Question 1

Suppose Firm XYZ paid a dividend of $1 per share last year, and this year's earnings per share was $3.The firm's target payout ratio is $\pi$ =0.50, and the value of the firm's speed of adjustment parameter is $\rho$ =0.3.What is the firm's expected dividend for this year?

A)0.85
B)1.00
C)1.15
D)1.30

1.15

Accepted Answer

The expected dividend is calculated using the formula: Expected Dividend = Last Year's Dividend + $\rho$ * (Target Dividend - Last Year's Dividend). The target dividend is $\pi$ * Earnings per Share = 0.50 * $3 = $1.50. Therefore, Expected Dividend = $1 + 0.3 * ($1.50 - $1) = $1.15.

Question 2

Which of the following correctly describes the Dutch auction method of share repurchase?&#10;A)The firm conducts open-market purchases.&#10;B)The firm specifies a price and a quantity of shares that it will repurchase.&#10;C)The firm auctions shares to the highest bidder, as long as that bidder meets the firm's reservation price.&#10;D)The firm establishes an acceptable range of prices, solicits and collects sell offers, calculates the average price of these offers, and this average price is applied to all tendered shares.

Accepted Answer

In a Dutch auction share repurchase, the firm sets a price range and shareholders submit offers to sell their shares at specific prices within that range. The firm then determines the lowest price at which it can buy the desired number of shares, and all shareholders who tendered at or below this price receive the same price.

Question 3

The dollar value of aggregate share repurchases has grown relative to aggregate dividends in recent years.

Accepted Answer

This trend reflects companies increasingly opting to return value to shareholders through buybacks rather than dividends, as repurchases can be more flexible and tax-efficient.

Question 4

Under what circumstances would a firm engage in share repurchases rather than increasing dividends?&#10;A)If the firm has excess free cash flow that management expects will continue indefinitely.&#10;B)If the firm has excess free cash flow that management expects will be only temporary.&#10;C)If shareholders are in a lower tax bracket for dividends than for realized capital gains.

Accepted Answer

Share repurchases are often used when a company has excess cash that it believes is not going to be a permanent situation. By buying back shares, the company can return value to shareholders in a flexible manner, without committing to the ongoing obligation of higher dividends that might be unsustainable in the long term.

Question 5

How does Jensen's free cash flow hypothesis relate to a firm's dividend policy?&#10;A)Dividends discipline management by forcing free cash flow to be disgorged to shareholders, thus mitigating management's tendency to engage in empire building.&#10;B)Dividends act as a signal of firm value.&#10;C)Dividends solve the principal-agent problem between shareholders and creditors.&#10;D)Dividends solve the underinvestment problem.

Accepted Answer

Jensen's free cash flow hypothesis suggests that dividends help discipline management by requiring them to return excess cash to shareholders, which can reduce the likelihood of management spending on projects that do not maximize shareholder value (often referred to as empire building). This is because when firms generate more cash than what is necessary for efficient operations and investments, management might be tempted to invest in suboptimal projects. By paying out dividends, the firm reduces the free cash flow available for such potentially wasteful expenditures.

Deck 14: Dividend Policy and Stock Repurchases