Chapter 14: Distributions To Shareholders: Dividends and Repurchases

Chapter 14: Distributions to Shareholders: Dividends and Repurchases
1. 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.
ANSWER: b
POINTS: 1
DIFFICULTY: Difficulty: Moderate
QUESTION TYPE: Multiple Choice
HAS VARIABLES: False
LEARNING OBJECTIVES: FMTP.EHRH.20.14.10 - LO: 14-10
NATIONAL STANDARDS: United States - BUSPROG: Analytic
STATE STANDARDS: United States - AK - DISC: Dividend policy
LOCAL STANDARDS: United States - OH - Default City - TBA
TOPICS: Stock repurchases and DRIPs
KEYWORDS: Bloom’s: Analysis
OTHER: TYPE: Multiple Choice: Conceptual
DATE CREATED: 8/9/2018 11:04 AM
DATE MODIFIED: 8/9/2018 11:04 AM

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. If a company offers a dividend reinvestment plan, almost all of its shareholders enroll
in the plan.
ANSWER: c
POINTS: 1
Copyright Cengage Learning. Powered by Cognero. Page 1

TOPICS: Dividends, DRIPs, and repurchases
DATE MODIFIED: 11/13/2018 4:56 PM

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. Companies may pay too high a price in a large open market repurchase if it takes too
long to complete.
d An investor’s capital gains from selling stock in a repurchase are always taxed at a
. higher rate than if the distribution were dividends.
e. The tax code encourages companies to pay dividends rather than reinvest earnings.
ANSWER: c
POINTS: 1
TOPICS: Dividend policy and stock repurchases

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 because a repurchase announcement usually is
seen as a positive signal from management.
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.
ANSWER: b
POINTS: 1
TOPICS: Miscellaneous dividend concepts
5. The following data apply to Garber Industries, Inc. (GII):

Value of operations $1,000
Short-term investments $100
Debt $300
Number of shares 100
The company plans on distributing $100 as dividend payments. What will the intrinsic per share stock price be
immediately after the distribution?
a. $6.32
b. $6.65
c. $7.00
d. $7.35
e. $7.72
ANSWER: c
RATIONALE: Prior to After
Distribution Distribution
Value of
$1,000.00 $1,000.00
operations
+ Value of
nonoperatin 100.00 0.00
g assets
Total
intrinsic $1,100.00 $1,000.00
value of firm
−Debt 300.00 300.00
Intrinsic
value of $ 800.00 $ 700.00
equity
÷ Number of
100.00 100.00
shares
Intrinsic
price per $ 8.00 $ 7.00
share
POINTS: 1
DIFFICULTY Difficulty: Challenging
:
QUESTION T Multiple Choice
YPE:
HAS VARIAB False
LES:
LEARNING O FMTP.EHRH.20.14.09 - LO: 14-9
BJECTIVES:
NATIONAL S United States - BUSPROG: Analytic
TANDARDS:
STATE STAN United States - AK - DISC: Dividend policy
DARDS:
LOCAL STAN United States - OH - Default City - TBA
DARDS:
TOPICS: Dividends and intrinsic stock price
OTHER: TYPE: Multiple Choice: Problem
NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero
payout ratio. These outcomes are noted in the topic [TOP] field if applicable.
DATE CREA 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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6. The following data apply to Elizabeth's Electrical Equipment:

Value of operations $20,000
Short-term investments $1,000
Debt $6,000
Number of shares 300
The company plans on distributing $1,000 by repurchasing stock. What will the intrinsic per share stock price be
immediately after the repurchase?
a. $47.50
b. $50.00
c. $52.50
d. $55.13
e. $57.88
ANSWER: b
RATIONALE: Prior to After
Distribution Distribution
Value of operations $20,000 $20,000
+ Value of nonoperating assets $ 1,000 $0
Total intrinsic value of firm $21,000 $20,000
− Debt $ 6,000 $ 6,000
Intrinsic value of equity $15,000 $14,000
÷ Number of shares 300 280
Intrinsic price per share $ 50.00 $ 50.00

