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Chapter 17

Dividend Policy and Internal Financing

True/False

1. Dividends per share divided by earnings per share (EPS) equals the dividend retention date.

Difficulty: Moderate

Keywords: dividend retention rate

2. The payment of dividends does not increase the monitoring of management’s investment activities.

Difficulty: Moderate

Keywords: agency costs, dividends

3. We typically expect to find rapidly growing firms to have high payout ratios.

Difficulty: Moderate

Keywords: payout ratios

4. A firm’s payout is calculated as the ratio of interest payments to earnings before interest and taxes (EBIT).

Difficulty: Moderate

Keywords: payout ratio

5. Information asymmetry takes into account the higher stock price that can be achieved due to certainty from the accessibility of information between management and investors.

Difficulty: Moderate

Keywords: information asymmetry

6. Dividend policy takes on greater importance the more perfect are the market conditions.

Difficulty: Easy

Keywords: dividend policy

7. If a firm were to unexpectedly omit payment of its quarterly dividend, that firm’s stock price would probably drop.

Difficulty: Easy

Keywords: eliminating a dividend

8. A stock dividend increases a firm’s retained earnings.

Difficulty: Easy

Keywords: retained earnings, stock dividend

9. As long as a firm has a positive level of retained earnings, it can pay a dividend.

Difficulty: Easy

Keywords: retained earnings

10. Unexpected dividends would cause investors to reassess their perceptions about a firm’s stock.

Difficulty: Easy

Keywords: unexpected dividends

11. After a stock split of 2–1, each investor will have one-half of the percentage ownership in the firm that he had before the split.

Difficulty: Moderate

Keywords: stock split

12. If a company in a perfect capital market decreased its dividend per share, an investor would be forced to sell his common stock at a depressed price.

Difficulty: Moderate

Keywords: perfect capital market

13. Other things equal, individuals in high income tax brackets should have a preference for firms that retain their earnings rather than pay dividends.

Difficulty: Moderate

Keywords: tax bracket, dividend

14. The ex-dividend date occurs prior to the declaration date.

Difficulty: Moderate

Keywords: ex-dividend date

15. As a firm’s investment opportunities increase, the dividend payout ratio should increase.

Difficulty: Moderate

Keywords: dividend payout policy

16. Security markets are considered to be perfect when firms can issue securities at no cost and the investor incurs no brokerage commissions.

Difficulty: Moderate

Keywords: perfect security markets

17. By virtue of its nature, dividend policy is inherently a wealth-creating activity for the firm’s owners.

Difficulty: Moderate

Keywords: dividend policy

18. Ownership control takes a higher priority for large corporations than for small to mid-sized companies.

Difficulty: Moderate

Keywords: ownership control

19. A firm with high profitability will always have the cash flow necessary to pay high dividends.

Difficulty: Moderate

Keywords: dividends, cash flow

20. When a firm makes the decision to pay dividends, it also makes the decision not to reinvest the cash in the firm.

Difficulty: Moderate

Keywords: dividends, cash flow

21. The residual dividend theory suggests that dividends should be paid to stockholders first, and then, what is left can be reinvested by the firm.

Difficulty: Moderate

Keywords: residual dividend theory

22. According to the expectations theory, dividend policy should be treated as a short-term residual.

Difficulty: Moderate

Keywords: expectations theory

23. A stable dividend policy generally leads to a lower required rate of return on the part of the investor when compared to similar stocks with erratic fluctuations in dividends.

Difficulty: Moderate

Keywords: stable dividend policy

24. In a perfect market, investors are concerned only with total returns and are not concerned whether it is in capital gains or dividend income.

Difficulty: Moderate

Keywords: perfect market

25. Increasing a firm’s dividend reduces the stock’s risk.

Difficulty: Easy

Keywords: increase in dividend, stock risk

26. When considering taxes, most investors prefer capital gains over dividend income.

Difficulty: Moderate

Keywords: capital gains versus dividend income

27. Due to the strengthening of the stock market over the past 50 years, stock splits and stock dividends are more common than cash dividends.

Difficulty: Easy

Keywords: stock dividends, stock splits

28. If we assume that the firm has already made its investment and borrowing decisions and the existence of perfect capital markets, then it follows that there is no relation between dividend policy and stock value.

Difficulty: Moderate

Keywords: perfect capital markets

29. The bird-in-the-hand dividend theory indicates that capital gains income has a higher value to the investor than does dividend income.

Difficulty: Moderate

Keywords: bird-in-the-hand dividend theory

30. Although there is criticism of the bird-in-the-hand dividend theory, there is still a strong perception among many investors and professional investment advisors that dividends are important.

Difficulty: Moderate

Keywords: bird-in-the-hand dividend theory

31. The view that dividends might actually hurt the investor is based on the argument that there is a difference in tax treatment for dividend income and capital gains income.

Difficulty: Moderate

Keywords: tax treatment of dividends

32. The residual dividend theory indicates that a firm would never pay dividends unless the firm’s profits were larger than its equity financing needs.

Difficulty: Moderate

Keywords: residual dividend theory

33. The clientele effect suggests that firms can change their dividend policy frequently with no potential adverse effect on the firm.

Difficulty: Moderate

Keywords: clientele effect

34. The information effect of dividends suggests that dividends are an important communication tool since management might have no other credible way to inform investors about future earnings.

Difficulty: Moderate

Keywords: information effect

35. The expectations theory of dividends indicates that management’s dividend decision might not be important unless it departs from what investors had expected.

