Question 1

The rightist position is that the market will reward firms for having

Accepted Answer

The answer of The rightist position is that the market...

Question 2

A key assumption of the Miller and Modigliani (MM)dividend irrelevance argument is that

Accepted Answer

The Miller and Modigliani dividend irrelevance theory assumes that new shares are sold at a fair price, among other assumptions, implying that the financing decisions (like dividend payments) do not affect the firm's value in a perfect market.

Question 3

According to behavioral finance, investors prefer dividends because

Accepted Answer

According to behavioral finance, investors prefer dividends because they prefer the discipline that comes from spending only the dividends. This is because dividends are seen as a tangible reward for holding onto a stock, and by spending only the dividends, investors can avoid making impulsive decisions with their investments.

Question 4

Miller and Modigliani's indifference proposition regarding dividend policy

Accepted Answer

Miller and Modigliani's indifference proposition assumes investors can sell their stock at a fair price, meaning there are no transaction costs or informational asymmetries that would prevent an investor from realizing the full value of their investment. The proposition states that investors are indifferent between stock dividends and cash dividends if they can sell their stock at a fair price, but it does not address tax rates or stock repurchases.

Question 5

The dividend-irrelevance proposition of Miller and Modigliani depends on the following relationship between investment policy and dividend policy:

Accepted Answer

The dividend-irrelevance proposition of Miller and Modigliani assumes that investment policy is independent of dividend policy, and that changes in dividend policy will not affect the value of the firm. Instead, the value of the firm depends only on its investment policy and the stream of future cash flows it generates, regardless of whether those cash flows are returned to shareholders through dividends or reinvested in the firm.

Question 6

Company X has 100 shares outstanding. It earns $1,000 per year and announces that it will use all $1,000 to repurchase its shares in the open market instead of paying dividends. Calculate the number of shares outstanding at the end of year 1, after the first share repurchase, if the required rate of return is 10 percent.

Accepted Answer

At a required rate of return of 10%, the present value of $1,000 is:

PV = $1,000 / (1 + 0.10) = $909.09

This amount can be used to repurchase shares at the current market price per share. If the market price per share is $10, then the number of shares repurchased will be:

Shares = $909.09 / $10 = 90.91

Thus, the number of shares outstanding at the end of year 1 will be:

Shares outstanding = 100 - 90.91 = 9.09

However, since a fractional share cannot be repurchased, the actual number of shares outstanding at the end of year 1 will be:

Shares outstanding = 100 - 90 = 10

Question 7

Even if both dividends and capital gains are taxed at the same ordinary income tax rate, the effect of each type of tax is different because

Accepted Answer

Dividends are taxed when distributed, while capital gains are deferred until the stock is sold. This means that investors have the option to delay paying taxes on capital gains until they choose to sell the asset, while taxes on dividends are due in the year they are paid out. Therefore, the effect of each type of tax is different, even if they are taxed at the same rate.

Question 8

If the corporate tax rate is 21 percent, what is the maximum effective tax rate on dividends received by another corporation?

Accepted Answer

The maximum effective tax rate on dividends received by another corporation is 21%*(1-21%) = 16.59%, which is equivalent to 6.3% after-tax rate (tax rate of 16.59% subtracted from 100%).

Question 9

Company X has 100 shares outstanding. It earns $1,000 per year and expects to pay all of it as dividends. If the firm expects to maintain this dividend forever, calculate the stock price after the dividend payment. (The required rate of return is 10 percent.)

Accepted Answer

To calculate the stock price after the dividend payment we use the Gordon Growth Model.

Stock price = (Dividend per share next year) / (Required rate of return - Dividend growth rate)

Since the company expects to pay all earnings as dividends, the dividend per share next year will be $1,000 / 100 shares = $10 per share.

The dividend growth rate is zero, since the company expects to maintain the same dividend forever.

Therefore: 
Stock price = $10 / (0.10 - 0) = $100

So the correct answer is B.

Question 10

If investors do not like dividends because of the additional taxes that they have to pay, how would you expect stock prices to behave on the ex-dividend date?

Accepted Answer

Typically, stock prices fall by less than the amount of the dividend on the ex-dividend date because while the dividend payment reduces the company's assets (and thus its stock value), investors may not sell off their shares aggressively due to the tax disadvantage of dividends. The market often partially prices in the dividend payment, but not fully, due to the perceived value of receiving a dividend despite the tax implications.

Question 11

Two corporations A and B have exactly the same risk, and both have a current stock price of $100. Corporation A pays no dividend and will have a price of $120 one year from now. Corporation B pays dividends and will have a price of $113 one year from now after paying the dividend. The corporations pay no taxes and investors pay no taxes on capital gains, but pay a 30 percent income tax on dividends. What is the value of the dividend that investors expect corporation B to pay one year from today?

