DISTRIBUTIONS TO SHAREHOLDERS:

DIVIDENDS AND REPURCHASES

True/False

Easy:

(14.3) Optimal distribution policy FR Answer: a EASY

1. The optimal distribution policy strikes that balance between current
dividends and capital gains that maximizes the firm’s stock price.
a. True

(14.3) Dividend irrelevance FR Answer: b EASY

2. The dividend irrelevance theory, proposed by Miller and Modigliani,
says that provided a firm pays at least some dividends, how much it
pays does not affect either its cost of capital or its stock price.
b. False

3. MM's dividend irrelevance theory says that while dividend policy does
not affect a firm's value, it can affect the cost of capital.
b. False

(14.3) Investors’ dividend preferences FR Answer: a EASY

4. 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.
a. True

(14.3) Dividends and stock prices FR Answer: b EASY

5. 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.
b. False

(14.7) Residual distribution policy FR Answer: a EASY

6. If a firm adopts a residual distribution policy, distributions are
determined as a residual after funding the capital budget.
Therefore, the better the firm's investment opportunities, the lower
its payout ratio should be.
a. True

(14.13) Stock dividends and splits FR Answer: a EASY

7. Stock dividends and stock splits should, at least conceptually, have
the same effect on shareholders’ wealth.
a. True

(14.33) Reverse split FR Answer: a EASY

8. A reverse split reduces the number of shares outstanding.
a. True
Medium:

(14.3) Dividend irrelevance FR Answer: a MEDIUM

9. 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.
a. True

(14.3) Dividend-growth tradeoff FR Answer: a MEDIUM

10. 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.
a. True

(14.5) Signaling hypothesis FR Answer: a MEDIUM

11. If the information content, or signaling, hypothesis is correct, then
changes in dividend policy can have an important effect on the firm’s
value and capital costs.
a. True

(14.7) Residual distribution policy FR Answer: b MEDIUM

12. 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 distribution policy.
b. False

(14.7) WACC and dividend policy FR Answer: b MEDIUM

13. If the shape of the curve depicting a firm's WACC versus its debt
ratio is more like a sharp "V", as opposed to a shallow "U", it will
be easier for the firm to maintain a steady dividend in the face of
varying investment opportunities or earnings from year to year.
b. False

(14.13) Stock splits FR Answer: a MEDIUM

14. Even if a stock split has no information content, and even if the
dividend per share adjusted for the split is not increased, there can
still be a real benefit (i.e., a higher value for shareholders) from
such a split, but any such benefit is probably small.
a. True
Multiple Choice: Conceptual

Easy:
xv. In the real world, dividends
a. are usually more stable than earnings.

xvi. You own 100 shares of Troll Brothers’ stock, which currently sells
for $120 a share. The company is contemplating a 2-for-1 stock
split. Which of the following best describes what your position will
be after such a split takes place?
b. You will have 200 shares of stock, and the stock will trade at or
near $60 a share.

Medium:
xvii. Myron Gordon and John Lintner believe that the required return
on equity increases as the dividend payout ratio is decreased. Their
argument is based on the assumption that
d. investors view dividends as being less risky than potential future
capital gains.

xviii. Which of the following should NOT influence a firm’s dividend

policy decision?
d. The fact that much of the firm’s equipment has been leased rather
than bought and owned.

xix. Which of the following statements about dividend policies is CORRECT?