Difficulty: Moderate

Keywords: expectations theory

36. Stock dividends and stock splits have generally been associated with companies that have growing earnings.

Difficulty: Moderate

Keywords: stock dividends and stock splits, growing earnings

37. Company managers strive to gradually increase dividend series over the long-term future.

Difficulty: Easy

Keywords: dividend series

38. Empirical evidence is conclusive that dividend policy matters.

Difficulty: Easy

Keywords: dividend policy

39. Legal restrictions on dividends might restrict dividends from being paid if the firm’s assets exceed its liabilities.

Difficulty: Easy

Keywords: legal restrictions

40. Dividend payout ratios are generally much lower for small or newly established firms than for large, publicly owned firms.

Difficulty: Easy

Keywords: dividend payout ratios

41. Dividends tend to be higher for firms with stable earnings.

Difficulty: Easy

Keywords: dividends, stable earnings

42. High levels of inflation tend not to affect dividend payments.

Difficulty: Moderate

Keywords: inflation, dividend payout

43. The stable dollar dividend policy is the most common.

Difficulty: Easy

Keywords: stable dividends

44. The increasing-stream hypothesis of dividend policy indicates that dividend stability is essentially a smoothing of the dividend stream to minimize the effect of other types of company reversals.

Difficulty: Moderate

Keywords: increasing-stream hypothesis

45. Managers avoid cutting dividends even in response to short-term fluctuations in earnings.

Difficulty: Moderate

Keywords: cutting dividends

46. A reasonable conclusion about dividend policy is that management should avoid surprising investors when it comes to the firm’s dividend decision.

Difficulty: Moderate

Keywords: dividends, avoiding surprises

47. German firms tend to pay out more dividends than British firms.

Difficulty: Moderate

Keywords: German versus British firms, dividend payout

48. The dividend declaration date is the date at which the stock transfer books are to be closed for determining the investor to receive the next dividend payment.

Difficulty: Moderate

Keywords: dividend declaration date

49. There is absolutely no difference on an economic basis between a stock dividend and a stock split.

Difficulty: Moderate

Keywords: stock dividend, stock split

50. Firms can use stock repurchases as a dividend substitute.

Difficulty: Moderate

Keywords: stock repurchases

Multiple Choice

51. Reasons why multinational firms enter international markets during economic prosperity include to:

a. find lower net present value (NPV) of projects.

b. dilute country-related economic risks.

c. achieve a competitive cost advantage.

1. both b and c.
2. all of the above.

Difficulty: Moderate

Keywords: international markets

52. Which of the following countries is MOST favored when corporate cash is available to U.S. multinational firms?

a. Italy

b. France

c. United Kingdom

d. Germany

Difficulty: Easy

Keywords: multinational firms and international funds

53. Flotation costs:

a. include the fees paid to the investment bankers, lawyers, and accountants involved in selling a new security issue.

b. encourage firms to pay large dividends.

c. are encountered whenever a firm fails to pay a dividend.

d. are incurred when investors fail to cash their dividend check.

Difficulty: Moderate

Keywords: flotation costs

54. According to the perfect markets approach to dividend policy:

a. other things equal, the greater the payout ratio, the greater the share price of the firm.

b. the price of a share of stock is not affected by dividend policy.

c. the firm should retain earnings so stockholders will receive a capital gain.

d. the firm should pay a dividend only after current equity financing needs have been met.

Difficulty: Moderate

Keywords: perfect markets

55. According to the residual theory of dividends, dividends are considered a residual after:

a. investment financing needs have been met.

b. preferred stock is issued.

c. EPS is allocated.

d. retained earnings are financed.

Difficulty: Moderate

Keywords: residual theory

56. The ex-dividend date is _________ the holder of record date.

a. five days before

b. two weeks before

c. four days before

d. three days after

Difficulty: Easy

Keywords: ex-dividend date

57. Dividends tend to be more stable than:

a. cash flow.

b. earnings.

c. preferred stock.

d. both b and c.

Difficulty: Easy

Keywords: dividend stability

58. All of the following might influence a firm’s dividend payment EXCEPT:

a. investment opportunities.

b. investor transaction costs.

c. common stock par value.

d. flotation costs.

Difficulty: Moderate

Keywords: dividend payment

59. A stock repurchase increases the:

a. retention ratio of earnings.

b. number of shares outstanding.

c. EPS.

d. both b and c.

Difficulty: Moderate

Keywords: stock repurchase

60. Stock splits decrease the:

a. number of shares to stockholders.

b. par value of the stock.

c. paid-in capital of the stock.

1. both b and c.
2. all of the above.

Difficulty: Moderate

Keywords: stock splits

61. Which of the following is not included in perfect capital markets?

a. Transaction costs

b. Personal taxes

1. Bankruptcy costs
2. Both a and c

e. All of the above

Difficulty: Moderate

Keywords: perfect capital markets

62. Which of the following are not subject to income taxes?

a. Commercial banks

b. Manufacturing corporations

c. Pension funds

d. None of the above

Difficulty: Moderate

Keywords: pension funds, tax implications

63. Which of the following dividend policies will cause dividends per share to fluctuate the most?

a. Constant dividend payout ratio

b. Stable dollar dividend

1. Small, low, regular dividend plus a year-end extra
2. Small, low, regular dividend

Difficulty: Moderate

Keywords: dividends per share fluctuation

64. For accounting purposes, a stock split has been defined as a stock dividend exceeding:

a. 25%.

b. 35%.

c. 45%.

d. 55%.

