Dividends
Dividends
TO SHAREHOLDERS:
CHAPTER
15
DIVIDENDS AND REPURCHASES
(Difficulty: E = Easy, M = Medium, and T = Tough)
Answer: d
Diff: E
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 are indifferent between dividends and capital gains.
b. Investors require that the dividend yield and capital gains yield
equal a constant.
c. Capital gains are taxed at a higher rate than dividends.
d. Investors view dividends as being less risky than potential future
capital gains.
e. 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.
Answer: d
Diff: E
Dividend payout
3
Answer: a
Diff: E
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Chapter 15 - Page 1
Dividend payout
4
Answer: c
Earnings stability.
Access to capital markets.
Profitable investment opportunities.
Collection of accounts receivable.
Stock price.
Dividend theories
5
Diff: E
Answer: e
describes
the
Diff: E
theories
N
of
Answer: c
Diff: E
Answer: e
Diff: E
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Chapter 15 - Page 2
Answer: a
Diff: E
Stock split
9
Answer: e
A stock split will cause a change in the total dollar amounts shown in
which of the following balance sheet accounts?
a.
b.
c.
d.
e.
Cash.
Common stock.
Paid-in capital.
Retained earnings.
None of the statements above is correct.
Stock split
10
Diff: E
Answer: b
Diff: E
You currently own 100 shares of stock in Beverly Brothers Inc. The stock
currently trades at $120 a share. The company is contemplating a 2-for-1
stock split. Which of the following best describes your position after
the proposed stock split takes place?
a. You will have 200 shares
near $120 a share.
b. You will have 200 shares
near $60 a share.
c. You will have 100 shares
near $60 a share.
d. You will have 50 shares of
$120 a share.
e. You will have 50 shares of
$60 a share.
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Chapter 15 - Page 3
11
Answer: a
Diff: E
12
Answer: e
Diff: E
Answer: c
Diff: E
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Chapter 15 - Page 4
Answer: e
Diff: E
Answer: e
Diff: E
Medium:
MM dividend theory
16
Answer: e
Diff: M
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Chapter 15 - Page 5
Dividend theory
17
Answer: a
Diff: M
Dividend theory
18
Answer: a
Diff: M
Dividend policy
19
Answer: b
Diff: M
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Chapter 15 - Page 6
Answer: c
Diff: M
Dividend policy
21
Answer: a
Diff: M
Diff: M
23
Answer: c
Answer: b
Diff: M
Answer: b
Diff: M
Answer: d
Diff: M
Congress passed a new tax law that reduced long-term capital gains tax
rates from 28 percent to 20 percent. The maximum tax rate for ordinary
personal income is 39.6 percent. Which of the following statements is
most correct for an investor in a high personal tax bracket?
a. The stock of a company that pays high cash dividends and has a
dividend reinvestment plan (DRIP) is a good investment for this
individual because he/she will receive more money that can then be
reinvested in the companys stock.
b. A 2-for-1 stock split is announced for a stock that the investor
currently holds. The company had split the stock because the stock
price had increased beyond the optimal price range and is expected to
continue to grow. This is good news to the investor because it means
that any gains from increased stock value will be taxed at a new
lower long-term capital gains rate when the stock is sold.
c. One of the companies in the investors portfolio recently announced
that it will embark on a stock repurchase plan. The lower long-term
capital gains tax rate will reduce the investors taxes if he/she
decides to tender some shares of stock in the company.
d. Statements b and c are correct.
e. All of the statements above are correct.
Answer: e
Diff: M
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Chapter 15 - Page 8
reinvestment plan.
d. Statements a and b are correct.
e. None of the statements above is correct.
Stock repurchases and stock splits
27
Answer: e
Diff: M
Answer: a
Diff: M
Answer: e
Diff: M
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Chapter 15 - Page 10
Answer: e
Diff: M
Answer: a
Diff: M
Answer: d
Diff: M
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Chapter 15 - Page 11
Answer: a
Diff: M
Miscellaneous concepts
34
Answer: b
Diff: M
Firm M is a mature firm in a mature industry. Its annual net income and
net cash flow are both consistently high and very stable. The companys
growth prospects are quite limited; therefore, the companys capital
budget is small relative to its net income. Firm N is a relatively new
firm in a new industry.
Its annual operating income fluctuates
considerably, but the company has substantial growth opportunities. Its
capital budget is expected to be large relative to its net income for
the foreseeable future.
Which of the following statements is most
correct?
a. Firm M probably has a lower debt ratio than Firm N.
b. Firm M probably has a higher dividend payout ratio than Firm N.
c. If the corporate tax rate increases, the debt ratio of both firms is
likely to fall.
d. Statements a and b are correct.
e. Statements b and c are correct.
