Question 1

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

Accepted Answer

If a firm's R&D efforts pay off and it now has more high-return investment opportunities, it may choose to invest more in these opportunities rather than pay out dividends. This would lead to a decrease in the firm's dividend payout ratio. Option A, B, and D do not relate to the firm's dividend payout ratio. Option E does not provide enough information to determine its impact on the firm's dividend payout ratio.

Question 2

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.

Accepted Answer

If investors prefer firms that retain most of their earnings, then the firm should set a low payout ratio to signal to investors that it plans to reinvest its earnings into future growth opportunities. By retaining more earnings, the firm can potentially generate higher future earnings, which in turn should lead to a higher stock price.

Question 3

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.

Accepted Answer

A sharp "V" shape indicates that the firm's WACC (Weighted Average Cost of Capital) increases rapidly with debt, suggesting higher financial risk and less flexibility in maintaining steady dividends through varying conditions.

Question 4

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.

Accepted Answer

While a stock split may not provide any informational advantage or increase in dividend per share, it can increase the liquidity of the stock and make it more affordable for individual investors to buy, potentially increasing demand and driving up the stock price. However, any resulting benefit is likely to be small.

Question 5

In the real world, dividends

Accepted Answer

Dividends are typically more stable than earnings because companies strive to maintain a consistent dividend payout to signal financial health and stability to investors, even when earnings may fluctuate due to various factors.

Question 6

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.

Accepted Answer

According to the bird-in-the-hand theory, investors prefer current dividends over potential capital gains, so reducing the dividend yield will likely lower the stock price and increase the required return. To keep the required return constant, the firm must increase growth by more than the reduction in dividend yield.

Question 7

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

Accepted Answer

MM's dividend irrelevance theory posits that dividend policy does not affect a firm's value or its cost of capital. According to this theory, the value of a firm is determined by its earning power and investment policy, not by how it distributes its earnings.

Question 8

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.

Accepted Answer

The dividend irrelevance theory, proposed by Modigliani and Miller, suggests that a firm's dividend policy has no effect on its stock price or its cost of capital. Therefore, adhering to a residual distribution policy is not a requirement under this theory, as the theory posits that how dividends are paid or whether they are paid at all does not impact the firm's value.

Question 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.

Accepted Answer

Miller and Modigliani argued that dividend payments do not affect the value of the firm, as the value of the firm is based on its earning power and risk.

Question 10

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

Accepted Answer

The optimal distribution policy for a firm is one that balances the need for current dividends to satisfy investors' desire for income with the potential for capital gains from reinvesting profits back into the company. This policy ultimately maximizes the firm's stock price.

Question 11

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.

Accepted Answer

This is because if the firm has better investment opportunities, it should prioritize investing in those opportunities rather than paying out dividends. This would result in a lower payout ratio as the dividend payout would be determined based on the leftover residual funds after investing in profitable projects.

Question 12

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

Accepted Answer

Gordon and Lintner's argument is based on the assumption that investors view dividends as being less risky than potential future capital gains, which leads to the belief that the required return on equity increases as the dividend payout ratio is decreased.

Question 13

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?

Accepted Answer

Trenton Publishing's strict residual dividend policy means that the company pays out a dividend based on its net income. Therefore, an increase in net income (option A) would provide the company with more funds to distribute as dividends, leading to an increase in dividend per share. The other options do not directly impact the amount of net income available for distribution as dividends.

Question 14

Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders' wealth.

Accepted Answer

Both stock dividends and stock splits increase the number of shares a shareholder holds while decreasing the price per share. This means that the total value of the shareholder's investment remains the same, and they do not gain or lose any wealth.

Question 15

A reverse split reduces the number of shares outstanding.

Accepted Answer

A reverse split reduces the number of shares outstanding by consolidating multiple existing shares into a single new share. For example, in a 1-for-10 reverse split, a shareholder owning 10 shares would have his or her shares consolidated into one new share. This results in a reduction in the total number of shares outstanding.

Question 16

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.

Accepted Answer

According to Modigliani and Miller's dividend irrelevance theory, the announcement of an increase in the cash dividend should not affect the price of the firm's stock because investors are indifferent to whether they receive dividends or capital gains.

Question 17

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?

Accepted Answer

After the stock split, you will have 200 shares of stock (2 times the original amount). However, the stock price will be adjusted to reflect the split, so the new price per share will be around $60 ($120 divided by 2). Therefore, your position will be 200 shares of stock trading at around $60 per share.

Question 18

Which of the following should NOT influence a firm's dividend policy decision?

Accepted Answer

The fact that much of the firm's equipment has been leased rather than bought and owned should not influence a firm's dividend policy decision. The decision about equipment leases is separate from the decision about dividend policy.

Question 19

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.

Accepted Answer

The dividend irrelevance theory, proposed by Miller and Modigliani, says that in perfect markets, the value of a firm is determined solely by its investment policy and is independent of its dividend policy. However, in real-world imperfect markets, dividend policy can have an impact on a firm's cost of capital and stock price, particularly for investors who rely on dividends for income. Therefore, the statement that how much a firm pays in dividends does not affect its cost of capital or stock price is not entirely true.

Question 20

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.

Accepted Answer

The information content hypothesis suggests that changes in dividend policy can signal important information about a firm's future prospects and financial health. If investors view the change in dividend policy as a positive signal, the firm's value could increase and its capital costs could decrease. Conversely, if investors view the change in dividend policy as a negative signal, the firm's value could decrease and its capital costs could increase. Therefore, changes in dividend policy can have an important effect on a firm's value and capital costs if the information content hypothesis is correct.

Quiz 14: Distributions to Shareholders: Dividends and Repurchases