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

xx. Which of the following would be most likely to lead to a decrease in

a firm’s dividend payout ratio?
c. Its R&D efforts pay off, and it now has more high-return investment
opportunities.

xxi. Trenton Publishing follows a strict residual dividend policy. All

else equal, which of the following factors would be most likely to
lead to an increase in the firm’s dividend per share?
a. The firm’s net income increases.

xxii. If a firm adheres strictly to the residual dividend policy, then if

its optimal capital budget requires the use of all earnings for a
given year (along with new debt according to the optimal debt/total
assets ratio), then the firm should pay
b. no dividends to common stockholders.

xxiii. If a firm adheres strictly to the residual dividend policy, the

issuance of new common stock would suggest that
c. no dividends were paid during the year.

xxiv. Which of the following statements is CORRECT?

c. Stock repurchases can be used by a firm that wants to increase
its debt ratio.
xxv. Which of the following statements is CORRECT?
d. If a company wants to raise new equity capital rather steadily over
time, a new stock dividend reinvestment plan would make sense. However,
if the firm does not want or need new equity, then an open market purchase
dividend reinvestment plan would probably make more sense.

xxvi. Which of the following statements is CORRECT?

d. Large stock repurchases financed by debt tend to increase earnings
per share, but they also increase the firm’s financial risk.

xxvii. Which of the following statements is CORRECT?

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

xxviii. Which of the following statements is CORRECT?

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

xxix. Which of the following statements is CORRECT?

b. 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 follow the strict residual dividend policy.

xxx. Firm M is a mature firm in a mature industry. Its annual net income
and net cash flows are both consistently high and stable. 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 firm 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?
b. Firm M probably has a higher dividend payout ratio than Firm N.

xxxi. Which of the following statements is CORRECT?

e. 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 10-for-1 so
as to bring the price down to something close to $50. Moreover, if
the price is relatively low—say $2 per share—then it can declare a
“reverse split” of say 1-for-25 so as to bring the price up to
somewhere around $50 per share.

xxxii. Which of the following statements is CORRECT?

a. 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.
xxxiii. Which of the following actions will best enable a company to raise
additional equity capital?
e. Begin a new-stock dividend reinvestment plan.

xxxiv. Which of the following statements is NOT CORRECT?

e. Stockholders pay no income tax on dividends if the dividends are
used to purchase stock through a dividend reinvestment plan

Medium/Hard:
xxxv. Which of the following statements is CORRECT?
a. If a firm follows the residual dividend policy, then a sudden
increase in the number of profitable projects is likely to reduce
the firm’s dividend payout.

Multiple Choice: Problems

Easy:
Brammer Corp.'s projected capital budget is $1,000,000, its target
xxxvicapital structure is 60% debt and 40% equity, and its forecasted
. net income is $550,000. If the company follows a residual dividend
policy, what total dividends, if any, will it pay out?
e. $150,000

xxxvii
Blease Inc. has a capital budget of $625,000, and it wants to
. maintain a target capital structure of 60% debt and 40% equity.
The company forecasts a net income of $475,000. If it follows the
residual dividend policy, what is its forecasted dividend payout
ratio?
d. 47.37%

xxxviii
P&D Co. has a capital budget of $1,000,000. The company wants to
. maintain a target capital structure which is 30% debt and 70%
equity. The company forecasts that its net income this year will
be $800,000. If the company follows a residual dividend policy,
what will be its total dividend payment?
a. $100,000

xxxixPate & Co. has a capital budget of $3,000,000. The company wants
. to maintain a target capital structure that is 15% debt and 85%
equity. The company forecasts that its net income this year will
be $3,500,000. If the company follows a residual dividend policy,
what will be its total dividend payment?
c. $950,000

xl D&P Co. has a capital budget of $2,000,000. The company wants to

. maintain a target capital structure that is 35% debt and 65%
equity. The company forecasts that its net income this year will
be $1,800,000. If the company follows a residual dividend policy,
what will be its total dividend payment?
e. $500,000
xli Becker Financial recently completed a 7-for-2 stock split. Prior
. to the split, its stock sold for $90 per share. If the total
market value was unchanged by the split, what was the price of the
stock following the split?
c. $25.71

Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to

the split, its stock sold for $150 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?
a. $50.00

xlii Ting 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 a residual dividend policy, 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?
b. $952,500

xliiiFauver Worldwide forecasts a capital budget of $650,000, and it

. wants to maintain a target capital structure of 40% debt and 60%
equity. It also wants to pay a dividend of $225,000. If the
company follows the residual dividend policy, how much net income
must it earn to meet its capital requirements, pay the dividend,
and keep the capital structure in balance?
b. $615,000

