D#$T #%&T#'($ T' $HA CHAPTE !

" EH')DE $: D#*#DE(D$ A(D $HA E EP& CHA$E$

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual Easy:

Dividends versus capital gains
1

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. apital gains are ta!ed at a higher rate than dividends. d. Investors view dividends as being less ris"y than potential future capital gains. e. Investors value a dollar of e!pected capital gains more highly than a dollar of e!pected dividends because of the lower ta! rate on capital gains.

Dividends, DRIPs, and repurchases

#

Answer: d

Diff: E

$hich of the following statements is most correct% a. In general& stoc" repurchases are ta!ed the same way as dividends. b. 'ne nice feature of dividend reinvestment plans is that they enable investors to reduce the ta!es paid on their dividends. c. 'n average& companies send a negative signal to the mar"etplace when they announce an increase in their dividend. d. If a company is interested in issuing new equity capital& a new stoc" dividend reinvestment plan probably ma"es more sense than an open mar"et dividend reinvestment plan. e. (tatements b and d are correct.

Dividend payout
)

Answer: a

Diff: E

In the real world& we find that dividends a. b. c. d. e. *sually e!hibit greater stability than earnings. +luctuate more widely than earnings. Tend to be a lower percentage of earnings for mature firms. ,re usually changed every year to reflect earnings changes. ,re usually set as a fi!ed percentage of earnings.

Chapter 14 - Page 1

Dividend payout
-

Answer: c

Diff: E

, decrease in a firm.s willingness to pay dividends is li"ely to result from an increase in its a. b. c. d. e. /arnings stability. ,ccess to capital mar"ets. 0rofitable investment opportunities. ollection of accounts receivable. (toc" price. Answer: e best describes the Diff: E of

Dividend theories
1

$hich of the following statements investors. preferences for dividends%

theories

a. Modigliani and Miller argue that investors prefer dividends to capital gains. b. The bird2in2hand theory suggests that a company can reduce its cost of equity capital by reducing its dividend payout ratio. c. The ta! preference theory suggests that a company can increase its stoc" price by increasing its dividend payout ratio. d. 'ne "ey advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy. e. The clientele effect suggests that companies should follow a stable dividend policy. Dividend theory and policy
3

Answer: c

Diff: E

$hich of the following statements is most correct% a. The bird2in2the2hand theory implies that a company can reduce its $, by reducing its dividend payout. b. The bird2in2the2hand theory implies that a company can increase its stoc" price by reducing its dividend payout. c. 'ne problem with following a residual dividend policy is that it can lead to erratic dividend payouts that may prevent the firm from establishing a reliable clientele of investors who prefer a particular dividend policy. d. (tatements a and c are correct. e. ,ll of the statements above are correct.

Optimal dividend policy

4

Answer: e

Diff: E

$hich of the following would not have an influence on the optimal dividend policy% a. The possibility of accelerating or delaying investment pro5ects. b. , strong shareholders. preference for current income versus capital gains. c. 6ond indenture constraints. d. The costs associated with selling new common stoc". e. ,ll of the statements above can have an effect on dividend policy.

Chapter 14 - Page 2

Residual dividend policy

7

Answer: a

Diff: E

Trenton 0ublishing follows a strict residual dividend policy. ,ll else being equal& which of the following factors are li"ely to cause an increase in the firm.s per2share dividend% a. ,n increase in its net income. b. The company increases the proportion of equity financing in its target capital structure. c. ,n increase in the number of profitable pro5ects that it wants to fund this year. d. (tatements a and b are correct. e. ,ll of the statements above are correct.

Stoc
8

split

Answer: e

Diff: E

, stoc" split will cause a change in the total dollar amounts shown in which of the following balance sheet accounts% a. ash. b. ommon stoc". c. 0aid2in capital. d. 9etained earnings. e. :one of the statements above is correct.

Stoc
1;

split

Answer: !

Diff: E

<ou currently own 1;; shares of stoc" in 6everly 6rothers Inc. The stoc" currently trades at =1#; a share. The company is contemplating a #2for21 stoc" split. $hich of the following best describes your position after the proposed stoc" split ta"es place% a. <ou will have =1#; a share. b. <ou will have =3; a share. c. <ou will have =3; a share. d. <ou will have =1#; a share. e. <ou will have =3; a share. #;; shares of stoc"& and the stoc" will trade at or near #;; shares of stoc"& and the stoc" will trade at or near 1;; shares of stoc"& and the stoc" will trade at or near 1; shares of stoc"& and the stoc" will trade at or near 1; shares of stoc"& and the stoc" will trade at or near

Chapter 14 - Page 3

Stoc
11

repurchases and DRIPs $hich of the following statements is most correct%

Answer: a

Diff: E

a. 'ne advantage of stoc" repurchases is that they are generally ta!ed more favorably than dividend payments. b. 'ne advantage of dividend reinvestment plans is that they enable investors to avoid paying ta!es on the dividends they receive. c. (toc" repurchases ma"e sense if a company is interested in increasing its equity ratio. d. (toc" repurchases ma"e sense if a company believes that its stoc" is overvalued and that it has a lot of profitable pro5ects to fund over the ne!t year. e. 'ne advantage of an open mar"et dividend reinvestment plan is that it increases the number of shares the company has outstanding. Repurchases, DRIPs, and stoc
1#

splits

Answer: e

Diff: E

$hich of the following statements is most correct% a. 'ne reason that companies tend to avoid stoc" repurchases is that dividend payments are ta!ed more favorably than stoc" repurchases. b. 'ne advantage of dividend reinvestment plans is that they allow shareholders to avoid paying ta!es on the dividends that they choose to reinvest. c. If a company announces a #2for21 stoc" split and the overall value of the firm remains unchanged& the company.s stoc" price must have doubled. d. ,ll of the statements above are correct. e. :one of the statements above is correct.

