You are on page 1of 35

Financial Management: Principles and Applications, 11e (Titman)

Chapter 16 Dividend Policy


16.1 How Do Firms Distribute Cash to Their Shareholders?
1) In response to a temporary decline in earnings per share, most companies would:
A) decrease their cash dividend.
B) not decrease their cash dividend.
C) suspend their cash dividend.
D) substitute a stock dividend for the cash dividend.
Answer: B
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
2) The ex-dividend date is ________ the holder of record date.
A) five days before
B) two weeks before
C) two days before
D) three days after
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: key dates
Principles: Principle 3: Cash Flows Are the Source of Value
3) Assume that Home Depot's annual dividend is $0.96 per share. This dividend would most
likely be paid as:
A) $0.48 twice a year.
B) $0.96 once a year.
C) whenever the company had extra cash.
D) $0.24 four times per year.
Answer: D
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value

1
Copyright 2011 Pearson Education, Inc.

4) ZZZ Corporation has declared a stock dividend that pays one share of stock for every 10
shares owned. What will happen to EPS immediately upon the distribution of the stock dividend?
A) There is not enough information to know.
B) EPS will increase by 10%.
C) EPS will not be affected by the stock dividend.
D) EPS will decrease by 10%.
Answer: D
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
5) Which of the following describes the effect of a stock dividend?
A) A stock dividend immediately increases the market price of a share of stock.
B) A stock dividend immediately decreases the paid-in capital account.
C) A stock dividend immediately increases the number of shares outstanding.
D) A stock dividend indicates that the company must be short on cash.
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
6) Trendy Corp. recently declared a 10% stock dividend. As of the date of the announcement,
Trendy had 10 million shares outstanding which were selling on the NYSE for $50 per share. An
accounting entry is required on the balance sheet in order to transfer an amount from retained
earnings to the common stock and additional paid-in capital accounts. What is the dollar amount
of retained earnings that will be transferred from retained earnings to the common stock account
as the result of the stock dividend? Assume that the par value of Trendy is $2 per share.
A) $6 million
B) $5 million
C) $4 million
D) $3 million
E) $2 million
Answer: E
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value

2
Copyright 2011 Pearson Education, Inc.

7) A stock dividend will cause changes in the dollar value of which of the below capital
accounts?
A) Common stock
B) Additional paid-in capital
C) Retained earnings
D) All of the above
Answer: D
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
8) Which of the following is the most widely accepted reason that motivates corporations to pay
stock dividends?
A) To keep the firm's beta within its optimal range
B) To conserve cash
C) To reallocate capital to shareholders
D) All of the above
Answer: B
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
9) Which of the following motivates corporations to split their common stock?
A) To keep the price of the firm's common stock within an optimum price range
B) To increase retained earnings
C) To reallocate capital to shareholders
D) To increase their paid-in capital
Answer: A
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
10) If a firm's EPS are $8.33, and the firm is paying a dividend of $1.25 per share, what is the
firm's dividend payout ratio?
A) 33%
B) 6%
C) 15%
D) 25%
E) 66%
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
3
Copyright 2011 Pearson Education, Inc.

11) Most stock splits:


A) increase the number of shares outstanding.
B) increase the value of the company.
C) tend to raise the price of the stock.
D) all of the above.
Answer: A
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
12) A stock split will cause changes in the dollar value of which of the following?
A) The total value of an investment in the company's stock
B) The book value of common equity
C) The market value of common equity
D) The price of the stock
Answer: D
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
13) Assume that on January 1 a firm announces that on June 30 they will pay a dividend of $2.50
per share to holders of record on March 30. When does the stock sell ex-dividend?
A) January 5
B) April 5
C) March 28
D) July 5
E) June 25
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
14) For accounting purposes, a stock split has been defined as a stock dividend exceeding:
A) 25%.
B) 35%.
C) 45%.
D) 55%.
Answer: A
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value

4
Copyright 2011 Pearson Education, Inc.

15) The final approval of a dividend payment comes from the:


A) controller.
B) president of the company.
C) board of directors.
D) Chief Financial Officer.
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: key dates
Principles: Principle 3: Cash Flows Are the Source of Value
16) The only definite result from a stock dividend or a stock split is:
A) an increase in the P/E ratio.
B) an increase in the common stock's market value.
C) an increase in the number of shares outstanding.
D) cannot be determined from the above.
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
17) Five years ago, Mr. Martinez purchased 1000 shares of JPM stock at $50 per share. If Mr.
Martinez ' tax rate is 25% would he prefer that the company pay a $5.00 per share dividend or
offer to repurchase 100 shares at $50 per share?
A) Pay the dividend because he would have no transaction costs.
B) It would make no difference because he would receive $5,000 either way.
C) Repurchase the stock because he would owe no taxes.
D) It would make no difference because the tax rate on dividends is the same as the tax rate on
capital gains.
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
18) The ________ designates the date on which the stock transfer books are closed in regard to a
dividend payment.
A) declaration date
B) ex-dividend date
C) date of record
D) payment date
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: key dates
Principles: Principle 3: Cash Flows Are the Source of Value
5
Copyright 2011 Pearson Education, Inc.

Use the following information to answer the following question(s).