Medium:
xliv Brooks Corp.'s projected capital budget is $2,000,000, its target
. capital structure is 60% debt and 40% equity, and its forecasted
net income is $600,000. If the company follows a residual dividend
policy, what total dividends, if any, will it pay out?
e. $0

D. 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 it
also wants to pay dividends of $500,000. If the company follows the
residual dividend policy, how much income must it earn, and what will
its dividend payout ratio be?

Net Income Payout

a. $898,750 55.63%

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 policy,
what is the maximum capital budget that is consistent with maintaining
the target capital structure?
d. $785,714
Dentaltech Inc. projects the following data for the coming year. If
the firm follows the residual dividend policy and also maintains its
target capital structure, what will its payout ratio be?

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

budget
Interest rate 10% % Debt 40%
Debt outstanding $5,000,000 % Equity 60%
Shares $5,000,000 Tax rate 40%
outstanding
d. 43.3%

Mortal Inc. expects to have a capital budget of $500,000 next year.

xlv 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 policy, how much in
dividends, if any, will it pay?
d. $50,000

xlvi Ross 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?
c. 50.00

xlviiKeys 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?
c. 7.00

Whited Products recently completed a 4-for-1 stock split. Prior to

xlviii
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
caused by the split, what was the stock price following the split?
c. $31.50

Medium/Hard:
(14.7) Residual dividend model--req'd Answer: MEDIUM/HARD
debt ratio CR e
xlix 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?
 e. 37.50%

l. 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 it thinks would follow the split. What is the
stock's expected price following the split?
b. $33.75

li 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 $1,000,000. If the company follows a residual
dividend policy, how much dividends will it pay or, alternatively,
how much new stock must it issue?

Dividends Stock Issued

e. $0 $200,000

Hard:
(14.7) Residual model--divs paid or stock Answer: HARD
issued CR e
lii DeAngelo Corp.'s projected net income is $150.0 million, its target
. capital structure is 25% debt and 75% equity, and its target payout
ratio is 65%. DeAngelo has more positive NPV projects than it can
finance without issuing new stock, but its board of directors had
decreed that it cannot issue any new shares in the foreseeable
future. The CFO now wants to determine how the maximum capital
budget would be affected by changes in capital structure policy
and/or the target dividend payout policy. Versus the current
policy, how much larger could the capital budget be if (1) the
target debt ratio were raised to 75%, other things held constant,
(2) the target payout ratio were lowered to 20%, other things held
constant, and (3) the debt ratio and payout were both changed by
the indicated amounts.

Increase in Capital Budget

Increase Lower
Debt to Payout to Do
75% 20% Both
E $140.0 $90.0 $410.0

liii The following data apply to Grullon-Ikenberry Inc. (GII):

Value of operations $1,000
Short-term investments $100
Debt $300
Number of shares 100
The company plans on distributing $50 million as dividend payments.
What will the intrinsic per share stock price be immediately after
the distribution?

C $7.00
liv The following data apply to Hill's Hiking Equipment:
Value of operations $20,000
Short-term investments $1,000
Debt $6,000
Number of shares 300
The company plans on distributing $50 million by repurchasing stock.
What will the intrinsic per share stock price be immediately after
the repurchase?
B $50.00
1. (14.3) Optimal distribution policy FR Answer: a EASY

