split?

Answer: 
a.     Number of shares after split = 3/2 × 100 = 150
b.     EPS before split = ($500,000/400,000) = $1.25
        Price per share before split = 8 × $1.25 = $10
        Total value of investment = $10 × 100 = $1,000
c.     Total number of shares after split = 3(400,000/2) = 600,000
        EPS after split = ($500,000/600,000) = $.8333
        Price per share after split = 8 × $.833 = $6.67
        Total value of investment after split = $6.67 × 150 = $1,000
d.    (1)   Stock splits are believed to have favorable information content. Splits are often associated with growth companies.
        (2)   Splits can conserve corporate cash if the firm has cash flow problems or needs additional funds for attractive investment opportunities.


16.2   Does Dividend Policy Matter?

1) Which of the following might cause dividend policy to affect shareholder wealth?
A) Taxes
B) Transaction costs
C) Changes in the firm's investment policies
D) All of the above
Answer:  D

2) A stock repurchase increases the
A) retention ratio of earnings.
B) number of shares outstanding.
C) EPS.
D) both B and C.

3) Transaction costs
A) encourage firms to retain earnings rather than pay dividends.
B) encourage firms to pay large dividends. rather than retain earnings.
C) are encountered whenever a firm pays a dividend.
D) are incurred when investors fail to cash their dividend check.


4) The Modigliani and Miller dividend irrelevancy theorem states that
A) dividends are preferable to stock repurchases.
B) the timing of cash distributions is important.
C) the timing of cash distributions is unimportant.
D) stock repurchases are preferable to dividends.

5) Assume that as the result of a firm announcing a large unexpected increase in its dividend payment, the price of the firm's common stock rises. This event would be consistent with which of the following?
A) The dividend irrelevance theory
B) The tax preference theory
C) The information effect
D) The beta effect

6) Millbury Gas and Oil's rate of return on equity is 12%. It can either pay a dividend of $5.00 today or reinvest the money and pay a dividend of $5.60 at the end of the year. From a shareholder's point of view, the value of the dividend paid now is ________ and the value of the dividend paid a year from now is ________.
A) $5.00, $4.46
B) $5.00, $5.00
C) $4.46, $5.00
D) $5.60, $5.00


7) In the absence of taxes, transaction costs, or changes in a firm's operating or investment policies
A) the greater the payout ratio, the greater the share price of the firm.
B) the price of a share of stock is not affected by dividend policy.
C) the firm should retain earnings so stockholders will receive a capital gain.
D) the firm should pay a dividend only after current equity financing needs have been met.

8) Assume that investors' have a 10% required rate of return on MTA stock.  According to the Modigliani and Miller dividend indifference theorem, if investors could choose between a $1.00 dividend today and $1.10 dividend one year from today
A) they would prefer $1.00 today.
B) they would prefer $1.10 one year from today.
C) neither alternative would satisfy them.
D) they would have no preference.

9) What might an investor reasonably expect from a company with excess cash and few internal investment growth opportunities?
A) The company will buy Treasury bills with all the excess cash.
B) The company will split its stock.
C) The company will declare a stock dividend.
D) The company will pay a cash dividend or repurchase some of its own shares.


10) If dividends and capital gains are taxed at the same rate, should investors prefer cash dividends or stock repurchases?
A) They would prefer to have neither a dividend nor a stock repurchase.
B) It would not matter. Either cash dividends or stock repurchases would result in the same after-tax cash flow.
C) They should prefer cash dividends to stock repurchases.
D) They should prefer stock repurchases to cash dividends.

11) Which of the following describes the clientele effect concept of dividend policy?
A) The clientele effect looks at investor preferences for dividends compared to share repurchase programs.
B) The clientele effect defines the relationship between the shareholder and a stockbroker.
C) The clientele effect focuses entirely on the stability of dividends.
D) Modern corporations do not consider shareholders to be "clients."

12) In the absence of taxes or transaction costs, investors
A) would prefer immediate dividends to future capital gains.
B) who did not want a dividend could use dividends to purchase more shares.
C) could create their own dividends by selling the appropriate number of shares.
D) Both B and C are correct.


