Chapter 16 - Payout Policy

Chapter 7.2: Payout Policy

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1. Firms can pay out cash to their shareholders in the following ways:
I) Dividends
II) Share repurchases
III) Interest payments 
A. I only
B. II only
C. I and II only
D. III only

2. Dividends are decided by:

I) The managers of a firm
II) The government
III) The board of directors 
A. I only
B. II only
C. III only
D. I and II only

3. Which of these dates occurs last in time (when arranged in the chronological order)? 
A. Payment date
B. Ex-dividend date
C. Record date
D. Dividend declaration date

4. Which of the following lists events in the chronological order from earliest to latest? 
A. Record date, declaration date, ex-dividend date
B. Declaration date, record date, ex-dividend date
C. Declaration date, ex-dividend date, record date
D. None of the above

 5. OnJanuary 2, Michigan Mining declared a $25-per-share quarterly dividend payable on

March 9th to stockholders of record on February 9. What is the latest date by which you could
purchase the stock and still get the recently declared dividend? 
A. February 5
B. February 6
C. February 7
D. February 8

6. Which of the following dividends is never in the form of cash?

I) Regular dividend
II) Special dividend
III) Stock dividend
IV) Liquidating dividend

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A. I only
B. II only
C. III only
D. I, II, and IV only

7. The following statements are true of dividend reinvestment plans (DRIPs):

I) offered by the companies to their shareholders
II) generally, new shares are issued at a discount
III) the dividends are taxable as ordinary income 
A. I only
B. I and II only
C. I, II and III
D. III only

8. Firms can repurchase shares in the following ways:

I) Open market repurchase
II) Through a tender offer
III) Through a Dutch auction process
IV) Through direct negotiation with a major shareholder 
A. I only
B. II only
C. III only
D. I, II, III, and IV

9. Dutch auction process is the same as: 

A. discriminatory price auction
B. uniform price auction
C. English auction
D. none of the above

 10. Thepar value of the outstanding shares is defined as: 

A. Retained earnings
B. Legal capital
C. Book value of equity
D. None of the above

11. The procedure where the firm states a series of prices at which it is prepared to repurchase
stock. Shareholders submit offers indicting how many shares they wish to sell at each price.
The firm then calculates the lowest price at which it is able to buy the desired number of
shares. This procedure is known as: 
A. Open market transaction
B. Dutch auction
C. Green mail
D. None of the above

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12. The most important difference between stock repurchases and cash dividends is that they:
I) Benefit different groups
II) Have different effects on corporate cash flow
III) May have different tax consequences 
A. I only
B. II only
C. III only
D. I, II, and III

13. Greenmail refers to the practice of a company purchasing its stock, usually at a high price,
from: 
A. Small shareholders who are happy with performance of the firm
B. A hostile shareholder who threatens to take over the firm
C. Large shareholders who are happy with performance of the firm
D. None of the above

14. Which of the following is not true? 

A. Firms have long-run target dividend payout ratios
B. Dividend changes follows shifts in long-term, sustainable earnings
C. Managers are reluctant to make dividend changes that might have to be reversed
D. All of the above

15. Generally, firms resort to repurchase of stock because:

I) Firms have accumulated large amount of excess cash
II) Firms want to change their capital structure
III) Firms want to substitute it for regular dividends 
A. I only
B. II only
C. I and II only
D. III only

16. Generally, firms resort to repurchase of stock during:

I) boom times at an increasing rate as firms accumulate excess cash
II) recession at an increasing rate because of the low stock price
III) boom as well as recession at a steady rate 
A. I only
B. II only
C. III only
D. II and III only

17. According to financial executives' views about dividend policy, the following statement is
the most frequently cited one:
I) we try to avoid reducing the dividend
II) we try to maintain a smooth dividend stream

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III) we look at the current dividend level
IV) we are reluctant to make a change that may have to be reversed 
A. I only
B. II only
C. III only
D. IV only

18. Generally, investors interpret the announcement of an increase in dividends as: 

A. bad news and the stock price drops
B. good news and the stock price increases
C. a non-event and does not affect the stock price
D. very bad news and the stock price plunges