Your firm is planning to pay a 15% stock dividend. The market price for the stock has been $84.
The table below presents the equity portion of your firm's balance sheet before the dividend.
Common stock
Par value
(1 million shares
outstanding; $4 par value)
$ 4,000,000
Paid-in capital
16,000,000
Retained earnings
30,000,000
Total equity
$50,000,000
19) Which of the following would result from payment of the stock dividend?
A) Total equity would remain at $50,000,000.
B) Total equity would increase to $57,500,000.
C) Total equity would decrease to $43,478,261.
D) The effect on the equity account would depend on the market's reaction to the dividend.
Answer: A
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
20) If instead of a stock dividend, your firm decided to split the stock 2-1, then the number of
shares outstanding and their par value per share would be:
A) 1 million; $4.
B) 1 million; $8.
C) 2 million; $2.
D) 2 million; $4.
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
21) The date upon which a dividend is formally declared by the board of directors is the
________ date.
A) declaration
B) record
C) payment
D) ex-dividend
Answer: A
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: key dates
Principles: Principle 3: Cash Flows Are the Source of Value
6
Copyright 2011 Pearson Education, Inc.

22) EG's board of directors announced a quarterly dividend of 25 cents. The ex-dividend date is
November 3. On November 2, EG's stock closed at $40.00 per share. What is the most likely
opening price on November 3?
A) $40.25
B) $39.75
C) $41.00
D) $39.00
Answer: B
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: key dates
Principles: Principle 3: Cash Flows Are the Source of Value
Use the following information to answer the following question(s).
Your firm is planning a 2 for 1 stock split. The market price for the stock has been $84. The table
below presents the equity portion of your firm's balance sheet before the split.
Common stock
Par value
(1 million shares
outstanding; $4 par value)
$ 4,000,000
Paid-in capital
16,000,000
Retained earnings
30,000,000
Total equity
$50,000,000
23) After the stock split, the number of shares outstanding, their par value and the total common
stock account will stand at:
A) 2,000,000; $4.00; $8,000,000.
B) 500,000; $8.00; $4,000,000.
C) 2,000,000; $2.00; $4,000,000.
D) 500,000; $2.00, $2,000,000.
Answer: C
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
24) Immediately after the stock split, the stock price will be approximately:
A) $42.
B) $84.
C) $2.00.
D) $8.00.
Answer: A
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
7
Copyright 2011 Pearson Education, Inc.

25) Immediately after the stock split, an investor who owned 100 share before the split will own:
A) 100 shares worth a total of $4200.
B) 200 shares worth a total of $8400.
C) 200 shares worth a total of $16,800.
D) 200 shares with a par value of $8.00 each.
Answer: B
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
26) A firm's payout is calculated as the ratio of retained earnings to earnings before interest and
taxes (EBIT).
Answer: FALSE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
27) If a firm were to unexpectedly omit payment of its quarterly dividend, that firm's stock price
would probably drop.
Answer: TRUE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
28) The dividend declaration date is the date at which the stock transfer books are to be closed
for determining the investor to receive the next dividend payment.
Answer: FALSE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
29) There is absolutely no difference on an economic basis between a stock dividend and a stock
split.
Answer: TRUE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
30) Firms can use stock repurchases as a dividend substitute.
Answer: TRUE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock repurchase
8
Copyright 2011 Pearson Education, Inc.

Principles: Principle 3: Cash Flows Are the Source of Value


31) The ex-dividend date occurs prior to the declaration date.
Answer: FALSE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: key dates
Principles: Principle 3: Cash Flows Are the Source of Value
32) Dividends tend to be higher for firms with stable earnings.
Answer: TRUE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
33) Dividend payout ratios are generally much lower for small or newly established firms than
for large, publicly owned firms.
Answer: TRUE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
34) After a stock split of 2-1, each investor will have one-half of the percentage ownership in the
firm that he had before the split.
Answer: FALSE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
35) Stock dividends and stock splits have the same overall effect.
Answer: TRUE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
36) Managers avoid cutting dividends even in response to short-term fluctuations in earnings.
Answer: TRUE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value

9
Copyright 2011 Pearson Education, Inc.

37) A reasonable conclusion about dividend policy is that management should avoid surprising
investors when it comes to the firm's dividend decision.
Answer: TRUE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
38) Due to the strengthening of the stock market over the past 50 years, stock splits and stock
dividends are more common than cash dividends.
Answer: FALSE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
39) By virtue of its nature, dividend policy is inherently a wealth-creating activity for the firm's
owners.
Answer: FALSE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
40) A stock dividend increases a firm's retained earnings.
Answer: FALSE
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value