13) Which of the following statements is most plausible?
A) Increases in stock price associated with a dividend increase are likely due to information conveyed by the increase.
B) Increases in stock price associated with a dividend increase are likely due to changes in the company's capital structure.
C) Increases in stock price associated with a dividend increase are likely due to investors' preference for dividends over capital gains.
D) Increases in stock price associated with a dividend increase are likely due to the favorable tax treatment of dividends over capital gains.

14) Chandler Corporation has 1 million shares outstanding. The current price per share is $20. If the company decides to pay a $2 million dollar dividend, the company will have ________ shares outstanding worth approximately ________.
A) 900,000, $20 per share
B) 1,000,000, $20 per share
C) 900,000, $22.22 per share
D) 1,000,000, $18 per share

15) Chandler Corporation has 1 million shares outstanding. The current price per share is $20. If the company decides to use $2 million dollars to repurchase shares at the market price, the company will have ________ shares outstanding worth approximately ________. Assume that the price does not change during the repurchase period.
A) 900,000, $20 per share
B) 1,000,000, $20 per share
C) 900,000, $22.22 per share
D) 1,000,000, $18 per share


16) Which of the following reasons is used to justify stock repurchases?
A) The repurchase narrows ownership.
B) The repurchase modifies the firm's capital structure.
C) The repurchase reduces the firm's costs associated with servicing small stockholders.
D) All of the above.

17) Dividend policy is influenced by
A) a company's investment opportunities.
B) a firm's capital structure mix.
C) a company's availability of internally generated funds.
D) all of the above.

18) M. Camus bought 1000 shares of Oran Co. at $60 per share and 100 shares of Gitane Co. at $40 per share.  Both stocks are now worth $50 per share.  Both companies have offered to repurchase their shares.  If M. Camus would like to have about $5,000 in cash, should he sell the Oran or Gitane?
A) Oran, because a tax deduction on the loss will leave him with more than $5,000 and taxes on the capital gain from Gitane would leave him with less than $5,000.
B) Gitane because the price is rising.
C) He should sell equal amounts of each so that his gains cancel out his losses.
D) there is no difference, he makes $5,000 either way.


19) Which of the following typically would NOT affect the dividend policy of the firm?
A) Today's dividend policy is affected by future dividend expectations among investors.
B) Managers are afraid to decrease their voting control of the company by issuing stock dividends.
C) The failure of so many high-tech and dot.com companies showed that dividends are important to long-term investors.
D) The current and future cash flow expectations of the company affect dividend policy.

20) Apple Computers decided to raise a large amount of money by selling bonds (previously the company had little or no debt) and use the proceeds to repurchase billions of dollars worth of the company's stock.  The decision was made after Apple stock lost more than 40% of its value in a six month period when most stock prices were rising.
A) Apple wanted to lower its cost of capital by substituting debt for equity.
B) Apple wanted to appease disappointed investors by offering them cash for their stock.
C) Apple wanted to increase earning per share by reducing the number of shares outstanding.
D) All of the above are reasonable explanations for Apple's decision.

21) If investor's expect a 15% rate of return on their investment, they will be indifferent between a $1.00 dividend received immediately or
A) $1.15 received at the end of the year.
B) $1.00 received later.
C) $0.87 received at the end of the year.
D) $1.00 increase in the stock price a year later.


22) Which of the following is a reason that a company would repurchase its own shares of stock in the market?
A) To reduce cash and the number of shares outstanding
B) To increase outstanding equity shares
C) To have shares available to offer a merger target
D) Both A and B

23) Since 2003 for most investors the tax rate on dividends has been ________ and the tax rate on capital gains has been ________.
A) 28%, 15%
B) 15%, 15%
C) 25%, 25%
D) 20%, 34%

24) Which of the following is the most probable way in which a shareholder will benefit from a stock split?
A) The immediately lower share price will attract enough increased interest in the stock to cause the market price to increase on a more consistent basis.
B) The immediately higher number of shares that an investor owns immediately increases the investor's wealth.
C) The shareholder can use the immediately increased wealth to borrow more money to buy even more shares at the immediately lower market price.
D) A shareholder can lose money after a stock split if the market believes that the split was an artificial way of attracting attention to a company that is not well managed.


25) Brimfield Corp. has total cash available of $1 million, but decides to match last year's dividend payout of $1.5 million. If the company raises the extra $500,000 by selling stock, the decision to pay out more than its available cash in dividends should
A) cause the stock price to increase.
B) have no effect on the value of the stock.
C) cause the stock price to decrease.
D) a company cannot use money raised by selling to stock to pay a dividend to existing stockholders.

