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CHAPTER 14: DISTRIBUTIONS TO SHAREHOLDERS: DIVIDENDS AND SHARE

REPURCHASES

o The optimal distribution policy strikes that balance between current dividends and capital
gains that maximizes the firm's stock price.

o True

o False

ANSWER: True

o Other things held constant, the higher a firm's target payout ratio, the higher its expected
growth rate should be.

o True

o False

ANSWER: False

RATIONALE: The higher the payout ratio, the less of its earnings the firm reinvests in the
business, and the lower the reinvestment rate, the lower the firm's growth rate.

o Miller and Modigliani's dividend irrelevance theory says that the percentage of its
earnings a firm pays out in dividends has no effect on either its cost of capital or its stock
price.

o True

o False

ANSWER: True
o Miller and Modigliani's dividend irrelevance theory says that the percentage of its
earnings a firm pays out in dividends has no effect on its cost of capital, but it does affect
its stock price.

o True

o False

ANSWER: False

o If investors prefer firms that retain most of their earnings, then a firm that wants to
maximize its stock price should set a low payout ratio.

o True

o False

ANSWER: True

o A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same
effect on the firm's stock price.

o True

o False

ANSWER: True

o A "reverse split" reduces the number of shares outstanding.

o True

o False

ANSWER: True
o The announcement of an increase in the cash dividend should, according to MM, lead to
an increase in the price of the firm's stock, other things held constant.

o True

o False

ANSWER: False

o The federal government sometimes taxes dividends and capital gains at different rates.
Other things held constant, an increase in the tax rate on dividends relative to that on
capital gains would logically lead to an increase in dividend payout ratios.

o True

o False

ANSWER: False

o The federal government sometimes taxes dividends and capital gains at different rates.
Other things held constant, if the tax rate on dividends is high relative to that on capital
gains, then individuals with low taxable incomes should favor stocks with low payouts
and high-income individuals should favor high-payout companies.

o True

o False

ANSWER: False

o It has been argued that investors prefer high-payout companies because dividends are
more certain (less risky) than the capital gains that are supposed to come from retained
earnings. However, Miller and Modigliani say that this argument is incorrect, and they
call it the "bird-in-the-hand fallacy." MM base their argument on the belief that most
dividends are reinvested in stocks, hence are exposed to the same risks as reinvested
earnings.

o True

o False

ANSWER: True

o Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their
argument that the value of the firm is determined only by its basic earning power and its
business risk.

o True

o False

ANSWER: True

o One implication of the bird-in-the-hand theory of dividends is that a given reduction in


dividend yield must be offset by a more than proportionate increase in growth in order to
keep a firm's required return constant, other things held constant.

o True

o False

ANSWER: True

o If a retired individual lives on his or her investment income, then it would make sense for
this person to prefer stocks with high payouts so he or she could receive cash without
going to the trouble and expense of selling stocks. On the other hand, it would make
sense for an individual who would just reinvest any dividends received to prefer a low-
payout company because that would save him or her taxes and brokerage costs.

o True
o False

ANSWER: True

o Some investors prefer dividends to retained earnings (and the capital gains retained
earnings bring), while others prefer retained earnings to dividends. Other things held
constant, it makes sense for a company to establish its dividend policy and stick to it, and
then it will attract a clientele of investors who like that policy.

o True

o False

ANSWER: True

o Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50%
dividend payout, announces that it is increasing the dividend to $1.50. The stock price
then jumps from $20 to $30. Some people would argue that this is proof that investors
prefer dividends to retained earnings. Miller and Modigliani would agree with this
argument.

o True

o False

ANSWER: False

RATIONALE: MM would disagree. They would say that investors took the dividend increase as
a signal that the firm's management expected higher future earnings. MM say dividends
have information content regarding future earnings.

o If the information content, or signaling, hypothesis is correct, then a change in a firm's


dividend policy can have an important effect on its stock price and cost of equity.

o True

o False
ANSWER: True

o If a firm uses the residual dividend model to set dividend policy, then dividends are
determined as a residual after providing for the equity required to fund the capital budget.
Under this model, the better the firm's investment opportunities, the lower its payout ratio
will be, other things held constant.

o True

o False

ANSWER: True

o If a firm uses the residual dividend model to set dividend policy, then dividends are
determined as a residual after providing for the equity required to fund the capital budget.
Under this model, the higher the firm's debt ratio, the lower its payout ratio will be, other
things held constant.

o True

o False

ANSWER: False

RATIONALE: The higher the debt ratio, the more dollars of debt will be used to fund a given
capital budget. So, the higher the debt ratio, the less equity will be needed, and this results in a
higher dividend payout ratio according to the residual dividend model.

o If management wants to maximize its stock price, and if it believes that the dividend
irrelevance theory is correct, then it must adhere to the residual dividend policy.

o True

o False

ANSWER: False
o If on January 3, 2014, a company declares a dividend of $1.50 per share, payable on
January 31, 2014, then the price of the stock should drop by approximately $1.50 on
January 31.

o True

o False

ANSWER: False

RATIONALE: This is false. The stock price will drop on the ex-dividend date, which is two
days prior to the holder of record date, which is well before the actual January 31 payment date.
Also, because the dividend is taxable, the price decline is generally somewhat less than the full
amount of the dividend.