Accepted Answer

Since both corporations have exactly the same risk, the investors would expect the same rate of return from both corporations. Let's assume that the rate of return is r. 
For Corporation A: 
Current Stock Price = $100 
Future Stock Price = $120 
Rate of return (r) = (120-100)/100 = 0.2 or 20%

For Corporation B: 
Current Stock Price = $100 
Future Stock Price after paying dividend = $113 
Let the dividend per share be x 
After paying the dividend, the price of the stock would be: 
(100-x) + (x*(1-0.3)) = 113 
Solving for x, we get x = $10 
So investors expect Corporation B to pay a dividend of $10 per share one year from today.

Question 12

Consider the payout policies of U.S. nonfinancial firms from 2011-2017. Which category had the highest percentage of firms?

Accepted Answer

During the period from 2011-2017, the majority of U.S. nonfinancial firms did not pay dividends or repurchase shares, making this category the most prevalent among the firms.

Question 13

The following are indicators that the firm has a cash surplus:.
I.Free cash flow is reliably positive.
II.The firm has a low debt ratio compared to similar firms.
III.The firm has sufficient debt capacity to cover unexpected opportunities or setbacks.

Accepted Answer

All three indicators suggest that the firm has a cash surplus. 
I. Positive free cash flow means that the firm has cash left over after it has covered its capital expenditures, which is a sign of financial strength. 
II. A low debt ratio means that the firm has less financial obligations to meet, which indicates that it has more cash available. 
III. Having sufficient debt capacity means that the firm can take advantage of unexpected opportunities without having to resort to expensive financing options, which is a sign of financial stability.

Question 14

One possible reason that shareholders often insist on higher dividends is

Accepted Answer

Shareholders may not trust managers to spend retained earnings wisely and may therefore push for higher dividends to receive the cash directly. This is especially true if the shareholders believe that they can use the cash more effectively than the company can.

Question 15

Company X has 100 shares outstanding. It earns $1,000 per year and expects to pay all of it as dividends. If the firm expects to maintain this dividend forever, calculate the stock price today. (The required rate of return is 10 percent.)

Accepted Answer

The price of a stock is equal to the present value of all future dividends discounted at the required rate of return. In this case, the dividends are expected to stay constant indefinitely, so we can use the perpetuity formula:

Price = Dividend / Required Rate of Return

Price = $1,000 / 0.10 = $10,000
Price per share = $10,000 / 100 = $100

Therefore, the correct answer is B) $100.

Question 16

A firm in Australia earns a pretax profit of $A10 per share. Suppose that it pays a corporate tax of $3 per share (30 percent tax rate)in taxes. The firm pays the remaining $A7 in dividends to a shareholder in the 40 percent marginal tax bracket. What is the amount of additional tax paid by the shareholder under an imputation tax system?

Accepted Answer

The shareholder pays an additional $A1 in taxes under an imputation tax system. This is because the shareholder is taxed on the $A7 dividend at their marginal tax rate of 40%, resulting in an additional tax liability of $A2.80. However, the shareholder also receives a tax credit for the $A3 in corporate taxes that the firm has already paid, which reduces their tax liability by $A1.80. Therefore, the shareholder's net additional tax liability is $A1.

Question 17

Which of the following investors has the strongest tax reason to prefer dividends over capital gains?

Accepted Answer

The answer of Which of the following investors has the...

Question 18

A firm in Australia earns a pretax profit of $A10 per share. Suppose that it pays a corporate tax of $3 per share (30 percent tax rate)in taxes. The firm pays the remaining $A7 in dividends to a shareholder in the 30 percent marginal tax bracket. What is the amount of additional tax paid by the shareholder under an imputation tax system?

Accepted Answer

Under an imputation tax system, the tax paid by the company on its profits is credited to the shareholders when dividends are paid out. Since the company has already paid a 30% tax on its profits, and the shareholder is also in the 30% tax bracket, the tax credit from the company's tax payment offsets the shareholder's tax liability on the dividends. Therefore, the shareholder pays no additional tax on the dividends received.

Question 19

If dividends are taxed more heavily than capital gains, then investors

Accepted Answer

Investors would prefer stocks with low dividend yields because the lower dividends mean they would incur less tax liability compared to stocks with high dividend yields, assuming capital gains are taxed at a lower rate.

Question 20

Dividend policy may affect firm value because
I.there is an unsatisfied clientele that prefer dividends to capital gains;
II.there are sufficient loopholes in the tax system that wealthy shareholders can avoid taxes on dividends;
III.well-managed companies prefer to signal their worth by paying high dividends

Accepted Answer

I. Dividend policy can affect firm value due to the existence of an unsatisfied clientele that prefers dividends over capital gains. This clientele effect can contribute to a reduction in the firm's share price if dividend policy changes. Therefore, the preferred strategy is to maintain the existing dividend policy.

III. When a firm pays high dividends, investors may perceive it as a signal of the firm's worth and financial stability. In this way, dividend policy can influence firm value. Companies that pay higher dividends may be perceived as less risky and more stable, which can lead to a higher stock price.

Quiz 16: Payout Policy