10
Copyright 2011 Pearson Education, Inc.

41) Kelly owns 10,000 shares in McCormick Spices, which currently has 500,000 shares
outstanding. The stock sells for $86 on the open market. McCormick's management has decided
on a 2-1 split.
a. Will Kelly's financial position alter after the split, assuming that the stocks will fall
proportionately?
b. Assuming only a 35% fall on each stock, what will be Kelly's value after the split?
Answer:
McCormick Spices Corporation - Stock Split
Market price
$86.00
Split multiple
2
Shares outstanding
500,000
a.
Investor's shares
= 10,000
Position before split
$860,000 = 10,000 shares $86 per share
Price after split $43.00 = $86/2
Kelly's shares after split 20,000 = 10,000 2
Position after split
$860,000 = 20,000 shares $43 per share
Net gain
$0
b.
Price fall
0.35
Price after split
$55.90 = $86.00(1 - .35)
Position after split
$1,118,000 = 20,000 shares $55.90 per share
Net gain
$258,000 = $1,118,000 - $860,000
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
42) Why has the popularity of stock repurchases been growing faster than the cash dividends as a
method for companies to distribute cash to their stockholders.
Answer: Stock repurchases allow investors to tailor the timing of cash flows to their individual
needs and tax situations. An investor with high current income can refuse the distribution,
thereby "reinvesting" the money, postponing taxes, and avoiding transaction fees. An investor
who wants or needs the income can sell shares back to the firm with no or very low transaction
fees and often at a price that is slightly higher than the market value.
From the firm's point of view, the effect on stock price of omitting a dividend is often
devastating, while there seems to be no equivalent penalty for not offering to repurchase shares.
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value

11
Copyright 2011 Pearson Education, Inc.

43) Explain the significance of each of the following:


a. announcement date
b. ex-dividend date
c. record date
d. payment date
Answer:
a. announcement date: Date at which the Board of Directors announces that a dividend will be
paid.
b. ex-dividend: date Date after which the stock trades ex-dividend. Investors who buy the stock
on or after the ex-dividend date do not receive the dividend. The previous owner does.
c. record date: Date on which the company examines its records to determine who is entitled to
the dividend.
d. payment date: The date at which cash is actually distributed to eligible shareholders (those
who purchased before the ex-dividend date.)
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: key dates
Principles: Principle 3: Cash Flows Are the Source of Value
44) What are the effects of stock splits and stock dividends? Why are they popular?
Answer: Economically, the only effect of a stock split or stock dividend is to increase the
number of shares in existence. Since these shares bring no additional cash into the firm, it is
obvious that neither book equity nor market equity increase as a result. Of necessity, the price per
share must fall to adjust for the number of additional shares.
A company whose shares sell for a relatively high price, say $200, might decide to split the
shares 4 for 1 creating 4 shares valued at $50 for every 1 share in existence. This action is based
on the belief that investors will prefer the lower price because a typical 100 share "round lot"
would then be more affordable. It also assumes that the price of a stock is influenced by supply
and demand for the stock rather than just future cash flows. In view of the importance of large
institutional investors who are not concerned with whether they buy 100,000 $50 shares or
50,000 $100 shares, this argument seems dubious.
It is also possible that managers use stock splits to hint at future good news concerning the
company's cash flows.
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value

12
Copyright 2011 Pearson Education, Inc.

45) XYZ Corporation has 400,000 shares of common stock outstanding, a P/E ratio of 8, and
$500,000 available for common stockholders. The board of directors has just voted a 3-2 stock
split.
a. If you had 100 shares of stock before the split, how many shares will you have after the split?
b. What was the total value of your investment in XYZ stock before the split?
c. What should be the total value of your investment in XYZ stock after the split?
d. In view of your answers to (b) and (c) above, why would a firm's management want to have a
stock split?
Answer:
a. Number of shares after split = 3/2 100 = 150
b. EPS before split = ($500,000/400,000) = $1.25
Price per share before split = 8 $1.25 = $10
Total value of investment = $10 100 = $1,000
c. Total number of shares after split = 3(400,000/2) = 600,000
EPS after split = ($500,000/600,000) = $.8333
Price per share after split = 8 $.833 = $6.67
Total value of investment after split = $6.67 150 = $1,000
d. (1) Stock splits are believed to have favorable information content. Splits are often
associated with growth companies.
(2) Splits can conserve corporate cash if the firm has cash flow problems or needs additional
funds for attractive investment opportunities.
Diff: 2
Topic: 16.1 How Do Firms Distribute Cash to Their Shareholders?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
16.2 Does Dividend Policy Matter?
1) Which of the following might cause dividend policy to affect shareholder wealth?
A) Taxes
B) Transaction costs
C) Changes in the firm's investment policies
D) All of the above
Answer: D
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value

13
Copyright 2011 Pearson Education, Inc.

2) A stock repurchase increases the:


A) retention ratio of earnings.
B) number of shares outstanding.
C) EPS.
D) both B and C.
Answer: C
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
3) Transaction costs:
A) encourage firms to retain earnings rather than pay dividends.
B) encourage firms to pay large dividends. rather than retain earnings.
C) are encountered whenever a firm pays a dividend.
D) are incurred when investors fail to cash their dividend check.
Answer: A
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
4) The Modigliani and Miller dividend irrelevancy theorem states that:
A) dividends are preferable to stock repurchases.
B) the timing of cash distributions is important.
C) the timing of cash distributions is unimportant.
D) stock repurchases are preferable to dividends.
Answer: C
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
5) Assume that as the result of a firm announcing a large unexpected increase in its dividend
payment, the price of the firm's common stock rises. This event would be consistent with which
of the following?
A) The dividend irrelevance theory
B) The tax preference theory
C) The information effect
D) The beta effect
Answer: C
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value

