Question 1

A "reverse split" reduces the number of shares outstanding.

Accepted Answer

In a reverse split, the number of shares outstanding is reduced, and the value of each share increases proportionally.

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

Investors who prefer firms that retain most of their earnings likely do so because retained earnings can be reinvested into the company for growth, potentially leading to a higher stock price in the future. Therefore, a firm aiming to maximize its stock price should cater to these investors by setting a low payout ratio, which means retaining more earnings within the company.

Question 3

If a retired individual lives on his or her investment income,then it would make sense for this person to prefer stocks with high payouts so he or she could receive cash without going to the trouble and expense of selling stocks.On the other hand,it would make sense for an individual who would just reinvest any dividends received to prefer a low-payout company because that would save him or her taxes and brokerage costs.

Accepted Answer

This statement correctly explains the preference of retirees and investors who want to reinvest dividends.

Question 4

Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends has no effect on either its cost of capital or its stock price.

Accepted Answer

Miller and Modigliani's theory states that in a perfect market, dividend policy does not affect a firm's stock price, as investors can create their own dividend by selling some of their shares. Therefore, the percentage of earnings a firm pays out in dividends does not affect its cost of capital or stock price.

Question 5

Suppose a firm that has been earning $2 and paying a dividend of $1.00,or a 50% dividend payout,announces that it is increasing the dividend to $1.50.The stock price then jumps from $20 to $30.Some people would argue that this is proof that investors prefer dividends to retained earnings.Miller and Modigliani would agree with this argument.

Accepted Answer

Miller and Modigliani's dividend irrelevance theory states that the value of the firm is not affected by its dividend policy. The increase in stock price may be due to other factors such as an increase in earnings or market speculation.

Question 6

If a firm uses the residual dividend model to set dividend policy,then dividends are determined as a residual after providing for the equity required to fund the capital budget.Under this model,the better the firm's investment opportunities,the lower its payout ratio will be,other things held constant.

Accepted Answer

In the residual dividend model, the dividend payout is determined after meeting the equity funding requirements of the firm's capital budget. Therefore, if the firm has better investment opportunities, it is likely to retain more earnings and pay out a lower dividend, resulting in a lower payout ratio.

Question 7

Some investors prefer dividends to retained earnings (and the capital gains retained earnings bring),while others prefer retained earnings to dividends.Other things held constant,it makes sense for a company to establish its dividend policy and stick to it,and then it will attract a clientele of investors who like that policy.

Accepted Answer

This statement is true. Establishing a dividend policy and sticking to it can help a company attract investors who prefer that policy, whether it be a focus on dividends or retained earnings. This can help create a stable investor base over time.

Question 8

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

The bird-in-the-hand theory of dividends suggests that investors prefer to receive dividends now rather than wait for potential future gains, so a reduction in dividend yield would be viewed negatively by investors. To maintain the same required return, the firm would need to increase its growth rate by more than the amount of the reduction in dividend yield.

Question 9

It has been argued that investors prefer high-payout companies because dividends are more certain (less risky)than the capital gains that are supposed to come from retained earnings.However,Miller and Modigliani say that this argument is incorrect,and they call it the "bird-in-the-hand fallacy." MM base their argument on the belief that most dividends are reinvested in stocks,hence are exposed to the same risks as reinvested earnings.

Accepted Answer

Miller and Modigliani argue that the belief that dividends are less risky than retained earnings is incorrect because most dividends are reinvested in stocks, which are exposed to the same risks as reinvested earnings. Therefore, investors do not have a "bird in the hand" with dividends and they are not necessarily less risky than capital gains from retained earnings.

Question 10

Other things held constant,the higher a firm's target payout ratio,the higher its expected growth rate should be.

Accepted Answer

The higher a firm's target payout ratio, the lower its expected growth rate should be, as the firm would have less funds available to reinvest in its business.

Question 11

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 dividend 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 dividend policy is not a requirement under this theory, as dividend payments are considered irrelevant to the firm's value.

Question 12

If a firm uses the residual dividend model to set dividend policy,then dividends are determined as a residual after providing for the equity required to fund the capital budget.Under this model,the higher the firm's debt ratio,the lower its payout ratio will be,other things held constant.

Accepted Answer

Under the residual dividend model, dividends are determined after funding the capital budget, but the firm's debt ratio primarily affects how much equity is needed, not directly the payout ratio. The payout ratio is more directly influenced by the firm's investment opportunities and profitability, not its debt ratio.

Question 13

The federal government sometimes taxes dividends and capital gains at different rates.Other things held constant,an increase in the tax rate on dividends relative to that on capital gains would logically lead to an increase in dividend payout ratios.

Accepted Answer

An increase in the tax rate on dividends relative to that on capital gains would lead to a decrease in the after-tax dividend yield, which would disincentivize firms from paying out dividends and instead encourage them to retain earnings or use them to repurchase shares. Therefore, it would likely lead to a decrease in dividend payout ratios.

Question 14

If the information content,or signaling,hypothesis is correct,then a change in a firm's dividend policy can have an important effect on its stock price and cost of equity.

Accepted Answer

According to the information content or signaling hypothesis, the change in the firm's dividend policy can act as a signal to investors about the firm's future prospects, which can affect its stock price and cost of equity. Therefore, A is the correct answer.

Question 15

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,other things held constant.

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, as they argue that dividend policy is irrelevant to stock value, assuming perfect capital markets, no taxes, and no transaction costs.

Question 16

Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends has no effect on its cost of capital,but it does affect its stock price.

Accepted Answer

Miller and Modigliani's dividend irrelevance theory posits that the dividend policy of a company has no effect on its stock price or its cost of capital, assuming perfect capital markets, no taxes, and no transaction costs.

Question 17

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's dividend irrelevance theory states that the value of the firm is determined only by its basic earning power and its business risk, and not by its dividend policy.

Question 18

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 is designed to balance current dividends and capital gains in a way that maximizes the firm's stock price.

Question 19

A 100% stock dividend and a 2:1 stock split should,at least conceptually,have the same effect on the firm's stock price.

Accepted Answer

Both a 100% stock dividend and a 2:1 stock split increase the number of shares outstanding while maintaining the same total value of the company. This means that the stock price should theoretically decrease by the same percentage as the increase in shares, resulting in the same overall value for existing shareholders. Therefore, the two actions should have the same effect on the firm's stock price.

Question 20

The federal government sometimes taxes dividends and capital gains at different rates.Other things held constant,if the tax rate on dividends is high relative to that on capital gains,then individuals with low taxable incomes should favor stocks with low payouts and high-income individuals should favor high-payout companies.

Accepted Answer

The statement is reversed; individuals with high taxable incomes, who are more affected by higher dividend tax rates, would prefer stocks with low payouts (to minimize taxable income from dividends), while those with lower taxable incomes might favor high-payout companies due to their lower relative tax burden.

Quiz 15: Distributions to Shareholders: Dividends and Share Repurchases