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Exam 16: Dividends

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Question 31

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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.

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Question 32

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Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $90 per share. The firm's total market value was unchanged by the split. Other things held constant, what is the best estimate of the stock's post-split price?

A) $30.00
B) $31.50
C) $33.08
D) $34.73
E) $36.47

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Question 33

Multiple Choice

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Clark Farms Inc. has the following data, and it follows the residual dividend model. Currently, it finances with 15% debt. Some Clark family members would like for the dividends to be increased. If Clark increased its debt ratio, which the firm's treasurer thinks is feasible, by how much could the dividend be increased, holding other things constant?

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

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 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.

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

New Orleans Builders Inc. has the following data. If it follows the residual dividend model, what is its forecasted dividend payout ratio?

Which of the following statements is CORRECT?

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

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.

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.

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?

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

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.

One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest.

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.

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.