Answer: b
0%
20%
40%
60%
80%
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Chapter 15 - Page 12
Diff: E
company wants to
percent debt and
income this year
dividend policy,
Answer: e
Diff: E
33.33%
40.00%
50.00%
60.00%
66.67%
0%
10%
28%
42%
56%
Diff: E
Strategic Systems Inc. expects to have net income of $800,000 during the
next year.
Its target, and current, capital structure is 40 percent
debt and 60 percent common equity.
The Director of Capital Budgeting
has determined that the optimal capital budget for next year is $1.2
million.
If Strategic uses the residual dividend model to determine
next years dividend payout, what is the expected dividend payout ratio?
a.
b.
c.
d.
e.
38
Answer: b
Answer: c
Diff: E
Powell Products anticipates that its capital budget next year will be $3
million. The company expects to report net income of $5 million this
year.
The companys target capital structure is 65 percent common
equity and 35 percent long-term debt.
Assume the company follows a
strict residual dividend policy. What is the expected dividend payout
ratio this year?
a. 65%
b. 39%
c. 61%
d. 56%
e. 100%
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Chapter 15 - Page 13
Diff: E
80%
60%
40%
20%
15%
Answer: d
41
75%
55%
50%
25%
47%
Diff: E
40
Answer: a
Answer: b
Diff: E
16.67%
41.67%
11.67%
0.00%
58.30%
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Chapter 15 - Page 14
38%
42%
58%
33%
22%
Stock split
Diff: E
$ 15
$ 45
$ 50
$150
$450
Stock split
Answer: c
44
Diff: E
Plato Inc. expects to have net income of $5,000,000 during the next
year. Platos target capital structure is 35 percent debt and 65 percent
equity. The companys director of capital budgeting has determined that
the optimal capital budget for the coming year is $6,000,000. If Plato
follows a residual dividend policy to determine the coming years
dividend, then what is Platos payout ratio?
a.
b.
c.
d.
e.
43
Answer: e
Answer: e
Diff: E
$270
$ 45
$180
$ 60
$ 30
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Chapter 15 - Page 15
Stock split
45
Answer: e
Diff: E
Tarheel Computings stock was trading at $150 per share before its
recent 3-for-1 stock split. The 3-for-1 split led to a 5 percent
increase in Tarheels market capitalization. (Market capitalization
equals the stock price times the number of shares.) What was Tarheels
price after the stock split?
a.
b.
c.
d.
e.
$472.50
$ 50.00
$ 47.62
$428.57
$ 52.50
Medium:
Residual dividend policy
46
Answer: d
Diff: M
Flavortech Inc. expects EBIT of $2,000,000 for the coming year. The
firms capital structure consists of 40 percent debt and 60 percent
equity, and its marginal tax rate is 40 percent. The cost of equity is
14 percent, and the company pays a 10 percent rate on its $5,000,000 of
long-term debt. One million shares of common stock are outstanding. In
its next capital budgeting cycle, the firm expects to fund one large
positive NPV project costing $1,200,000, and it will fund this project
in accordance with its target capital structure. Assume that new debt
will have an interest rate of 10 percent. If the firm follows a residual
dividend policy and has no other projects, what is its expected dividend
payout ratio?
a.
b.
c.
d.
e.
82.6%
60.0%
40.0%
17.4%
5.6%
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Chapter 15 - Page 16
Grant Grocers
projects:
is
Project
Project V
Project W
Project X
Project Y
Project Z
Answer: b
considering
the
following
Size of Project
$1.0 million
1.2 million
1.2 million
1.2 million
1.0 million
average-risk
Diff: M
investment
IRR of Project
12.0%
11.5
11.0
10.5
10.0
Answer: c
Diff: M
Your company has decided that its capital budget during the coming year
will be $20 million. Its optimal capital structure is 60 percent equity
and 40 percent debt. Its earnings before interest and taxes (EBIT) are
projected to be $34.667 million for the year.
The company has $200
million of assets; its average interest rate on outstanding debt is 10
percent; and its tax rate is 40 percent.
If the company follows the
residual dividend policy and maintains the same capital structure, what
will its dividend payout ratio be?
a.
b.
c.
d.
e.
15%
20%
25%
30%
35%
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Chapter 15 - Page 17
$ 600,000
$ 857,143
$1,000,000
$1,428,571
$2,000,000
Diff: M
50
Answer: b
Answer: d
Diff: M
$ 43.2
$ 50.0
$ 64.8
$ 86.4
$108.0
Stock repurchase
51
Answer: c
Diff: M
Makeover Inc. believes that at its current stock price of $16.00 the
firm is undervalued in the market.