2. (14.3) Dividend irrelevance FR Answer: b EASY

3. (14.3) Dividend irrelevance FR Answer: b EASY

4. (14.3) Investors’ dividend preferences FR Answer: a EASY

5. (14.3) Dividends and stock prices FR Answer: b EASY

6. (14.7) Residual distribution policy FR Answer: a EASY

7. (14.13) Stock dividends and splits FR Answer: a EASY

8. (14.13) Reverse split FR Answer: a EASY

9. (14.3) Dividend irrelevance FR Answer: a MEDIUM

10. (14.3) Dividend-growth tradeoff FR Answer: a MEDIUM

11. (14.5) Signaling hypothesis FR Answer: a MEDIUM

12. (14.7) Residual distribution policy FR Answer: b MEDIUM

13. (14.7) WACC and dividend policy FR Answer: b MEDIUM

14. (14.13) Stock splits FR Answer: a MEDIUM

xv. (14.6) Dividend payout CR Answer: a EASY

xvi. (14.13) Stock splits CR Answer: b EASY

xvii. (14.3) Dividends versus capital gains CR Answer: d MEDIUM

xviii. (14.3) Optimal dividend policy CR

Answer: d MEDIUM

xix. (14.5) Dividend theories CR Answer: e MEDIUM

xx. (14.7) Dividend payout CR Answer: c MEDIUM

xxi. (14.7) Residual dividend policy CR Answer: a MEDIUM

xxii. (14.8) Residual dividend policy CR Answer: b MEDIUM

xxiii. (14.8) Residual dividend policy CR

Answer: c MEDIUM

xxiv. (14.10) Stock repurchases and DRIPs CR Answer: c MEDIUM

xxv. (14.10) Dividends, DRIPs, and repurchases CR Answer: d MEDIUM

xxvi. (14.10) Dividend policy and stock repurchases CR Answer: d MEDIUM

xxvii. (14.10) Miscellaneous dividend concepts CR

Answer: c MEDIUM

xxviii. (14.12) Dividend theory CR

 Answer: e MEDIUM

xxix. (14.12) Dividend policy CR Answer: b MEDIUM

xxx. (14.12) Miscellaneous dividend concepts CR Answer: b MEDIUM

xxxi. (14.13) Stock dividends and stock splits CR Answer: e MEDIUM

xxxii. (Comp: 14.9-14.13) Miscellaneous dividend concepts CR

Answer: a MEDIUM

xxxiii. (Comp: 14.9-14.14) Miscellaneous dividend concepts CR

Answer: e MEDIUM

xxxiv. (Comp: 14.13,14.14) Stock repurchases and stock splits CR

Answer: e MEDIUM

xxxv. (14.12) Dividend policy CR Answer: a MEDIUM/HARD

xxxvi.(14.7) Residual model-divs paid, divs always positive CR

Answer: e EASY

Capital budget $1,000,000

% Equity 40%
Net income (NI) $550,000
Dividends paid = NI – [% Equity(Capital budget)] $150,000

xxxvii.(14.7) Residual dividend model--dividend payout ratio CR

Answer: d EASY

Capital budget $625,000

Equity ratio 40%
Net income (NI) $475,000
Dividends paid = NI – (Equity ratio)(Capital budget) $225,000
Dividend payout ratio = Dividends paid/NI 47.37%

xxxviii.(14.7) Residual dividend policy—nonalgorithmic CR

Answer: a EASY

The amount of new investment which must be financed with equity is:
$1,000,000  70% = $700,000.

Since the firm has $800,000 of net income only $100,000 will be left for dividends.

xxxix.(14.7) Residual dividend policy—nonalgorithmic CR

Answer: c EASY

The amount of new investment which must be financed with equity is:
$3,000,000  85% = $2,550,000.

Since the firm has $3,500,000 of net income, $950,000 = $3,500,000 – $2,550,000 will be left for dividends.

xl. (14.7) Residual dividend policy—nonalgorithmic CR Answer: e EASY

The amount of new investment which must be financed with equity is:
 $2,000,000  65% = $1,300,000.