26) Fred Handel owns 2000 shares of Haydn Inc. stock which is currently selling for $18 per share. If the company repurchases 10% of its outstanding shares at $18 per share and Fred chooses to sell back 200 shares
A) his investment in the company and his percentage of ownership will each decrease by 10%.
B) his investment in the company and his percentage of ownership will stay the same.
C) his investment in the company will decrease by $3,600 and his percentage of ownership will stay the same.
D) the value of his remaining shares will increase to $20 per share and his percentage of ownership will fall by 10%.

27) Fred Handel owns 2000 shares of Haydn Inc. stock which is currently selling for $18 per share. If the company repurchases 10% of its outstanding shares at $18 per share and Fred chooses not to sell any shares back to the company
A) the value of his shares will stay the same and his percentage ownership of the company will increase by 10%.
B) his investment in the company and his percentage of ownership will stay the same.
C) his investment in the company will decrease by $3,600 and his percentage of ownership will stay the same.
D) the value of his remaining shares will stay the same and his percentage of ownership will increase by 11.11%.

28) ZZZ Corporation had net income of $100 million last year and 50 million common shares outstanding. They declared an 8% stock dividend. Calculate EPS before and after the stock dividend.
A) EPS before would be $2; after the dividend, EPS would be $1.85.
B) There is not enough information to make this calculation.
C) EPS before would be $0.50; after the dividend, EPS would be $0.46.
D) Since they made $100 million in net income, the EPS cannot change.

29) Information asymmetry takes into account the higher stock price that can be achieved due to certainty from the accessibility of information between management and investors.
Answer:  FALSE

30) According to the Modigliani & Miller dividend indifference theorem, if a company decreased its dividend per share, an investor would be forced to sell his common stock at a depressed price.
Answer:  FALSE

31) Dividend payouts have the effect of lowering the company's debt to equity ratio.
Answer:  FALSE


32) As a firm's investment opportunities increase, the dividend payout ratio should increase.
Answer:  FALSE

33) The timing of dividend payments will not matter if the firm's rate of return on equity and the investor's required rate of return are the same.
Answer:  TRUE

34) Although the rates have changed from time to time, dividends and capital gains have always been taxed at the same rate in the U.S.
Answer:  FALSE

35) Empirical evidence is conclusive that dividend policy matters.
Answer:  FALSE

36) When a firm begins to pay dividends, it is signalling that it always expects to have enough cash flow to maintain and increase its dividend payout.
Answer:  TRUE


37) The clientele effect suggests that a firm's dividend policy will be affected by the needs of the shareholders.
Answer:  TRUE

38) The clientele effect suggests that firms can change their dividend policy frequently with no potential adverse effect on the firm.
Answer:  FALSE

39) A firm with high profitability will always have the cash flow necessary to pay high dividends.
Answer:  FALSE

40) When a firm makes the decision to pay dividends, it also makes the decision not to reinvest the cash in the firm.
Answer:  TRUE

41) Dividends per share divided by earnings per share (EPS) equals the dividend retention date.
Answer:  FALSE


42) Under what conditions would the Modigliani and Miller dividend indifference theorem be literally true.

Answer:  The Modigliani and Miller dividend indifference theorem requires that investors be able to buy and sell stock without incurring any transaction costs, such as brokerage costs. In addition, companies can issue stock without incurring any cost in doing so. It assumes that there are no personal or corporate taxes. Complete information about the firm is readily available, and there are no conflicts of interest between management and stockholders. Lastly, financial distress and bankruptcy costs are nonexistent.

43) In 2013, Apple Computers decided to raise a large amount of money by selling bonds (previously the company had little or no debt) and use the proceeds to repurchase billions of dollars worth of the company's stock.  The decision was made after Apple stock lost more than 40% of its value in a six month period when most stock prices were rising. What were the company's intentions?

Answer:  Apple may have been trying to appease disappointed shareholders by offering them cash for their shares, essentially saying: "If you think you can do better with another investment, go ahead."  By substituting debt for equity, it would be lowering its cost of capital.  By reducing the number of shares outstanding, Apple hopes to increase earning per share, giving a boost to its languishing stock price.  Apple may also have been reluctantly signalling that it expects slower growth and diminished investment opportunities in the future.