o If on January 3, 2014, a company declares a dividend of $1.50 per share, payable on


January 31, 2014, to holders of record on January 17, then the price of the stock should
drop by approximately $1.50 on January 15, which is the ex- dividend date.

o True

o False

ANSWER: True

RATIONALE: This is true. The stock price will drop on the ex-dividend date, which is two days
prior to the holder of record date, which is well before the actual January 31 payment date. Note,
though, that because the dividend is taxable, the price decline may be somewhat less than the full
amount of the dividend.

o One advantage of dividend reinvestment plans is that they allow shareholders to delay
paying taxes on the dividends that they choose to reinvest.

o True

o False

ANSWER: False
o There are two types of dividend reinvestment plans. Under one type of plan, the firm uses
the cash that would have been paid as dividends to buy stock on the open market. Under
the other type, the company issues new stock, keeps the cash that would have been paid
out, and in effect sells new stock to those investors who choose to reinvest their
dividends.

o True

o False

ANSWER: True

o If a firm pays out all of its earnings as dividends and its stockholders then elect to have
all of their dividends reinvested, the company should reconsider its dividend policy and
possibly move to a lower dividend payout ratio.

o True

o False

ANSWER: True

RATIONALE: This is true, because if the company retains its earnings rather than paying them
out, investors should receive capital gains rather than dividend income, and the taxes on those
gains will be deferred until the stock is sold. Note that the money will be reinvested by the
company in either case, so the risk to stockholders under dividend reinvestment and retained
earnings should be the same.

o If a firm declares a 20:1 stock split, and the pre-split price was $500, then we might
expect the post-split price to be

$25. However, it often turns out that the post-split price will be higher than $25. This higher
price could be due to signaling effects investors believe that management split the stock because
they think the firm is going to do better in the future. The higher price could also be because
investors like lower-priced shares.

o True

o False
ANSWER: True

o Your firm uses the residual dividend model to set dividend policy. Market interest rates
suddenly rise, and stock prices decline. Your firm's earnings, investment opportunities,
and capital structure do not change. If the firm follows the residual dividend model, then
its dividend payout ratio would increase.

o True

o False

ANSWER: True

RATIONALE: (1) The firm's WACC would increase, (2) this would cause fewer projects to be
accepted, (3) this would lead to a smaller capital budget, (4) thus less money would be needed to
fund the capital budget, (5) thus less equity would be needed, so (6) the dividend payout ratio
would increase.

o Suppose you plotted a curve which showed a Firm U's WACC on the vertical axis and its
debt ratio on the horizontal Then you plotted a similar curve for Firm V. The curve for
firm U resembled a shallow "U," while that for Firm V resembled a sharp "V." Both
firms have debt ratios that cause their WACCs to be minimized. Other things held
constant, it would be easier for Firm V than for Firm U to maintain a steady dividend in
the face of varying investment opportunities and earnings from year to year.

o True

o False

ANSWER: False

RATIONALE: Firm U could fund its capital budget with varying amounts of debt without
causing large changes in its WACC and thus in its value and stock price. Firm V could not vary
its debt ratio without increasing its WACC. Thus, Firm V would have to raise and lower its
dividend payout in order to obtain the equity it needed to support its capital budget. Firm U, on
the other hand, could maintain a stable, steady dividend, and let the debt ratio vary without
causing much harm to its stock price.
o In the real world, dividends

o are usually more stable than earnings.

o fluctuate more widely than earnings.

o tend to be a lower percentage of earnings for mature firms.

o are usually changed every year to reflect earnings changes, and these changes are
randomly higher to lower, depending on whether earnings increased or decreased.

o are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if


EPS = $2.00, then DPS would equal $0.80. Once the percentage is set, then
dividend policy is on "automatic pilot" and the dividend actually paid depends
strictly on earnings.

ANSWER: a

o You own 100 shares of Troll Brothers' stock, which currently sells for $120 a share. The
company is about to declare a 2-for-1 stock split. Which of the following best describes
your likely position after the split?

o You will have 200 shares of stock, and the stock will trade at or near $120 a
share.

o You will have 200 shares of stock, and the stock will trade at or near $60 a share.

o You will have 100 shares of stock, and the stock will trade at or near $60 a share.

o You will have 50 shares of stock, and the stock will trade at or near $120 a share.

o You will have 50 shares of stock, and the stock will trade at or near $600 a share.

ANSWER: b

o Myron Gordon and John Lintner believe that the required return on equity increases as
the dividend payout ratio is Their argument is based on the assumption that

o investors are indifferent between dividends and capital gains.


o investors require that the dividend yield plus the capital gains yield equal a
constant.

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

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

o investors prefer a dollar of expected capital gains to a dollar of expected


dividends because of the lower tax rate on capital gains.

ANSWER: d

o Your firm adheres strictly to the residual dividend model. All else equal, which of the
following factors would be most likely to lead to an increase in the firm's dividend per
share?

o The firm's net income increases.

o The company increases the percentage of equity in its target capital structure.

o The number of profitable potential projects increases.

o Congress lowers the tax rate on capital gains, leaving the rest of the tax code
unchanged.

o Earnings are unchanged, but the firm issues new shares of common stock.

