Question 1

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

The higher the debt ratio,the more dollars of debt will be used to fund a given capital budget.So,the higher the debt ratio,the less equity will be needed,and this results in a higher dividend payout ratio according to the residual dividend model.

Question 2

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 value per share proportionally. Therefore, in theory, they should have the same effect on the firm's stock price.

Question 3

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 because most dividends are reinvested in stocks and are exposed to the same risks as retained earnings. Therefore, high-payout companies are not inherently less risky than low-payout companies in terms of capital gains potential.

Question 4

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 5

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

The information content hypothesis suggests that dividend policy acts as a signal to investors about a firm's future prospects, and therefore a change in dividend policy can affect stock price and cost of equity.

Question 6

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 logically lead to a decrease in dividend payout ratios, as companies might prefer to retain earnings or repurchase shares to provide returns to shareholders in a more tax-efficient manner.

Question 7

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 is irrelevant to its market value and that dividends do not affect the stock price. Therefore, adhering to a residual dividend policy is not a requirement under this theory, as it posits that the way dividends are paid out (or not) does not impact the firm's value or stock price.

Question 8

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 maximize the value of the firm's stock, which is achieved by striking a balance between current dividends and capital gains. This is done through careful analysis of factors such as the firm's capital needs, growth opportunities, and investor preferences. Ultimately, the goal is to generate the highest possible return for investors, which translates into a higher stock price.

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

According to the dividend irrelevance theory proposed by Miller and Modigliani, the value of the firm is determined only by its basic earning power and its business risk, regardless of its dividend policy.

Question 10

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

It is true that establishing a consistent dividend policy can attract investors who prefer that policy.

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

This statement is true. A retired individual living on investment income would prefer high-payout stocks for cash flow, while someone reinvesting dividends would prefer low-payout stocks to save on taxes and brokerage costs.

Question 12

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

MM would disagree.They would say that investors took the dividend increase as a signal that the firm's management expected higher future earnings.MM say dividends have information content regarding future earnings.

Question 13

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

Accepted Answer

A reverse split consolidates existing shares so that multiple shares become one share, reducing the number of shares outstanding.

Question 14

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 should be reversed: individuals with high taxable incomes, who are subject to higher tax rates on dividends, would prefer stocks with low payouts (to minimize dividend income) and favor capital gains, which might be taxed at a lower rate. Conversely, individuals with low taxable incomes might prefer high-payout companies due to their lower relative tax burden on dividends.

Question 15

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

This is correct according to the bird-in-the-hand theory, which suggests that investors prefer to receive dividends now rather than relying on uncertain future capital gains. Therefore, a reduction in dividend yield would decrease the attractiveness of the stock to investors and must be offset by a greater increase in growth to maintain the required return.

Question 16

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

Accepted Answer

The higher the payout ratio,the less of its earnings the firm reinvests in the business,and the lower the reinvestment rate,the lower the firm's growth rate.

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

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 18

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 determined based on the amount of equity required to fund the capital budget. If the firm has better investment opportunities, they will require more equity to fund these projects, which will leave less available for dividend payouts, resulting in a lower payout ratio. Therefore, the statement is true.

Question 19

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 a low payout ratio (meaning the company retains a higher percentage of earnings) may increase investor confidence and potentially lead to higher stock prices.

Question 20

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 dividend irrelevance theory argues that the payment of dividends does not affect the value of the firm or the cost of capital, under certain assumptions about the market and the firm's investment opportunities. This theory suggests that investors are indifferent between receiving dividends and retaining earnings for future growth, and that changes in dividend policy should not impact stock prices.

Quiz 15: Distributions to Shareholders: Dividends and Share Repurchases