Question 1

A company is most apt to repurchase stock rather than pay out dividends when the firm:

Accepted Answer

Repurchasing stock allows a company to return cash to shareholders without committing to regular future payments, unlike dividends which suggest a recurring commitment.

Question 2

If the total assets of a firm are unaffected by a stock dividend, then:

Accepted Answer

Stock dividends distribute additional shares to shareholders, not cash, so the total value of an investor's holdings doesn't change, just the number of shares they own. This action doesn't directly affect the firm's total assets or the investor's wealth.

Question 3

You purchased a stock today. What should you expect if the stock goes ex-dividend tomorrow?

Accepted Answer

When a stock goes ex-dividend, it means that anyone who buys the stock after that date will not be eligible to receive the next dividend payment. Therefore, the stock price typically declines by the amount of the dividend payment to reflect this change in eligibility.

Question 4

How much should an investor pay now for a stock expected to sell for $30 one year from now if the stock offers a $2 dividend, dividends are taxed at 40%, capital gains are taxed at 20%, and a 15% after-tax return is expected on the investment?

Accepted Answer

0.15 = [$2 × (1 - 0.40)]/P₀ + [($30 - P₀)/P₀](1 - 0.20); P₀ = $26.53

Question 5

Which one of these parties is most apt to prefer a stock with a low-dividend payout policy?

Accepted Answer

Growth-seeking investors typically prefer companies that reinvest their earnings into the business rather than paying out dividends, as they believe this leads to greater long-term growth potential. Therefore, they tend to prefer stocks with a low-dividend payout policy.

Question 6

An increase in share price following an increase in dividends is logical if the:

Accepted Answer

An increase in dividends can signal higher future earnings for the company, which can increase investor confidence and lead to a rise in share price. However, the other options do not necessarily lead to a logical increase in share price. Borrowing to obtain cash for the dividend can be viewed negatively by investors, and a temporary dividend may not have a lasting impact on the company's financial health. The clientele effect, which refers to the tendency of certain types of investors to prefer stocks with certain dividend characteristics, may also play a role in share price changes but is not mentioned in the question.

Question 7

Why are dividend changes rather than the absolute level of dividends perceived to be more important to managers and shareholders?

Accepted Answer

Dividend changes are perceived to be more important than the absolute level of dividends because they are thought to signal future expectations. Changes in the dividend payout ratio can indicate a shift in the company's financial performance, strategy, or outlook. Managers and shareholders use this information to make decisions about investments, and to determine the company's overall financial health. MM's argument that the absolute level of dividends is irrelevant supports this idea, as the focus should be on the signals provided by dividend changes rather than on the level of dividends themselves.

Question 8

What effect does a stock dividend have on the book and market values of the firm?

Accepted Answer

A stock dividend redistributes a company's retained earnings to its shareholders in the form of additional shares, rather than cash. This action increases the number of shares outstanding but does not change the total value of the company's equity. Therefore, both the book value and market value of the firm remain constant immediately following the dividend, as the value is merely divided among a larger number of shares.

Question 9

MM's proposition of dividend irrelevance depends upon:

Accepted Answer

MM's proposition of dividend irrelevance is based on the efficiency of capital markets, specifically the assumption that investors have access to the same information and can buy and sell stocks at fair prices. Therefore, the value of a firm should not be affected by its dividend policy, as the market will account for the expected future cash flows whether they are paid out as dividends or reinvested back into the company. The other choices (A, B, C) are not necessarily required for MM's proposition to hold.

Question 10

Which one of the following signals is most likely to elicit a decrease in share price?

Accepted Answer

A decrease in the regular quarterly dividend is most likely to elicit a decrease in share price, as shareholders may interpret this as a sign of financial distress or weak performance.

Question 11

An investor owns 300 shares of stock currently selling for $70 per share. After a 3-for-2 stock split, the investor will have:

Accepted Answer

New shares = 300 × 3/2 = 450 sharesNew price = $70 × 2/3 = $46.67

Question 12

A firm has $250,000 to spend on either a one-time special dividend or on a share repurchase program. If the share repurchase is selected, then the firm's:

Accepted Answer

When a firm spends money on either a special dividend or a share repurchase, the value of the firm decreases by the amount spent. This is because the firm is distributing cash to shareholders, reducing the firm's assets by the amount of the distribution, whether it's through a dividend or a share repurchase.

Question 13

After the payment of a 25% stock dividend, an investor has 500 shares of stock and $400 cash. What did the investor have prior to the stock dividend?

Accepted Answer

Old shares = 500/(1 + 0.25) = 400 shares

Question 14

Compare the after-tax returns for a corporation that invests in preferred stock with a 12% dividend versus a common stock with no dividend but a 16% capital gain. The corporation's tax rate is 35%. The:

Accepted Answer

After-tax returns:R_P = 0.12 - (0.12 × 0.30 × 0.35) = 0.1074, or 10.74%R_C = 0.16(1 - 0.35) = 0.1040, or 10.40%Difference = 10.74% - 10.40 = 0.34%

Question 15

Which statement is true concerning the one-year after-tax return on the following stocks, assuming a 40% tax rate on dividends and a 20% tax rate on capital gains: Stock A is purchased for $50, offers a 5% dividend yield, and is sold for $56; stock B is purchased for $60, offers no dividend yield, but is sold after one year for $70.

Accepted Answer

R_A = [0.05 × $50 × (1 - 0.40)]/$50 + [($56 - 50)/$50](1 - 0.20) = 0.1260, or 12.60%R_B = [($70 - 60)/$60](1 - 0.20) = 0.1333, or 13.33%Difference = 13.33% - 12.60 = 0.73%

Question 16

Why may a large increase in earnings not translate into a large increase in dividends?

Accepted Answer

Managers may wish to assess the persistence of increased earnings before deciding to increase dividends. This means they need to evaluate whether the increase in earnings is a temporary or a long-term trend before deciding to distribute the earnings to shareholders. Therefore, there may not be an immediate correlation between a large increase in earnings and a large increase in dividends.

Question 17

Automatic dividend reinvestment plans allow firms to:

Accepted Answer

Automatic dividend reinvestment plans allow firms to reduce their cash outflow to shareholders by automatically reinvesting the dividends into additional company shares instead of paying out the cash dividend to shareholders. This can help the company retain more cash for other purposes such as investments, debt reduction, or operations.

Question 18

Capital gains may be preferred by investors over dividends even if dividends and capital gains are taxed at the same rate because:

Accepted Answer

One advantage of capital gains over dividends is that taxes on capital gains can be timed. Investors can choose when to sell the asset that has appreciated in value, which allows them to defer the tax liability until a later date. This can be beneficial for investors who may be in a lower tax bracket in the future or who have other offsetting capital losses to reduce their tax liability.

Question 19

With respect to the dividend-payment process, the price of a share of stock can logically be expected to drop on:

Accepted Answer

The ex-dividend date is the first day that a stock trades without its dividend, meaning anyone who purchases the stock on or after this date will not receive the upcoming dividend payment. As a result, the stock price typically drops by the amount of the dividend on the ex-dividend date.

Question 20

Based on the dividend growth model, the price of a stock will remain constant if the dividend is cut, provided that the:

Accepted Answer

The dividend growth model (Gordon Growth Model) calculates the price of a stock by dividing the dividend per share by the difference between the required rate of return and the dividend growth rate. If the dividend is cut but the growth rate increases proportionately, the price of the stock remains constant because the expected future dividends, growing at a faster rate, compensate for the initial lower dividend.

Quiz 17: Payout Policy