Difficulty: Moderate

Keywords: stock split

65. Which of the following would influence a firm’s decision about dividends for large firms?

a. Ownership control

1. Liquidity position
2. Earnings predictability

d. Both b and c

e. All of the above

Difficulty: Moderate

Keywords: determinants of dividend policy

66. A firm that maintains dollar dividends will generally not increase the dividend unless:

a. a stock split occurs.

b. the firm merges with another profitable firm.

c. the firm is sure that a higher dividend level can be maintained.

d. the price-earnings (P/E) ratio increased steadily over the past five years.

Difficulty: Moderate

Keywords: increasing dividends

67. A justification for stable dividends could be:

a. satisfaction of guaranteed current income.

b. satisfaction for stockholders’ informational needs.

c. existence of legal listing.

d. all of the above.

Difficulty: Moderate

Keywords: stable dividends

68. The final approval of a dividend payment comes from the:

a. controller.

b. president of the company.

c. board of directors.

d. Chief Financial Officer.

Difficulty: Moderate

Keywords: approval of dividend payment

69. The only definite result from a stock dividend or a stock split is:

a. an increase in the P/E ratio.

b. an increase in the common stock’s market value.

c. an increase in the number of shares outstanding.

d. cannot be determined from the above.

Difficulty: Moderate

Keywords: stock dividend, stock split

70. Dividend policy is influenced by:

a. a company’s investment opportunities.

b. a firm’s capital structure mix.

c. a company’s availability of internally generated funds.

d. all of the above.

e. none of the above.

Difficulty: Moderate

Keywords: dividend policy

71. The __________ designates the date on which the stock transfer books are closed in regard to a dividend payment.

a. declaration date

b. ex-dividend date

c. date of record

d. payment date

Difficulty: Moderate

Keywords: date of record

72. Which of the following conclusions on the importance of a dividend policy is FALSE?

a. As a firm’s investment opportunities increase, the dividend payout ratio should decrease.

b. The firm’s expected earning power and the risk of these earnings are more important to the investor than the dividend policy.

c. Dividends can influence stock price by the investor’s desire to minimize and/or defer taxes and from the role of dividends in minimizing agency costs.

d. In order to avoid surprising investors, management should anticipate financing needs for the short-term but not for the long-term.

Difficulty: Moderate

Keywords: dividend policy

73. Many European companies follow a low mid-year, higher end-of-the-year dividend policy. What type of U.S. investor would not be attracted to the stock of these European companies? Investor clientele who want:

a. very predictable dividend cash flow to meet income needs.

b. unpredictable dividends for higher returns.

c. less risk-averse investments than the typical investment.

d. both a & c.

Difficulty: Moderate

Keywords: stock in European companies

74. The problem with the constant dividend payout ratio is:

a. investors might come to expect a specified amount.

b. the dollar amount of the dividend fluctuates from year to year.

c. management is reluctant to cut the dividend even if there are low profits in a year.

d. all of the above are possible problems.

Difficulty: Moderate

Keywords: constant dividend payout ratio

75. Which of the following is not a rationale given for a stock dividend or split?

a. The price will not fall proportionately to the share increase.

b. An optimum price range does not exist.

c. There is positive informational content associated with the announcement.

d. The actual dividend paid is too certain.

Difficulty: Moderate

Keywords: stock dividend, stock split

76. What is the fundamental purpose of a stock split?

a. A split shows the company’s preference for retaining funds.

b. A split immediately brings the stock price to a lower trading range.

c. A split immediately increases the investor’s wealth.

d. A split increases the threat of a hostile takeover.

Difficulty: Moderate

Keywords: stock split

77. All of the following are methods available to a corporation who desires to repurchase stock EXCEPT:

a. offering to employees who own an interest in the firm.

b. open market.

c. tender offer to all existing stockholders.

d. offer to one or more major stockholders on a negotiated basis.

Difficulty: Moderate

Keywords: stock repurchase methods

78. The conclusion that one dividend policy is as good as another is consistent with which of the following statements?

a. In the aggregate, investors are concerned only with total returns from investment decisions.

b. Investors are indifferent about whether their returns come from capital gains or from dividend income.

c. Investors recognize that the dividend decision, given the investment policy, is really a choice of financing strategy.

d. All of the above.

Difficulty: Moderate

Keywords: dividend policy

79. Which of the following typically would not affect the dividend policy of the firm?

a. Today’s dividend policy is affected by future dividend expectations among investors.

b. Managers are afraid to decrease their voting control of the company by issuing stock dividends.

c. The failure of so many high-tech and dot.com companies showed that dividends are important to long-term investors.

d. The current and future cash flow expectations of the company affect dividend policy.

Difficulty: Moderate

Keywords: dividend policy

80. Which of the following statements about the residual dividend theory is FALSE?

a. The firm will maintain its optimum debt ratio in financing future investments.

b. Dividend policy by itself has no direct influence on the market price of the firm’s common stock.

c. The firm will issue new common stock to finance investment opportunities in order to ensure that some dividend will be paid.

d. The firm’s investment opportunities, capital structure, and profitability all influence the firm’s dividend policy.

Difficulty: Moderate

Keywords: residual dividend theory

Use the following information to answer questions 81-83. Epsilon, Inc. finances 30% of its investments with debt and 70% with common equity. Currently, the firm has generated $3 million from operations that can be used to finance the common equity portion of new investments or to pay common dividends. Epsilon uses a residual dividend policy.

81. If Epsilon has $3 million in positive NPV investment opportunities that it can accept without increasing its marginal cost of capital, then:

a. Epsilon will pay no dividends.

b. Epsilon will pay $900,000 in dividends.

c. Epsilon will accept less than the $3 million in projects so it can pay a dividend.

d. Epsilon will have to issue new common equity to be able to invest in all positive NPV projects.

