Question 1

The Rent It Company declared a dividend of $.60 a share on October 20^th to holders of record on Monday, November 1^st. The dividend is payable on December 1^st. You purchased 100 shares of Rent It Company stock on Wednesday, October 27^th. How much dividend income will you receive on December 1^st from the Rent It Company?

Accepted Answer

Since you purchased the shares before the record date (November 1st), you are entitled to the dividend. With 100 shares and a dividend of $.60 per share, the total dividend income is 100 * $.60 = $60.00.

Question 2

A corporation has cash flow in excess of investment needs and normal dividend payments. The corporation is considering two alternative uses of the excess funds. In Alternative 1, the corporation increases current dividends. In Alternative 2, the corporation makes a three-year loan and uses the loan proceeds to pay dividends at the end of three years. The following information may be used in choosing between the alternatives. Stockholders can earn 5% after taxes on their investments. The corporate tax rate is 30%. Stockholders currently have a 20% tax rate and will have a 25% tax rate next year. At what pretax return on the loan are stockholders indifferent between the alternatives?

Accepted Answer

To find the pretax return on the loan at which stockholders are indifferent between the two alternatives, we need to compare the after-tax return to the stockholders in both scenarios. For Alternative 1 (increasing current dividends), the after-tax return to stockholders is straightforward. They receive the dividends now and pay taxes at their current rate of 20%. For Alternative 2 (making a loan and paying dividends after three years), we need to calculate the effective after-tax return, taking into account the corporate tax rate, the future personal tax rate, and the fact that the investment return needs to be pretax. Let's denote the required pretax return on the loan as $R$. The corporation pays taxes on this return at a rate of 30%, so the after-tax return is $R \times (1 - 0.30)$. This after-tax return is then distributed to stockholders after three years, who will pay taxes on it at a rate of 25%. The stockholders are indifferent when the after-tax value of the dividends in both alternatives is the same. In Alternative 1, for every $1 of dividend, the after-tax value today is $0.80 (since $1 \times (1 - 0.20) = $0.80). For Alternative 2, the after-tax value of the dividends in three years, for every $1 of dividend paid out of the loan proceeds, is calculated as follows:$$1 \times R \times (1 - 0.30) \times (1 - 0.25)$$Since stockholders can earn 5% after taxes on their investments, the equivalent value today of receiving this after-tax amount in three years is found by discounting it at the stockholders' after-tax rate of return (5%). Setting the present value of the after-tax return from Alternative 2 equal to the after-tax return from Alternative 1 gives us the equation to solve for $R$. However, the calculation of $R$ directly from the given information involves understanding that the indifference point requires equating the present value of the after-tax proceeds from the loan to the immediate after-tax dividends.Given the complexity of deriving $R$ directly without the specific steps or the formula used in the calculation, it's acknowledged that the correct answer involves understanding the tax implications and the time value of money. The correct pretax return on the loan that makes stockholders indifferent is 10.4%, but the explanation provided here is simplified and does not detail the mathematical derivation, which involves equating the present value of the after-tax proceeds from the loan to the immediate after-tax dividends, considering the corporate and personal tax rates, and the time value of money.

Question 3

An open market purchase is:

Accepted Answer

An open market purchase refers to the process where a company buys back its own shares from the open market, just like any other buyer, without any specific arrangements with sellers. This is a common method for companies to return value to shareholders and reduce the number of shares outstanding.

Question 4

Although dividend payments reduce the total firm funds to pay bondholders the payment of dividends can reduce agency costs by:

Accepted Answer

Paying dividends reduces the free cash flow available to managers, which can limit their ability to spend on non-value adding activities (perquisite consumption), thus reducing agency costs.

Question 5

The observed empirical fact that stocks attract particular investors based on the firm's dividend policy and the resulting tax impact on investors is called the:

Accepted Answer

The clientele effect refers to the phenomenon where stocks attract particular investors based on the firm's dividend policy and the resulting tax implications for investors. Different investors have different preferences for dividend policies due to their tax situations, leading them to gravitate towards companies whose dividend policies match their preferences.

Question 6

Consider two corporations, G and H, that have exactly the same risk. They both have a current stock price of $60. Corporation G pays no dividend and will have a price of $66 one year from now. Corporation H pays dividends and will have a price of $63 one year from now after payment of a dividend. Corporations pay no income taxes. Investors pay no taxes on capital gains, but they pay a 30% income tax on dividends. What is the value of the dividend that investors expect Corporation G to pay?

Accepted Answer

Given that both corporations have the same risk and investors are indifferent between investing in either corporation, the after-tax return must be the same for both. Corporation G's stock price will increase from $60 to $66, a gain of $6. To find the equivalent after-tax return for Corporation H, we need to account for the dividend and the increase in stock price from $60 to $63. Let D be the dividend paid by Corporation H. The after-tax value of the dividend is D*(1-0.30) = 0.7D. The total after-tax return for an investor in Corporation H is $3 (from the increase in stock price) + 0.7D (the after-tax value of the dividend). This total return should equal the $6 gain from Corporation G for the investments to be equivalent. Therefore, $3 + 0.7D = $6, solving for D gives D = $4.29.

Question 7

Dividends are relevant and dividend policy irrelevant when:

Accepted Answer

CDividends are considered relevant when they impact the firm's value, which happens when there's a trade-off between dividends at different dates, as it affects investors' preferences and investment decisions. Both choices B and C describe scenarios where dividend policy establishes this trade-off, making dividends relevant in these contexts.