44) Georges Bizet owns 10,000 shares of Pearl Co. purchased at an average price of $15 per share. The tax rate on both dividends and capital gains is 15%. Would Bizet prefer a $2.00 per share dividend or to sell 1,000 shares back to the company at $20 per share? Compute his after-tax income from each option.

Answer:  If Bizet receives the dividend, his tax will be $20,000 × .15 = $3,000 and he would have $17,000 in after-tax income. If the company repurchases the share, he will have a capital gain of $20 - $15=$5 per share. 

Of the $20,000 he receives by selling back the shares, only $5,000 would be taxable. His tax would be $5,000 × .15 = $750, so his after-tax income would be $20,000 - $750 = $19,250. He would be better off by $2,250.


45) Because money has a time value investors should prefer that dividends be paid sooner rather than later. Agree or disagree. Explain your answer with a numerical example.

Answer:  When investors buy a company's shares, they assume that the company will earn a rate of return on equity that equals or exceeds their required rate of return. If an investor requires a 10% rate of return and the company decides to defer a $100 dividend for a year, the company will reinvest the $100 at its ROE and it will grow to $110. 

Reinvesting the money will allow the firm to pay a later dividend that is large enough to provide the investor with her required rate of return. In other words, if an investor requires 10%, she should be indifferent between a $100 dividend now and a $110 dividend a year from now. Note that the 10% includes compensation for the risk of the future cash flow, the same risk the investor was willing to take when she bought the stock.


46) What is meant by "dividend clienteles"? Give specific examples.

Answer:  Some investors purchase stocks with a record of paying stable dividends as a higher yielding alternative to bonds or certificates of deposits. Such investors could be retirees or institutions who need the dividends for their operating budgets. 

Other investors prefer that the company reinvest all available funds in growth and would rather not receive dividends. These investors are often high income individuals who would have to pay high taxes. Such investors prefer to build wealth for the future rather than increase their current income.

47) Pettry, Inc. expects EPS this year to be $5.25. If EPS grows at an average annual rate of 10%, and if Pettry pays 60% of its earnings as dividends, what will the expected dividend per share be in 10 years?

Answer: 
$5.25 (1 + 0.10)10 = 13.62 = EPS in 10 years
$13.62 × 0.6 = $8.17 = Expected dividends per share


48)  You are considering the stock of two firms to add to your portfolio. The companies differ only with respect to their dividend policies. For both firms, investors expect EPS for each of the next two years to be $7 and dividends and ending price for each of the next two periods to be:

                                    D1            D2                  P2
        Firm A              $2             $2             $60.70
        Firm B                 4               4               56.42

The required rate of return for the stock of Firm A is 14%. Ignore taxes or transaction fees.
a.    How much would investors pay for the stock of Firm A?
b.    How much would investors pay for the stock of Firm B?
c.     For a less-than-perfect world, provide an argument for each of the following:
        (1)   Investors prefer the dividend policy of Firm A.
        (2)   Investors prefer the dividend policy of Firm B.
        (3)   Firms prefer the dividend policy of Firm A.

Answer: 
a.     Po = ($2.00/1.14) + [($2.00 + $60.72)/(1.14)2]
        Po = $50
b.     Exactly the same in the perfect capital market environment.
        Po = ($4.00/1.14) + (($4.00 + $56.42)/(1.14)2)
        Po = $50
c.     (1)   Investors can pay a lower capital gains tax on the growth.
        (2)   Investors in this firm may need current income.
        (3)   Firms need additional equity to finance growth.

49) Noblesville Auto Supply Company's stock is trading ex-dividend at $5 per share. The company just paid a 10% stock dividend. The P/E ratio for the stock is 10. What was the price of the stock prior to trading ex-dividend?