Difficulty: Moderate

Keywords: net present value, residual dividend policy

82. If Epsilon has $2.1 million in positive NPV investment opportunities that it can accept without increasing its marginal cost of capital, then:

a. Epsilon will pay no dividends.

b. Epsilon will pay $900,000 in dividends.

c. Epsilon will pay $1,470,000 in dividends.

d. Epsilon will pay $1,530,000 in dividends.

Difficulty: Moderate

Keywords: net present value, dividends

83. If Epsilon has $4.3 million in positive NPV investment opportunities that it can accept without increasing its marginal cost of capital, then:

a. Epsilon will pay no dividends.

b. Epsilon will pay $3 million in dividends.

c. Epsilon will accept less than the $4.3 million in projects so it can pay a dividend.

d. Epsilon will pay $1 million in dividends.

Difficulty: Moderate

Keywords: net present value, dividends

84. The agency cost theory of dividends suggests:

a. dividends might make a meaningful contribution to firm value.

b. dividends do not affect the ability to monitor management’s investment activities.

c. dividend policy is irrelevant.

d. none of the above.

Difficulty: Moderate

Keywords: agency cost theory

85. Which of the following conclusions about dividend policy is reasonable?

a. An inverse relation should exist between the amount of acceptable investments a firm has and the dividends remitted to investors.

b. Management’s actions regarding dividends might carry greater weight than a statement by management that earnings will be increasing.

c. Management should avoid surprising investors when it comes to the firm’s dividend decision.

d. All of the above are reasonable.

Difficulty: Moderate

Keywords: dividend policy

86. Which of the following is NOT consistent with the life cycle growth theory of dividend policy?

a. In the growth stage, a company should declare stock dividends.

b. In the development stage, a company should pay some low cash dividends.

c. In the maturity stage, a company should pay moderate to high cash dividends.

d. In the expansion stage, a company should pay low to medium cash dividends.

Difficulty: Moderate

Keywords: life cycle growth theory

87. Which of the following statements is true?

a. The constant dividend payout ratio keeps the dollar amount of the dividend stable.

b. If the firm maintains a stable dollar dividend policy, then the dividend usually does not increase unless management is convinced that the higher dividend can be maintained in the future.

c. The dividend policy which allows for an extra dividend at year-end in prosperous years includes a fairly large regular dividend payment per share every year.

d. All of the above are true.

Difficulty: Moderate

Keywords: stable dollar dividends

88. When comparing a stock dividend and a stock split, we know that:

a. the stock split is defined as a stock dividend exceeding 25%.

b. the stock dividend affects retained earnings and the capital accounts on the balance sheet.

c. the stock split does not affect the dollar amounts of the balance sheet accounts.

d. all of the above are true.

Difficulty: Moderate

Keywords: stock dividend, stock split

Use the following information to answer questions 89-93. Your firm is planning to issue a 15% stock dividend. The market price for the stock has been $28. The table below presents the equity portion of your firm’s balance sheet prior to the distribution.

Common stock

Par value (1 million shares

outstanding; $4 par value) $ 4,000,000

Paid-in capital 16,000,000

Retained earnings 30,000,000

Total equity $50,000,000

89. The 15% stock dividend increases the number of shares outstanding by:

a. 150,000.

b. 1,150,000.

c. 2 million.

d. 1 million.

Difficulty: Moderate

Keywords: stock dividend

90. The new balances, after the stock dividend is paid, in the par value, paid-in capital, and retained earnings accounts are, respectively:

a. $600,000; $3,600,000; $4,200,000.

b. $4,600,000; $19,600,000; $25,800,000.

c. $4,000,000; $16,000,000; $30,000,000.

d. none of the above.

Difficulty: Moderate

Keywords: stock dividend

91. Which of the following statements would be true if a 3–2 stock split were declared?

a. The common stock account remains constant, but each share now represents only a 2/3 proportion.

b. The retained earnings account would decrease.

c. The cash account would decrease.

d. The market price of a share of common stock would increase automatically by a 3-to-2 factor.

Difficulty: Moderate

Keywords: stock split

92. If instead of a stock dividend, your firm decided to split the stock 2–1, then the number of shares outstanding and their par value per share would be:

a. 1 million; $4.

b. 1 million; $8.

c. 2 million; $2.

d. 2 million; $4.

Difficulty: Moderate

Keywords: stock dividend

93. If instead of a stock dividend, your firm decided to split the stock 2–1, then the new balances, after the stock split, in the par value, paid-in capital, and retained earnings accounts are, respectively:

a. $600,000; $3,600,000; $4,200,000.

b. $4,600,000; $19,600,000; $25,800,000.

c. $4,000,000; $16,000,000; $30,000,000.

Difficulty: Moderate

Keywords: stock dividend

94. Which of the following reasons is used to justify stock repurchases?

a. The repurchase is a means for providing an internal investment opportunity.

b. The repurchase modifies the firm’s capital structure.

c. The repurchase reduces the firm’s costs associated with servicing small stockholders.

d. All of the above.