Dividend policy and stoc

1)

repurchases

Answer: d

Diff: E

"

$hich of the following statements is most correct% a. The ta! code encourages companies to pay dividends. b. If a company uses the residual dividend model to determine its dividend payout ratio& its dividend payout will tend to increase whenever it has a large number of investment opportunities. c. The clientele effect encourages companies to adopt a strict version of the residual dividend model. d. In many cases& stoc" repurchases tend to increase earnings per share& but they also increase the firm.s debt ratio and financial ris". e. (toc" repurchases are ta!ed the same way as dividends are ta!ed.

Chapter 14 - Page 4

#iscellaneous dividend concepts

1-

Answer: c

Diff: E

$hich of the following statements is most correct% a. If a company puts in place a #2for21 stoc" split& its stoc" price should roughly double. b. (hare repurchases are ta!ed less favorably than dividends> this e!plains why companies typically pay dividends and avoid share repurchases. c. 'n average& a company.s stoc" price tends to rise when it announces that it is initiating a share repurchase program. d. (tatements a and b are correct. e. ,ll of the statements above are correct.

#iscellaneous dividend concepts

11

Answer: e

Diff: E

$hich of the following statements is most correct% a. The bird2in2the2hand theory argues that investors prefer dividends because dividends are ta!ed more favorably than capital gains. b. (toc" repurchases increase the number of outstanding shares. c. The clientele effect can e!plain why companies tend to vary their dividends a lot on a year2to2year basis. d. (tatements a and b are correct. e. :one of the statements above is correct.

#iscellaneous dividend concepts

13

Answer: e

Diff: E

$hich of the following statements is most correct% a. The ta! preference hypothesis suggests that companies can reduce their costs of capital by increasing their dividend payout ratios. b. 'ne advantage of the residual dividend policy is that it leads to a stable dividend payout& which is desired by investors. c. +irms with a large number of investment opportunities and a relatively small amount of cash tend to have above average dividend payouts. d. (tatements a and b are correct. e. :one of the statements above is correct.

Medium:
Dividend theory
14

Answer: a

Diff: #

$hich of the following statements is most correct% a. The ta! preference theory states that& all else equal& investors prefer stoc"s that pay low dividends because retained earnings can lead to capital gains that are ta!ed at a lower rate. b. ,n increase in the cost of equity capital ?"s@ when a company announces an increase in its dividend per share& would be consistent with the bird2in2the2hand theory. c. ,n increase in the stoc" price when a company decreases its dividend is consistent with the signaling theory. d. , dividend policy that involves paying a consistent percentage of net income is the best policy if the Aclientele effectB is correct. Chapter 14 - Page 5

e. (tatements a and d are correct. Dividend policy

17

Answer: !

Diff: #

$hich of the following statements is most correct% a. The Ta! ode encourages companies to pay large dividends to their shareholders. b. If your company has established a clientele of investors who prefer large dividends& the company is unli"ely to adopt a residual dividend policy. c. If a firm follows a residual dividend policy& holding all else constant& its dividend payout will tend to rise whenever the firm.s investment opportunities improve. d. (tatements b and c are correct. e. ,ll of the statements above are correct.

Dividend policy
18

Answer: c

Diff: #

$hich of the following statements is most correct% a. If ongress cuts the capital gains rate& but leaves the personal ta! rate unchanged& then this would provide an incentive for companies to increase their dividend payouts. b. Cespite its drawbac"s& a residual dividend policy is an effective way to stabiliDe dividend payouts& which ma"es it easier for firms to attract a clientele that prefers high dividends. c. If a firm follows a residual dividend policy& then a sudden increase in the number of profitable pro5ects is li"ely to reduce the firm.s dividend payout. d. ,ll of the statements above are correct. e. :one of the statements above is correct.

Dividend policy
#;

Answer: a

Diff: #

$hich of the following statements is most correct% a. The bird2in2the2hand theory would predict that companies could decrease their cost of equity financing by raising their dividend payout. b. The clientele effect can e!plain why firms often change their dividend policies. c. 'ne advantage of adopting a residual dividend policy is that it ma"es it easier for corporations to maintain dividend clienteles. d. (tatements a and c are correct. e. :one of the statements above is correct.

Residual dividend policy

#1

Answer: c

Diff: #

If a firm adheres strictly to the residual dividend policy& a sale of new common stoc" by the company would suggest that a. b. c. d. e. The dividend payout ratio has remained constant. The dividend payout ratio is increasing. :o dividends were paid for the year. The dividend payout ratio is decreasing. The dollar amount of investments has decreased.

Chapter 14 - Page 6

Chapter 14 - Page 7

Residual dividend policy

##

Answer: !

Diff: #

If a firm adheres strictly to the residual dividend policy& then if its optimal capital budget requires the use of all earnings for that year ?along with new debt according to the optimal debtEtotal assets ratio@& the firm should pay a. b. c. d. e. :o dividends e!cept out of past retained earnings. :o dividends to common stoc"holders. Cividends& in effect& out of a new issue of common stoc". Cividends by borrowing the money ?debt@. /ither statement c or statement d above could be used. Answer: ! Diff: #

Dividends versus capital gains

#)

Modigliani and Miller ?MM@ argued that dividend policy is irrelevant. 'n the other hand& Gordon and Lintner ?GL@ argued that dividend policy does matter. GL.s argument rests on the contention that a. "s F C1E0; G g is constant for any dividend policy. b. 6ecause of perceived differences in ris"& investors value a dollar of dividends more highly than a dollar of e!pected capital gains. c. Investors& because of ta! differentials& value a dollar of e!pected capital gains more highly than a dollar of dividends. d. Most investors will reinvest rather than spend dividends& so it would save investors money ?ta!es@ if corporations simply reinvested earnings rather than paid them out as dividends. e. :one of the statements above is correct.