ANSWER: a

o If a firm adheres strictly to the residual dividend policy, and if its optimal capital budget
requires the use of all earnings for a given year (along with new debt according to the
optimal debt/assets ratio), then the firm should pay

o the same dividend as it paid the prior year.

o no dividends to common stockholders.

o dividends only out of funds raised by the sale of new common stock.

o dividends only out of funds raised by borrowing money (i.e., issuing debt).

o dividends only out of funds raised by selling off fixed assets.


ANSWER: b

o If a firm adheres strictly to the residual dividend model, the issuance of new common
stock would suggest that

o the dividend payout ratio has remained constant.

o the dividend payout ratio is increasing.

o no dividends will be paid during the year.

o the dividend payout ratio is decreasing.

o the dollar amount of capital investments had decreased.

ANSWER: c

o Which of the following does NOT normally influence a firm's dividend policy decision?

o The firm's ability to accelerate or delay investment projects without adverse


consequences.

o A strong preference by most of its shareholders for current cash income versus
potential future capital gains.

o Constraints imposed by the firm's bond indenture.

o The fact that much of the firm's equipment is leased rather than bought and
owned.

o The fact that Congress is considering changes in the tax law regarding the
taxation of dividends versus capital gains.

ANSWER: d
o Which of the following would be most likely to lead to a decrease in a firm's dividend
payout ratio?

o Its earnings become more stable.

o Its access to the capital markets increases.

o Its research and development efforts pay off, and it now has more high-return
investment opportunities.

o Its accounts receivable decrease due to a change in its credit policy.

o Its stock price has increased over the last year by a greater percentage than the
increase in the broad stock market averages.

ANSWER: c

o Which of the following statements is CORRECT?

o When firms are deciding on the size of stock splits--say whether to declare a 2-
for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-
for-1 split, because then the after-split price will be higher than if the 3-for-1 split
had been used.

o Back before the SEC was created in the 1930s, companies would declare reverse
splits in order to boost their stock prices. However, this was determined to be a
deceptive practice, and reverse splits are illegal today.

o Stock splits create more administrative problems for investors than stock
dividends, especially determining the tax basis of their shares when they decide to
sell them, so today stock dividends are used far more often than stock splits.

o When a company declares a stock split, the price of the stock typically declines--
for example, by about 50% after a 2-for-1 split--and this necessarily reduces the
total market value of the firm's equity.

o If a firm's stock price is quite high relative to most stocks-- say $500 per share--
then it can declare a stock split of say 20-for-1 so as to bring the price down to
something close to $25. Moreover, if the price is relatively low--say $2 per share-
-then it can declare a "reverse split" of say 1-for-10 so as to bring the price up to
somewhere around $20 per share.
ANSWER: e

o Which of the following statements about dividend policies is CORRECT?

o Miller and Modigliani argued that investors prefer dividends to capital gains
because dividends are more certain than capital gains. They call this the "bird-in-
the-hand" effect.

o One reason that companies tend to favor distributing excess cash as dividends
rather than by repurchasing stock is that dividends are normally taxed at a lower
rate than gains on repurchased stock.

o One advantage of dividend reinvestment plans is that they allow shareholders to


delay paying taxes on the dividends that they choose to reinvest.

o One key advantage of the residual dividend model is that it enables a company to
follow a stable dividend policy.

o The clientele effect suggests that companies should follow a stable dividend
policy.

ANSWER: e

o Which of the following statements is CORRECT?

o One disadvantage of dividend reinvestment plans is that they increase transactions


costs for investors who want to increase their investment in the company.

o One advantage of dividend reinvestment plans is that they enable investors to


postpone paying taxes on the dividends credited to their account.

o Stock repurchases can be used by a firm that wants to increase its debt ratio.

o Stock repurchases make sense if a company expects to have a lot of profitable


new projects to fund over the next few years, provided investors are aware of
these investment opportunities.

o One advantage of an open market dividend reinvestment plan is that it provides


new equity capital and increases the shares outstanding.
ANSWER: c

o Which of the following statements is CORRECT?

o Under the tax laws as they existed in 2011, a dollar received by an individual
taxpayer as interest income is taxed at the same rate as a dollar received as
dividends.

o One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the
taxes investors would have to pay if they received cash dividends.

o Empirical research indicates that, in general, companies send a negative signal to


the marketplace when they announce an increase in the dividend. As a result,
share prices fall when dividend increases are announced because investors
interpret the increase as a signal that the firm expects fewer good investment
opportunities in the future.

o If a company needs to raise new equity capital, a new-stock dividend


reinvestment plan would make sense. However, if the firm does not need new
equity, then an open market purchase dividend reinvestment plan would probably
make more sense.

o Dividend reinvestment plans have not caught on in most industries, and today
over 99% of all DRIPs are offered by utilities.

