Question 1

In the real world, dividends

Accepted Answer

Dividends are usually more stable than earnings because companies tend to smooth dividends over time, maintaining them even when earnings fluctuate, to provide consistent returns to shareholders.

Question 2

Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio?

Accepted Answer

If a firm's R&D efforts pay off and it has more high-return investment opportunities, it is likely to retain more earnings to invest in these opportunities, leading to a decrease in the dividend payout ratio.

Question 3

Which of the following should NOT influence a firm's dividend policy decision?

Accepted Answer

The leasing of equipment is an operational decision and does not directly impact the firm's dividend policy.

Question 4

If a firm adheres strictly to the residual dividend policy, then if its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/total assets ratio), then the firm should pay

Accepted Answer

Under a residual dividend policy, dividends are paid only from leftover earnings after all profitable investment opportunities have been funded. If all earnings are needed for the capital budget, no dividends are paid.

Question 5

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 setting a low payout ratio allows the firm to retain more earnings for future growth opportunities, which can lead to higher stock prices in the long run.

Question 6

Trenton Publishing follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase in the firm's dividend per share?

Accepted Answer

An increase in the firm's net income would lead to an increase in the residual amount available for dividends, thus increasing the dividend per share under a residual dividend policy.

Question 7

MM's dividend irrelevance theory says that while dividend policy does not affect a firm's value, it can affect the cost of capital.

Accepted Answer

MM's dividend irrelevance theory posits that dividend policy does not affect a firm's value or its cost of capital, assuming perfect capital markets, no taxes, and no transaction costs.

Question 8

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.

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 because investors are indifferent to whether they receive dividends or capital gains.

Question 9

If the shape of the curve depicting a firm's WACC versus its debt ratio is more like a sharp "V", as opposed to a shallow "U", it will be easier for the firm to maintain a steady dividend in the face of varying investment opportunities or earnings from year to year.

Accepted Answer

A sharp "V" shape indicates that there is a narrow range of optimal debt ratios for the firm, and any deviation from this range will result in a significant increase in WACC. This means that the firm may not be able to maintain a steady dividend as easily because changes in investment opportunities or earnings could push the firm out of its optimal debt range, resulting in higher WACC and potentially lower dividends. A shallow "U" shape, on the other hand, indicates a broader range of optimal debt ratios, giving the firm more flexibility to adjust its capital structure without significantly impacting its WACC.

Question 10

Even if a stock split has no information content, and even if the dividend per share adjusted for the split is not increased, there can still be a real benefit (i.e., a higher value for shareholders) from such a split, but any such benefit is probably small.

Accepted Answer

While a stock split may not have much fundamental impact on a company's value, it can lead to increased liquidity and demand for the stock, which could potentially result in a higher stock price. However, any benefit from a stock split is typically minor in the grand scheme of things.

Question 11

A reverse split reduces the number of shares outstanding.

Accepted Answer

A reverse split consolidates multiple shares into a single share, therefore reducing the number of shares outstanding.

Question 12

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 true since the bird-in-the-hand theory suggests that investors prefer to receive dividends now rather than potential future capital gains, and thus a reduction in dividend yield may decrease investor interest in the stock. Therefore, to maintain the same required return, the company would need to increase its growth rate to compensate for the lower dividend yield.

Question 13

The dividend irrelevance theory, proposed by Miller and Modigliani, says that provided a firm pays at least some dividends, how much it pays does not affect either its cost of capital or its stock price.

Accepted Answer

The dividend irrelevance theory states that the value of a firm is determined solely by its investment policy and not by its dividend policy. However, it does not say that how much a firm pays in dividends has no effect on its stock price or cost of capital. In fact, some investors may prefer a higher dividend payout and thus be willing to pay more for the stock, which could affect the stock price. Additionally, a higher dividend payout could lead to a higher cost of equity capital, as investors may expect a higher return on their investment.

Question 14

Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that

Accepted Answer

Myron Gordon and John Lintner's argument is based on the assumption that investors view dividends as being less risky than potential future capital gains. They believe that investors prefer the certainty of dividends over the uncertainty of capital gains, leading to a higher required return on equity when the dividend payout ratio is decreased.

Question 15

If a firm adopts a residual distribution policy, distributions are determined as a residual after funding the capital budget. Therefore, the better the firm's investment opportunities, the lower its payout ratio should be.

Accepted Answer

A residual distribution policy prioritizes funding the capital budget before making distributions. Therefore, if a firm has better investment opportunities, it will allocate more funds towards its capital budget and have a lower payout ratio.

Question 16

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

Question 17

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 one that achieves the optimal balance between dividends and capital gains. This policy is designed to maximize shareholder wealth, which is reflected in the firm's stock price. Therefore, the statement is true.

Question 18

If the information content, or signaling, hypothesis is correct, then changes in dividend policy can have an important effect on the firm's value and capital costs.

Accepted Answer

The information content hypothesis suggests that changes in dividend policy convey information about a firm's future prospects, potentially affecting its perceived risk and thus its value and capital costs.

Question 19

Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders' wealth.

Accepted Answer

Both stock dividends and stock splits increase the number of shares owned by shareholders while decreasing the value per share. This means that the total value of shareholders' holdings remains the same before and after these events. Therefore, they should have the same effect on shareholders' wealth.

Question 20

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 basic earning power and business risk and not by its dividend policy.

Quiz 14: Distributions to Shareholders: Dividends and Repurchases