$a%es, DRIPs, and stoc

#-

splits

Answer: d

Diff: #

ongress passed a new ta! law that reduced long2term capital gains ta! rates from #7 percent to #; percent. The ma!imum ta! rate for ordinary personal income is )7.3 percent. $hich of the following statements is most correct for an investor in a high personal ta! brac"et% a. The stoc" of a company that pays high cash dividends and has a dividend reinvestment plan ?C9I0@ is a good investment for this individual because heEshe will receive more money that can then be reinvested in the company.s stoc". b. , #2for21 stoc" split is announced for a stoc" that the investor currently holds. The company had split the stoc" because the stoc" price had increased beyond the optimal price range and is e!pected to continue to grow. This is good news to the investor because it means that any gains from increased stoc" value will be ta!ed at a new lower long2term capital gains rate when the stoc" is sold. c. 'ne of the companies in the investor.s portfolio recently announced that it will embar" on a stoc" repurchase plan. The lower long2term capital gains ta! rate will reduce the investor.s ta!es if heEshe decides to tender some shares of stoc" in the company. d. (tatements b and c are correct. e. ,ll of the statements above are correct.

Chapter 14 - Page 8

$a%es, DRIPs, and dividends

#1

Answer: e

Diff: #

$hich of the following statements is most correct% a. A:ew2stoc"B dividend reinvestment plans are similar to stoc" dividends because they both increase the number of shares outstanding but don.t change the total equity of a firm. b. Investors receiving stoc" dividends must pay ta!es on the new shares at the time the stoc" dividends are received. c. (toc"holders pay no income ta! on dividends reinvested in a dividend reinvestment plan. d. (tatements a and b are correct. e. :one of the statements above is correct.

Stoc
#3

repurchases and stoc

splits

Answer: e

Diff: #

$hich of the following statements is most correct% a. (toc" repurchases can be used by firms to defend against hostile ta"eovers since they increase the proportion of debt in a firm.s capital structure. b. ,fter a )2for21 stoc" split& a company.s price per share will fall and its number of shares outstanding will rise. c. Investors can interpret a stoc" repurchase by a firm as a signal that the firm.s managers believe the stoc" is underpriced. d. (tatements a and b are correct. e. ,ll of the statements above are correct.

#iscellaneous dividend concepts

#4

Answer: a

Diff: #

$hich of the following statements is most correct% a. ompanies can repurchase shares either ?1@ to change their capital structures or ?#@ to distribute cash to stoc"holders without paying cash dividends. In the second situation& ta! considerations will probably play a "ey role in the decision to repurchase stoc" versus to pay more cash dividends. (toc" dividends provide investors with additional shares of stoc"& not cash& yet many investors must pay cash in the form of ta!es on the value of the stoc" dividends. +or this reason& stoc" dividends are rarely used today. The bird2in2the2hand theory of dividend policy could be re5ected immediately if personal income ta!es were abolished. If the curve relating the $, and the debt ratio loo"s li"e a sharp AH&B this would ma"e it more feasible for a firm to follow the residual dividend policy than if the curve loo"s li"e a shallow bowl ?or a shallow A*B@. The open mar"et type of dividend reinvestment plan is the best type for firms that need to bring in new equity capital.

b.

c. d.

e.

Chapter 14 - Page 9

#iscellaneous dividend concepts

#7

Answer: e

Diff: #

$hich of the following statements is most correct% a. If a firm repurchases its stoc" in the open mar"et& the shareholders that tender are sub5ect to capital gains ta!es. b. If you own 1;; shares in a company.s stoc"& and the company does a #2for21 stoc" split& you will own #;; shares in the company following the split. c. (ome dividend reinvestment plans increase the amount of equity capital available to the firm. d. (tatements a and b are correct. e. ,ll of the statements above are correct.

#iscellaneous dividend concepts

#8

Answer: e

Diff: #

$hich of the following statements is most correct% a. ,n open2mar"et dividend reinvestment plan is li"ely to be attractive to companies that are loo"ing to issue additional shares of common stoc". b. (toc" repurchases have the effect of reducing financial leverage. c. If a company does a #2for21 stoc" split& its stoc" price will roughly double. d. ,ll of the statements above are correct. e. :one of the statements above is correct.

#iscellaneous dividend concepts

);

Answer: a

Diff: #

$hich of the following statements is most correct% a. If a company wants to issue new shares of common stoc" and also wants to implement a dividend reinvestment plan& then it should implement a new2stoc" dividend reinvestment plan& rather than an open2mar"et purchase plan. b. If a company underta"es a )2for21 stoc" split& then the number of shares outstanding should fall& and the stoc" price should rise. c. If a company wants to reduce its debt ratio& then it should repurchase some of its common stoc". d. (tatements a and c are correct. e. (tatements b and c are correct.

#iscellaneous dividend concepts

)1

Answer: d

Diff: #

$hich of the following statements is most correct% a. If you were testing dividend theories and found that a dividend increase resulted in higher stoc" prices& then you could rule out all other theories and conclude that the bird2in2the2hand theory was most consistent with the evidence you found. b. The clientele effect suggests that investors choose their investments based on firms. past dividend policies and changes to established dividend policies may be costly to investors. c. Cividends paid under a residual dividend policy might send conflicting signals to investors. d. (tatements b and c are correct.

Chapter 14 - Page 10

e. ,ll of the statements above are correct. #iscellaneous dividend concepts

)#

Answer: a

Diff: #

$hich of the following actions will enable a company to raise additional equity capital ?that is& which of the following will raise the total boo" value of equity@% a. b. c. d. e. The establishment of a new2stoc" dividend reinvestment plan. , stoc" split. The establishment of an open2mar"et purchase dividend reinvestment plan. , stoc" repurchase. (tatements a and d are correct. Answer: ! Diff: #

#iscellaneous concepts
))

+irm 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 company.s growth prospects are quite limited> therefore& the company.s capital budget is small relative to its net income. +irm : 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 e!pected to be large relative to its net income for the foreseeable future. $hich of the following statements is most correct% a. +irm M probably has a lower debt ratio than +irm :. b. +irm M probably has a higher dividend payout ratio than +irm :. c. If the corporate ta! rate increases& the debt ratio of both firms is li"ely to fall. d. (tatements a and b are correct. e. (tatements b and c are correct.

Multiple Choice: P+o,lems Easy:

Residual dividend policy
)-

Answer: !