19. Generally, investors interpret the announcement of a decrease in dividends as: 

A. bad news and the stock price drops
B. good news and the stock price increases
C. a non-event and does not affect the stock prices
D. very good news and the stock price jumps up

 20. Generally,investors view the announcement of open-market repurchase of stocks as: 

A. bad news and the stock price drops
B. good news and the stock price increases
C. a non-event and does not affect the stock prices
D. very good news and the stock price jumps up

21. One key assumption of the Miller and Modigliani (MM) dividend irrelevance argument is
that: 
A. Future stock prices are certain
B. There are no capital gains taxes
C. All investments are risk-free
D. New shares are sold at a fair price

22. The indifference proposition regarding dividend policy: 

A. Assumes that tax rates increase at the same rate as inflation
B. Assumes that investors are indifferent about the timing of dividend payments
C. States that investors are indifferent between stock dividends and cash dividends
D. States that investors are indifferent between stock repurchase and cash dividends

 23. One key assumption of the Miller and Modigliani (MM) dividend irrelevance is that: 
A. Future stock prices are certain
B. There are no capital gains taxes
C. Capital markets are efficient
D. All investments are risk-free
 24. The dividend-irrelevance proposition of Miller and Modigliani depends on the following

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relationship between investment policy and dividend policy. 
A. The level of investment does not influence or matter to the dividend decision
B. Once the dividend policy is set the investment decision can be made as desired
C. The investment policy is set before the dividend decision and not changed by dividend
policy
D. None of the above

25. Company X has 100 shares outstanding. It earns $1,000 per year and expects to pay all of
it as dividends. If the firm expects to maintain this dividend forever, Calculate the stock price
today. (The required rate of return is 10%) 
A. $110
B. $90
C. $100
D. None of the above

Dividends = 1000/100 = $10; P = 10/0.1 = $100

26. Company X has 100 shares outstanding. It earns $1,000 per year and expects to pay all of
it as dividends. If the firm expects to maintain this dividend forever, Calculate the stock price
after the dividend payment. (The required rate of return is 10%) 
A. $110
B. $90
C. $100
D. None of the above

Dividends = 1000/100 = $10; P = 10/0.1 = $100;

Price after dividend payment = $90

27. Company X has 100 shares outstanding. It earns $1,000 per year and expects repurchase
its shares in the open market instead of paying dividends. Calculate the number of shares
outstanding at the end of year-1, if the required rate of return is 10%. 
A. 110
B. 90
C. 100
D. None of the above

Share price before repurchase = [1000/100]/0.1 = 100

Instead of paying dividends they can repurchase 10 shares

28. One possible reason that shareholders often insist on higher dividends is: 
A. They agree with Miller and Modigliani
B. Tax consideration
C. The stock market is efficient
D. They do not trust managers to spend retained earnings wisely

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29. The rightist position is that the market will reward firms that: 
A. Have high dividend yield.
B. Have low dividend yield.
C. Are well managed, regardless of dividend yield.
D. None of the above.

30. According to behavioral finance investors prefer dividends because: 

A. investors prefer the discipline that comes from spending only the dividends
B. of the tax consideration
C. stock market is efficient
D. all of the above

31. If investors do not like dividends because of the additional taxes that they have to pay,
how would you expect stock prices to behave on the ex-dividend date? 
A. Fall by more than the amount of the dividend
B. Fall exactly by the amount of the dividend
C. Fall by less than the amount of the dividend
D. Cannot be predicted

32. If both dividends and capital gains are taxed at the same ordinary income tax rate, the
effect of tax is different because: 
A. Capital gains are actually taxed, while dividends are taxed on paper only
B. Dividends are taxed when distributed while capital gains are deferred until the stock is sold
C. Both dividends and capital gains are taxed every year
D. Both A and C

33. If dividends are taxed more heavily than capital gains, the investors: 
A. Should be willing to pay more for stocks with low dividend yields
B. Should be willing to pay more for high dividend yields
C. Should be willing to pay the same for stocks regardless of the dividend yields
D. Cannot be predicted as stock prices fluctuate randomly

