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Exam 14: Distributions to Shareholders: Dividends and Share Repurchases

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Question 31

True/False

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If on January 3, 2014, a company declares a dividend of $1.50 per share, payable on January 31, 2014, then the price of the stock should drop by approximately $1.50 on January 31.

A) True
B) False

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Question 32

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The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price.

A) True
B) False

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Question 33

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

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

Fauver Industries plans to have a capital budget of $650,000. It wants to maintain a target capital structure of 40% debt and 60% equity, and it also wants to pay a dividend of $225,000. If the company follows the residual dividend model, how much net income must it earn to meet its investment requirements, pay the dividend, and keep the capital structure in balance?

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

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.

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.

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.

If a firm adheres strictly to the residual dividend model, the issuance of new common stock would suggest that

Ring Technology has a capital budget of $850,000, it wants to maintain a target capital structure of 35% debt and 65% equity, and it also wants to pay a dividend of $400,000. If the company follows the residual dividend model, how much net income must it earn to meet its capital budgeting requirements and pay the dividend, all while keeping its capital structure in balance?

If a firm declares a 20:1 stock split, and the pre-split price was $500, then we might expect the post-split price to be $25. However, it often turns out that the post-split price will be higher than $25. This higher price could be due to signaling effects investors believe that management split the stock because they think the firm is going to do better in the future. The higher price could also be because investors like lower-priced shares.

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.

Which of the following statements is CORRECT?

Sheehan Corp. is forecasting an EPS of $3.00 for the coming year on its 500,000 outstanding shares of stock. Its capital budget is forecasted at $800,000, and it is committed to maintaining a $2.00 dividend per share. It finances with debt and common equity, but it wants to avoid issuing any new common stock during the coming year. Given these constraints, what percentage of the capital budget must be financed with debt?

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.

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.

Dentaltech Inc. projects the following data for the coming year. If the firm follows the residual dividend model and also maintains its target capital structure, what will its dividend payout ratio be? $\begin{array} { l c l c } \text { EBIT } & \$ 2,000,00 & \text { Capital budget } & \$ 850,000 \\\text { Interest rate } & 10 \% & \% \text { Debt } & 40 \% \\\text { Debt outstanding } & \$ 5,000,00 & \% \text { Equity } & 60 \% \\\text { Shares outstanding } & 5,000,000 & \text { Tax rate } & 40 \%\end{array}$

Walter Industries is a family owned concern. It has been using the residual dividend model, but family members who hold a majority of the stock want more cash dividends, even if that means a slower future growth rate. Neither the net income nor the capital structure will change during the coming year as a result of a dividend policy change to the indicated target payout ratio. By how much would the capital budget have to be cut to enable the firm to achieve the new target dividend payout ratio? $\begin{array} { l r } \% \text { Debt } & 35 \% \\\% \text { Equity } = 1.0 - \% \text { Debt } & 65 \% \\\text { Capital budget under the residual dividend model } & \$ 5,000,000 \\\text { Net income; it will not change this year even if dividends increase } & \$ 3,500,000 \\\text { Equity to support the capital budget = \% Equity } \times \text { Capital budget } & \$ 3,250,000 \\\text { Dividends paid = NI - Equity needed } & \$ 250,000 \\\text { Currently projected dividend payout ratio } & 7.1 \% \\\text { Target dividend payout ratio } & 70.0 \%\end{array}$

Your firm uses the residual dividend model to set dividend policy. Market interest rates suddenly rise, and stock prices decline. Your firm's earnings, investment opportunities, and capital structure do not change. If the firm follows the residual dividend model, then its dividend payout ratio would increase.