Difficulty: Moderate

Keywords: stock repurchases

95. If a firm’s EPS are $8.33, and the firm is paying a dividend of $1.25 per share, what is the firm’s dividend payout ratio?

a. 33%

b. 6%

c. 15%

d. 25%

e. 66%

Difficulty: Moderate

Keywords: dividend payout ratio

96. Franklin Electric is presently generating earnings available to common shareholders of $7.25 per share. The firm’s income tax rate is 40%. Franklin is paying a dividend to the preferred shareholders of $2.10 per share. The firm’s dividend payout ratio on common stock is 20%. What is the amount per share that Franklin will pay in dividends to common shareholders?

a. $0.58

b. $1.45

c. $3.12

d. $0.42

e. $2.20

Difficulty: Moderate

Keywords: dividends per share

97. Which of the following statements is true?

a. According to the bird-in-the-hand theory, investors value capital gains greater than they value cash dividends.

b. According to the residual theory of dividends, a firm should only invest in capital projects after the payment of dividends to preferred and common stockholders.

c. According to the clientele effect, a firm can make a substantial alteration to its dividend payment without any effect on the price of its stock.

d. According to the dividend irrelevance theory, there is no relationship between a firm’s dividend policy and the value of its common stock.

Difficulty: Moderate

Keywords: dividend irrelevance theory

98. According to the residual theory of dividends:

a. dividends are to be paid out only after investment financing needs have been met.

b. earnings remaining after payment of preferred stock dividends should be paid to common stockholders.

c. dividend payments are a constant percentage of EPS.

d. a dividend is the residual above the payout ratio.

Difficulty: Moderate

Keywords: residual dividend theory

99. Assume that as the result of a firm announcing a large unexpected increase in its dividend payment, the price of the firm’s common stock rises. This event would be consistent with which of the following?

a. The dividend irrelevance theory

b. The tax preference theory

c. The information effect

d. The beta effect

Difficulty: Moderate

Keywords: the information effect

100. Which of the following policies would not lead to potentially significant fluctuations in annual dividends?

a. The residual dividend approach

b. The constant dividend payout ratio approach

c. The stock dividend approach

d. The constant dividend cash yield approach

Difficulty: Moderate

Keywords: stock dividend approach

101. Which of the following considerations would be expected to influence a firm’s decision regarding the payment of dividends?

a. Earnings predictability

b. Legal restrictions

c. Liquidity position

d. All of the above

Difficulty: Moderate

Keywords: considerations in paying dividends

102. The date upon which a dividend is formally declared by the board of directors is the ______ date:

a. declaration.

b. record.

c. payment.

d. ex-dividend.

Difficulty: Moderate

Keywords: declaration date

103. Stock splits:

a. increase the number of shares outstanding.

b. decrease the common stock account by the amount of the split.

c. reduce retained earnings.

d. increase the total wealth of stockholders.

e. none of the above.

Difficulty: Moderate

Keywords: stock splits

104. The dividend policy that states smoothing of the dividend stream in order to minimize the effect of company reversals is called the:

a. increasing-stream hypothesis of dividend policy.

b. stable dollar dividend policy.

c. clientele effect policy.

d. “bird-in-the-hand” policy.

Difficulty: Moderate

Keywords: dividend policies

105. What might an investor reasonably expect from a company with excess cash and few internal investment growth opportunities?

a. The company will buy Treasury bills with all the excess cash.

b. The company will split its stock 3–2.

c. The company will declare a stock dividend.

d. The company will repurchase some of its own shares.

Difficulty: Moderate

Keywords: excess cash, stock repurchase

106. Which of the following is a description of the residual theory of dividend policy?

a. A high enough dividend is paid to maintain a stable total dividend payment.

b. A high enough dividend is paid to maintain a stable dividend payout ratio.

c. The dividend level is adjusted to maintain a stable dividend in relation to cash flow.

d. The dividend level is set to the full amount of profits that remain after the company commits to internal investment funding.

Difficulty: Moderate

Keywords: residual dividend theory

107. Which of the following describes the clientele effect concept of dividend policy?

a. The clientele effect looks at investor preferences for dividends compared to share repurchase programs.

b. The clientele effect defines the relationship between the shareholder and a stockbroker.

c. The clientele effect focuses entirely on the stability of dividends.

d. Modern corporations do not consider shareholders to be "clients."

Difficulty: Moderate

Keywords: clientele effect

108. The bird-in-the-hand theory of dividends suggests that investors will value cash dividends more highly than potential capital gains. This argument is based on the assumption that:

a. investors are indifferent between dividends and capital gains.

b. investors require that the dividend yield and capital gains yield equal a constant.

c. capital gains are taxed at a higher rate than dividends.

d. investors view dividends as being less risky than potential future capital gains.

Difficulty: Moderate

Keywords: bird-in-the-hand dividend theory

109. Which of the following statements is correct?

a. The effect of new information about a company on the firm’s stock price depends more on how the new information compares to expectations than on the actual announcement itself.

b. If an increase in the cost of equity capital occurs when a company announces an increase in its dividend per share, this would be consistent with the bird-in-the-hand theory.

c. An increase in the stock price when a company decreases its dividend is consistent with the signaling theory.

d. A dividend policy that involves paying a consistent percentage of net income is the best policy if the clientele effect is correct.