Answer:  EPS after stock dividend = ($5.00/10.00) = $.50
EPS after stock dividend = (EPS before stock dividend)/(1.10)
($.50)(1.10) = $.55 = EPS before stock dividend
Stock price prior to stock dividend = (10)($.55) = $5.50


50) Trevor Co.'s future earnings for the next four years are predicted below. Assuming there are 500,000 shares outstanding, what will the yearly dividend per share be if the dividend policy is as follows?
a.    A constant payout ratio of 40%
b.    Stable dollar dividend targeted at 40% of the average earnings over the four-year period
c.     Small, regular dividend of $0.75 plus a year-end extra of 40% of profits exceeding $1 million

                  Trevor Co.
        Year 1         $ 900,000
        Year 2         1,200,000
        Year 3             850,000
        Year 4         1,350,000

Answer: 
a.    .40($900,000)/500,000 = $0.72
        .40($1,200,000)/500,000 = $0.96
        .40($850,000)/500,000 = $0.68
        .40($1,350,000)/500,000 = $1.08
b.    .40($1,075,000) = $430,000/500,000 = $0.86
c.     Year 1 $0.75 = $0.75
        Year 2 $0.75 + $0.16 = $0.91
        Year 3 $0.75 = $0.75
        Year 4 $0.75 + $0.28 = $1.03


16.3   Cash Distribution Policies in Practice

1) According to the residual dividend payout policy, dividends are considered a residual after
A) investment financing needs have been met.
B) preferred stock is issued.
C) EPS is allocated.
D) retained earnings are financed.

2) Common stock dividends tend to be more stable than
A) cash flow.
B) earnings.
C) preferred stock dividends.
D) bond interest.

3) Which of the following dividend policies would cause dividends per share to fluctuate the most?
A) Residual dividend policy
B) Stable dollar dividend
C) Small, low, regular dividend plus a year-end extra
D) Small, low, regular dividend


4) All of the following might influence a firm's dividend payment EXCEPT
A) investment opportunities.
B) investor transaction costs.
C) common stock par value.
D) flotation costs.

5) Which of the following would influence a firm's decision about dividends for large firms?
A) Ownership control
B) Liquidity position
C) Earnings predictability
D) Both B and C

6) A firm that maintains stable cash dividends will generally not increase the dividend unless
A) a stock split occurs.
B) the firm merges with another profitable firm.
C) the firm is sure that a higher dividend level can be maintained.
D) the price-earnings (P/E) ratio increased steadily over the past five years.

7) From the firm's point of view, a major advantage of stock repurchases over cash dividends is
A) a commitment to maintain or increase repurchases every year.
B) a stronger signal about the firm's financial strength.
C) that they restrain agency costs. 
D) that the repurchases imply no commitment to pay the same amount or more every year.


8) The problem with the residual dividend policy ratio is
A) investors might come to expect a specified amount.
B) the dollar amount of the dividend fluctuates from year to year.
C) management is reluctant to cut the dividend even if there are low profits in a year.
D) all of the above are possible problems.

9) Which of the following statements about the residual dividend theory is FALSE?
A) The firm will maintain its optimum debt ratio in financing future investments.
B) Dividend policy by itself has no direct influence on the market price of the firm's common stock.
C) The firm will issue new common stock to finance investment opportunities in order to ensure that some dividend will be paid.
D) The firm's investment opportunities, capital structure, and profitability all influence the firm's dividend policy.

10) Which of the following motivates corporations to enter into stock repurchase programs?
A) Favorable impact on EPS
B) Expected favorable impact on stock price
C) To modify the firm's capital structure
D) All of the above


11) Which of the following is the most important factor motivating dividend policy for large American corporations?
A) Changes in EPS
B) Maintain constant dividend payout ratio
C) Avoiding flotation costs of selling new stock
D) Avoid reducing dividends per share

12) Which of the following is most likely to have a negative impact on stock price?
A) Omitting a stock repurchase offer
B) Failure to increase the dividend at the same rate as previous years
C) Cutting the dividend per share in dollar terms
D) Reducing the dividend payout ratio

13) Which of the following is least important to repurchase decisions of large American corporations?
A) The previous level of dividends.
B) The tax consequences to shareholders.
C) Lack of good investment opportunities for cash retained in the firm.
D) The company is holding more cash than it would like.

14) In practice, firms tend to increase their dividend
A) when the stock seems to be underpriced in the market.
B) reducing cash to force executives to focus on efficient investment decisions.
C) only when they believe they can sustain the increased payout indefinitely.
D) when company is holding more cash than it would like.

15) Which of the following statements is true?
A) The stable dividend payout ratio keeps the dollar amount of the dividend stable.
B) Dividends usually do not increase unless management is convinced that the higher dividend can be maintained in the future.
C) The dividend policy which allows for an extra dividend at year-end in prosperous years includes a fairly large regular dividend payment per share every year.
D) All of the above are true.