# shares repurchased =
Value of nonoperating assets /
Price prior to distribution $20.00
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Repurchases and intrinsic stock price
NOTES: With some combinations of variables, the residual policy may result in zero
dividends and a zero payout ratio. These outcomes are noted in the topic [TOP]
field if applicable.
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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7. The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the
firm's stock price.
a. True
b. Fals
e
ANSWER: True
POINTS: 1
DIFFICULTY: Difficulty: Easy
QUESTION TYPE: True / False
NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking
TOPICS: Optimal distribution policy
KEYWORDS: Bloom’s: Knowledge
8. 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. Fals
e
ANSWER: False
POINTS: 1
TOPICS: Dividend irrelevance
9. 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. Fals
e
ANSWER: False
POINTS: 1
10. 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. Fals
e
ANSWER: True
POINTS: 1
TOPICS: Investors' dividend preferences
11. 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. Fals
e
ANSWER: False
POINTS: 1
TOPICS: Dividends and stock prices
12. 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. Fals
e
ANSWER: True
POINTS: 1

KEYWORDS: Bloom’s: Comprehension
13. 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. Fals
e
ANSWER: True
POINTS: 1
TOPICS: Dividend-growth tradeoff
14. 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. investors are indifferent between dividends and capital gains.
ANSWER: c
POINTS: 1
TOPICS: Dividends versus capital gains
15. 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.
ANSWER: c
POINTS: 1
TOPICS: Optimal dividend policy
16. If the signaling, hypothesis (which is also called the information content hypothesis) is correct, then changes in
dividend policy can have an important effect on the firm's value and capital costs.
a. True
b. Fals
e
ANSWER: True
POINTS: 1

TOPICS: Signaling hypothesis
17. 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.
ANSWER: d
POINTS: 1
TOPICS: Dividend theories
18. 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.

ANSWER: a
POINTS: 1
TOPICS: Dividend payout
19. 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. Fals
e
ANSWER: True
POINTS: 1
TOPICS: Residual distribution policy
20. 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. Fals
e
ANSWER: False
POINTS: 1

TOPICS: Residual distribution policy
21. 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. Fals
e
ANSWER: False
POINTS: 1
TOPICS: WACC and dividend policy
22. 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.
d 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.
ANSWER: b
POINTS: 1