Diff: E

0etersen o. has a capital budget of =1&#;;&;;;. The company wants to maintain a target capital structure that consists of 3; percent debt and -; percent equity. The company forecasts that its net income this year will be =3;;&;;;. If the company follows a residual dividend policy& what will be its payout ratio% a. b. c. d. e. ;I #;I -;I 3;I 7;I

Chapter 14 - Page 11

Residual dividend policy

)1

Answer: e

Diff: E

handler

ommunications.

+' has provided the following informationJ

The company.s capital budget is e!pected to be =1&;;;&;;;. The company.s target capital structure is 4; percent debt and ); percent equity. The company.s net income is =-&1;;&;;;.

If the company follows a residual dividend policy& what portion of its net income should it pay out as dividends this year% a. b. c. d. e. )).))I -;.;;I 1;.;;I 3;.;;I 33.34I Answer: ! Diff: E

Residual dividend policy

)3

(trategic (ystems Inc. e!pects to have net income of =7;;&;;; during the ne!t year. Its target& and current& capital structure is -; percent debt and 3; percent common equity. The Cirector of apital 6udgeting has determined that the optimal capital budget for ne!t year is =1.# million. If (trategic uses the residual dividend model to determine ne!t year.s dividend payout& what is the e!pected dividend payout ratio% a. b. c. d. e. ;I 1;I #7I -#I 13I Answer: c Diff: E

Residual dividend policy

)4

0owell 0roducts anticipates that its capital budget ne!t year will be =) million. The company e!pects to report net income of =1 million this year. The company.s target capital structure is 31 percent common equity and )1 percent long2term debt. ,ssume the company follows a strict residual dividend policy. $hat is the e!pected dividend payout ratio this year% a. 31I b. )8I c. 31I d. 13I e. 1;;I

Chapter 14 - Page 12

Residual dividend policy

)7

Answer: a

Diff: E

,rden Manufacturing follows a strict residual dividend policy. The company is forecasting that its net income will be =1;; million this year. The company anticipates that its capital budget will be =#1; million. The company has a target capital structure that consists of 1; percent equity and 1; percent long2term debt. $hat is the company.s anticipated dividend payout ratio% a. b. c. d. e. 41I 11I 1;I #1I -4I Answer: d Diff: E

Residual dividend policy

)8

9edwood (ystems follows a strict residual dividend policy. The company estimates that its capital e!penditures this year will be =-; million& its net income will be =); million& and its target capital structure is 3; percent equity and -; percent debt. $hat will be the company.s dividend payout ratio% a. b. c. d. e. 7;I 3;I -;I #;I 11I Answer: ! Diff: E

Residual dividend policy

-;

$olfpac" Multimedia follows a strict residual dividend policy. $olfpac" forecasts that its net income will be =1# million this year. The company has no depreciation e!pense so its net cash flow is =1# million& and its target capital structure consists of 4; percent equity and ); percent debt. $olfpac".s capital budget is =1; million. $hat is the company.s dividend payout ratio% a. b. c. d. e. 13.34I -1.34I 11.34I ;.;;I 17.);I

Chapter 14 - Page 13

Residual dividend policy

-1

Answer: e

Diff: E

0lato Inc. e!pects to have net income of =1&;;;&;;; during the ne!t year. 0lato.s target capital structure is )1 percent debt and 31 percent equity. The company.s director of capital budgeting has determined that the optimal capital budget for the coming year is =3&;;;&;;;. If 0lato follows a residual dividend policy to determine the coming year.s dividend& then what is 0lato.s payout ratio% a. b. c. d. e. )7I -#I 17I ))I ##I Answer: c Diff: E "

Residual dividend policy

-#

(imon *tility e!pects to have net income of =1 billion this year. The company has an estimated capital budget of =- billion& and its capital structure consists of 31 percent common equity and )1 percent debt. If the company follows a strict residual dividend policy& what is the company.s e!pected dividend payout ratio% a. ;.;;I b. )1.;;I c. -7.;;I d. 31.;;I e. 1;;.;;I

Residual dividend policy

-)

Answer: e

Diff: E

"

6ettis 6us o. uses the residual dividend model to determine its common dividend payout. This year the company e!pects its net income to be =# million& and it e!pects to have a #1 percent common dividend payout ratio. The company.s target common equity ratio is -; percent& and the firm is financed with only common equity and debt. $hat is the company.s forecasted total capital budget for the year% a. b. c. d. e. =1.#1 =#.#1 =#.1; =).#1 =).41 million million million million million

Chapter 14 - Page 14

Dividend and capital !udget

--

Answer: e

Diff: E

,llensworth Motors forecasts that its earnings per share will be =).;; this year. The company has 1;; million shares of stoc" outstanding. ,llensworth estimates that its capital budget for the upcoming year will be =7;; million& and it is committed to funding the entire capital budget. The company is also committed to maintaining its dividend of =#.;; per share& and it wants to avoid issuing new common stoc". The company.s capital structure consists of debt and common stoc". Given the above constraints& what portion of the =7;; million capital budget will be funded with debt% a. b. c. d. e. 1).1)I -3.;#I -;.;;I 3.#1I )4.1;I Answer: c Diff: E

Stoc
-1

split

,lbany Motors recently completed a )2for21 stoc" split. 0rior to the split& the company had 1; million shares outstanding and its stoc" price was =11; per share. ,fter the split& the total mar"et value of the company.s stoc" equaled =1.1 billion. $hat was the price of the company.s stoc" following the stoc" split% a. b. c. d. e. = 11 = -1 = 1; =11; =-1; Answer: e Diff: E

Stoc
-3

split

Loiselle Graphics recently announced a )2for21 stoc" split. 0rior to the split& the company.s stoc" was trading at =8; per share. The split had no effect on the wealth of the company.s investors. $hat will be the new stoc" price% a. b. c. d. e. =#4; = -1 =17; = 3; = ); Answer: ! Diff: E "