34. If investors have a marginal tax rate of 20% and a firm has announced a dividend of $5; 
A. The price of stock should decrease by $4 on the ex-dividend date
B. The price of the stock should decrease by $5 on the ex-dividend date
C. The price of the stock should increase by $5 on the ex-dividend date
D. The price of the stock should increase by $4 on the ex-dividend date

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35. Two corporations A and B have exactly the same risk and both have a current stock price
of $100. Corporation A pays no dividend and will have a price of $120 one year from now.
Corporation B pays dividends and will have price of $113 one year from now after paying the
dividend. The corporations pay no taxes and investors pay no taxes on capital gains but pay a
tax of 30% income tax on dividends. What is the value of the dividend that investors expect
corporation B to pay one year from today? 
A. $7
B. $13
C. $10
D. None of the above

Dividend = (120 - 113)/0.7 = $10

36. Which of the following investors have the strongest tax reason to prefer dividends over
capital gains? 
A. Pension funds
B. Financial institutions
C. Individuals
D. Corporations

37. If the corporate tax rate is 35%, what is the maximum effective tax rate on dividends
received by another corporation? 
A. 35%
B. 30%
C. 10.5%
D. None of the above

70% of dividends received by another corporation is tax-exempt. Tax rate = (0.3) * (0.35) =
0.105 = 10.5%

38. According to middle-of-the-roaders, a firm's value is not affected by its dividend policy

because: 
A. of the clientele effect
B. of the tax loopholes available to wealthy stockholders
C. well-managed companies prefer to signal their worth by paying high dividends
D. All of the above

39. A firm in Australia earns a pretax profit of $A10 per share. It pays a corporate tax of $3
per share (30% tax rate) in taxes. The firm pays the remaining $A7 in dividends to a
shareholder in 30% tax bracket. What is the amount of tax paid by the shareholder under the
imputation tax system? 
A. $A2.10
B. Zero
C. $A3.00
D. None of the above

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40. A firm in Australia earns a pretax profit of $A10 per share. It pays a corporate tax of $3
per share (30% tax rate) in taxes. The firm pays the remaining $A7 in dividends to a
shareholder in 40% tax bracket. What is the amount of tax paid by the shareholder under the
imputation tax system? 
A. $A1.00
B. Zero
C. $A4.00
D. None of the above

41. What would best explain the reluctance of General Motors to eliminate its dividend in
2008, only a few months before its financial collapse and eventual government takeover? 
A. Clientele effect
B. Leftist theory
C. Rightest theory
D. Signaling hypothesis

42. What dividend policy is probably the best from a financial standpoint, but not likely to be
accepted by the market place or investors? 
A. High dividend
B. Low dividend
C. Residual dividend
D. Signaling dividend

 43. Firms can pay out cash to their shareholders in two ways: cash dividends and stock
dividends. FALSE

44. In 2005, ExxonMobil was the largest repurchaser of its own shares with $18.2 billion
worth of repurchases. TRUE

 45. Adoption of Rule 10b-18 by the SEC, in the year 1982, has protected firms from being
prosecuted for manipulating their share price through share repurchases. TRUE

46. The managers of the firm set the dividend paid to the shareholders. FALSE

47. Usually "special" or "extra" dividend is unlikely to be repeated in the future. TRUE

48. Because greenmail involves the repurchase of stock at a price higher than the market
price, all shareholders benefit. FALSE

49. Many companies have automatic dividend reinvestment plans (DRIPs). TRUE

50. An alternative to paying cash dividends is to pay stock dividends. FALSE

51. Dividend payments are used to change the capital structure by replacing equity with
debt. FALSE

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52. Firms have long-run target dividend payout ratios. TRUE

53. Stock repurchases are like bumper dividends, but they are not typically substitute for
regular cash dividends. TRUE

54. Managers are reluctant to make dividend changes that may have to be reversed. TRUE

55. Managers try to avoid reducing the dividend. TRUE

56. Miller and Modigliani's argument for dividend irrelevance assumes an efficient

market. TRUE

57. Australia follows the imputation tax system. TRUE

58. The original work conducted on the dividend payout practices of companies was
conducted by Lintner. TRUE

59. If you accept the dividend irrelevancy theory, it is possible to maintain a high dividend
clientele and still fund future growth. TRUE