Makeover plans to repurchase 2.4
million of its 20 million shares outstanding.
The firms managers
expect that they can repurchase the entire 2.4 million shares at the
expected equilibrium price after repurchase.
The firms current
earnings are $44 million. If managements assumptions hold, what is the
expected per-share market price after repurchase?
a.
b.
c.
d.
e.
$16.00
$17.26
$18.18
$20.00
$24.40
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Chapter 15 - Page 18
CHAPTER 15
ANSWERS AND SOLUTIONS
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Chapter 15 - Page 19
Dividends
versus
capital
Answer: d
2.
Answer: d
gains
Diff: E
Diff: E
Dividend
Answer: a
payout
Dividend
Answer: c
Diff: E
payout
Diff: E
Dividend
Answer: e
theories
Diff: E
Answer: c
Diff: E
Optimal
dividend
Answer: e
8.
Answer: a
policy
Diff: E
Diff: E
Statement a is true. If net income increases, and all else is equal (that is,
the same number of projects are available to invest in as before, etc.), the
company will have more money left over after making its investments to pay
out as dividends. Statement b is false. If the company increases the
proportion of equity financing in its target capital structure, it will
either need to increase the proportion of equity (by increasing retained
earnings, therefore, leaving less money for dividends) or reduce the
proportion of debt it uses (meaning it will have less debt to finance new
projects and will need more of its retained earnings to make investments).
Statement c is false. If the company has more profitable projects, it will
leave less money for dividends.
9
Stock
Answer: e
Diff: E
split
10.
Stock split
Answer: b
Diff: E
With a 2-for-1 stock split, the price is (roughly) halved and the number of
shares doubles.
11.
Answer: a
Diff: E
Answer: e
Diff: E
Dividend payments are taxed at the personal tax rate. Stock repurchases end
up producing capital gains, which are taxed at a lower rate than the personal
tax rate. Therefore, statement a is false. Dividend reinvestment plans
(DRIPs) are not a way to circumvent the IRS. The company really paid a
dividend, which is taxed like ordinary income. You chose to reinvest it. The
IRS doesnt care whether you bought more stock or bought a new car. You still
receive the income and you still pay income taxes on it. Therefore, statement
b is false. If there is a 2-for-1 stock split, this means that for every
share you used to own, you now own two. In order for your net wealth to
remain unchanged, the stock price would have to fall by half, not double.
Therefore, statement c is false. Since statements a, b, and c are false, the
correct choice is statement e.
13.
Answer: c
Diff: E
14
Miscellaneous
dividend
Answer: e
Diff: E
concepts
N
Answer: e
Diff: E
Statement e is the correct choice. The tax preference theory suggests that
individuals prefer capital gains to dividends due to the capital gains
preferential tax treatment. A residual dividend policy leads to an unstable
dividend payment.
The residual policy is used only to develop a long-run
dividend payout policy.
A firm with a large number of investment
opportunities and a small amount of cash would have a low dividend payout.
16
MM
dividend
Answer: e
17
theory
Dividend
Diff: M
Answer: a
theory
Diff: M
The dividend irrelevance theory is MMs theory, and states that dividend
policy has no effect on either the price of a firms stock or its cost of
capital. Therefore, the slope of a regression of dividend yield and capital
gains would equal -1.0. The tax preference theory prefers capital gains to
dividends, while the bird-in-the-hand (G-L) theory prefers dividends to
capital gains. The clientele effect assumes that investors are attracted to
a firms particular dividend payout policy.
18
Dividend
Answer: a
theory
Diff: M
Dividend policy
20
Answer: b
Dividend
Diff: M
Answer: c
policy
Diff: M
Statement c is true; the other statements are false. Investors would prefer
their distributions in the form of capital gains since they are made
relatively more attractive with a cut in the capital gains tax rate. A
residual policy does not stabilize dividend payouts.
A residual policy
involves paying dividends only after all profitable projects have been
undertaken.
An increase in the availability of these projects would leave
Dividend policy
Answer: a
Diff: M
Answer: c
Diff: M
Statement c is true; the other statements are false. The residual dividend
policy implies that dividends should be paid only out of leftover earnings.
The sale of new stock implies that the firm has already used all retained
earnings. Therefore, no dividends would have been paid.
23
.
24
Answer: b
Dividends
versus
capital
Answer: b
25
Taxes,
DRIPs,
and
Answer: d
Diff: M
gains
Diff: M
stock
Diff: M
splits
R
Answer: e
Diff: M
28
Answer: e
Miscellaneous
Diff: M
dividend
Answer: a
concepts
Diff: M
Answer: e
Diff: M
30
Miscellaneous
dividend
Answer: e
concepts
Diff: M
Answer: a
Diff: M
Statement a is true; the other statements are false. A 3-for-1 split results
in an increase in the number of shares outstanding and a fall in the price
per share. The firm would increase its debt ratio by repurchasing some of its
own shares.
