Question 1

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

According to the dividend irrelevance theory proposed by Miller and Modigliani, the dividend policy of a firm has no impact on its cost of capital or stock price, as investors are assumed to be rational and indifferent between receiving dividends and having the earnings reinvested in the company.

Question 2

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 and maintaining a consistent dividend policy can help a company attract a specific group of investors who prefer that policy, and can help the company maintain stable relationships with its shareholders.

Question 3

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

False

Question 4

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 a firm is independent of the dividend policy. Therefore, a change in the dividend policy should not affect the stock price in their view. Other factors, such as changes in expected future earnings or interest rates, could be driving the increase in stock price.

Question 5

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

According to the dividend irrelevance theory, the value of the firm is not affected by its dividend policy, as long as the basic earning power and business risk remain the same. Miller and Modigliani argued that the value of the firm is determined solely by these factors, and not by the way in which earnings are distributed to shareholders.

Question 6

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 decreasing the price per share proportionally. This means that the total value of the shares held by an investor remains the same. Therefore, both actions should have the same effect on the firm's stock price.

Question 7

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. When a firm decides to pay out more of its earnings to shareholders as dividends, it leaves less money available to reinvest in the business for future growth. Therefore, a higher payout ratio typically implies a lower expected growth rate.

Question 8

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, the firm's stock price is likely to increase if they set a low payout ratio and reinvest most of their earnings back into the company. This leads to potential growth opportunities for the company, which can create value for shareholders in the long term.

Question 9

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 suggests that investors prefer dividends as they are certain, rather than relying on potentially uncertain future capital gains. Therefore, if a company reduces its dividend yield (thus providing investors with less of a "bird in the hand"), they may require a higher growth rate to compensate for the reduced certainty in their returns. This implies that a given reduction in dividend yield must be offset by a more than proportionate increase in growth to maintain a constant required return for investors.

Question 10

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 answer of The federal government sometimes taxes dividends and...

Question 11

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

A retired individual who lives on investment income would want stocks with high payouts to receive cash without selling, while someone who would reinvest only wants low-payout stocks to save on taxes and costs.

Question 12

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

Accepted Answer

A reverse split is a process where a company reduces the number of outstanding shares by consolidating several shares into one share, resulting in a higher share price. This is also known as a stock consolidation or reverse stock split.

Question 13

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 aims to maximize shareholder wealth, which is reflected in the stock price. Therefore, the distribution policy needs to balance dividends and capital gains to achieve the highest stock price possible.

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, a change in a firm's dividend policy can signal valuable information to investors and affect their perception of the firm's future prospects, which in turn can impact the stock price and cost of equity. Therefore, the statement is true.

Question 15

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 residual dividend policy suggests that a company should first invest in all available positive net present value projects and then use the remaining earnings to pay dividends. However, if management believes in the dividend irrelevance theory, which states that the value of a company is determined by its investment decisions rather than its dividend policy, then it may not necessarily adhere to the residual dividend policy. In such a case, the company might choose to reinvest all profits into projects that create more value for shareholders rather than paying out dividends. Therefore, the answer is false.

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, other things held constant.

Accepted Answer

The answer of The announcement of an increase in the...

Question 17

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

The answer of Miller and Modigliani's dividend irrelevance theory says...

Question 18

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

The answer of The federal government sometimes taxes dividends and...

Question 19

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 "bird-in-the-hand fallacy" is incorrect and that dividends are not less risky than capital gains from retained earnings because most dividends are reinvested in stocks and therefore exposed to the same risks as reinvested earnings.

Question 20

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, dividends are paid after all the required capital expenditures are met. If the firm has better investment opportunities, then it would require more funds for capital expenditures, which would result in a lower payout ratio. Therefore, the statement is true.

Quiz 15: Dividends

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.

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.

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.

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

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

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.

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.

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

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

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.

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.

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.

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.

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.