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CHAPTER 17
DISTRIBUTIONS TO SHAREHOLDERS:
DIVIDENDS AND REPURCHASES
Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.
True/False
Easy:
(17.3) Optimal distribution policy FR Answer: a EASY
[1]. The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm’s stock price.
a. True
b. False
(17.3) Dividend irrelevance FR Answer: b EASY
[2]. The dividend irrelevance theory, proposed by Miller and Modigliani, says that provided a firm pays at least some dividends, how much it pays does not affect either its cost of capital or its stock price.
a. True
b. False
(17.3) Dividend irrelevance FR Answer: b EASY
[3]. MM's dividend irrelevance theory says that while dividend policy does not affect a firm's value, it can affect the cost of capital.
a. True
b. False
(17.3) Investors’ dividend preferences FR Answer: a EASY
[4]. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a low payout ratio.
a. True
b. False
(17.3) Dividends and stock prices FR Answer: b EASY
[5]. The announcement of an increase in the cash dividend should, according to MM, lead to an increase in the price of the firm's stock.
a. True
b. False
(17.7) Residual distribution policy FR Answer: a EASY
[6]. If a firm adopts a residual distribution policy, distributions are determined as a residual after funding the capital budget. Therefore, the better the firm's investment opportunities, the lower its payout ratio should be.
a. True
b. False
(17.13) Stock dividends and splits FR Answer: a EASY
[7]. Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders’ wealth.
a. True
b. False
(17.33) Reverse split FR Answer: a EASY
[8]. A reverse split reduces the number of shares outstanding.
a. True
b. False
Medium:
(17.3) Dividend irrelevance FR Answer: a MEDIUM
[9]. Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk.
a. True
b. False
(17.3) Dividend-growth tradeoff FR Answer: a MEDIUM
[10]. One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must be offset by a more than proportionate increase in growth in order to keep a firm's required return constant, other things held constant.
a. True
b. False
(17.5) Signaling hypothesis FR Answer: a MEDIUM
[11]. If the information content, or signaling, hypothesis is correct, then changes in dividend policy can have an important effect on the firm’s value and capital costs.
a. True
b. False
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(17.7) Residual distribution policy FR Answer: b MEDIUM
[12]. If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual distribution policy.
a. True
b. False
(17.7) WACC and dividend policy FR Answer: b MEDIUM
[13]. If the shape of the curve depicting a firm's WACC versus its debt ratio is more like a sharp "V", as opposed to a shallow "U", it will be easier for the firm to maintain a steady dividend in the face of varying investment opportunities or earnings from year to year.
a. True
b. False
(17.13) Stock splits FR Answer: a MEDIUM
[14]. Even if a stock split has no information content, and even if the dividend per share adjusted for the split is not increased, there can still be a real benefit (i.e., a higher value for shareholders) from such a split, but any such benefit is probably small.
a. True
b. False
Multiple Choice: Conceptual
Easy:
(17.6) Dividend payout CR Answer: a EASY
[15]. In the real world, dividends
a. are usually more stable than earnings.
b. fluctuate more widely than earnings.
c. tend to be a lower percentage of earnings for mature firms.
d. are usually changed every year to reflect earnings changes, and these changes are randomly higher or lower, depending on whether earnings increased or decreased.
e. are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if EPS = $2.00, then DPS will equal $0.80. Once the percentage is set, then dividend policy is on “automatic pilot” and the actual dividend depends strictly on earnings.
(17.13) Stock splits CR Answer: a EASY
[16]. Poff Industries’ stock currently sells for $120 a share. You own 100 shares of the stock. The company is contemplating a 2-for-1 stock split. Which of the following best describes what your position will be after such a split takes place?
a. You will have 200 shares of stock, and the stock will trade at or near $60 a share.
b. You will have 100 shares of stock, and the stock will trade at or near $60 a share.
c. You will have 50 shares of stock, and the stock will trade at or near $120 a share.
d. You will have 50 shares of stock, and the stock will trade at or near $60 a share.
e. You will have 200 shares of stock, and the stock will trade at or near $120 a share.
Medium:
(17.3) Dividends versus capital gains CR Answer: c MEDIUM
[17]. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that
a. investors require that the dividend yield and capital gains yield equal a constant.
b. capital gains are taxed at a higher rate than dividends.
c. investors view dividends as being less risky than potential future capital gains.
d. investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains.
e. a. investors are indifferent between dividends and capital gains.
(17.3) Optimal dividend policy CR Answer: c MEDIUM
[18]. Which of the following should not influence a firm’s dividend policy decision?
a. A strong preference by most shareholders for current cash income versus capital gains.
b. Constraints imposed by the firm’s bond indenture.
c. The fact that much of the firm’s equipment has been leased rather than bought and owned.
d. The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains.
e. The firm’s ability to accelerate or delay investment projects.