14
Copyright 2011 Pearson Education, Inc.

6) Millbury Gas and Oil's rate of return on equity is 12%. It can either pay a dividend of $5.00
today or reinvest the money and pay a dividend of $5.60 at the end of the year. From a
shareholder's point of view, the value of the dividend paid now is ________ and the value of the
dividend paid a year from now is ________.
A) $5.00, $4.46
B) $5.00, $5.00
C) $4.46, $5.00
D) $5.60, $5.00
Answer: B
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
7) In the absence of taxes, transaction costs, or changes in a firm's operating or investment
policies:
A) the greater the payout ratio, the greater the share price of the firm.
B) the price of a share of stock is not affected by dividend policy.
C) the firm should retain earnings so stockholders will receive a capital gain.
D) the firm should pay a dividend only after current equity financing needs have been met.
Answer: B
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
8) Which of the following is included in the Modigliani and Miller dividend indifference
theorem?
A) Transaction costs
B) Personal taxes
C) Changes in the firm's investment policies
D) All of the above
Answer: D
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
9) What might an investor reasonably expect from a company with excess cash and few internal
investment growth opportunities?
A) The company will buy Treasury bills with all the excess cash.
B) The company will split its stock.
C) The company will declare a stock dividend.
D) The company will pay a cash dividend or repurchase some of its own shares.
Answer: D
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
15
Copyright 2011 Pearson Education, Inc.

Principles: Principle 3: Cash Flows Are the Source of Value


10) If dividends and capital gains are taxed at the same rate, should investors prefer cash
dividends or stock repurchases?
A) They would prefer to have neither a dividend nor a stock repurchase.
B) It would not matter. Either cash dividends or stock repurchases would result in the same aftertax cash flow.
C) They should prefer cash dividends to stock repurchases.
D) They should prefer stock repurchases to cash dividends.
Answer: B
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: clientele
Principles: Principle 3: Cash Flows Are the Source of Value
11) Which of the following describes the clientele effect concept of dividend policy?
A) The clientele effect looks at investor preferences for dividends compared to share repurchase
programs.
B) The clientele effect defines the relationship between the shareholder and a stockbroker.
C) The clientele effect focuses entirely on the stability of dividends.
D) Modern corporations do not consider shareholders to be "clients."
Answer: A
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: clientele
Principles: Principle 3: Cash Flows Are the Source of Value
12) In the absence of taxes or transaction costs, investors:
A) would prefer immediate dividends to future capital gains.
B) who did not want a dividend could use dividends to purchase more shares.
C) could create their own dividends by selling the appropriate number of shares.
D) Both B and C are correct.
Answer: D
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value

16
Copyright 2011 Pearson Education, Inc.

13) Which of the following statements is most plausible?


A) Increases in stock price associated with a dividend increase are likely due to information
conveyed by the increase.
B) Increases in stock price associated with a dividend increase are likely due to changes in the
company's capital structure.
C) Increases in stock price associated with a dividend increase are likely due to investors'
preference for dividends over capital gains.
D) Increases in stock price associated with a dividend increase are likely due to the favorable tax
treatment of dividends over capital gains.
Answer: A
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: information effect
Principles: Principle 4: Market Prices Reflect Information
14) Chandler Corporation has 1 million shares outstanding. The current price per share is $20. If
the company decides to pay a $2 million dollar dividend, the company will have ________
shares outstanding worth approximately ________.
A) 900,000, $20 per share
B) 1,000,000, $20 per share.
C) 900,000, $22.22 per share.
D) 1,000,000, $18 per share.
Answer: D
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
15) Chandler Corporation has 1 million shares outstanding. The current price per share is $20. If
the company decides to use $2 million dollars to repurchase shares at the market price, the
company will have ________ shares outstanding worth approximately ________. Assume that
the price does not change during the repurchase period.
A) 900,000, $20 per share
B) 1,000,000, $20 per share
C) 900,000, $22.22 per share
D) 1,000,000, $18 per share
Answer: A
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value

17
Copyright 2011 Pearson Education, Inc.

16) Which of the following reasons is used to justify stock repurchases?


A) The repurchase narrows ownership.
B) The repurchase modifies the firm's capital structure.
C) The repurchase reduces the firm's costs associated with servicing small stockholders.
D) All of the above.
Answer: D
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
17) Dividend policy is influenced by:
A) a company's investment opportunities.
B) a firm's capital structure mix.
C) a company's availability of internally generated funds.
D) all of the above.
Answer: D
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
18) All of the following are methods available to a corporation who desires to repurchase stock
EXCEPT:
A) offering to employees who own an interest in the firm.
B) open market.
C) tender offer to all existing stockholders.
D) offer to one or more major stockholders on a negotiated basis.
Answer: A
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
19) Which of the following typically would NOT affect the dividend policy of the firm?
A) Today's dividend policy is affected by future dividend expectations among investors.
B) Managers are afraid to decrease their voting control of the company by issuing stock
dividends.
C) The failure of so many high-tech and dot.com companies showed that dividends are important
to long-term investors.
D) The current and future cash flow expectations of the company affect dividend policy.
Answer: B
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
18
Copyright 2011 Pearson Education, Inc.

20) Which of the following conclusions about dividend policy is reasonable?