Stoc
-4

split

*rlacher Cigital.s stoc" is trading at =1#; a share. The company plans to announce a )2for2# stoc" split. The stoc" split is e!pected to increase the company.s mar"et capitaliDation by 1 percent. $hat is the e!pected stoc" price after the stoc" split is completed% a. =178.;; b. = 7-.;; c. = 7;.;; Chapter 14 - Page 15

Stoc
-7

d. = 1;.-; e. = 41.3; split

Answer: e

Diff: E

Tarheel omputing.s stoc" was trading at =11; per share before its recent )2 for21 stoc" split. The )2for21 split led to a 1 percent increase in Tarheel.s mar"et capitaliDation. ?Mar"et capitaliDation equals the stoc" price times the number of shares.@ $hat was Tarheel.s price after the stoc" split% a. b. c. d. e. =-4#.1; = 1;.;; = -4.3# =-#7.14 = 1#.1;

Medium:
Residual dividend policy
-8

Answer: d

Diff: #

+lavortech Inc. e!pects /6IT of =#&;;;&;;; for the coming year. The firm.s capital structure consists of -; percent debt and 3; percent equity& and its marginal ta! rate is -; percent. The cost of equity is 1- percent& and the company pays a 1; percent interest rate on its =1&;;;&;;; of long2term debt. 'ne million shares of common stoc" are outstanding. In its ne!t capital budgeting cycle& the firm e!pects to fund one large positive :0H pro5ect costing =1&#;;&;;;& and it will fund this pro5ect in accordance with its target capital structure. ,ssume that new debt will also have an interest rate of 1; percent. If the firm follows a residual dividend policy and has no other pro5ects& what is its e!pected dividend payout ratio% a. b. c. d. e. 7#.3I 3;.;I -;.;I 14.-I 1.3I Answer: ! the following independent& 0ro5ect I99 1#.;I 11.1 11.; 1;.1 1;.; Diff: #

Residual dividend policy

1;

Grant Grocers is considering investment pro5ectsJ 0ro5ect 0ro5ect H 0ro5ect $ 0ro5ect K 0ro5ect < 0ro5ect L

average2ris"

(iDe of 0ro5ect =1.; million 1.# million 1.# million 1.# million 1.; million

The company has a target capital structure that consists of 1; percent debt and 1; percent equity. Its after2ta! cost of debt is 7 percent& its cost of equity is estimated to be 1).1 percent& and its net income is =#.1 million. If the company follows a residual dividend policy& what will be its payout ratio% a. b. 1#I )#I

Chapter 14 - Page 16

c. 1-I d. 33I e. 1;;I Residual dividend policy

11

Answer: c

Diff: #

<our company has decided that its capital budget during the coming year will be =#; million. Its optimal capital structure is 3; percent equity and -; percent debt. Its earnings before interest and ta!es ?/6IT@ are pro5ected to be =)-.334 million for the year. The company has =#;; million of assets> its average interest rate on outstanding debt is 1; percent> and its ta! rate is -; 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. 11I #;I #1I );I )1I Answer: ! Diff: #

Residual dividend and capital !udget

1#

6roc" 6rothers wants to maintain its capital structure that consists of ); percent debt and 4; percent equity. The company forecasts that its net income this year will be =1&;;;&;;;. The company follows a residual dividend policy and anticipates a dividend payout ratio of -; percent. $hat is the siDe of the company.s capital budget% a. b. c. d. e. = 3;;&;;; = 714&1-) =1&;;;&;;; =1&-#7&141 =#&;;;&;;; Answer: d Diff: #

Residual dividend and capital !udget

1)

The following facts apply to your companyJ Target capital structureJ /6ITJ ,ssetsJ Ta! rateJ ost of new and old debtJ 1;I debt> 1;I equity. =#;; million. =1;; million. -;I. 7I.

6ased on the residual dividend policy& the payout ratio is 3; percent. Mow large ?in millions of dollars@ will the capital budget be% a. b. c. d. e. = -).# = 1;.; = 3-.7 = 73.=1;7.;

Chapter 14 - Page 17

Stoc
1-

repurchase

Answer: c

Diff: #

Ma"eover Inc. believes that at its current stoc" price of =13.;; the firm is undervalued in the mar"et. Ma"eover plans to repurchase #.- million of its #; million shares outstanding. The firm.s managers e!pect that they can repurchase the entire #.- million shares at the e!pected equilibrium price after repurchase. The firm.s current earnings are =-- million. If management.s assumptions hold& what is the e!pected per2share mar"et price after repurchase% a. b. c. d. e. =13.;; =14.#3 =17.17 =#;.;; =#-.-;

Chapter 14 - Page 18

A($-E CHAPTE $ A(D $')&T#'($ !"

Chapter 14 - Page 19

&

Dividends

versus

capital Diff: E Diff: E

gains

Answer: d #& Dividends, DRIPs, and repurchases Answer: d

(tatement a is false> repurchases are ta!ed as capital gains. (tatement b is false> investors still have to pay income ta!es on reinvested dividends. (tatement c is false> an increase in dividends is usually a positive signal. (tatement d is true. ) & Dividend Answer: a & Dividend Answer: c 1 & Dividend Answer: e payout Diff: E payout Diff: E theories Diff: E

(tatement e is true> the others are false. MM developed the dividend irrelevance theory. 9educing the payout would have the effect of increasing the cost of equity if the bird2in2the2hand theory holds. The ta! preference theory suggests that a company can increase its stoc" price by reducing its payout ratio. The residual dividend policy should be followed to determine the long2run target payout ratio. If followed year to year& dividends would fluctuate. 3& Dividend theory and policy Answer: c Diff: E

(tatement c is true> the others are false. The bird2in2the2hand theory implies that a company can reduce its $, and increase its stoc" price by increasing its dividend payout. 4 & Optimal dividend policy

Answer: e 7& Residual dividend policy Answer: a

Diff: E Diff: E

(tatement a is true. If net income increases& and all else is equal ?that is& the same number of pro5ects are available to invest in as before& etc.@& the company will have more money left over after ma"ing its investments to pay out as dividends. (tatement b is false. If the company increases the proportion of equity financing in its target capital structure& it will need to either 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 pro5ects and will need more of its retained earnings to ma"e investments@. (tatement c is false. If the company has more profitable pro5ects& this will leave less money for dividends. 8 & Stoc split

Answer: e 1; & Stoc split Answer: !