Question 8

A firm has a market value equal to its book value. Currently, the firm has excess cash of $600 and other assets of $5,400. Equity is worth $6,000. The firm has 500 shares of stock outstanding and net income of $900. What will the new earnings per share be if the firm uses its excess cash to complete a stock repurchase?

Accepted Answer

The answer of A firm has a market value equal...

Question 9

An investor is more likely to prefer a high dividend payout if a firm:

Accepted Answer

If a firm has few, if any, positive net present value projects, it means that it may not be investing in profitable opportunities to grow the business. In this case, the investor may prefer a high dividend payout as it provides a steady stream of income. Other options provided do not necessarily make a high dividend payout more attractive to an investor.

Question 10

If stockholders care about taxes, then stocks should attract clienteles based on dividend yields. Surveys support this by showing that the highest dividend yield stocks are held by investors in the:

Accepted Answer

Investors in the lowest tax bracket are more likely to hold the highest dividend yield stocks because they face lower tax liabilities on dividend income compared to investors in higher tax brackets. This aligns with the clientele effect theory, suggesting that investors choose stocks that best fit their tax situation.

Question 11

All else equal, the market value of a stock will tend to decrease by roughly the amount of the dividend on the:

Accepted Answer

The market value of a stock tends to decrease by approximately the amount of the dividend on the ex-dividend date because this is the date on which a new buyer of the stock is no longer entitled to receive the dividend that has been declared. This adjustment reflects the fact that the dividend value is now going to be paid out to the seller rather than the buyer.

Question 12

If both dividends and capital gains are currently taxed at the same ordinary income tax rate, the effect of the tax is different because:

Accepted Answer

Dividends are taxed in the year they are received, whereas capital gains taxes are deferred until the asset (e.g., stock) is sold, potentially allowing for tax planning and deferral benefits.

Question 13

Which of the following statements is not true?

Accepted Answer

Dividend payments are distributions of earnings to shareholders and represent a cash outflow for the firm, but they are not considered costs in the traditional sense of operating expenses. Capital gains, on the other hand, do not represent a direct cost to the firm; they are realized by the shareholders when they sell their shares at a higher price than they purchased them. The statement incorrectly categorizes dividend payments as costs to the firm in the same manner as operational costs.

Question 14

Murphy's, Inc. has 10,000 shares of stock outstanding with a par value of $1.00 per share. The market value is $8 per share. The balance sheet shows $32,500 in the capital in excess of par account, $10,000 in the common stock account, and $42,700 in the retained earnings account. The firm just announced a 10% (small) stock dividend. What will the balance in the retained earnings account be after the dividend?

Accepted Answer

The firm is distributing a 10% stock dividend on 10,000 shares, which equals 1,000 new shares. Since the market value is $8 per share, the total value of the dividend is $8,000. However, for accounting purposes, stock dividends are recorded at par value in the common stock account and the excess in the capital in excess of par account. With a par value of $1.00 per share, the common stock account increases by $1,000 (1,000 shares * $1.00), and the capital in excess of par increases by $0 since the calculation is based on par value for a stock dividend. Therefore, the retained earnings account decreases by the total value of the dividend at market price, which is $8,000, resulting in a new balance of $34,700 ($42,700 - $8,000).

Question 15

A firm announces that it is willing to purchase a number of shares back at various prices and shareholders have the option to indicate how many shares they are willing to sell at various prices. This process is called a:

Accepted Answer

This process is called a Dutch auction. In a Dutch auction for share repurchases, the company announces it wants to buy back shares and asks shareholders at what price they are willing to sell their shares. The company then determines the lowest price at which it can buy back the desired amount of shares. This method allows the company to efficiently repurchase shares by paying a fair market price determined through shareholder bids.

Question 16

You own 300 shares of Abco, Inc. stock. The company has stated that it plans on issuing a dividend of $.60 a share one year from today and then issuing a final liquidating dividend of $2.20 a share two years from today. Your required rate of return is 9%. Ignoring taxes, what is the value of one share of this stock today?

Accepted Answer

The answer of You own 300 shares of Abco, Inc....

Question 17

The increase in the stock price after a dividend increase is called the information content effect because:

Accepted Answer

The information content effect refers to the market's reaction to a dividend increase as a positive signal about the company's future earnings prospects. When a company increases its dividend, it often signals to investors that the management is confident about the company's future earnings and financial health, leading investors to adjust their expectations of future earnings upward.

Question 18

For a firm to develop a sensible, useful dividend policy, the three things that should be considered are:

Accepted Answer

Dividends should not be paid if there are positive NPV projects available, as investing in these projects is expected to create more value for shareholders. Issuing stock to pay dividends is generally not advisable as it can dilute existing shareholders' value. Repurchasing shares with surplus cash is a good option if there are no positive NPV projects, as it can return value to shareholders and signal confidence in the company's future prospects.

Question 19

If dividends are taxed at higher rates than are capital gains, then high dividend payout stocks should sell at lower prices, everything else equal, compared to low dividend paying stocks. One implication of this is that investors in _____ tax brackets will tend to prefer high dividend payout stocks.

Accepted Answer

Investors in zero tax brackets would prefer high dividend payout stocks because they are not affected by the higher tax rates on dividends, unlike investors in higher tax brackets.

Question 20

Investing in preferred stock in other companies might be an attractive use of the firm's cash because:

Accepted Answer

Preferred stock often comes with tax advantages for corporate investors. Specifically, the dividends received deduction (DRD) allows corporations to exclude a portion of the dividends received from their taxable income, making preferred stock an attractive investment option.

Quiz 19: Dividends and Other Payouts