A) An inverse relation should exist between the amount of acceptable investments a firm has and
the dividends remitted to investors.
B) Management's actions regarding dividends might carry greater weight than a statement by
management that earnings will be increasing.
C) Management should avoid surprising investors when it comes to the firm's dividend decision.
D) All of the above are reasonable.
Answer: D
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
21) If investor's expect a 15% rate of return on their investment, they will be indifferent between
a $1.00 dividend received immediately or:
A) $1.15 received at the end of the year.
B) $1.00 received later.
C) $0.87 received at the end of the year.
D) $1.00 increase in the stock price a year later.
Answer: A
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
22) Which of the following is a reason that a company would repurchase its own shares of stock
in the market?
A) To reduce cash and the number of shares outstanding
B) To increase outstanding equity shares
C) To have shares available to offer a merger target
D) Both A and B
Answer: A
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
23) Since 2003 for most investors the tax rate on dividends has been ________ and the tax rate
on capital gains has been ________.
A) 28%, 15%
B) 15%, 15%
C) 25%, 25%
D) 20%, 34%
Answer: B
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
19
Copyright 2011 Pearson Education, Inc.

24) Which of the following is the most probable way in which a shareholder will benefit from a
stock split?
A) The immediately lower share price will attract enough increased interest in the stock to cause
the market price to increase on a more consistent basis.
B) The immediately higher number of shares that an investor owns immediately increases the
investor's wealth.
C) The shareholder can use the immediately increased wealth to borrow more money to buy even
more shares at the immediately lower market price.
D) A shareholder can lose money after a stock split if the market believes that the split was an
artificial way of attracting attention to a company that is not well managed.
Answer: A
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
25) Brimfield Corp. has total cash available of $1 million, but decides to match last year's
dividend payout of $1.5 million. If the company raises the extra $500,000 by selling stock, the
decision to pay out more than its available cash in dividends should:
A) cause the stock price to increase.
B) have no effect on the value of the stock.
C) cause the stock price to decrease.
D) a company cannot use money raised by selling to stock to pay a dividend to existing
stockholders.
Answer: B
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
26) Fred Handel owns 2000 shares of Haydn Inc. stock which is currently selling for $18 per
share. If the company repurchases 10% of its outstanding shares at $18 per share and Fred
chooses to sell back 200 shares:
A) his investment in the company and his percentage of ownership will each decrease by 10%.
B) his investment in the company and his percentage of ownership will stay the same.
C) his investment in the company will decrease by $3,600 and his percentage of ownership will
stay the same.
D) the value of his remaining shares will increase to $20 per share and his percentage of
ownership will fall by 10%.
Answer: C
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value

20
Copyright 2011 Pearson Education, Inc.

27) Fred Handel owns 2000 shares of Haydn Inc. stock which is currently selling for $18 per
share. If the company repurchases 10% of its outstanding shares at $18 per share and Fred
chooses not to sell any shares back to the company,
A) the value of his shares will stay the same and his percentage ownership of the company will
increase by 10%.
B) his investment in the company and his percentage of ownership will stay the same.
C) his investment in the company will decrease by $3,600 and his percentage of ownership will
stay the same.
D) the value of his remaining shares will stay the same and his percentage of ownership will
increase by 11.11%.
Answer: D
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
28) ZZZ Corporation had net income of $100 million last year and 50 million common shares
outstanding. They declared an 8% stock dividend. Calculate EPS before and after the stock
dividend.
A) EPS before would be $2; after the dividend, EPS would be $1.85.
B) There is not enough information to make this calculation.
C) EPS before would be $0.50; after the dividend, EPS would be $0.46.
D) Since they made $100 million in net income, the EPS cannot change.
Answer: A
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
29) Information asymmetry takes into account the higher stock price that can be achieved due to
certainty from the accessibility of information between management and investors.
Answer: FALSE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: information effect
Principles: Principle 4: Market Prices Reflect Information
30) According to the Modigliani & Miller dividend indifference theorem, if a company decreased
its dividend per share, an investor would be forced to sell his common stock at a depressed price.
Answer: FALSE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value

21
Copyright 2011 Pearson Education, Inc.

31) Dividend policy takes on greater importance when transaction fees and taxes are lower.
Answer: FALSE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
32) As a firm's investment opportunities increase, the dividend payout ratio should increase.
Answer: FALSE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
33) The timing of dividend payments will not matter if the firm's rate of return on equity and the
investor's required rate of return are the same.
Answer: TRUE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
34) When considering taxes, most investors prefer capital gains over dividend income.
Answer: TRUE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
35) Empirical evidence is conclusive that dividend policy matters.
Answer: FALSE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
36) The information effect of dividends suggests that dividends are an important communication
tool since management might have no other credible way to inform investors about future
earnings.
Answer: TRUE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: information effect
Principles: Principle 3: Cash Flows Are the Source of Value

22
Copyright 2011 Pearson Education, Inc.

37) The clientele effect suggests that a firm's dividend policy will be affected by the needs of the
shareholders.
Answer: TRUE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: clientele
Principles: Principle 3: Cash Flows Are the Source of Value
38) The clientele effect suggests that firms can change their dividend policy frequently with no
potential adverse effect on the firm.
Answer: FALSE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: clientele
Principles: Principle 3: Cash Flows Are the Source of Value
39) A firm with high profitability will always have the cash flow necessary to pay high
dividends.
Answer: FALSE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
40) When a firm makes the decision to pay dividends, it also makes the decision not to reinvest
the cash in the firm.
Answer: TRUE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
41) Dividends per share divided by earnings per share (EPS) equals the dividend retention date.
Answer: FALSE
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value