32
.
Answer: d
Diff: M
Answer: a
Diff: M
Miscellaneous concepts
Answer: b
Diff: M
Statement a is false.
Since Firm M has less business risk than N, it is
likely to have a higher debt ratio than N because M can take on more
financial risk. Statement b is true.
Firm M will have a higher dividend
payout ratio than N since it does not need the funds for investment.
Statement c is false. If the corporate tax rate increases, debt financing
will become more attractive to both firms.
35
Residual
dividend
Answer: b
policy
Diff: E
The amount of new investment which must be financed with equity is:
$1,200,000 40% = $480,000. Since the firm has $600,000 of net income only
$120,000 will be left for dividends. This means the payout ratio is
$120,000/$600,000 = 20%.
36
.
Answer: e
Diff: E
Answer: b
Diff: E
38.
Expected NI
$800,000
Equity requirement
720,000
Available for dividends
$ 80,000
Payout ratio = $80,000/$800,000 = 0.10 = 10%.
Residual dividend policy
Answer: c
Diff: E
Answer: a
Diff: E
Since the capital budget is $250 million and the capital structure is 50%
equity and 50% debt, $125 million of the capital budget will come from debt
and $125 million will come from equity. Subtracting the $125 million (needed
for the equity portion) from NI, leaves you with $375 million to pay out as
dividends. $375/$500 is a 75% payout ratio.
40.
41
Answer: d
Diff: E
Step 1:
Step 2:
Step 3:
Residual
dividend
Answer: b
Diff: E
policy
N
Facts given:
NI = $12 million; NCF = $12 million; Capital budget = $10
million; Target capital structure: 70% equity, 30% debt.
Of this $10 million, 70% will be funded with equity ($7 million), and 30%
with debt ($3 million). Therefore, the company will use $7 million of its
net income towards its capital budget. This leaves $5 million ($12 million $7 million) for dividends.
Payout ratio = Div/NI
= $5 million/$12 million
= 41.67%.
42
.
Answer: e
Diff: E
Stock split
Answer: c
Diff: E
The shareholder gets three shares for every one he/she used to have, so now
he/she has three times as many shares. In order to have the same amount of
wealth, the value of each share must fall to 1/3 of what it was before.
Therefore, the new per share value is $150/3 = $50. Before the split, a
shareholder with one share had $150 of stock. Now, after the split, a
shareholder with three shares will have 3 $50 = $150 of stock.
44.
Stock split
Answer: e
Diff: E
1 share of stock will now become 3 shares, but the total dollar value must
remain the same. Therefore, the new stock price is $90/3 = $30.
45
Stock
Answer: e
Diff: E
split
N
If the stock splits 3-for-1, there will be 3 shares now for each one that
used to exist.
If the number of shares triples, the price of each share
would be 1/3 of what it was before. Therefore, the price would immediately
be 1/3 of $150, or $50. However, the stock split also led to a 5 percent
increase in the stock price. Therefore, the new price would be $50 1.05 =
$52.50.
46
Residual
dividend
Answer: d
EBIT
Int
EBT
Taxes
NI
Project funding
Residual earnings
payable as dividends
Dividend payout ratio =
47
.
$2,000,000
548,000
$1,452,000
580,800
$ 871,200
720,000
Diff: M
policy
R
Diff: M
The companys WACC is 8%(0.5) + 13.5%(0.5) = 10.75%. Comparing the WACC with
the project IRRs reveals that the company will undertake projects V, W, and
X. Total financing costs for these projects is $3,400,000. Of this amount,
0.5($3,400,000) = $1,700,000 will be financed from retained earnings. Thus,
$2,500,000 - $1,700,000 = $800,000 will be available for dividends. The
payout ratio is then $800,000/$2,500,000 = 32%.
48
.
Answer: c
Diff: M
Answer: b
Diff: M
Since the company expects to pay out 40% of net income or $400,000, it must
expect to have $600,000 of retained earnings available for capital
investment. Given that the firm will finance new investment with 70% equity
and 30% debt, $600,000 must represent 70 percent of the firms capital
budget, that is, $600,000 = (0.7)CB or CB = $857,143.
50
Residual
dividend
and
capital
Answer: d
budget
Diff: M
$43.20
= $86.40 million.
0.5
Stock repurchase
Answer: c
Step 1:
Step 2:
Step 3:
Step 4:
Diff: M