ANSWER: d

o Which of the following statements is CORRECT?

o Historically, the tax code has encouraged companies to pay dividends rather than
retain earnings.

o If a company uses the residual dividend model to determine its dividend


payments, dividend payout will tend to increase whenever its profitable
investment opportunities increase relatively rapidly.

o The more a firm's management believes in the clientele effect, the more likely the
firm is to adhere strictly to the residual dividend model.

o Large stock repurchases financed by debt tend to increase expected earnings per
share, but they also tend to increase the firm's financial risk.
o A dollar paid out to repurchase stock has the same tax benefit as a dollar paid out
in dividends. Thus, both companies and investors should be indifferent between
distributing cash through dividends and stock repurchase programs.

ANSWER: d

o Which of the following statements is CORRECT?

o If a company has a 2-for-1 stock split, its stock price should roughly double.

o Capital gains earned on shares repurchased are taxed less favorably than
dividends, which is why companies typically pay dividends and avoid share
repurchases.

o Very often, a company's stock price will rise when it announces that it plans to
commence a share repurchase Such an announcement could lead to a stock price
decline, but this does not normally happen.

o Stock repurchases increase the number of outstanding shares.

o The clientele effect is the best explanation for why companies tend to vary their
dividend payments from quarter to quarter.

ANSWER: c

RATIONALE: c is correct, but perhaps the easiest way to answer this question is to eliminate
the other choices, which are obviously wrong.

o Which of the following statements is CORRECT?

o Firms with a lot of good investment opportunities and a relatively small amount
of cash tend to have above- average dividend payout ratios.

o One advantage of the residual dividend model is that it leads to a stable dividend
payout, which investors like.

o An increase in the stock price when a company cuts its dividend is consistent with
signaling theory as postulated by MM.
o If the "clientele effect" is correct, then for a company whose earnings fluctuate, a
policy of paying a constant percentage of net income will probably maximize its
stock price.

o Stock repurchases make the most sense at times when a company believes its
stock is undervalued.

ANSWER: e

o Which of the following statements is CORRECT?

o One advantage of dividend reinvestment plans is that they enable investors to


avoid paying taxes on the dividends they receive.

o If a company has an established clientele of investors who prefer a high dividend


payout, and if management wants to keep stockholders happy, it should not
adhere strictly to the residual dividend model.

o If a firm adheres strictly to the residual dividend model, then, holding all else
constant, its dividend payout ratio will tend to rise whenever its investment
opportunities improve.

o If Congress eliminates taxes on capital gains but leaves the personal tax rate on
dividends unchanged, this would motivate companies to increase their dividend
payout ratios.

o Despite its drawbacks, following the residual dividend model will tend to stabilize
actual cash dividends, and this will make it easier for firms to attract a clientele
that prefers high dividends, such as retirees.

ANSWER: b

o Firm M is a mature company in a mature industry. Its annual net income and cash flows
are consistently high and However, M's growth prospects are quite limited, so its capital
budget is small relative to its net income. Firm N is a relatively new company in a new
and growing industry. Its markets and products have not stabilized, so its annual
operating income fluctuates considerably. However, N has substantial growth
opportunities, and its capital budget is expected to be large relative to its net income for
the foreseeable future. Which of the following statements is CORRECT?

o Firm M probably has a lower target debt ratio than Firm N.

o Firm M probably has a higher target dividend payout ratio than Firm N.

o If the corporate tax rate increases, the debt ratio of both firms is likely to decline.

o The two firms are equally likely to pay high dividends.

o Firm N is likely to have a clientele of shareholders who want a consistent, stable


dividend income.

ANSWER: b

o Which of the following statements is CORRECT?

o If a firm repurchases some of its stock in the open market, then shareholders who
sell their stock for more than they paid for it will be subject to capital gains taxes.

o An open-market dividend reinvestment plan will be most attractive to companies


that need new equity and would otherwise have to issue additional shares of
common stock through investment bankers.

o Stock repurchases tend to reduce financial leverage.

o If a company declares a 2-for-1 stock split, its stock price should roughly double.

o One advantage of adopting the residual dividend model is that this makes it easier
for corporations to meet the requirements of Modigliani and Miller's dividend
clientele theory.

ANSWER: a

o Which of the following actions will best enable a company to raise additional equity
capital, other things held constant?

o Refund long-term debt with lower cost short-term debt.

o Declare a stock split.


o Begin an open-market purchase dividend reinvestment plan.

o Initiate a stock repurchase program.

o Begin a new-stock dividend reinvestment plan.

ANSWER: e

o Which of the following statements is NOT CORRECT?

o Stock repurchases can be used by a firm as part of a plan to change its capital
structure.

o After a 3-for-1 stock split, a company's price per share should fall, but the number
of shares outstanding will rise.

o Investors may interpret a stock repurchase program as a signal that the firm's
managers believe the stock is undervalued, or, alternatively, as a signal that the
firm does not have many good investment opportunities.

o A company can repurchase stock to distribute a large one-time cash inflow, say
from the sale of a division, to stockholders without having to increase its regular
dividend.

o Stockholders pay no income tax on dividends if the dividends are used to


purchase stock through a dividend reinvestment plan.