TOPICS: Dividend payout
23. 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.
ANSWER: e
POINTS: 1
TOPICS: Residual dividend policy
24. The projected capital budget of Kandell Corporation is $1,000,000, its target capital structure is 60% debt and 40%
equity, and its forecasted net income is $550,000. If the company follows a residual dividend policy, what total dividends,
if any, will it pay out?
a. $122,176
b. $128,606
c. $135,375
d. $142,500
e. $150,000
ANSWER: e
RATIONALE: Capital budget $1,000,000
% Equity 40%
Net income (NI) $550,000
Dividends paid = NI − [% Equity(Capital budget)] $150,000
POINTS: 1
DIFFICULTY Difficulty: Easy
:
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HAS VARIAB False
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BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Residual model-divs paid, divs always positive
KEYWORDS: Bloom’s: Application
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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25. Grandin Inc. is evaluating its dividend policy. It has a capital budget of $625,000, and it wants to maintain a target
capital structure of 60% debt and 40% equity. The company forecasts a net income of $475,000. If it follows the residual
dividend policy, what is its forecasted dividend payout ratio?
a. 40.61
%
b. 42.75
%
c. 45.00
%
d. 47.37
%
e. 49.74
%
ANSWER: d
RATIONALE: Capital budget $625,000
Equity ratio 40%
Dividends paid = NI − (Equity ratio)(Capital budget) $225,000
Dividend payout ratio = Dividends paid/NI 47.37%
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Residual dividend model–dividend payout ratio
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
FIED:
26. The capital budget of Creative Ventures Inc. is $1,000,000. The company wants to maintain a target capital structure
that is 30% debt and 70% equity. The company forecasts that its net income this year will be $800,000. If the company
follows a residual dividend policy, what will be its total dividend payment?
a. $100,000
b. $200,000
c. $300,000
d. $400,000
e. $500,000
ANSWER: a
RATIONALE: The amount of new investment which must be financed with equity is: $1,000,000
× 70% = $700,000. Since the firm has $800,000 of net income only $100,000 will
be left for dividends.
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Residual dividend policy–nonalgorithmic
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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27. Rohter Galeano Inc. is considering how to set its dividend policy. It has a capital budget of $3,000,000. The company
wants to maintain a target capital structure that is 15% debt and 85% equity. The company forecasts that its net income
this year will be $3,500,000. If the company follows a residual dividend policy, what will be its total dividend payment?
a. $205,000
b. $500,000
c. $950,000
d. $2,550,000
e. $3,050,000
ANSWER: c
× 85% = $2,550,000. Since the firm has $3,500,000 of net income, $950,000 =
$3,500,000 − $2,550,000 will be left for dividends.
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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28. Sanchez Company has planned capital expenditures that total $2,000,000. The company wants to maintain a target
capital structure that is 35% debt and 65% equity. The company forecasts that its net income this year will be $1,800,000.
If the company follows a residual dividend policy, what will be its total dividend payment?
a. $100,000
b. $200,000
c. $300,000
d. $400,000
e. $500,000
ANSWER: e
× 65% = $1,300,000. Since the firm has $1,800,000 of net income only $500,000
= $1,800,000 − $1,300,000 will be left for dividends.
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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29. McCann Publishing has a target capital structure of 35% debt and 65% equity. This year's capital budget is $850,000
and it wants to pay a dividend of $400,000. If the company follows a residual dividend policy, how much net income must
it earn to meet its capital budgeting requirements and pay the dividend, all while keeping its capital structure in balance?
a. $904,875
b. $952,500
c. $1,000,125
d. $1,050,131
e. $1,102,638
ANSWER: b
Equity ratio 65%
Dividends to be paid $400,000
Required net income = Dividends + (Capital budget × % Equity) $952,500
POINTS: 1
DIFFICULTY Difficulty: Moderate
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Residual dividend model–find net income
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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30. Harvey's Industrial Plumbing Supply's target capital structure consists of 40% debt and 60% equity. Its capital budget
this year is forecast to be $650,000. It also wants to pay a dividend of $225,000. If the company follows the residual
dividend policy, how much net income must it earn to meet its capital requirements, pay the dividend, and keep the capital
structure in balance?
a. $584,250
b. $615,000
c. $645,750
d. $678,038
e. $711,939
ANSWER: b
% Equity 60%
Dividends to be paid $225,000
Required net income = Dividends + (Capital budget × % Equity) $615,000
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Residual dividend model–find net income
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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31. Victor Rumsfeld Inc.'s dividend policy is under review by its board. Its projected capital budget is $2,000,000, its
target capital structure is 60% debt and 40% equity, and its forecasted net income is $600,000. If the company follows a
residual dividend policy, what total dividends, if any, will it pay out?
a. $240,000
b. $228,000
c. $216,600
d. $205,770
e. $0
ANSWER: e
% Equity 40%
Dividends paid = NI − [% Equity(Capital Budget)] $0
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Residual model–divs paid, divs are zero
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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32. The capital budget forecast for the Santano Company is $725,000. The CFO wants to maintain a target capital
structure of 45% debt and 55% equity, and it also wants to pay dividends of $500,000. If the company follows the residual
dividend policy, how much income must it earn, and what will its dividend payout ratio be?
Net Income Payout