23
Copyright 2011 Pearson Education, Inc.

42) Under what conditions would the Modigliani and Miller dividend indifference theorem be
literally true.
Answer: The Modigliani and Miller dividend indifference theorem requires that investors be
able to buy and sell stock without incurring any transaction costs, such as brokerage costs. In
addition, companies can issue stock without incurring any cost in doing so. It assumes that there
are no personal or corporate taxes. Complete information about the firm is readily available, and
there are no conflicts of interest between management and stockholders. Lastly, financial distress
and bankruptcy costs are nonexistent.
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
43) List the benefits of a firm repurchasing its own stock.
Answer: Stock repurchases can be very advantageous to a firm. First, repurchases are a means
for providing an internal investment opportunity as well as an approach for modifying a firm's
capital structure. In general, repurchases create a favorable impact on EPS. Elimination of a
minority ownership group of stockholders can be achieved as well. The firm can minimize the
dilution in EPS associated with mergers and can reduce the costs associated with servicing small
stockholders.
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
44) Georges Bizet owns 10,000 shares of Pearl Co. purchased at an average price of $15 per
share. The tax rate on both dividends and capital gains is 15%. Would Bizet prefer a $2.00 per
share dividend or to sell 1,000 shares back to the company at $20 per share? Compute his aftertax income from each option.
Answer: If Bizet receives the dividend, his tax will be $20,000 .15 = $3,000 and he would
have $17,000 in after-tax income. If the company repurchases the share, he will have a capital
gain of $20 - $15=$5 per share. Of the $20,000 he receives by selling back the shares, only
$5,000 would be taxable. His tax would be $5,000 .15 = $750, so his after-tax income would
be $20,000 - $750 = $19,250. He would be better off by $2,250.
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value

24
Copyright 2011 Pearson Education, Inc.

45) Because money has a time value investors should prefer that dividends be paid sooner rather
than later. Agree or disagree. Explain your answer with a numerical example.
Answer: When investors buy a company's shares, they assume that the company will earn a rate
of return on equity that equals or exceeds their required rate of return. If an investor requires a
10% rate of return and the company decides to defer a $100 dividend for a year, the company
will reinvest the $100 at its ROE and it will grow to $110. Reinvesting the money will allow the
firm to pay a later dividend that is large enough to provide the investor with her required rate of
return. In other words, if an investor requires 10%, she should be indifferent between a $100
dividend now and a $110 dividend a year from now. Note that the 10% includes compensation
for the risk of the future cash flow, the same risk the investor was willing to take when she
bought the stock.
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
46) What is meant by "dividend clienteles"? Give specific examples.
Answer: Some investors purchase stocks with a record of paying stable dividends as a higher
yielding alternative to bonds or certificates of deposits. Such investors could be retirees or
institutions who need the dividends for their operating budgets. Other investors prefer that the
company reinvest all available funds in growth and would rather not receive dividends. These
investors are often high income individuals who would have to pay high taxes. Such investors
prefer to build wealth for the future rather than increase their current income.
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: clientele
Principles: Principle 3: Cash Flows Are the Source of Value
47) Pettry, Inc. expects EPS this year to be $5.25. If EPS grows at an average annual rate of 10%,
and if Pettry pays 60% of its earnings as dividends, what will the expected dividend per share be
in 10 years?
Answer: $5.25 (1 + 0.10)10 = 13.62 = EPS in 10 years
$13.62 0.6 = $8.17 = Expected dividends per share
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value

25
Copyright 2011 Pearson Education, Inc.

48) You are considering the stock of two firms to add to your portfolio. The companies differ
only with respect to their dividend policies. For both firms, investors expect EPS for each of the
next two years to be $7 and dividends and ending price for each of the next two periods to be:
D1
D2
P2
Firm A
$2
$2
$60.70
Firm B
4
4
56.42
The required rate of return for the stock of Firm A is 14%. Ignore taxes or transaction fees.
a. How much would investors pay for the stock of Firm A?
b. How much would investors pay for the stock of Firm B?
c. For a less-than-perfect world, provide an argument for each of the following:
(1) Investors prefer the dividend policy of Firm A.
(2) Investors prefer the dividend policy of Firm B.
(3) Firms prefer the dividend policy of Firm A.
Answer:
a. Po = ($2.00/1.14) + [($2.00 + $60.72)/(1.14)2]
Po = $50
b. Exactly the same in the perfect capital market environment.
Po = ($4.00/1.14) + (($4.00 + $56.42)/(1.14)2)
Po = $50
c. (1) Investors can pay a lower capital gains tax on the growth.
(2) Investors in this firm may need current income.
(3) Firms need additional equity to finance growth.
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
49) Noblesville Auto Supply Company's stock is trading ex-dividend at $5 per share. The
company just paid a 10% stock dividend. The P/E ratio for the stock is 10. What was the price of
the stock prior to trading ex-dividend?
Answer: EPS after stock dividend = ($5.00/10.00) = $.50
EPS after stock dividend = (EPS before stock dividend)/(1.10)
($.50)(1.10) = $.55 = EPS before stock dividend
Stock price prior to stock dividend = (10)($.55) = $5.50
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value