Difficulty: Moderate

Keywords: effect of new information

110. Super Growth Corp. has decided to increase its dividend to $5 per share beginning next year. The firm’s growth rate is expected to be 12.5% for the foreseeable future. Investors require a rate of return on the firm’s stock of 18%. Utilize the Gordon Model to calculate the expected price of the firm’s stock.

a. $64

b. $75

c. $83

d. $91

e. $98

Difficulty: Moderate

Keywords: expected price of stock

111. Assume that on January 1 a firm announces that on June 30 they will pay a dividend of $2.50 per share to holders of record on March 30. When does the stock sell ex-dividend?

a. January 5

b. April 5

c. March 26

d. July 5

e. June 25

Difficulty: Moderate

Keywords: ex-dividend date

112. Which of the following is the most widely accepted reason that motivates corporations to pay stock dividends?

a. To keep the firm’s beta within its optimal range

b. To conserve cash

c. To reallocate capital to shareholders

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: stock dividends

113. Which of the following motivates corporations to split their common stock?

a. To keep the price of the firm’s common stock within an optimum price range

b. To increase retained earnings

1. To reallocate capital to shareholders
2. To increase their paid-in capital

Difficulty: Moderate

Keywords: stock split

114. Which of the following describes the effect of a stock dividend?

a. A stock dividend immediately increases the market price of a share of stock.

b. A stock dividend immediately decreases the paid-in capital account.

c. A stock dividend immediately increases the number of shares outstanding.

d. A stock dividend indicates that the company must be short on cash.

Difficulty: Moderate

Keywords: stock dividend

115. Which of the following motivates corporations to enter into stock repurchase programs?

a. Favorable impact on EPS

b. Expected favorable impact on stock price

c. To modify the firm’s capital structure

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: stock repurchases

116. Which of the following is a reason that a company would repurchase its own shares of stock in the market?

a. To award employees

b. To increase outstanding equity shares

c. To have shares available to offer a merger target

d. Both a & b

e. All of the above

Difficulty: Moderate

Keywords: stock repurchases

117. Which of the following is the most probable way in which a shareholder will benefit from a stock split?

a. The immediately lower share price will attract enough increased interest in the stock to cause the market price to increase on a more consistent basis.

b. The immediately higher number of shares that an investor owns immediately increases the investor’s wealth.

c. The shareholder can use the immediately increased wealth to borrow more money to buy even more shares at the immediately lower market price.

d. A shareholder can lose money after a stock split if the market believes that the split was an artificial way of attracting attention to a company that is not well managed.

Difficulty: Moderate

Keywords: stock split

118. A stock split will cause changes in the dollar value of which of the below capital accounts?

a. Common stock

b. Additional paid-in capital

c. Retained earnings

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: stock split

119. Select Corp. recently declared a 15% stock dividend. As of the date of the announcement, Select Corp. had 16 million shares outstanding which were selling on the NYSE for $46 per share. An accounting entry is required on the balance sheet in order to transfer an amount from retained earnings to the common stock and additional paid-in capital accounts. What is the dollar amount of retained earnings that will be transferred from retained earnings as the result of the stock dividend? Assume that the par value of Select Corp. is $2 per share.

a. $80.4 million

b. $110.4 million

c. $140.4 million

d. $2170.4 million

Difficulty: Moderate

Keywords: stock dividend

120. ZZZ Corporation has declared a stock dividend that pays one share of stock for every 10 shares owned. What will happen to EPS immediately upon the distribution of the stock dividend?

a. There is not enough information to know.

b. EPS will increase by 10%.

c. EPS will not be affected by the stock dividend.

d. EPS will decrease by 10%.

Difficulty: Moderate

Keywords: stock dividend

121. ZZZ Company, Inc. has 100,000 shares outstanding with a $0.10 par value. The shares were issued for $20. The stock is currently selling for $40. ZZZ now has $10 million in retained earnings and has declared a cash dividend of $2 per share. What will happen to the retained earnings account when the dividend obligation is recorded?

a. It will increase by $2 million.

b. It will not be affected because the dividend only lowers the cash account.

c. It will decrease by $200,000.

d. It will not be affected because the dividend only affects the dividends payable account.

Difficulty: Moderate

Keywords: retained earnings, dividends

122. ZZZ Corporation had net income of $100 million last year and 50 million common shares outstanding. They declared an 8% stock dividend. Calculate EPS before and after the stock dividend.

a. EPS before would be $2; after the dividend, EPS would be $1.85.

b. There is not enough information to make this calculation.

c. EPS before would be $0.50; after the dividend, EPS would be $0.46.

d. Since they made $100 million in net income, the EPS cannot change.

Difficulty: Moderate

Keywords: earnings per share, stock dividend

123. Trendy Corp. recently declared a 10% stock dividend. As of the date of the announcement, Trendy had 10 million shares outstanding which were selling on the NYSE for $50 per share. An accounting entry is required on the balance sheet in order to transfer an amount from retained earnings to the common stock and additional paid-in capital accounts. What is the dollar amount of retained earnings that will be transferred from retained earnings to the common stock account as the result of the stock dividend? Assume that the par value of Trendy is $2 per share.

a. $6 million

b. $5 million

c. $4 million

d. $3 million

e. $2 million

Difficulty: Moderate

Keywords: retained earnings, stock dividend

124. A stock dividend will cause changes in the dollar value of which of the below capital accounts?

a. Common stock

b. Additional paid-in capital

c. Retained earnings

d. All of the above

Difficulty: Moderate

Keywords: stock dividend

Short Answer

125. Define perfect capital markets and discuss its assumptions.

Difficulty: Moderate

Keywords: perfect competition

126. List the benefits of a firm repurchasing its own stock.

Difficulty: Moderate

Keywords: stability and dividends

127. Pettry, Inc. expects EPS this year to be $5.25. If EPS grow at an average annual rate of 10%, and if Pettry pays 60% of its earnings as dividends, what will the expected dividend per share be in 10 years?

$13.62 × 0.6 = $8.17 = Expected dividends per share

Difficulty: Easy

Keywords: expected dividends per share

128. Klone Enterprises maintains a capital structure of 40% debt and 60% equity. If additions to retained earnings for the coming year are expected to be $36 million, how large can the capital budget be? Assume the existing capital structure is to be maintained.

