Pay-out Policies

Questions & Answers

Question 1
Retained earnings are:
a. an indication of a company's liquidity.
b. the same as cash in the bank.
c. not important when determining dividends.
d. the cumulative earnings of the company after dividends.

Question 2
Which of the following is an argument for the relevance of dividends?
a. Informational content.
b. Reduction of uncertainty
c. Some investors' preference for current income.
d. All of the above.

Question 3
All of the following are true of stock splits EXCEPT:
a. market price per share is reduced after the split.
b. the number of outstanding shares is increased.
c. retained earnings are changed.
d. proportional ownership is unchanged.

Question 4
If Mateus Enterprises, Inc., repurchased 50 percent of its outstanding common stock from
the open (secondary) market, the result would be
a. a decline in EPS.
b. an increase in cash.
c. a decrease in total assets.
d. an increase in the number of stockholders.

Question 5
The dividend-payout ratio is equal to
a. the dividend yield plus the capital gains yield.
b. dividends per share divided by earnings per share.
c. dividends per share divided by par value per share.
d. dividends per share divided by current price per share.

Question 6
Empirical results on financial signalling indicate that an increase (a decrease) in dividends
leads to a positive (negative) excess common stock return
True or False?
These results support the financial signalling effect as an increase (decrease) in dividends
leads to a positive (negative) excess common stock return.

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Question 7
Stock repurchases have a positive signalling effect.
True or False?
The signal by a repurchase is that management believes the stock is undervalued and the
best investment decision for funds -- a positive signal.

Question 8
Which of the following dividends is never in the form of cash?
a. Regular dividend
b. Special dividend
c. Stock dividend
d. Liquidation dividend

Question 9
Dividends are decided by:
a. The managers of a firm
b. The employees of a firm
c. The board of directors
d. The government

Question 10
Which of these dates occurs the last in time (when arranged in chronological order)?
a. Payment date
b. Ex-dividend date
c. Record date
d. Dividend declaration date

Question 11
The most important difference between stock repurchases and cash dividends is that they:
a. Benefit different groups
b. Have different effects on corporate cash flow
c. Have different effects on current stock price
d. May have different tax consequences

Question 12
Which of the following is true?
a. Firms have long-run target dividend payout ratios
b. Dividend changes follows shifts in long-term sustainable earnings
c. Managers are reluctant to make dividend changes that might have to be reversed
d. All of the above

Question 13
Generally, a reduction in dividend is interpreted by investors as
a. Bad news and the stock price drops
b. Good news and the stock price increases
c. A non-event and does not affect the stock prices

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d. All of the above

Question 14
Institutional investors typically
a. Prefer dividends to share repurchases
b. Find dividends attractive because they need to pay dividends to their own investors
c. Hold more dividend paying stocks than individual investors
d. All of the above

Question 15
Survey evidence on dividend policy shows that managers typically
a. Try to avoid reducing dividends per share
b. Pay dividends similar to the dividends per share they have paid recently
c. Are reluctant to make dividend changes that might have to be reversed later
d. All of the above

Question 16
Survey evidence shows that managers typically
a. Target earnings per share when making dividend decisions
b. Pay out dividends to reduce cash and decrease potential agency problems
c. Initiate dividends when they believe their shares are undervalued.
d. Believe that dividend cuts have strong negative consequences from investor

Question 17
A firm that follows a strict residual dividend policy is likely to maintain a stable pattern of
dividends over time
True of False
A strict residual dividend policy results in a highly volatile dividend payout pattern.

Question 18
Suppose the personal tax rate on dividend income increases. All else equal, one would
expect the cost of equity for high-dividend firms to decrease.
True of False
If personal tax rates increase, investors will demand a higher return in order to maintain
their level of spendable income. This raises the cost of equity.

Question 19
Suppose a firm wishes to transfer cash to its shareholders. The only way to do so is to pay a
dividend
True of False
The firm could also repurchase shares.

Question 20
Companies are far more reluctant to cut dividends than to increase them. Why might this be
the case? What are the implications for financial markets when firms announce that they
will be cutting dividends?

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You should discuss cutting dividends may send a very negative signal to markets. When
firms announce that they will be cutting dividends, markets assume the worst, i.e. that the
firm is in serious financial trouble and the company’s stock price usually drops sharply.

Question 21
Discuss whether a policy of paying out no dividends means that a company has no value.

If a firm pays out zero dividends, then according to the dividend growth model it has no
value. However, the dividend growth model is only a guide to the value of a firm, and there
are many cases of companies which pay zero or negligible dividends, for example, young
companies who are reinvesting profits for growth. Such companies will attract investors
looking for capital growth, or who expect dividends in future periods, when the model can
be applied.

Question 22
It is sometimes suggested that firms should follow a “residual” dividend policy. With such a
policy, the main idea is that a firm should focus on meeting its investment needs and
maintaining its desired debt−equity ratio. Having done so, a firm pays out any leftover, or
residual, income as dividends. What do you think would be the chief drawback to a residual
dividend policy?

The chief drawback to a residual dividend policy is the variability in dividend payments. This
is a problem because investors tend to want a somewhat predictable cash flow. Also, if
there is information content to dividend announcements, then the firm may be
inadvertently telling the market that it is expecting a downturn in earnings prospects when
it cuts a dividend, when in reality its prospects are very good. In a compromise policy, the
firm maintains a relatively constant dividend. It increases dividends only when it expects
earnings to remain at a sufficiently high level to pay the larger dividends, and it lowers the
dividend only if it absolutely has to.