Diff: E

Diff: E

$ith a #2for21 stoc" split& the price is ?roughly@ halved and the number of shares doubles. 11& Stoc repurchases and DRIPs Answer: a Diff: E

(tatement a is true. If a company repurchases stoc" instead of paying dividends& the e!isting shares will go up in value. This capital gain is ta!ed at a lower rate than dividends& which are ta!ed at ordinary income ta! rates. (tatement b is false. ,s soon as the dividend is paid& the ta!es due are calculated. The I9( doesn.t care if the investor reinvests them or buys a plane with them. (tatement c is false. If a company repurchases its stoc"& it reduces assets ?it uses cash to buy bac" the shares@ and reduces equity. The amount of debt remains unchanged> however& since equity has decreased the proportion of debt increases. (tatement d is false. If a company believes the stoc" is overvalued& it will not repurchase shares because it will end up paying too much for the shares. If the company has many profitable pro5ects& it will want to invest in those and not use its cash to repurchase shares. (tatement e is false. ,n open2mar"et C9I0 means that dividends are used to buy shares from someone else on the secondary mar"et. The total number of shares outstanding does not change. 1#& Repurchases, DRIPs, and stoc splits Answer: e Diff: E

Cividend payments are ta!ed at the personal ta! rate. (toc" repurchases end up producing capital gains& which are ta!ed at a lower rate than the personal ta! rate. Therefore& statement a is false. Cividend reinvestment plans ?C9I0s@ are not a way to circumvent the I9(. The company really paid a dividend& which is ta!ed li"e ordinary income. <ou chose to reinvest it. The I9( doesn.t care whether you bought more stoc" or bought a new car. <ou still receive the income and you still pay income ta!es on it. Therefore& statement b is false. If there is a #2for21 stoc" 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 stoc" price would have to fall by half& not double. Therefore& statement c is false. (ince statements a& b& and c are false& the correct choice is statement e. 1) & Dividend policy and stoc repurchases "

Answer: d

Diff: E

The correct answer is statement d. (ince dividends are e!posed to double ta!ation& statement a is incorrect. (tatement b is also incorrect. Just the opposite will occur. ,s the number of a firm.s investment opportunities increase& its payout will tend to decrease. (tatement c is also incorrect. The clientele effect suggests that there are investors with different dividend preferences. (o& even though a firm adopts a policy less than a strict residual dividend model& investors e!ist who will still be attracted to the firm.s policy. +inally& statement e is incorrect. (toc" repurchases may not be ta!ed at all& whereas dividends are always ta!ed as ordinary income to the investor. Therefore& statement d is the correct choice. 1-& #iscellaneous dividend concepts Answer: c Diff: E

(tatement c is true> the others are false. If a #2for21 stoc" split is initiated& a firm.s stoc" price should decrease by one2half its original price. 9epurchases allow shareholders to obtain capital gains by selling their stoc"& which are ta!ed at a lower rate than dividends. (ince repurchase announcements are viewed as positive signals by investors& the stoc" price would tend to increase. 11 & #iscellaneous dividend Answer: e concepts

Diff: E

(tatement a is false> the theory states that investors prefer dividends because they are more certain about receiving dividends than they are about capital gains. In addition& the statement is false because capital gains are ta!ed more favorably than dividends. (tatement b is false because stoc" repurchases decrease the number of outstanding shares. (tatement c is false. If a company attracts a particular clientele& it would want to "eep that clientele. hanging its dividends frequently would ma"e it impossible for any one clientele to be happy. Therefore& the correct choice is statement e. 13& #iscellaneous dividend concepts (tatement e is prefer capital capital gains. payment. The payout policy. small amount of 14 & Answer: e Diff: E

correct. The ta! preference theory suggests that individuals gains to dividends due to the preferential ta! treatment for , residual dividend policy leads to an unstable dividend residual policy is used only to develop a long2run dividend , firm with a large number of investment opportunities and a cash would have a low dividend payout. Dividend Answer: a theory Diff: #

(tatement a is true> the other statements are false. The bird2in2the2hand theory states that investors prefer dividends> therefore& if dividends are increased& the cost of equity decreases. The signaling theory states that dividend decreases are Abad newsB& so stoc" price will decrease. 0aying a consistent percentage of net income will result in fluctuating dividends because net income fluctuates. The clientele effect states that investors prefer a stoc" that has a high or low steady dividend& but not a fluctuating one. 17 & 18 Dividend policy & Answer: ! Dividend Answer: c Diff: # policy Diff: #

#;

(tatement 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 ta! rate. , residual policy does not stabiliDe dividend payouts. , residual policy involves paying dividends only after all profitable pro5ects have been underta"en. ,n increase in the availability of these pro5ects would leave less available for dividends after pro5ects are financed. & Dividend policy

Answer: a

Diff: #

#1 &

(tatement a is true> the other statements are false. The clientele effect suggests that firms should change dividend policies infrequently. The residual dividend policy would ma"e it difficult for investors to reliably predict dividends and form clienteles. Residual dividend policy Answer: c Diff: #

(tatement c is true> the other statements are false. The residual dividend policy implies that dividends should be paid only out of AleftoverB earnings. The sale of new common stoc" implies that the firm has already used all retained earnings. Therefore& no dividends would have been paid. ## & #) Residual dividend policy & Dividends Answer: ! versus Diff: # gains

capital Diff: # stoc Diff: #

Answer: ! #& $a%es, DRIPs, and

splits R

Answer: d

#1 &

(tatements b and c are true> therefore& d is the correct answer. The dividends in a C9I0 are still ta!ed at the personal income ta! rate> this would be a bad investment for an individual in a high ta! brac"et. (toc" splits are good signals because management believes the stoc" price will continue to increase. The increases in the stoc" price will be ta!ed at the lower long2term capital gains ta! rate when the stoc" is sold. The investor will be ta!ed at the lower long2term capital gains rate if she tenders her shares in a stoc" repurchase. $a%es, DRIPs, and dividends Answer: e Diff: #