Difficulty: Easy

Keywords: capital budget and capital structure

129. You are considering the stock of two firms to add to your portfolio. The companies differ only with respect to their dividend policies. For both firms, investors expect EPS for each of the next two years to be $7 and dividends and ending price for each of the next two periods to be:

D1 D2 P2

Firm A $2 $2 $60.70

Firm B 4 4 56.42

The required rate of return for the stock of Firm A is 14%. Assuming perfect capital markets:

a. How much would investors pay for the stock of Firm A?

b. How much would investors pay for the stock of Firm B?

c. For a less-than-perfect world, provide an argument for each of the

following:

(1) Investors prefer the dividend policy of Firm A.

(2) Investors prefer the dividend policy of Firm B.

(3) Firms prefer the dividend policy of Firm A.

a. Po = ($2.00/1.14) + [($2.00 + $60.72)/(1.14)2]

Po = $50

b. Exactly the same in the perfect capital market environment.

Po = ($4.00/1.14) + (($4.00 + $56.42)/(1.14)2)

Po = $50

c. (1) Tax structure

(2) Investors’ need for current income

(3) Firms need additional equity to finance growth.

Difficulty: Moderate

Keywords: stock price, dividends

130. The Clysdale Corporation has an optimal capital structure consisting of 40% debt and 60% equity. The marginal cost of capital is calculated to be 14%. Total earnings available to common stockholders for the coming year total $1.2 million.

Investment opportunities are:

Project Investment IRR(%)

A $1,200,000 21

B 100,000 19

C 600,000 15

D 200,000 13

a. According to the residual dividend theory, what should the firm’s total dividend payment be?

b. If the firm paid a total dividend of $480,000 and restricted equity financing to internally generated funds, which projects should be selected? Assume the marginal cost of capital is

constant.

a. Select Projects A, B, C for an investment of $1,900,000

$1,900,000 × .4 = $760,000 debt

$1,900,000 × .6 = $1,140,000 common equity

Dividend payment $1,200,000 - $1,140,000 = $60,000

b. $1,200,000 - $480,000 = $720,000 for investment. Choose Project A only.

Difficulty: Moderate

Keywords: residual dividend theory, project selection

131. XYZ Corporation has 400,000 shares of common stock outstanding, a P/E ratio of 8, and $500,000 available for common stockholders. The board of directors has just voted a 3–2 stock split.

a. If you had 100 shares of stock before the split, how many shares will you have after the split?

b. What was the total value of your investment in XYZ stock before the split?

c. What should be the total value of your investment in XYZ stock after the split?

d. In view of your answers to (b) and (c) above, why would a firm’s management want to have a stock split?

a. Number of shares after split = 3/2 × 100 = 150

b. EPS before split = ($500,000/400,000) = $1.25

Price per share before split = 8 × $1.25 = $10

Total value of investment = $10 × 100 = $1,000

c. Total number of shares after split = 3(400,000/2) = 600,000

EPS after split = ($500,000/600,000) = $.8333

Price per share after split = 8 × $.833 = $6.67

Total value of investment after split = $6.67 × 150 = $1,000

d. (1) Stock splits are believed to have favorable information content. Splits are often associated with growth companies.

(2) Splits can conserve corporate cash if the firm has cash flow problems or needs additional funds for attractive investment opportunities.

Difficulty: Moderate

Keywords: stock split

132. Coppell Timber Company had total earnings last year of $5 million but expects total earnings to drop to $4,750,000 this year because of a slump in the housing industry. There are currently 1 million shares of common stock outstanding. The company has $4 million worth of investments to undertake this year. The company finances 40% of its investments with debt and 60% with equity capital. The company paid $3 per share in dividends last year.

a. If the company follows a pure residual dividend policy, how large a dividend will each shareholder receive this year?

b. If the company maintains a constant dividend payout ratio each year, how large a dividend will each shareholder receive this year?

c. If the company follows a constant dollar dividend policy, how large a dividend will each shareholder receive this year?

a. Equity financing for new investments = $4,000,000(.60) = $2,400,000

Residual dividends = $4,750,000 - $2,400,000 = $2,350,000

Dividends per share = ($2,350,000/1,000,000) = $2.35

b. Dividends = ($3.00)(1,000,000) = $3,000,000

Dividend payout ratio = ($3,000,000/$5,000,000) = .60

Dividends this year = (.60)($4,750,000) = $2,850,000

Dividends per share = ($2,850,000/1,000,000) = $2.85

c. Dividends per share = $3.00

Difficulty: Moderate

Keywords: residual dividend theory, constant dollar dividend policy

133. Noblesville Auto Supply Company’s stock is trading ex-dividend at $5 per share. The company just paid a 10% stock dividend. The P/E ratio for the stock is 10. What was the price of the stock prior to trading ex-dividend?

EPS after stock dividend = ($5.00/10.00) = $.50

EPS after stock dividend = (EPS before stock dividend)/(1.10)

($.50)(1.10) = $.55 = EPS before stock dividend

Stock price prior to stock dividend = (10)($.55) = $5.50

Difficulty: Moderate

Keywords: stock price, stock dividend

134. The equity section of the TMW Corporation balance sheet is shown below. The company’s common stock is currently trading at $20 per share. Reconstruct the equity section of the balance sheet assuming:

a. a 2–1 stock split.

b. a 5% stock dividend.