26
Copyright 2011 Pearson Education, Inc.

50) Trevor Co.'s future earnings for the next four years are predicted below. Assuming there are
500,000 shares outstanding, what will the yearly dividend per share be if the dividend policy is
as follows?
a. A constant payout ratio of 40%
b. Stable dollar dividend targeted at 40% of the average earnings over the four-year period
c. Small, regular dividend of $0.75 plus a year-end extra of 40% of profits exceeding $1 million
Trevor Co.
Year 1 $ 900,000
Year 2 1,200,000
Year 3
850,000
Year 4 1,350,000
Answer:
a. .40($900,000)/500,000 = $0.72
.40($1,200,000)/500,000 = $0.96
.40($850,000)/500,000 = $0.68
.40($1,350,000)/500,000 = $1.08
b. .40($1,075,000) = $430,000/500,000 = $0.86
c. Year 1 $0.75 = $0.75
Year 2 $0.75 + $0.16 = $0.91
Year 3 $0.75 = $0.75
Year 4 $0.75 + $0.28 = $1.03
Diff: 2
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
16.3 Cash Distribution Policies in Practice
1) According to the residual dividend payout policy, dividends are considered a residual after:
A) investment financing needs have been met.
B) preferred stock is issued.
C) EPS is allocated.
D) retained earnings are financed.
Answer: A
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: residual dividend
Principles: Principle 3: Cash Flows Are the Source of Value
2) Dividends tend to be more stable than:
A) cash flow.
B) earnings.
C) preferred stock.
D) both B and C.
Answer: B
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
27
Copyright 2011 Pearson Education, Inc.

Principles: Principle 3: Cash Flows Are the Source of Value


3) Which of the following dividend policies would cause dividends per share to fluctuate the
most?
A) Residual dividend policy
B) Stable dollar dividend
C) Small, low, regular dividend plus a year-end extra
D) Small, low, regular dividend
Answer: A
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
4) All of the following might influence a firm's dividend payment EXCEPT:
A) investment opportunities.
B) investor transaction costs.
C) common stock par value.
D) flotation costs.
Answer: C
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
5) Which of the following would influence a firm's decision about dividends for large firms?
A) Ownership control
B) Liquidity position
C) Earnings predictability
D) Both B and C
Answer: D
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
6) A firm that maintains stable cash dividends will generally not increase the dividend unless:
A) a stock split occurs.
B) the firm merges with another profitable firm.
C) the firm is sure that a higher dividend level can be maintained.
D) the price-earnings (P/E) ratio increased steadily over the past five years.
Answer: C
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
28
Copyright 2011 Pearson Education, Inc.

7) A justification for stable dividends could be:


A) satisfaction of guaranteed current income.
B) satisfaction for stockholders' informational needs.
C) existence of legal listing.
D) all of the above.
Answer: D
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
8) The problem with the residual dividend policy ratio is:
A) investors might come to expect a specified amount.
B) the dollar amount of the dividend fluctuates from year to year.
C) management is reluctant to cut the dividend even if there are low profits in a year.
D) all of the above are possible problems.
Answer: B
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: residual dividend
Principles: Principle 3: Cash Flows Are the Source of Value
9) Which of the following statements about the residual dividend theory is FALSE?
A) The firm will maintain its optimum debt ratio in financing future investments.
B) Dividend policy by itself has no direct influence on the market price of the firm's common
stock.
C) The firm will issue new common stock to finance investment opportunities in order to ensure
that some dividend will be paid.
D) The firm's investment opportunities, capital structure, and profitability all influence the firm's
dividend policy.
Answer: C
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: residual dividend
Principles: Principle 3: Cash Flows Are the Source of Value
10) Which of the following motivates corporations to enter into stock repurchase programs?
A) Favorable impact on EPS
B) Expected favorable impact on stock price
C) To modify the firm's capital structure
D) All of the above
Answer: D
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
29
Copyright 2011 Pearson Education, Inc.

11) Which of the following is the most important factor motivating dividend policy for large
American corporations?
A) Changes in EPS
B) Maintain constant dividend payout ratio
C) Avoiding flotation costs of selling new stock
D) Avoid reducing dividends per share
Answer: D
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
12) Which of the following is most likely to have a negative impact on stock price?
A) Omitting a stock repurchase offer
B) Failure to increase the dividend at the same rate as previous years
C) Cutting the dividend per share in dollar terms
D) Reducing the dividend payout ratio
Answer: C
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
13) Which of the following is least important to repurchase decisions of large American
corporations?
A) The stock seems to be underpriced in the market.
B) Reducing cash to force executives to focus on efficient investment decisions.
C) Lack of good investment opportunities for cash retained in the firm.
D) The company is holding more cash than it would like.
Answer: B
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
14) In practice, firms tend to increase their dividend:
A) when the stock seems to be underpriced in the market.
B) Reducing cash to force executives to focus on efficient investment decisions.
C) only when they believe they can sustain the increased payout indefinitely.
D) when company is holding more cash than it would like.
Answer: C
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value

30
Copyright 2011 Pearson Education, Inc.

15) Which of the following statements is true?