(17.5) Dividend theories CR Answer: d MEDIUM
[19]. Which of the following statements about dividend policies is correct?
a. One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases.
b. One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest.
c. One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy.
d. The clientele effect suggests that companies should follow a stable dividend policy.
e. Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the “bird-in-the hand” effect.
(17.7) Dividend payout CR Answer: b MEDIUM
[20]. Which of the following would be most likely to lead to a decrease in a firm’s dividend payout ratio?
a. Its access to the capital markets increases.
b. Its R&D efforts pay off, and it now has more high-return investment opportunities.
c. Its accounts receivable decrease due to a change in its credit policy.
c. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages.
e. Its earnings become more stable.
(17.7) Residual dividend policy CR Answer: e MEDIUM
[21]. Reynolds Paper Products Corporation follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase in the firm’s dividend per share?
a. The company increases the percentage of equity in its target capital structure.
b. The number of profitable potential projects increases.
c. Congress lowers the tax rate on capital gains. The remainder of the tax code is not changed.
d. Earnings are unchanged, but the firm issues new shares of common stock.
e. The firm’s net income increases.
(17.8) Residual dividend policy CR Answer: a MEDIUM
[22]. If a firm adheres strictly to the residual dividend policy, then if its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/total assets ratio), then the firm should pay
a. no dividends to common stockholders.
b. dividends only out of funds raised by the sale of new common stock.
c. dividends only out of funds raised by borrowing money (i.e., issue debt).
d. dividends only out of funds raised by selling off fixed assets.
e. no dividends except out of past retained earnings.
(17.8) Residual dividend policy CR Answer: b MEDIUM
[23]. If a firm adheres strictly to the residual dividend policy, the issuance of new common stock would suggest that
a. the dividend payout ratio is increasing.
b. no dividends were paid during the year.
c. the dividend payout ratio is decreasing.
d. the dollar amount of investments has decreased.
e. the dividend payout ratio has remained constant.
(17.10) Stock repurchases and DRIPs CR Answer: b MEDIUM
[24]. Which of the following statements is correct?
a. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account.
b. Stock repurchases can be used by a firm that wants to increase its debt ratio.
c. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities.
d. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding.
e. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their ownership in the company.
(17.10) Dividends, DRIPs, and repurchases CR Answer: c MEDIUM
[25]. Which of the following statements is correct?
a. One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends.
b. Empirical research indicates that, in general, companies send a negative signal to the marketplace when they announce an increase in the dividend, and as a result share prices fall when dividend increases are announced. The reason is that investors interpret the increase as a signal that the firm has relatively few good investment opportunities.
c. If a company wants to raise new equity capital rather steadily over time, a new stock dividend reinvestment plan would make sense. However, if the firm does not want or need new equity, then an open market purchase dividend reinvestment plan would probably make more sense.
d. Dividend reinvestment plans have not caught on in most industries, and today about 99% of all companies with DRIPs are utilities.
e. Under the tax laws as they existed in 2008, a dollar received for repurchased stock must be taxed at the same rate as a dollar received as dividends.
(17.10) Dividend policy and stock repurchases CR Answer: c MEDIUM
[26]. Which of the following statements is correct?
a. If a company uses the residual dividend model to determine its dividend payments, dividends payout will tend to increase whenever its profitable investment opportunities increase.
b. The stronger management thinks the clientele effect is, the more likely the firm is to adopt a strict version of the residual dividend model.
c. Large stock repurchases financed by debt tend to increase earnings per share, but they also increase the firm’s financial risk.
d. A dollar paid out to repurchase stock is taxed at the same rate as a dollar paid out in dividends. Thus, both companies and investors are indifferent between distributing cash through dividends and stock repurchase programs.
e. The tax code encourages companies to pay dividends rather than retain earnings.
(17.10) Miscellaneous dividend concepts CR Answer: b MEDIUM
[27]. Which of the following statements is correct?
a. Capital gains earned in a share repurchase are taxed less favorably than dividends; this explains why companies typically pay dividends and avoid share repurchases.
b. Very often, a company’s stock price will rise when it announces that it plans to commence a share repurchase program. Such an announcement could lead to a stock price decline, but this does not normally happen.
c. Stock repurchases increase the number of outstanding shares.
d. The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter.
e. If a company has a 2-for-1 stock split, its stock price should roughly double.
(17.12) Dividend theory CR Answer: d MEDIUM
[28]. Which of the following statements is correct?
a. One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like.
b. An increase in the stock price when a company decreases its dividend is consistent with signaling theory as postulated by MM.
c. If the “clientele effect” is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize the stock price.
d. Stock repurchases make the most sense at times when a company believes its stock is undervalued.
e. Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above average payout ratios.
(17.12) Dividend policy CR Answer: a MEDIUM
[29]. Which of the following statements is correct?
a. If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not follow the strict residual dividend policy.