a. $ 898,750 55.63%
b. $ 943,688 58.41%
c. $ 990,872 61.34%
d. $1,040,415 64.40%
e. $1,092,436 67.62%
ANSWER: a
Equity ratio 55%
Dividends paid $500,000
NI = Divs + (Eq % × Cap Bud) $898,750
Payout = Dividends/NI 55.63%
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Residual model–find NI, then divs and payout
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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33. United Builders wants to maintain a target capital structure with 30% debt and 70% equity. Its forecasted net income
is $550,000, and because of market conditions, the company will not issue any new stock during the coming year. If the
firm follows the residual dividend policy, what is the maximum capital budget that is consistent with maintaining the
target capital structure?
a. $673,652
b. $709,107
c. $746,429
d. $785,714
e. $825,000
ANSWER: d
RATIONALE: % Debt 30%
% Equity 70%
Net income $550,000
Max capital budget = NI/% Equity $785,714
Check: Is calculated max cap bud × %Equity =
$550,000= net income
NI?
POINTS: 1
:
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HAS VARIAB False
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BJECTIVES:
TANDARDS:
DARDS:
DARDS:
DATE CREAT 8/9/2018 11:04 AM
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34. Silvana Inc. projects the following data for the coming year. If the firm follows the residual dividend policy and also
maintains its target capital structure, what will its payout ratio be?
EBIT $2,000,000Capital budget $850,000
Interest rate 10%% Debt 40%
Debt outstanding $5,000,000% Equity 60%
Shares outstanding $5,000,000Tax rate 25%
a. 46.9
%
b. 49.3
%
c. 51.9
%
d. 54.7
%
e. 57.4
%
ANSWER: d
RATIONALE: EBIT $2,000,000Capital budget $850,000
Interest rate 10%% Debt 40%
Debt outstanding $5,000,000% Equity 60%
Shares outstanding $5,000,000Tax rate 25%
EBIT $2,000,000
− Interest expense = interest rate × debt 500,000
Taxable income $1,500,000
− Taxes = Tax rate × income 375,000
Net income (NI) $1,125,000
− Equity needed for capital budget = % Equity(capital budget) = 510,000
Dividends = NI − Equity needed $ 615,000
Payout ratio = Dividends/NI 54.67%
POINTS: 1
:
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HAS VARIAB False
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BJECTIVES:
TANDARDS:
DARDS:
DARDS:
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 1/27/2019 9:18 PM
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35. David Rose Inc. forecasts a capital budget of $500,000 next year with forecasted net income of $400,000. The
company wants to maintain a target capital structure of 30% debt and 70% equity. If the company follows the residual
dividend policy, how much in dividends, if any, will it pay?
a. $42,869
b. $45,125
c. $47,500
d. $50,000
e. $52,500
ANSWER: d
RATIONALE: % Debt 30%
% Debt 70%
Capital budget $500,000
Net income $400,000
Equity requirement = Cap Bud × % Equity = $350,000
Dividends = NI − Equity requirement = $50,000
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
Dividend may be zero
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36. Warren Supply Inc. is evaluating its capital budget. The company finances with debt and common equity, but because
of market conditions, wants to avoid issuing any new common stock during the coming year. It is forecasting an EPS of
$3.00 for the coming year on its 500,000 outstanding shares of stock. Its capital budget is forecasted at $800,000, and it is
committed to maintaining a $2.00 dividend per share. Given these constraints, what percentage of the capital budget must
be financed with debt?
a. 30.54
%
b. 32.15
%
c. 33.84
%
d. 35.63
%
e. 37.50
%
ANSWER: e
RATIONALE: EPS $3.00
Shares outstanding 500,000
DPS $2.00
Capital budget $800,000
Net income = EPS × Shares outstanding = $1,500,000
Dividends paid = DPS × Shares outstanding = $1,000,000
Retained earnings available $500,000
Capital budget − Retained earnings = Debt needed $300,000
Debt needed/Capital budget = % Debt financing 37.5%
POINTS: 1
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HAS VARIAB False
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BJECTIVES:
TANDARDS:

DARDS:
DARDS:
TOPICS: Residual dividend model–req'd debt ratio
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37. Getler Inc.'s projected capital budget is $2,000,000, its target capital structure is 40% debt and 60% equity, and its
forecasted net income is $1,000,000. If the company follows a residual dividend policy, how much dividends will it pay
or, alternatively, how much new stock must it issue?
Dividends Stock Issued

a. $514,425 $162,901
b. $541,500 $171,475
c. $570,000 $180,500
d. $600,000 $190,000
e. $ 0 $200,000
ANSWER: e
% Equity 60%
Net income (NI) $1,000,000
Dividends paid = NI − [% Equity(Cap. Bud)], stock
Dividends:or new stock:
issued if
dividends zero or neg $0$200,000
POINTS: 1
:
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HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:

TOPICS: Residual model–divs paid or stock issued
DATE CREAT 8/9/2018 11:04 AM
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DATE MODI 8/9/2018 11:04 AM
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38. Norton Electrical has quite a few positive NPV projects from which to choose. The problem is that it has more of
these projects than it can finance without issuing new stock and the board of directors refuses to issue any new shares in
the foreseeable future. Norton's projected net income is $150.0 million, its target capital structure is 25% debt and 75%
equity, and its target payout ratio is 65%. The CFO now wants to determine how the maximum capital budget would be
affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how
much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the
target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed
by the indicated amounts.
Increase in Capital Budget

Increase Lower
Debt to 75% Payout to 20% Do both
a. $114.0 $73.3 $333.9
b. $120.0 $77.2 $351.5
c. $126.4 $81.2 $370.0
d. $133.0 $85.5 $389.5
e. $140.0 $90.0 $410.0
ANSWER: e
RATIONALE: New Maximums:
Current If increase If lower If do
maximum debt payout both
NI $150.0 $150.0 $150.0 $150.0
%Debt 25.0% 75.0% 25.0% 75.0%
%Equity 75.0% 25.0% 75.0% 25.0%
% Payout 65.0% 65.0% 20.0% 20.0%
Dividends $97.5 $97.5 $30.0 $30.0
Retained earnings $52.5 $52.5 $120.0 $120.0
Max. capital budget = RE/%Equity $70.0 $210.0 $160.0 $480.0
Increase over current: Changed amt − Current
NA $140.0 $90.0 $410.0
max.
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Residual model–divs paid or stock issued
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
39. 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.
ANSWER: a
POINTS: 1
40. 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.
ANSWER: b
POINTS: 1

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.
ANSWER: d
POINTS: 1
TOPICS: Dividend theories

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.
b If a firm follows a strict residual dividend policy, then, holding all else constant, its
. dividend payout ratio will tend to rise whenever the firm's investment opportunities
improve.
c. If Congress eliminates taxes on capital gains but leaves the personal tax rate on
dividends unchanged, this would motivate companies to increase their dividend payout
ratios.
d Despite its drawbacks, following the residual dividend policy will tend to stabilize
. actual cash dividends, and this will make it easier for firms to attract a clientele that
prefers high dividends, such as retirees.
e. One advantage of dividend reinvestment plans is that they enable investors to avoid
paying taxes on the dividends they receive.
ANSWER: a
POINTS: 1
TOPICS: Dividend policy
43. Consider two very different firms, M and N. Firm M is a mature firm in a mature industry. Its annual net income and
net cash flows are both consistently high and stable. However, M's growth prospects are quite limited, so its capital budget
is small relative to its net income. Firm N is a relatively new firm in a new and growing industry. Its markets and products
have not stabilized, so its annual operating income fluctuates considerably. However, N has substantial growth
opportunities, and its capital budget is expected to be large relative to its net income for the foreseeable future. Which of
the following statements is correct?
a. Firm M probably has a higher dividend payout ratio than Firm N.
b. If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
c. The two firms are equally likely to pay high dividends.
d. Firm N is likely to have a clientele of shareholders who want to receive consistent,
stable dividend income.
e. Firm M probably has a lower debt ratio than Firm N.
ANSWER: a
POINTS: 1