ANSWER: e

o Which of the following statements is CORRECT?

o If a firm follows the residual dividend model, then a sudden increase in the
number of profitable projects would be likely to lead to a reduction of the firm's
dividend payout ratio.

o The clientele effect explains why so many firms change their dividend policies so
often.
o One advantage of adopting the residual dividend model is that this policy makes it
easier for a corporation to attract a specific and well-identified dividend clientele.

o New-stock dividend reinvestment plans are similar to stock dividends because


they both increase the number of shares outstanding but don't change the firm's
total amount of book equity.

o Investors who receive stock dividends must pay taxes on the value of the new
shares in the year the stock dividends are received.

ANSWER: a

o Which of the following statements is CORRECT?

o Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50%
dividend payout, announces that it is increasing the dividend to $1.50. The stock
price then jumps from $20 to $30. Some people would argue that this is proof that
investors prefer dividends to retained earnings. Miller and Modigliani would
agree with this argument.

o Other things held constant, the higher a firm's target dividend payout ratio, the
higher its expected growth rate should be.

o Miller and Modigliani's dividend irrelevance theory says that the percentage of its
earnings that a firm pays out in dividends has no effect on its cost of capital, but it
does affect its stock price.

o The federal government sometimes taxes dividends and capital gains at different
rates. Other things held constant, an increase in the tax rate on dividends relative
to that on capital gains would logically lead to a decrease in dividend payout
ratios.

o If investors prefer firms that retain most of their earnings, then a firm that wants
to maximize its stock price should set a high dividend payout ratio.

ANSWER: d

o Portland Plastics Inc. has the following data. If it follows the residual dividend model,
what is its forecasted dividend payout ratio?
Capital budget $12,500

% Debt 40%

Net income (NI) $11,500

o 25.36%

o 28.17%

o 31.30%

o 34.78%

o 38.26%

ANSWER: d

RATIONALE:

Capital budget $12,500

Net income (NI) $11,500

% Debt 40%

% Equity = 1.0 % Debt = 60%

Equity needed to support the capital


budget = % Equity Capital budget $7,500

Dividends paid = NI Equity needed if positive,


otherwise $0.0. $4,000

Payout ratio = Dividends paid/NI = 34.78%


o Becker Financial recently declared a 2-for-1 stock split. Prior to the split, the stock sold
for $80 per share. If the firm's total market value is unchanged by the split, what will the
stock price be following the split?

o $36.10

o $38.00

o $40.00

o $42.00

o $44.10

ANSWER: c

RATIONALE:

Number of new shares 2

Number of old shares 1

Old (pre-split) price $80

New price = Old price (Old shares/New shares) = $40.00

o Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its stock
sold for $90 per share. The firm's total market value was unchanged by the split. Other
things held constant, what is the best estimate of the stock's post-split price?

o $30.00

o $31.50

o $33.08

o $34.73

o $36.47
ANSWER: a

RATIONALE:

Number of new shares 3

Number of old shares 1

Pre-split stock price $90.00

Post-split stock price: P0/New per old =


$30.00

o Mid-State BankCorp recently declared a 7-for-2 stock split. Prior to the split, the stock
sold for $80 per share. If the firm's total market value is unchanged by the split, what will
the stock price be following the split?

o $20.63

o $21.71

o $22.86

o $24.00

o $25.20

ANSWER: c

RATIONALE:

Number of new shares 7

Number of old shares 2

Old (pre-split) price $80.00


New price = Old price (Old shares/New shares) = $22.86

o Fauver Industries plans to have a capital budget of $650,000. It wants to maintain a target
capital structure of 40% debt and 60% equity, and it also wants to pay a dividend of
$225,000. If the company follows the residual dividend model, how much net income
must it earn to meet its investment requirements, pay the dividend, and keep the capital
structure in balance?

o $584,250

o $615,000

o $645,750

o $678,038

o $711,939

ANSWER: b

RATIONALE:

Capital budget $650,000

% Equity 60%

Dividends to be paid $225,000

Required net income = Dividends + (Capital budget % Equity) = $615,000

o Ring Technology has a capital budget of $850,000, it wants to maintain a target capital
structure of 35% debt and 65% equity, and it also wants to pay a dividend of $400,000. If
the company follows the residual dividend model, how much net income must it earn to
meet its capital budgeting requirements and pay the dividend, all while keeping its capital
structure in balance?
o $ 904,875

o $ 952,500

o $1,000,125

o $1,050,131

o $1,102,638

ANSWER: b

RATIONALE:

Capital budget $850,000

Equity ratio 65%

Dividends to be paid $400,000

Required net income = Dividends + (Capital budget % Equity) = $952,500

o Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target
capital structure of 45% debt and 55% equity, and she also wants to pay a dividend of
$500,000. If the company follows the residual dividend model, how much income must it
earn, and what will its dividend payout ratio be?

o $ 898,750; 55.63%

o $ 943,688; 58.41%

o $ 990,872; 61.34%

o $1,040,415; 64.40%

o $1,092,436; 67.62%

Capital budget $725,000


Equity ratio 55%

Dividends paid $500,000

ANSWER: a RATIONALE:

NI = Dividends + (Equity % Capital budget) = $898,750 Payout = Dividends/NI = 55.63%

o Banerjee Inc. wants to maintain a target capital structure with 30% debt and 70% equity.
Its forecasted net income is $550,000, and its board of directors has decreed that no new
stock can be issued during the coming year. If the firm follows the residual dividend
model, what is the maximum capital budget that is consistent with maintaining the target
capital structure?

o $673,652

o $709,107

o $746,429

o $785,714

o $825,000

ANSWER: d

RATIONALE:
% Debt 30%

% Equity 70%

Net income $550,000

Max. capital budget = NI/% Equity $785,714

Check: Is calculated Max. capital budget % Equity = NI? $550,000 = Net income

o Dentaltech Inc. projects the following data for the coming year. If the firm follows the
residual dividend model and also maintains its target capital structure, what will its
dividend payout ratio be?