(tatement e is true. :ew2stoc" C9I0s increase the equity of a firm. Investors receive new shares with a stoc" dividend& but don.t incur any ta!es unless they sell the shares later for a gain. (toc"holders do pay ta!es on dividends reinvested. #3 & #4 Stoc & repurchases and stoc splits #iscellaneous Answer: e Diff: # concepts

dividend Answer: a

Diff: #

+irms often repurchase shares to enable them to change their capital structure more quic"ly than they could do so normally. ,lso& firms repurchase shares to distribute cash to those stoc"holders desiring to sell their stoc". (toc"holders receive capital gains& and long2term capital gains are ta!ed at lower rates than cash dividends. Thus& for individuals in high2 ta! brac"ets capital gains would be preferred to cash dividends. onsequently& ta! considerations play a "ey role in the decision to repurchase stoc" versus to pay more cash dividends. The other statements are false. #7 & #iscellaneous dividend concepts Answer: e Diff: #

#8

&

#iscellaneous

dividend Answer: e

concepts

Diff: #

); &

(tatement e is the correct answer. ,n open2mar"et dividend reinvestment plan buys e!isting shares in the mar"et. :o new additional shares are issued. (toc" repurchases increase financial leverage by reducing equity. $ith a #2 for21 split& a firm.s stoc" price would roughly halve. #iscellaneous dividend concepts Answer: a Diff: #

)1 &

(tatement a is true> the other statements are false. , )2for21 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. #iscellaneous dividend concepts Answer: d Diff: #

)# &

(tatements b and c are true> therefore& statement d is the correct choice. , dividend increase leading to an increase in stoc" price is consistent with signaling also. #iscellaneous dividend concepts The correct answer is a. new equity for the firm. #iscellaneous concepts Answer: a Diff: #

'f the statements& only statement a will result in Answer: ! Diff: #

)) &

(tatement a is false. (ince +irm M has less business ris" than :& it is li"ely to have a higher debt ratio than : because M can ta"e on more financial ris". (tatement b is true. +irm M will have a higher dividend payout ratio than : since it does not need the funds for investment. (tatement c is false. If the corporate ta! rate increases& debt financing will become more attractive to both firms. )& Residual dividend policy

Answer: !

Diff: E

)1 &

The amount of new investment that must be financed with equity isJ =1&#;;&;;; -;I F =-7;&;;;. (ince the firm has =3;;&;;; of net income only =1#;&;;; will be left for dividends. This means the payout ratio is =1#;&;;;E=3;;&;;; F #;I. Residual dividend policy Answer: e Diff: E

)3

=1&;;;&;;; ;.) F =1&1;;&;;; of retained earnings needed to fund the capital budget. =-&1;;&;;; 2 =1&1;;&;;; F =)&;;;&;;; of net income available for dividends. Cividend payout ratio F =)&;;;&;;;E=-&1;;&;;; F ;.3334& or 33.34I.

&

Residual dividend policy /quity requirement F ;.3?=1&#;;&;;;@ F =4#;&;;;. /!pected :I =7;;&;;; /quity requirement 4#;&;;; ,vailable for dividends = 7;&;;; 0ayout ratio F =7;&;;;E=7;;&;;; F ;.1; F 1;I.

Answer: !

Diff: E

)4&

Residual dividend policy

Answer: c

Diff: E

'ut of the =) million capital budget& 31 percent must be funded by equity& so ?;.31@?=)&;;;&;;;@ F =1&81;&;;; of the capital budget must be funded from retained earnings. /arnings available to be paid out as dividends F =1&;;;&;;; 2 =1&81;&;;; F =)&;1;&;;;. 0ayout ratio F =)&;1;&;;;E=1&;;;&;;; F 31I. )7& Residual dividend policy Answer: a Diff: E

(ince the capital budget is =#1; million and the capital structure is 1;I equity and 1;I debt& =1#1 million of the capital budget will come from debt and =1#1 million will come from equity. (ubtracting the =1#1 million ?needed for the equity portion@ from :I& leaves you with =)41 million to pay out as dividends. =)41E=1;; is a 41I payout ratio. )8& Residual dividend policy (tep 1J Answer: d Diff: E

Cetermine the equity portion that will be used to fund capital e!pendituresJ apital e!penditures are =-; million. +orty percent of this will be funded by debt and 3; percent by equity. The equity portion used to fund capital e!penditures F ;.3 =-; million F =#- million. Cetermine the amount of net income left to pay dividendsJ If =#- million of net income is used to pay for capital pro5ects& there will be =3 million of net income left to pay dividends& =); 2 =#- F =3 million. alculate the dividend payout ratioJ 0ayout ratio F CivE:I F =3E=); F #;I.

(tep #J

(tep )J

-;

&

Residual

dividend

policy

Answer: !

Diff: E

+acts givenJ :I F =1# million> : + F =1# million> apital budget F =1; million> Target capital structureJ 4;I equity& );I debt. 'f this =1; million& 4;I will be funded with equity ?=4 million@& and );I

with debt ?=) million@. Therefore& the company will use =4 million of its net income towards its capital budget. This leaves =1 million ?=1# million 2 =4 million@ for dividends. 0ayout ratio F CivE:I F =1 millionE=1# million F -1.34I. -1 & Residual dividend policy

Answer: e

Diff: E

If the firm.s optimal capital budget requires =3&;;;&;;; in financing& then& to stay at its target capital structure& 0lato will retain earnings of =3&;;;&;;; ;.31 F =)&8;;&;;;. This leaves =1&;;;&;;; 2 =)&8;;&;;; F =1&1;;&;;; available for dividends. Thus& 0lato.s payout ratio is =1&1;;&;;;E=1&;;;&;;; F ;.## F ##I. -#& Residual dividend policy Answer: c Diff: E "

The capital budget is =- billion. 'f that budget& 31 percent will be paid for with common equity to "eep the capital structure the same. The equity will come from additions to retained earnings or net income. ;.31 =- billion capital budget F =#.3 billion. This leaves =1 2 =#.3 F =#.- billion of net income to pay as dividends. 0ayout ratio F -)&

=#.- billion F -7I. =1.; billion

Answer: e Diff: E "

Residual dividend policy :I F =#&;;;&;;;> Cividend 0ayout F #1I>

ommon /quity F -;I> and Cebt F 3;I.

