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 its cost of capital, but it does affect its stock price.

Accepted Answer

False

Question 2

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 dividend payout ratios, as it would make it more expensive for companies to distribute dividends to shareholders. Companies may choose to instead retain earnings or use them for share buybacks instead of paying out dividends.

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

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 Miller and Modigliani's dividend irrelevance theory, the value of a firm is determined by its earning power and business risk, regardless of its dividend policy.

Question 5

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

Accepted Answer

The answer of Other things held constant, the higher a...

Question 6

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

If management believes in the dividend irrelevance theory, then it should not matter whether the company pays dividends or retains earnings, as the stock price will be determined by the company's investment decisions and profitability. Therefore, the company may choose to follow a regular dividend policy or a residual dividend policy, depending on other factors such as investment opportunities and financial needs.

Question 7

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 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, then a firm's stock price would likely increase if it sets a low payout ratio and retains more earnings to invest in growth opportunities. This is because investors believe that the firm will generate higher profits in the future and have a greater potential for capital appreciation.

Question 9

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

Accepted Answer

A reverse split consolidates multiple shares into a single share, resulting in a decrease in the total number of shares outstanding.

Question 10

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 not affected by its dividend policy, and that investors are indifferent between receiving dividends and retaining earnings. The increase in stock price could be due to various factors such as an increase in earnings, positive news about the company, or a change in market conditions. Therefore, the fact that the stock price increased after an increase in dividend payout does not necessarily prove that investors prefer dividends over retained earnings.

Question 11

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 for the company, but do not change the fundamental value of the company. Therefore, both should have the same effect on the firm's stock price.

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 better the firm's investment opportunities, the lower its payout ratio will be, other things held constant.

Accepted Answer

The residual dividend model assumes that dividends are paid after all the positive net present value investment opportunities have been taken. Therefore, the better the firm's investment opportunities, the more it will retain earnings to fund these investments and the lower its payout ratio will be.

Question 13

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 states that a firm's dividend payout ratio does not affect its cost of capital or stock price. This theory assumes perfect capital markets without taxes or transaction costs. However, in the real world, taxes and clienteles of investors with different preferences for dividends may influence a firm's dividend policy.

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

The information content hypothesis suggests that a change in a firm's dividend policy sends a signal to the market about the firm's future prospects, which can affect investors' perception of the firm's risk and future earnings potential. This, in turn, can influence the stock price and cost of equity.

Question 15

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 dividends are not less risky than capital gains because most dividends are reinvested in stocks, which are exposed to the same risks as reinvested earnings.

Question 16

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. Retired individuals who rely on investment income may prefer stocks with high payouts as it allows them to receive cash without selling stocks, while individuals who reinvest dividends may prefer low-payout companies to save on taxes and brokerage costs.

Question 17

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 18

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 consistent dividend policy can attract investors who prefer steady income, while retaining earnings can attract investors who prefer long-term growth potential through capital gains. By sticking to a specific policy, a company can maintain a loyal investor base.

Question 19

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

According to the bird-in-the-hand theory of dividends, investors prefer to receive dividends in the present rather than relying on potential future capital gains. Therefore, a reduction in dividend yield would make a company less attractive to these investors, resulting in a higher required return in order to compensate for the decrease in dividend income. This can only be offset by a more than proportionate increase in growth, as stated in the implication.

Question 20

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 for a firm is one that maximizes the stock price, which involves balancing current dividends and capital gains.

Quiz 14: Distributions to Shareholders: Dividends and Share Repurchases