EBIT $2,000,000 Capital budget $850,000

Interest rate 10% % Debt 40%

Debt outstanding $5,000,000 % Equity 60%

Shares outstanding 5,000,000 Tax rate 40%

o 37.2%

o 39.1%

o 41.2%

o 43.3%

o 45.5%

ANSWER: d
RATIONALE:

EBIT $2,000,000 Capital


budget $850,000

Interest rate 10% %


Debt 40%

Debt outstanding $5,000,000 % Equity 60%

Shares outstanding 5,000,000 Tax rate 40%

EBIT $2,000,000

Interest expense = Interest rate Debt 500,000

Taxable income $1,500,000

Taxes = Tax rate Income 600,000

Net income (NI) $ 900,000

Equity needed for capital budget = % Equity(Capital budget) $ 510,000

Dividends = NI Equity needed $ 390,000

Payout ratio = Dividends/NI = 43.33%

o Mortal Inc. expects to have a capital budget of $500,000 next year. The company wants
to maintain a target capital structure with 30% debt and 70% equity, and its forecasted net
income is $400,000. If the company follows the residual dividend model, how much in
dividends, if any, will it pay?

o $45,125

o $47,500
o $50,000

o $52,500

o $55,125

ANSWER: c

RATIONALE:

% Debt 30%

% Equity 70%

Capital budget $500,000

Net income $400,000

Equity requirement = Capital budget % Equity $350,000

Dividends = NI Equity requirement = $50,000

o Torrence Inc. has the following data. If it uses the residual dividend model, how much
total dividends, if any, will it pay out?

Capital budget $1,000,000

% Debt 60%

Net income (NI) $625,000

o $183,264 b. $192,909 c. $203,063 d. $213,750 e. $225,000

ANSWER: e

RATIONALE:
Capital budget $1,000,000

Net income (NI) $625,000

% Debt 60%

% Equity = 1.0 % Debt 40%

Equity needed to support the capital budget = % Equity Capital budget $400,000

Dividends paid = NI Equity needed if positive (otherwise, $0.0) = $225,000

o NY Fashions has the following data. If it follows the residual dividend model, how much
total dividends, if any, will it pay out?

Capital budget $1,500,000

% Debt 65%

Net income (NI) $550,000

o $20,363

o $21,434

o $22,563

o $23,750

o $25,000

ANSWER: e

RATIONALE:

Capital budget $1,500,000

Net income (NI) $550,000


% Debt 65%

% Equity = 1.0 % Debt 35%

Equity needed to support the capital budget = % Equity Capital budget $525,000

Dividends paid = NI Equity needed if positive (otherwise, $0.0) = $25,000

o Chicago Brewing has the following data, dollars in thousands. If it follows the residual
dividend model, what will its dividend payout ratio be?

Capital budget $5,000

% Debt 45%

Net income (NI) $5,300

o 48.11%

o 50.52%

o 55.57%

o 61.13%

o 67.24%

ANSWER: a

RATIONALE:

Capital budget $5,000

Net income (NI) $5,300


% Debt 45%

% Equity = 1.0 % Debt 55%

Equity needed to support the capital budget = % Equity


Capital budget $2,750

Dividends paid = NI Equity needed if positive (otherwise,


$0.0) $2,550

Payout ratio = Dividends paid/NI = 48.11%

o LA Moving Company has the following data, dollars in thousands. If it follows the
residual dividend model, what will its dividend payout ratio be?

Capital budget $5,000

% Debt 45%

Net income (NI) $7,000

o 60.71%

o 63.75%

o 70.13%

o 77.14%

o 84.85%

ANSWER: a

RATIONALE:

Capital budget $5,000


Net income (NI) $7,000

% Debt 45%

% Equity = 1.0 % Debt 55%

Equity needed to support the capital budget = % Equity

Capital budget $2,750

Dividends paid = NI Equity needed if positive (otherwise, $0.0) $4,250

Payout ratio = Dividends paid/NI = 60.71%

o New Orleans Builders Inc. has the following data. If it follows the residual dividend
model, what is its forecasted dividend payout ratio?