16) Which of the following is more true of cash dividends than of repurchase offers?
A) The amount of cash to be returned to shareholders is flexible on a year to year basis.
B) External funds would be raised before reducing stock repurchase offers but not before cutting cash distributions.
C) Cash distribution decisions would take priority over investment decisions.
D) The stock price would be severely penalized if the cash distribution is reduced.

17) For a company with unpredictable investment needs and opportunities, the best way to distribute cash to shareholders would be
A) a residual dividend policy.
B) to repurchase company stock.
C) to issue preferred rather than common stock.
D) to pay dividends on an irregular basis.


18) According to the residual theory of dividends
A) dividends are to be paid out only after investment financing needs have been met.
B) earnings remaining after payment of preferred stock dividends should be paid to common stockholders.
C) dividend payments are a constant percentage of EPS.
D) a dividend is the residual above the payout ratio.

19) Franklin Electric is presently generating earnings available to common shareholders of $7.25 per share. The firm's income tax rate is 40%. Franklin is paying a dividend to the preferred shareholders of $2.10 per share. The firm's dividend payout ratio on common stock is 20%. What is the amount per share that Franklin will pay in dividends to common shareholders?
A) $0.58
B) $1.45
C) $3.12
D) $0.42
E) $2.20

20) Which of the following policies would appeal to an investor using dividends to increase her retirement income?
A) Maintaining smoothly increasing dividends from year to year.
B) A residual dividend policy.
C) Maintaining a constant dividend payout ratio.


21) The dividend policy that states smoothing of the dividend stream in order to minimize the effect of company reversals is called the
A) increasing-stream hypothesis of dividend policy.
B) stable dividend policy.
C) clientele effect policy.
D) residual payout policy.

22) Which of the following considerations would be expected to influence a firm's decision regarding the payment of dividends?
A) Earnings predictability
B) Legal restrictions
C) Liquidity position
D) All of the above

23) Groups of investors who prefer one distribution method over another are known as
A) pressure groups.
B) return chasers.
C) dividend clienteles.
D) retirees.

24) We typically expect to find rapidly growing firms to have high payout ratios.
Answer:  FALSE


25) Reducing dividends will usually have a negative impact on the stock price.
Answer:  TRUE

26) The residual dividend theory suggests that dividends should be paid to stockholders first, and then, what is left can be reinvested by the firm.
Answer:  FALSE

27) Company managers strive to gradually increase dividend series over the long-term future.
Answer:  TRUE

28) Unexpected dividend changes would cause investors to reassess their perceptions about a firm's stock.
Answer:  TRUE

29) Managers are prohibited from using dividend changes and repurchase offers to communicate information concerning their future expectations concerning the firm's cash flows.
Answer:  FALSE


30) European firms tend to pay out more dividends than U. S. firms.
Answer:  TRUE

31) The stable dividend policy is the most common.
Answer:  TRUE

32) The residual dividend theory indicates that a firm would never pay dividends unless the firm's profits were larger than its equity financing needs.
Answer:  TRUE

33) Share repurchases convey information to investors that the shares are underpriced.
Answer:  TRUE

34) Compare management's motives for preferring either stock repurchases or cash dividends.

Answer:  Cash dividends and repurchase offers are both ways to return cash to shareholders and both tend to convey positive information about the company's stock price and future earnings. Once a company begins paying cash dividends, it is under considerable pressure to at least match and preferably increase dividends each year. 

Repurchase offers put less pressure on management to pay out cash each year. They are more like the "residual dividend policy" in that the company only needs to pay out cash when all other demands have been met.


35) Compare the Stable Dividend Payout to the Residual Dividend Policy.

Answer:  A stable dividend payout policy tries to avoid unpleasant surprises to the company's shareholder clientele who may depend on the dividends to meet their income needs. Companies who follow this policy consider the predictability of dividends more important than the size or payout ratio and only increase dividends when they are quite certain that they can maintain the increased payout. 

A company that followed a residual dividend policy would only pay a dividend after all operational and investment needs had been met. Such a policy would lead to large year to year fluctuations in the dollar amount of dividends. The residual dividend policy is much less popular with investors and therefore with managers as well.

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