TMW Corporation

Balance Sheet

Common Stock:

Par value (4 million shares; $2 par value) $ 8,000,000

Paid-in capital 22,000,000

Retained earnings 40,000,000

a.

Common Stock:

Par value (8 million shares; $1 par value) $ 8,000,000

Paid-in capital 22,000,000

Retained earnings 40,000,000

b.

Common Stock:

Par value (4.2 million shares; $2 par value) $ 8,400,000b

Paid-in capital 25,600,000c

Retained earnings 36,000,000a

aMarket value of stock dividend = ($20)(4,000,000)(.05) = $4,000,000

Retained earnings = $40,000,000 - $4,000,000 =$36,000,000

bPar value = $8,000,000 + ($2.00)(200,000) =$8,400,000

cPaid-in capital = $22,000,000 + $4,000,000 -$400,000 = $25,600,000

Difficulty: Moderate

Keywords: stock split, stock dividend

135. Ernest T. Bass Frozen Frog Legs, Inc. has found three acceptable investment opportunities. The three projects require a total of $3 million in financing. It is the company’s policy to finance its investments by using 35% debt and 65% common equity. The firm has generated $2.2 million dollars from its operations that could be used to finance the common equity portion of its investments.

a. What portion of the new investments will be financed by common equity and what portion by debt?

b. According to the residual dividend theory, how much would be paid out in dividends?

a. Common equity = .65 × $3 million = $1,950,000

Debt = .35 × $3 million = $1,050,000

b. Dividends = $2,200,000 - $1,950,000 = $250,000

Difficulty: Moderate

Keywords: residual dividend theory

136. Ted Tech, Inc. is offering a 10% stock dividend. The firm currently has 200,000 shares outstanding and after-tax profits of $800,000. The current price of the stock is $48.

a. Calculate the new EPS.

b. What is the original price/earnings multiple?

c. Providing that the price/earnings multiple stays the same, what will the new stock price be after the stock dividend?

a. EPS = ($800,000/200,000 (1.10)) = $3.636

b. price/earnings multiple = $48/$4 = 12

c. 12 × $3.636 = $43.63

Difficulty: Moderate

Keywords: earnings per share, price/earnings multiple, stock dividend

137. If flotation costs for a common stock issue are 18%, how large will a stock issue have to be so that the firm will net $8 million? If the market price of the common stock is $132, how many shares must be issued?

a. $8,000,000 = x - .18x = x(1 - .18)

x = $8,000,000/.82 = $9,756,097

b. x = $9,756,097/$132 = 73,910

Difficulty: Moderate

Keywords: market price common stock

138. Outpost has 2 million shares of common stock outstanding, net income is $300,000, the P/E ratio is 9, and management is considering an 18% stock dividend. What will be the expected effect on the price of the common stock? If an investor owns 300 shares in the company, how does this change his total value? Explain.

a. Before dividend

Shares outstanding 2,000,000

Net income $300,000

EPS $0.15

P/E 9

Current price $ 1.35 = $0.15 × 9

Investor’s shares 300

Value before dividend $ 405.00 = $1.35 × 300 shares

After dividend

Shares outstanding 2,360,000 = 2,000,000 × (1 + 0.18)

New EPS $0.127

New price $1.144 = $0.127 × 9

Investor’s shares 354 = 300 × 1.18

Value after dividend $ 405.00 = 354 × $1.144

Change $ 0.00 = $405 (before)

$405 (after)

The total value of the investor’s holdings does not change because the price of the stock reacted fully to the increase in the shares outstanding.

Difficulty: Hard

Keywords: effect on common stock price, stock dividend

139. Kelly owns 10,000 shares in McCormick Spices, which currently has 500,000 shares outstanding. The stock sells for $86 on the open market. McCormick’s management has decided on a 2–1 split.

a. Will Kelly’s financial position alter after the split, assuming that the stocks will fall proportionately?

b. Assuming only a 35% fall on each stock, what will be Kelly’s value after the split?

McCormick Spices Corporation - Stock Split

Market price $86.00

Split multiple 2

Shares outstanding 500,000

a.

Investor’s shares = 10,000

Position before split $860,000 = 10,000 shares × $86 per share

Price after split $43.00 = $86/2

Kelly’s shares after split 20,000 = 10,000 × 2

Position after split $860,000 = 20,000 shares × $43 per share

Net gain $0

b.

Price fall 0.35

Price after split $55.90 = $86.00(1 - .35)

Position after split $1,118,000 = 20,000 shares × $55.90 per share

Net gain $258,000 = $1,118,000 - $860,000

Difficulty: Hard

Keywords: stock split

140. Trevor Co.’s future earnings for the next four years are predicted below. Assuming there are 500,000 shares outstanding, what will the yearly dividend per share be if the dividend policy is as follows?

a. A constant payout ratio of 40%

b. Stable dollar dividend targeted at 40% of the average earnings over the four-year period

c. Small, regular dividend of $0.75 plus a year-end extra of 40% of profits exceeding $1 million

Trevor Co.

Year 1 $ 900,000

Year 2 1,200,000

Year 3 850,000

Year 4 1,350,000

a. .40($900,000)/500,000 = $0.72

.40($1,200,000)/500,000 = $0.96

.40($850,000)/500,000 = $0.68

.40($1,350,000)/500,000 = $1.08

b. .40($1,075,000) = $430,000/500,000 = $0.86

c. Year 1 $0.75 = $0.75

Year 2 $0.75 + $0.16 = $0.91

Year 3 $0.75 = $0.75

Year 4 $0.75 + $0.28 = $1.03

Difficulty: Moderate

Keywords: dividends per share