The addition to retained earnings F 41I =#&;;;&;;; F =1&1;;&;;;. The forecasted total capital budget is ,ddition to 9/EI of ommon /quity F =1&1;;&;;;E;.-; F =)&41;&;;;. -& Dividend and capital !udget

Answer: e

Diff: E

9etained earnings are ?=).;; 2 =#.;;@ 1;; million F =1;; million. Therefore& the percentage of the capital budget that is funded with debt isJ ?=7;; N =1;;@E=7;; F ;.)41 or )4.1I.

-1&

Stoc

split

Answer: c

Diff: E

The shareholder gets three shares for every one heEshe used to have& so now heEshe has three times as many shares. In order to have the same amount of wealth& the value of each share must fall to 1E) of what it was before. Therefore& the new per share value is =11;E) F =1;. 6efore the split& a

shareholder with one share had =11; of stoc". :ow& after the split& a shareholder with three shares will have ) =1; F =11; of stoc". -3& Stoc split Answer: e Diff: E

1 share of stoc" will now become ) shares& but the total dollar value must remain the same. Therefore& the new stoc" price is =8;E) F =);. -4& Stoc split Answer: ! Diff: E "

+or every two shares you own& you will receive three shares. (o& if you had two shares with a total value of # =1#; F =#-;& now you will have three shares with a value of =#-; as a direct effect of the split. Mowever& in this case the announcement of the split will send prices up by 1 percent. ?(plits sometimes signal good information about the company.s prospects.@ (o the price will rise by 1 percent because of the signaling effect& so the share price is =#-;E) 1.;1 F =7-. -7 & Stoc Answer: e Diff: E split

If the stoc" splits )2for21& there will be ) shares now for each one that used to e!ist. If the number of shares triples& the price of each share would be 1E) of what it was before. Therefore& the price would immediately be 1E) of =11;& or =1;. Mowever& the stoc" split also led to a 1 percent increase in the stoc" price. Therefore& the new price would be =1; 1.;1 F =1#.1;. -8 & Residual dividend policy

Answer: d /6IT Int /6T Ta!es :I 0ro5ect funding 9esidual earnings payable as dividends 1; & =#&;;;&;;; 1-7&;;; =1&-1#&;;; 17;&7;; = 741&#;; 4#;&;;; = 111&#;;

Diff: #

?=1&-7;&;;; debt O 1;I coupon@ ?=1&-1#&;;; /6T O -;I ta! rate@ =1&#;;&;;; pro5ect fundedJ ;.3; equity F =4#;&;;; ;.-; debt F =-7;&;;;

Cividend payout ratio F =111&#;;E=741&#;; F 14.)3I 14.-I. Residual dividend policy Answer: ! Diff: #

11

The company.s $, is 7I?;.1@ G 1).1I?;.1@ F 1;.41I. omparing the $, with the pro5ect I99s reveals that the company will underta"e pro5ects H& $& and K. Total financing costs for these pro5ects is =)&-;;&;;;. 'f this amount& ;.1?=)&-;;&;;;@ F =1&4;;&;;; will be financed from retained earnings. Thus& =#&1;;&;;; 2 =1&4;;&;;; F =7;;&;;; will be available for dividends. The payout ratio is then =7;;&;;;E=#&1;;&;;; F )#I. & Residual dividend policy Answer: c apital budget F =#; million. 'ptimal capital structureJ 3;I equity& -;I debt. /6IT F =)-.334 million. ,ssets F =#;; million. Diff: #

"d F 1;I> T F -;I> Cividend payout F % Cebt F ;.-;?=#;; million@ F =7; million. Interest F ;.1;?=7; million@ F =7 million. /6IT =)-.334 Int 7.;;; /6T =#3.334 Ta!es ?-;I@ 1;.334 :I =13.;;; apital budget F =#; million. /quity needed F ;.3;?=#; million@ F =1# million. :I /quity needed ,mount remaining for dividend Cividend payout F =-E=13 F #1I. 1# & Residual dividend and capital !udget =13 1# = -

Answer: !

Diff: #

(ince the company e!pects to pay out -;I of net income or =-;;&;;;& it must e!pect to have =3;;&;;; of retained earnings available for capital investment. Given that the firm will finance new investment with 4;I equity and );I debt& =3;;&;;; must represent 4; percent of the firm.s capital budget& that is& =3;;&;;; F ?;.4@ 6 or 6 F =714&1-). 1) & Residual dividend and capital !udget

Answer: d Cebt F ;.1?,ssets@ F ;.1?=1;;@ F =#1; million. Interest F ;.;7?=#1;@ F =#; million. /6T F /6IT 2 I F =#;; 2 =#; F =17;. :I F =17; 2 Ta!es F =17; 2 =17;?;.-@ F ;.3?=17;@ F =1;7 million. Cividends F =1;7?;.3@ F =3-.7; million. 9etained earnings F :I 2 C F =1;7.;; 2 =3-.7; F =-).#; million.

Diff: #

Malf of the capital budget will be debt& half common equity from retained earnings& so the capital budget will beJ apital budget F 1-

=-).#; F =73.-; million. ;.1

&

Stoc

repurchase

Answer: c

Diff: #

(tep 1J (tep #J (tep )J

urrent /0( F =-- millionE#; million F =#.#; per share. 0E/ ratio F =13.;;E=#.#; F 4.#4!. /0( after repurchase F =-- millionE14.3 million F =#.1;.

(tep -J

/!pected mar"et price after repurchaseJ 4.#4 =#.1; F =17.141 F =17.17 per share.