A) The stable dividend payout ratio keeps the dollar amount of the dividend stable.
B) Dividends usually do not increase unless management is convinced that the higher dividend
can be maintained in the future.
C) The dividend policy which allows for an extra dividend at year-end in prosperous years
includes a fairly large regular dividend payment per share every year.
D) All of the above are true.
Answer: B
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
16) Which of the following is more true of cash dividends than of repurchase offers?
A) The amount of cash to be returned to shareholders is flexible on a year to year basis.
B) External funds would be raised before reducing stock repurchase offers but not before cutting
cash distributions.
C) Cash distribution decisions would take priority over investment decisions.
D) The stock price would be severely penalized if the cash distribution is reduced.
Answer: A
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
17) What is the fundamental purpose of a stock split?
A) A split shows the company's preference for retaining funds.
B) A split immediately brings the stock price to a lower trading range.
C) A split immediately increases the investor's wealth.
D) A split increases the threat of a hostile takeover.
Answer: B
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
18) According to the residual theory of dividends:
A) dividends are to be paid out only after investment financing needs have been met.
B) earnings remaining after payment of preferred stock dividends should be paid to common
stockholders.
C) dividend payments are a constant percentage of EPS.
D) a dividend is the residual above the payout ratio.
Answer: A
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: residual dividend
Principles: Principle 3: Cash Flows Are the Source of Value
31
Copyright 2011 Pearson Education, Inc.

19) Franklin Electric is presently generating earnings available to common shareholders of $7.25
per share. The firm's income tax rate is 40%. Franklin is paying a dividend to the preferred
shareholders of $2.10 per share. The firm's dividend payout ratio on common stock is 20%. What
is the amount per share that Franklin will pay in dividends to common shareholders?
A) $0.58
B) $1.45
C) $3.12
D) $0.42
E) $2.20
Answer: B
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
20) Stock splits:
A) increase the number of shares outstanding.
B) decrease the common stock account by the amount of the split.
C) reduce retained earnings.
D) increase the total wealth of stockholders.
E) none of the above.
Answer: A
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
21) The dividend policy that states smoothing of the dividend stream in order to minimize the
effect of company reversals is called the:
A) increasing-stream hypothesis of dividend policy.
B) stable dividend policy.
C) clientele effect policy.
D) residual payout policy.
Answer: B
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: residual dividend
Principles: Principle 3: Cash Flows Are the Source of Value

32
Copyright 2011 Pearson Education, Inc.

22) Which of the following considerations would be expected to influence a firm's decision
regarding the payment of dividends?
A) Earnings predictability
B) Legal restrictions
C) Liquidity position
D) All of the above
Answer: D
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
23) Groups of investors who prefer one distribution method over another are known as:
A) pressure groups.
B) return chasers.
C) dividend clienteles.
D) retirees.
Answer: C
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: clientele
Principles: Principle 3: Cash Flows Are the Source of Value
24) We typically expect to find rapidly growing firms to have high payout ratios.
Answer: FALSE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
25) A stable dividend policy generally leads to a lower required rate of return on the part of the
investor when compared to similar stocks with erratic fluctuations in dividends.
Answer: TRUE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
26) The residual dividend theory suggests that dividends should be paid to stockholders first, and
then, what is left can be reinvested by the firm.
Answer: FALSE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: residual dividend
Principles: Principle 3: Cash Flows Are the Source of Value

33
Copyright 2011 Pearson Education, Inc.

27) Company managers strive to gradually increase dividend series over the long-term future.
Answer: TRUE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
28) Unexpected dividend changes would cause investors to reassess their perceptions about a
firm's stock.
Answer: TRUE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
29) Information asymmetry takes into account the higher stock price that can be achieved due to
certainty from the accessibility of information between management and investors.
Answer: FALSE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: information effect
Principles: Principle 4: Market Prices Reflect Information
30) European firms tend to pay out more dividends than U. S. firms.
Answer: TRUE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
31) The stable dividend policy is the most common.
Answer: TRUE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
32) The residual dividend theory indicates that a firm would never pay dividends unless the
firm's profits were larger than its equity financing needs.
Answer: TRUE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: residual dividend
Principles: Principle 3: Cash Flows Are the Source of Value

34
Copyright 2011 Pearson Education, Inc.

33) Share repurchases convey information to investors that the shares are underpriced.
Answer: TRUE
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: information effect
Principles: Principle 3: Cash Flows Are the Source of Value
34) Compare management's motives for preferring either stock repurchases or cash dividends.
Answer: Cash dividends and repurchase offers are both ways to return cash to shareholders and
both tend to convey positive information about the company's stock price and future earnings.
Once a company begins paying cash dividends, it is under considerable pressure to at least match
and preferably increase dividends each year. Repurchase offers put less pressure on management
to pay out cash each year. They are more like the "residual dividend policy" in that the company
only needs to pay out cash when all other demands have been met.
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
35) Compare the Stable Dividend Payout to the Residual Dividend Policy.
Answer: A stable dividend payout policy tries to avoid unpleasant surprises to the company's
shareholder clientele who may depend on the dividends to meet their income needs. Companies
who follow this policy consider the predictability of dividends more important than the size or
payout ratio and only increase dividends when they are quite certain that they can maintain the
increased payout. A company that followed a residual dividend policy would only pay a dividend
after all operational and investment needs had been met. Such a policy would lead to large year
to year fluctuations in the dollar amount of dividends. The residual dividend policy is much less
popular with investors and therefore with managers as well.
Diff: 2
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value

35
Copyright 2011 Pearson Education, Inc.