60. Briefly explain the chronology of dividend payment. 

The board of directors set the dividend for a firm. The date on which the board of directors
announce the dividend is called the declaration date. Dividend will be paid to shareholders as
of record date. Two business days prior to record date is the ex-dividend date. Shares bought
on the ex-dividend date or later does not come with the dividend. The date checks are mailed
to the shareholders is the payment date.

61. What is SEC Rule 10b-18? Briefly explain. 

SEC Rule 10b-18 was adopted in 1982. Prior to adoption of this rule, firms that repurchased
the shares of their own firm were liable for prosecution for manipulating their share price.
SEC Rule 10b-18 has provisions that protect firms against such a prosecution.

62. Briefly discuss different ways in which a firm can pay dividends to its shareholders. 

Firms pay a regular cash dividend each quarter. Occasionally, firms pay extra or special
dividends. Frequently firms also declare stock dividends. That is, shareholders receive
additional shares of stock instead of cash. Many times firms might repurchase their own
stock. This is in lieu of paying dividends. "Greenmail" is another form of share repurchase.

63. Briefly explain the information content of share repurchase. 

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Share repurchases are generally a rare event. When a firm announces a repurchase program it
is not making a long-term commitment. Firms repurchase shares when they accumulated cash
that they are not able to invest profitably. Share repurchase may indicate under priced stock.
Share repurchase may also be used to signal management's confidence in the future of the
firm.

64. State Miller and Modigliani's proposition on dividend irrelevance. 

Miller and Modigliani state that in a world without taxes, transaction costs or other market
imperfections, dividend policy followed is irrelevant to the value of the firm.

65. Rightists argue that increasing a firm's dividend will increase its value. State some key
points in their assertion. 

Investors prefer cash to capital gains as cash dividends are certain and capital gains are
uncertain; many investors prefer cash, as they need it for living expenses; investors see the
information converged by dividend payments as indicative of a firm's good performance.

66. Briefly describe the leftists' point of view on dividends and taxes. 

If the dividends are taxed at a higher rate than capital gains, firms should pay the lowest cash
dividends. By shifting their distribution policy, corporations can transform dividends into
capital gains. Leftists generally favor low dividend payout.

67. Briefly explain how current tax laws favor capital gains? 

Tax rate on capital gains tax rate is 20%, while for taxable income it is much higher. Tax laws
favor capital gains in another way. Taxes on dividends have to be paid immediately. But,
taxes on capital gains can be deferred until the shares are sold and capital gains realized. The
longer the shareholders wait, less the present value of capital gains liability.

 68. Briefly describe the middle-of-the-roaders' position. 

Middle-of-the-roaders hold that a firm's value is not affected by its dividend policy.

 69. Briefly explain how shareholders' returns are taxed twice in the United States? 

Shareholders' returns are taxed at the corporate level as corporate tax, and at the shareholders
level as either income tax or capital gains tax.

70. Briefly describe the "imputation tax system." 

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In the imputation tax system, shareholders are taxed on dividends, but they receive a tax
deduction, which is equal to their share of the corporate tax that the company has paid. This is
followed in Australia.

71. Briefly explain how the shareholders are taxed twice in the U.S.A. using an example. 

   

72. Briefly explain how the imputation tax system works in Australia using an example. 

   

73. A retiree believes that investing in a non-dividend paying growth firm, that requires the
periodic sale of stock for income, will eventually lead to a loss of all shares. Explain the flaw
in this logic. 

A growth firm, by definition, we have an increasing share price. Over time the firm will either
have stock splits to maintain a stock price within a certain trading range or the price will go
up substantially over time. In the case of stock splits, the retiree will get an ever increasing
number of shares. In the case of an increasing share price, the retiree will need to liquidate an
ver decreasing quantity of shares. In either case, the share will not disappear any faster than
they would through dividend payments.

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