a. The clientele effect can explain why so many firms change their dividend policies so
often.
b One advantage of adopting the residual dividend policy is that this policy makes it
. easier for corporations to develop a specific and well-identified dividend clientele.
c. New-stock dividend reinvestment plans are similar to stock dividends because they
both increase the number of shares outstanding but don't change the firm's total
amount of book equity.
d Investors who receive stock dividends must pay taxes on the value of the new shares in
. the year the stock dividends are received.
e. If a firm follows the residual dividend policy, then a sudden increase in the number of
profitable projects is likely to reduce the firm's dividend payout.
ANSWER: e
POINTS: 1
DIFFICULTY: Difficulty: Challenging
TOPICS: Dividend policy
45. Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders' wealth.
a. True
b. Fals
e
ANSWER: True
POINTS: 1
TOPICS: Stock dividends and stock splits
46. A reverse split reduces the number of shares outstanding.

a. True
b. Fals
e
ANSWER: True
POINTS: 1
TOPICS: Reverse split
47. 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. Fals
e
ANSWER: True
POINTS: 1
TOPICS: Stock splits

48. 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.
ANSWER: a
POINTS: 1
TOPICS: Stock splits
49. Which of the following statements is CORRECT?

a. Back before the SEC was created in the 1930s, companies would declare reverse splits
in order to boost their stock prices. However, this was determined to be a deceptive
practice, and it is illegal today.
b Stock splits create more administrative problems for investors than stock dividends,
. especially determining the tax basis of their shares when they decide to sell them, so
today stock dividends are used far more often than stock splits.
c. When a company declares a stock split, the price of the stock typically declines⎯by
about 50% after a 2-for-1 split⎯and this necessarily reduces the total market value of
the equity.
d If a firm's stock price is quite high relative to most stocks⎯say $500 per share⎯then
. it can declare a stock split of say 10-for-1 so as to bring the price down to something
close to $50. Moreover, if the price is relatively low⎯say $2 per share⎯then it can
declare a "reverse split" of say 1-for-25 so as to bring the price up to somewhere
around $50 per share.
e. When firms are deciding on the size of stock splits⎯say whether to declare a 2-for-1
split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split,
because then the after-split price will be higher than if the 3-for-1 split had been used.
ANSWER: d
POINTS: 1