Since the firm has $1,800,000 of net income only $500,000 = $1,800,000 – $1,300,000 will be left for dividends.

xli. (14.13) Stock splits--fractional splits CR Answer: c EASY

Number of new shares 7

Number of old shares 2
Old (pre-split) price $90
New price = Old price × (Old shrs/New shrs) $25.71

xlii. (14.7) Residual dividend model-find net income CR Answer: b EASY/MEDIUM

Capital budget $850,000

Equity ratio 65%
Dividends to be paid $400,000
Required net income = Dividends + (Capital budget  % Equity) $952,500

xliii.(14.7) Residual dividend model-find net income CR

Answer: b EASY/MEDIUM

Capital budget $650,000

% Equity 60%
Dividends to be paid $225,000
Required net income = Dividends + (Capital budget  % Equity) $615,000

xliv. (14.7) Residual model--divs paid, divs are zero CR Answer: e MEDIUM

Capital budget $2,000,000

% Equity 40%
Net income (NI) $600,000
Dividends paid = NI – [% Equity(Capital Budget)] $0

xlv. (14.7) Residual dividend policy;dividend may be zero CRAnswer: d MEDIUM

% Debt 30%
% Debt 70%
Capital budget $500,000
Net income $400,000
Equity requirement = Cap Bud x % Equity = $350,000
Dividends = NI − Equity requirement = $50,000

xlvi. (14.13) Stock splits--reverse split CR Answer: c MEDIUM

Current price $0.50

Target price $25.00
Old shares surrendered per 1 new share = Target price/Old price 50.00

xlvii.(14.13) Stock splits--optimal stock split CR

Answer: c MEDIUM

Current price $175.00

Target price $25.00
No. of new shares per 1 old share = Current price/Target price 7.00
xlviii.(14.13) Stock splits--positive market reaction CR

Answer: c MEDIUM

New shares per 1 old share 4

Pre-split stock price $120
% value increase 5%
Post-split stock price = (P0/New per old)(% Value increase) $31.50

xlix. (14.7) Residual dividend model-req'd debt ratio CR Answer: e MEDIUM/HARD

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%

l. (14.13) Stock splits--positive market reaction CR Answer: b MEDIUM/HARD

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/(Old shares/New shares) $32.14
New price after value increase = Prior  (1 + % Value increase) $33.75

li. (14.7) Residual model-divs paid or stock issued CR Answer: e MEDIUM/HARD

Capital budget $2,000,000

% Equity 60%
Net income (NI) $1,000,000
Dividends: or new stock:
Dividends paid = NI − [% Equity(Cap. Bud)], stock issued if dividends zero or neg $0 $200,000

lii. (14.7) Residual model--divs paid or stock issued CR Answer: e HARD

New Maximums:
Current If increase If lower If do
maximum debt payout both
NI $150.0 $150.0 $150.0 $150.0
%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%
Dividends $97.5 $97.5 $30.0 $30.0
Retained earnings $52.5 $52.5 $120.0 $120.0
Max. capital budget = RE/%Equity $70.0 $210.0 $160.0 $480.0
Increase over current: Changed amt − Current max. NA $140.0 $90.0 $410.0

liii. (14.10) Dividends and intrinsic stock price CR Answer: c HARD

Prior to After
Distribution Distribution
Value of operations $1,000.00 $1,000.00
+ Value of nonoperating assets 100.00 0.00
Total intrinsic value of firm $1,100.00 $1,000.00
− Debt 300.00 300.00
Intrinsic value of equity $800.00 $700.00
÷ Number of shares 100.00 100.00
Intrinsic price per share $8.00 $7.00

liv. (14.10) Repurchases and intrinsic stock price CR Answer: b HARD

Prior to After
Distribution Distribution
Value of operations $20,000 $20,000
+ Value of nonoperating assets $1,000 $0
Total intrinsic value of firm $21,000 $20,000
− Debt $6,000 $6,000
Intrinsic value of equity $15,000 $14,000
÷ Number of shares 300 280
Intrinsic price per share $50.00 $50.00
 # shares repurchased =
Value of nonoperating assets /
Price prior to distribution $20.00