Capital budget $7,500

% Debt 35%

Net income (NI) $6,500

o 18.23%

o 20.25%

o 22.50%

o 25.00%

o 27.50%

ANSWER: d

RATIONALE:
Capital budget $7,500

Net income (NI) $6,500

% Debt 35%

% Equity = 1.0 % Debt 65%

Equity needed to support the capital budget = % Equity

Capital budget $4,875

Dividends paid = NI Equity needed if positive (otherwise,


$0.0) $1,625

Payout ratio = Dividends paid/NI = 25.00%

o Ross-Jordan Financial has suffered losses in recent years, and its stock currently sells for
only $0.50 per share. Management wants to use a reverse split to get the price up to a
more "reasonable" level, which it thinks is $25 per share. How many of the old shares
must be given up for one new share to achieve the $25 price, assuming this transaction
has no effect on total market value?

o 47.50

o 49.88

o 50.00

o 52.50

o 55.13

ANSWER: c

RATIONALE:

Current price $0.50

Target price $25.00


Old shares surrendered per 1 new share = Target price/Old price = 50.00

o Keys Financial has done extremely well in recent years, and its stock now sells for $175
per share. Management wants to get the price down to a more typical level, which it
thinks is $25 per share. What stock split would be required to get to this price, assuming
the transaction has no effect on the total market value? Put another way, how many new
shares should be given per one old share?

o 6.98

o 7.00

o 7.35

o 7.72

o 8.10

ANSWER: b

RATIONALE:

Current price $175.00

Target price $25.00

No. of new shares per 1 old share = Current price/Target price = 7.00

o Whited Products recently completed a 4-for-1 stock split. Prior to the split, its stock sold
for $120 per share. If the firm's total market value increased by 5% as a result of
increased liquidity and favorable signaling effects, what was the stock price following the
split?

o $29.93

o $31.50

o $33.08
o $34.73

o $36.47

ANSWER: b

RATIONALE:

New shares per 1 old share 4

Pre-split stock price $120

% value increase 5%

Post-split stock price = (P0/[(New shares per old shares) (1 + % Value increase)] = $31.50

o Clark Farms Inc. has the following data, and it follows the residual dividend model.
Currently, it finances with 15% debt. Some Clark family members would like for the
dividends to be increased. If Clark increased its debt ratio, which the firm's treasurer
thinks is feasible, by how much could the dividend be increased, holding other things
constant?

Capital budget $3,000,000

Net income (NI) $3,500,000

% Debt now 15%

% Debt after change 60%

o $1,093,500

o $1,215,000

o $1,350,000
o $1,485,000

o $1,633,500

ANSWER: c

RATIONALE:

Old New

%
Debt 15%
60%

% Equity = 1.0 %
Debt 85%
40%

Capital budget $3,000,000 $3,000,000

Net income (NI) $3,500,000 $3,500,000

Equity needed to support the capital budget = % Equity

Capital budget $2,550,000 $1,200,000

Dividends paid = NI Equity needed if positive

(otherwise, $0.0) $950,000 $2,300,000

Increase in dividends paid = $1,350,000

o Purcell Farms Inc. has the following data, and it follows the residual dividend model.
Currently, it finances with 15% debt. Some Purcell family members would like for the
dividend payout ratio to be increased. If Purcell increased its debt ratio, which the firm's
treasurer thinks is feasible, by how much could the dividend payout ratio be increased,
holding other things constant?
Capital budget $3,000,000

Net income (NI) $3,500,000

% Debt now 15%

% Debt after change 60%

o 38.6%

o 40.5%

o 42.5%

o 44.7%

o 46.9%

ANSWER: a

RATIONALE:

Old New

%
Debt 15%
60%

% Equity = 1.0 %
Debt 85%
40%

Capital budget $3,000,000 $3,000,000

Net income (NI) $3,500,000 $3,500,000

Equity needed to support the capital budget = % Equity


Capital budget $2,550,000 $1,200,000

Dividends paid = NI Equity needed if positive


(otherwise, $0.0) $950,000 $2,300,000
Dividend payout
ratio 27.1%
65.7%

Increase in dividend payout ratio = 38.6%

o Whitman Antique Cars Inc. has the following data, and it follows the residual dividend
model. Some Whitman family members would like more dividends, and they also think
that the firm's capital budget includes too many projects whose NPVs are close to zero. If
Whitman reduced its capital budget to the indicated level, by how much could dividends
be increased, holding other things constant?

Original capital budget $3,000,000

New capital budget $2,000,000

Net income $3,500,000

% Debt 40%

o $486,000

o $540,000

o $600,000

o $660,000

o $726,000

ANSWER: c

RATIONALE:

Old New
%
Debt 40%
40%

% Equity = 1.0 %
Debt 60%
60%

Capital budget $3,000,000 $2,000,000

Net income (NI) $3,500,000 $3,500,000

Equity needed to support the capital budget


= % Equity Capital budget $1,800,000
$1,200,000

Dividends paid = NI Equity needed if positive


(otherwise, $0.0) $1,700,000 $2,300,000

Increase in dividends paid = $600,000

o Pavlin Corp.'s projected capital budget is $2,000,000, its target capital structure is 40%
debt and 60% equity, and its forecasted net income is $900,000. If the company follows
the residual dividend model, how much dividends will it pay or, alternatively, how much
new stock must it issue?