TOPICS: Stock dividends and stock splits

a. An open-market dividend reinvestment plan will be most attractive to companies that
need new equity and would otherwise have to issue additional shares of common stock
through investment bankers.
b Stock repurchases tend to reduce financial leverage.
.
c. If a company declares a 2-for-1 stock split, its stock price should roughly double.
d One advantage of adopting the residual dividend policy is that this makes it easier for
. corporations to meet the requirements of Modigliani and Miller's dividend clientele
theory.
e. If a firm repurchases some of its stock in the open market, then shareholders who sell
their stock for more than they paid for it will be subject to capital gains taxes.
ANSWER: e
POINTS: 1
51. Yesterday, Berryman Investments was selling for $90 per share. Today, the company completed a 7-for-2 stock split.
If the total market value was unchanged by the split, what is the price of the stock today?
a. $23.21
b. $24.43
c. $25.71
d. $27.00
e. $28.35
ANSWER: c
RATIONALE: Number of new shares 7
Number of old shares 2
Old (pre-split) price $90
New price = Old price × (Old shrs/New shrs) $25.71
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Stock splits–fractional splits
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
52. Last week, Weschler Paint Corp. completed a 3-for-1 stock split. Immediately prior to the split, its stock sold for $150
per share. The firm's total market value was unchanged by the split. Other things held constant, what is the best estimate
of the stock's post-split price?
a. $50.00
b. $52.50
c. $55.13
d. $57.88
e. $60.78
ANSWER: a
Pre-split stock price $150
Post-split stock price: P0/New per old = $50.00
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Stock splits–simple splits
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
53. In recent years Constable Inc. has suffered losses, and its stock currently sells for only $0.50 per share. Management
wants to use a reverse split to get the price up to a more "reasonable" level, which it thinks is $25 per share. How many of
the old shares must be given up for one new share to achieve the $25 price, assuming this transaction has no effect on total
market value?
a. 47.50
b. 49.88
c. 50.00
d. 52.50
e. 55.13
ANSWER: c
RATIONALE: Current price $0.50
Target price $25.00
Old shares surrendered per 1 new share = Target price/Old price 50.00
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Stock splits–reverse split
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
54. Brinkley Resources stock has increased significantly over the last five years, selling now for $175 per share.
Management feels this price is too high for the average investor and wants to get the price down to a more typical level,
which it thinks is $25 per share. What stock split would be required to get to this price, assuming the transaction has no
effect on the total market value? Put another way, how many new shares should be given per one old share?
a. 6.65
b. 6.98
c. 7.00
d. 7.35
e. 7.72
ANSWER: c
RATIONALE: Current price $175.00
Target price $25.00
No. of new shares per 1 old share = Current price/Target price 7.00
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Stock splits–optimal stock split
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
55. Downie Foods recently completed a 4-for-1 stock split. Prior to the split, its stock sold for $120 per share. If the firm's
total market value increased by 5% as a result of increased liquidity caused by the split, what was the stock price
following the split?
a. $28.43
b. $29.93
c. $31.50
d. $33.08
e. $34.73
ANSWER: c
RATIONALE: New shares per 1 old share 4
Pre-split stock price $120
% value increase 5%
Post-split stock price = (P0/New per old)(% Value increase) $31.50
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Stock splits–positive market reaction
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
56. The Meltzer Corporation is contemplating a 7-for-3 stock split. The current stock price is $75.00 per share, and the
firm believes that its total market value would increase by 5% as a result of the improved liquidity that it thinks would
follow the split. What is the stock's expected price following the split?
a. $32.06
b. $33.75
c. $35.44
d. $37.21
e. $39.07
ANSWER: b
Old (pre-split) price $75.00
% Increase in value 5%
New price before value increase = Old price/(Old shares/New
$32.14
shares)
New price after value increase = Prior × (1 + % Value increase) $33.75
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DARDS:
TOPICS: Stock splits–positive market reaction
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
57. Which of the following actions will best enable a company to raise additional equity capital?
a. Declare a stock split.
b. Begin an open-market purchase dividend reinvestment plan.
c. Initiate a stock repurchase program.
d. Begin a new-stock dividend reinvestment plan.
e. Refund long-term debt with lower cost short-term debt.
ANSWER: d
POINTS: 1
58. Which of the following statements is NOT correct?

a. After a 3-for-1 stock split, a company's price per share should fall, but the number of
shares outstanding will rise.
b Investors can interpret a stock repurchase program as a signal that the firm's managers
. believe the stock is undervalued.
c. Companies can repurchase shares to distribute large inflows of cash, say from the sale
of a division, to stockholders without paying cash dividends.
d Stockholders pay no income tax on dividends if the dividends are used to purchase
. stock through a dividend reinvestment plan.
e. Stock repurchases can be used by a firm as part of a plan to change its capital
structure.
ANSWER: d
POINTS: 1
TOPICS: Stock repurchases and stock splits

Chapter 14: Distributions To Shareholders: Dividends and Repurchases

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Chapter 14: Distributions To Shareholders: Dividends and Repurchases

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases

1. Which of the following statements is correct?

2. Which of the following statements is correct?

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3. Which of the following statements is correct?

4. Which of the following statements is correct?

5. The following data apply to Garber Industries, Inc. (GII):

6. The following data apply to Elizabeth's Electrical Equipment:

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17. Which of the following statements about dividend policies is correct?

18. In the real world, dividends

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Net Income Payout

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Dividends Stock Issued

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Increase in Capital Budget

41. Which of the following statements is correct?

42. Which of the following statements is correct?

44. Which of the following statements is correct?

46. A reverse split reduces the number of shares outstanding.

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49. Which of the following statements is CORRECT?

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50. Which of the following statements is correct?

58. Which of the following statements is NOT correct?

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