Question 1

According to the bird-in-the-hand dividend theory,investors value a dollar of expected capital gain more highly than a dollar of expected dividends because capital gains are more unpredictable than dividends.

Accepted Answer

According to the bird-in-the-hand dividend theory, investors value a dollar of expected dividends more highly than a dollar of expected capital gains because dividends are considered more certain than capital gains.

Question 2

Federal tax law is irrelevant to corporate dividend policy because dividends are not tax deductible.

Accepted Answer

Federal tax law is relevant to corporate dividend policy because dividends are taxed at the shareholder level, influencing the attractiveness of dividends compared to capital gains, which can affect a company's decision on whether to distribute profits as dividends or reinvest them.

Question 3

In a perfect market,investors are only concerned with total returns and are not concerned whether it is in capital gains or dividend income.

Accepted Answer

In a perfect market, investors are rational and only concerned with maximizing their total returns, whether it is in the form of capital gains or dividend income. They do not have a preference for one over the other, as long as the overall return is optimal.

Question 4

As a corporation's investment opportunities increase,the dividend payout ratio should decrease so that the corporation can avoid flotation costs.

Accepted Answer

When a corporation has more investment opportunities, it is beneficial to retain earnings to finance these investments, thereby reducing the dividend payout ratio to save on flotation costs associated with raising new capital.

Question 5

The residual dividend theory is based on the observation that flotation costs make the cost of new common stock significantly higher than the cost of retained earnings.

Accepted Answer

The residual dividend theory suggests that a company should fund its capital expenditures and dividends using retained earnings first, and then use external financing if needed. This is because the cost of issuing new common stock (external financing) is higher due to flotation costs such as underwriting fees, legal fees, and other expenses. Therefore, it is more cost-effective to use retained earnings for funding when possible.

Question 6

When considering taxes,most investors prefer capital gains over dividend income.

Accepted Answer

This is because taxes on capital gains are typically lower than taxes on dividend income. Additionally, investors have greater control over when they realize capital gains, whereas they have no say in when dividends are paid out.

Question 7

If a firm were to unexpectedly omit payment of its quarterly dividend,that firm's stock price would probably drop.

Accepted Answer

Stock prices are often influenced by a company's dividend payment history and the expectation of future payments. If a company unexpectedly omits payment of its dividend, it can signal financial trouble or a change in the company's financial priorities, which can cause investors to lose confidence and sell their shares, leading to a drop in the stock price.

Question 8

We typically expect to find rapidly growing firms to have high payout ratios.

Accepted Answer

Rapidly growing firms usually reinvest their earnings in the business to sustain their growth. Therefore, they tend to have lower payout ratios and allocate a larger portion of their earnings to investments and expansion rather than distributing the earnings to shareholders.

Question 9

The existence of taxes can directly affect a common shareholder's preference for capital gains or dividend income.

Accepted Answer

When taxes on capital gains are higher than taxes on dividends, shareholders may prefer to receive dividend income instead of capital gains to minimize their tax burden. Conversely, when taxes on dividends are higher than taxes on capital gains, shareholders may prefer to receive capital gains instead of dividend income.

Question 10

The residual dividend theory suggests that dividends should be paid to stockholders first,and then what is left can be reinvested by the firm.

Accepted Answer

The residual dividend theory suggests that dividends should be paid out of the remaining earnings after all profitable investment opportunities have been funded.

Question 11

Low dividends may increase stock value due to the advantage of tax deferral that comes with capital gains.

Accepted Answer

Low dividends can lead to higher capital gains, which are taxed at a lower rate and can be deferred until the realization of the investment. This tax advantage can increase the demand for the stock, leading to a higher price and potentially increasing its overall value.

Question 12

Under the ideal conditions of perfect capital markets,dividend policy has no effect upon share price.

Accepted Answer

In perfect capital markets, all investors have access to the same information and can buy or sell shares freely without transaction costs. Therefore, dividend policy does not affect the value of the firm or its share price. Investors can create their desired income stream by buying or selling shares, depending on their individual preferences for income versus capital gains. This is known as the dividend irrelevance theory, proposed by Miller and Modigliani in 1961.

Question 13

An investor who requires an 18% percent return for a stock that pays no dividends and requires a 12% return for a stock that pays its entire return from dividends may be following the bird-in-the-hand dividend theory.

Accepted Answer

The bird-in-the-hand dividend theory implies that investors prefer a certain dividend payment today to a future uncertain capital gains, and therefore they require a higher return for stocks that do not pay dividends or have low dividend yields. The fact that the investor requires an 18% return for a non-dividend stock and a lower 12% return for a stock that pays all its return from dividends suggests that they prioritize the immediate income, which is consistent with the bird-in-the-hand theory.

Question 14

If a company in a perfect capital market decreased its dividend per share,an investor would be forced to sell his common stock at a depressed price.

Accepted Answer

In a perfect capital market, the decrease in dividend per share would be reflected in the stock price through a corresponding increase in the company's capital reserves. While a decrease in dividend may result in some investors selling their shares, the market as a whole would not be forced to sell at a depressed price.

Question 15

Security markets are considered to be perfect when firms can issue securities at no cost and the investor incurs no brokerage commissions.

Accepted Answer

In perfect security markets, it is assumed that there are no transaction costs, including the costs for issuing securities and brokerage commissions, allowing for frictionless trading and investment.

Question 16

Since stock dividends do not require payment in cash,their impact on a corporation's share price can be only positive (if there is an information effect)or neutral,but not negative.

Accepted Answer

While it is true that stock dividends do not require payment in cash, their impact on a corporation's share price can be negative. This is because the increase in the number of shares outstanding due to the stock dividend can dilute the value of existing shares, leading to a decrease in share price. However, there may be other factors at play such as the information effect mentioned in the statement, which can mitigate or even outweigh the negative impact.

Question 17

When an unexpected change in dividend policy develops,investors may attach informational content to the events.

Accepted Answer

Investors may interpret a change in dividend policy as an indication of the company's financial health, growth prospects, or management strategy. Therefore, a surprising shift in dividend payments may convey significant information about the company's future prospects and could affect investors' valuation and decision-making.

Question 18

According to the "bird-in-the-hand" dividend theory,the required return for a stock that pays its entire return from dividends is higher than the required return for a high-growth stock that pays no dividend.

Accepted Answer

The "bird-in-the-hand" dividend theory suggests that investors value dividends more than future capital gains because dividends are seen as less risky. Therefore, the required return for a stock that pays dividends might actually be lower than for a high-growth stock that pays no dividend, as investors are willing to accept a lower return for the perceived lower risk.

Question 19

A firm's dividend policy provides information pertaining to the firm's payout ratio and its stability.

Accepted Answer

A firm's dividend policy includes its decisions on how much of its earnings will be paid out as dividends (payout ratio) and how consistent those payouts will be over time (stability). Therefore, this statement is true.

Question 20

The residual theory of dividends connects a firm's dividend policy and its level of capital investments.

Accepted Answer

The residual theory of dividends suggests that a firm's dividend policy is determined by the amount of funds left over after financing its capital investments. In other words, the firm will invest in projects that have a positive net present value (NPV) and then pay out any remaining profits as dividends. Therefore, the level of capital investments will have an impact on the amount of funds available for dividend payments.

Quiz 13: Dividend Policy and Internal Financing