o $462,983; $244,352

o $487,350; $257,213

o $513,000; $270,750

o $540,000; $285,000

o $ 0; $300,000

ANSWER: e

RATIONALE:
Capital budget $2,000,000

% Equity 60%

Net income (NI) $900,000

Equity required for capital budget = % Equity Capital


budget $1,200,000

Dividends = NI Equity required if > 0


(otherwise, 0) = $0

Required new stock = NI Equity required if < 0


(otherwise, 0) = $300,000

Dividends paid = NI [% Equity(Cap. bud.)], Dividends: or new stock:

stock issued if dividends zero or


neg. $0 $300,000

o Grullon Co. is considering a 7-for-3 stock split. The current stock price is $75.00 per
share, and the firm believes that its total market value would increase by 5% as a result of
the improved liquidity that should follow the split. What is the stock's expected price
following the split?

o $32.06

o $33.75

o $35.44

o $37.21

o $39.07

ANSWER: b

RATIONALE:

Number of new shares 7

Number of old shares 3


Old (pre-split) price $75.00

% Increase in value 5%

New price before value increase = Old price/(New shares/Old


shares) $32.14

New price after value increase = Prior (1 + % Value increase) = $33.75

o Walter Industries is a family owned concern. It has been using the residual dividend
model, but family members who hold a majority of the stock want more cash dividends,
even if that means a slower future growth rate. Neither the net income nor the capital
structure will change during the coming year as a result of a dividend policy change to
the indicated target payout ratio. By how much would the capital budget have to be cut to
enable the firm to achieve the new target dividend payout ratio?

% Debt 35%

% Equity = 1.0 % Debt 65%

Capital budget under the residual dividend model $5,000,000

Net income; it will not change this year even if dividends increase $3,500,000

Equity to support the capital budget = % Equity Capital budget $3,250,000

Dividends paid = NI Equity needed $250,000

Currently projected dividend payout ratio 7.1%

Target dividend payout ratio 70.0%

o $2,741,538

o $3,046,154
o $3,384,615

o $3,723,077

o $4,095,385

ANSWER: c

RATIONALE:

Old New

Net income (NI) $3,500,000 $3,500,000

%
Debt 35%
35%

% Equity = 1.0 %
Debt 65%
65%

New target dividend payout ratio 70%

Target dividend = Target dividend payout


NI $2,450,000

Target retained earnings (RE) = NI


Dividends $1,050,000

Max. capital budget = RE/%


Equity $1,615,385

Check: % Equity Capital budget consistent = Calculated


RE? Yes $1,050,000

New capital budget Old capital budget = $1,615,385 $5,000,000 = $3,384,615


o Sheehan Corp. is forecasting an EPS of $3.00 for the coming year on its 500,000
outstanding shares of stock. Its capital budget is forecasted at $800,000, and it is
committed to maintaining a $2.00 dividend per share. It finances with debt and common
equity, but it wants to avoid issuing any new common stock during the coming year.
Given these constraints, what percentage of the capital budget must be financed with
debt?

o 30.54%

o 32.15%

o 33.84%

o 35.63%

o 37.50%

ANSWER:
RATIONALE:

EPS $3.00

Shares outstanding 500,000

DPS $2.00

Capital budget $800,000

Net income = EPS Shares outstanding $1,500,000

Dividends paid = DPS Shares outstanding $1,000,000

Retained earnings available $500,000

Capital budget Retained earnings = Debt needed $300,000


Debt needed/Capital budget = % Debt financing = 37.5%

o Del Grasso Fruit Company has more positive NPV projects than it can finance under its
current policies without issuing new stock, but its board of directors had decreed that it
cannot issue any new shares in the foreseeable future. Your boss, the CFO, wants to
know how the capital budget would be affected by changes in capital structure policy
and/or the target dividend payout policy. You obtained the following data, which shows
the firm's projected net income (NI), its current capital structure and dividend payout
policies, and three possible new policies. Projected net income for the coming year will
not be affected by a policy change. How much larger could the capital budget be if (1) the
target de ratio were raised to the indicated amount, other things held constant, (2) the
target payout ratio were lowered to the indicated amount, other things held constant, or
(3) the debt ratio and dividend payout were both changed by the indicated amounts?

Current Policy Changes

Policy Increase Debt Lower Payout Do Both

Projected NI $175.0 $175.0 $175.0 $175.0

% Debt 25.0% 75.0% 25.0% 75.0%

% Equity 75.0% 25.0% 75.0% 25.0%

% Payout 65.0% 65.0% 20.0% 20.0%

o $133.0; $ 85.5; $389.6

o $140.0; $ 90.0; $410.1

o $147.4; $ 94.8; $431.7

o $155.2; $ 99.8; $454.4

o $163.3; $105.0; $478.3


ANSWER: e

RATIONALE:

Current New Maximum If New Maximum If New


Maximum If

Found as: Maximum Increase Debt Lower Payout Do Both

NI Given $175.0 $175.0 $175.0 $175

% Debt 25.0% 75.0% 25.0% 75.0

% Equity 75.0% 25.0% 75.0% 25.0

% Payout 65.0% 65.0% 20.0% 20.0

Dividends

Payout % NI $113.8 $113.8 $35.0 $35

Ret. earnings, RE

NI Dividends $61.3 $61.3 $140.0 $140

Max. cap. Budget

RE/% Equity $81.7 $245.0 $186.7 $560

Increase: New max. Current max. = $163.3 $105.0 $478

Percentage increase:

New max./Current max. 1.0 = 200.0% 128.6% 585.7%