Test ID: 7440559
Dividends and Share Repurchases: Analysis
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In a world with taxes and brokerage costs:
dividend policy may be relevant.
Modigliani and Miller say that dividend policy is relevant. Modigliani and Miller say that dividend policy is irrelevant.
Explanation
Modigliani and Miller assume a world without taxes and transaction costs. They (correctly) claim that the validity of their theory should be judged on empirical tests, not the realism of their assumptions. Myron Gordon and John Lintner have championed the "bird-in-the-hand" theory, which gives greater value to firms with high dividend yields because investors perceive dividends to be less risky than capital gains.
The Skubin Candy Company is a highly profitable and rapidly growing maker of chocolates and other confections. Skubin's management team is considering various dividend policies and is most concerned about the possibility of the dividend amount decreasing from one year to another and the negative reaction from investors that such a decrease may cause. Under which dividend policy would Skubin's dividend be mostlikely to decline ina given year?
Residual dividend.
Longer-term residual dividend. Target payout ratio.
Explanation
Since SkubinCandy Corporation is aprofitable, rapidly growing company, a target payout policy is likely to lead to consistent
dividend increases.Aresidual dividendapproach, however, could lead to adecrease in the dividend if the company has sufficient positive NPV investment opportunities, thus leaving fewerdollars available fordividendpayments.
Stargell Industries follows a strict residual dividendpolicy.The company has acapital budget of $3,000,000.It has a target
capital structure that consists of30% debt and70% equity.The company forecasts that its net income will be $3,500,000.
What will be the company's expecteddividendpayout ratio this year? 40%.
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Question #6 of 45
QuestionID:462689Explanation
In order to maintain the optimal capital structure, new projects will be financed with the same mix ofdebt and equity. Therefore, if the capital budget is $3,000,000fornext year the equity portion will be 70% of $3,000,000, or $2,100,000.The
remainder will be financed withdebt.If Net Income is $3,500,000 thendividends will be $1,400,000. (Dividends = Net Income − equity portion ofcapital budget = $3,500,000 − $2,100,000).The dividendpayout ratio is equal to dividends divided by net income. $1,400,000 / $3,500,000 = 0.40 or40%.
Which of the following statements regarding dividendpolicies is CORRECT?
Companies using a longer-term residual dividend policy pay a steady dividend
based on long-term forecast of their capital budget.
Aconstant payout ratio approach is likely to result ina lowerrisk premium assigned to
acompany by investors.
Companies following adividend stability policy seek to pay aconstant dollaramount
per share overa long period of time.
Explanation
Companies following a longer-term residual dividendapproachforecast theircapital budget overa longer time frame (5-10
years). Leftover earnings over this periodare allocatedas dividends andpaid out inrelatively equal amounts each year.The other statements are incorrect. Witha stable dividendpolicy, companies seek to increase theirdividend each yearat a constant rate.Aconstant payout approach means that dividends will vary inproportion with earnings, likely resulting involatile
dividends andahigherrisk premium.
According to the "clientele effect" ofdividendpolicy, which of the following groups is mostlikely to be attracted to low dividend payouts?
High-income individual investors.
Tax exempt pensionfunds.
Corporations exempt from taxes on 85% ofdividend income.
Explanation
High-income individuals inhigh tax brackets wouldprefercapital gains overdividends as they have the greatest benefit from
deferral of taxes.
ᅞ A)
A person who believes in the clientele effect and a proponent of the "bird-in-hand"
Question #9 of 45
QuestionID:462696ᅞ A) ᅞ B) ᅚ C)
Question #10 of 45
QuestionID:462703ᅚ A) ᅞ B) ᅞ C)
Question #11 of 45
QuestionID:462701Explanation
Taxesondividendsareonefactor that sometimesdiscouragescompaniesfrompaying dividends, howeverifmost shareholdersare tax exempt, tax considerationsareunlikely todiscourageacompanyfrommaking dividendpayouts.A company withhighflotationcostsislesslikely topayout highdividends, toensure that projectscan befinanced through earningsand to thusavoid theexpenseofissuing new shares.Bondholdersareoftencontractuallyprotectedfromhigh dividendpayouts; strong debt covenantsarelikely toprevent thecompanyfrommaking highdividendpayouts.
International Pulp, aSwiss-basedpapercompany, hasannualpretax earnings (inSwissfrancs)ofSF 600.Thecorporate tax rateonretainedearningsis55%, and thecorporate tax rate that applies toearningspaidout asdividendsis30%.
Furthermore, International Pulppaysout 30% ofitsearningsasdividends, and theindividual tax rate that applies todividends is40%.
What is theeffective tax rateoncorporateearningspaidout asdividends?
48%. 70%. 58%.
Explanation
Thisisanexampleofasplit-ratecorporate tax system.Thecalculationof theeffective tax rateonaSwissfrancofcorporate incomedistributedasdividendsis basedon thecorporate tax ratefordistributedincome.
Theeffective tax rateonincomedistributedasdividends = 30% + [(1 − 30%) × 40%] = 58%.
Under theresidualdividendmodel, firmsfinanced with100% equity woulddoallof thefollowing EXCEPT: borrow money to maintain the dividend payout schedule.
determine theiroptimalcapital budgets.
paydividendsonlyifmoreearningsareavailable thanneeded tosupport theoptimal capital budget.
Explanation
ᅞ A) ᅚ B) ᅞ C)
Question #12 of 45
QuestionID:462684ᅞ A) ᅚ B) ᅞ C)
Last year, Calfee Multimediahadearningsof $4.00pershareandpaidadividendof $0.30.In thecurrent year, thecompany expects toearn $5.20pershare.Calfeehasa30% target payout ratio.If theexpecteddividendfor thisyearis $0.39, what timeperiodisCalfeemostlikelyusing inorder to bring itsdividendup to the target payout?
8 years. 4years.
3years.
Explanation
Theformula todetermine theexpecteddividendina target payout approachis:
Expecteddividend = (previousdividend) + [(expectedincreasein EPS) × (target payout ratio) × (adjustment factor)], where the adjustment factoris1 / numberofyearsover which theadjustment will takeplace.
Using thenumbers given:
$0.39 = $0.30 + [($5.20 - $4.00) × (0.30) × (1 / n)] $0.39 = $0.30 + [($1.20) × (0.30) × (1 / n)] $0.09 = $0.36 × (1 / n)
0.25 = (1 / n) n = 4
Inarecent lectureat aseminar titled "Dividends - DoTheyReally Matter?", Matthew Janowski, CFA, made thefollowing two statementsregarding theinformationcontent individendpolicychangesacrosscountries:
Statement 1:In the U.S., investorsinfer that smallchangesindividendsdonot sendamajorsignalabout acompany'sfuture prospects toexisting andpotentialshareholders.
Statement 2:InAsiancountriessuchas Japan, investorsareunlikely toassume that evenalargechangeindividendpolicy signalsanything about acompany'sfutureprospect.
Withrespect to Janowski'sstatements:
both are correct. onlyoneiscorrect. bothareincorrect.
Explanation
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QuestionID:462714TinaDonaldsonis theChief Financial Officerfor Outback SupplyCorporation (OSC). OSCisconsidering revising itsdividend payout policyandDonaldsonhas beenasked by the boardofdirectors tosuggest alternativesfor the board toconsider. Donaldsonpreparesamemolisting the benefitsofaresidualdividendmodel.Thememoincludes three keypoints: Point 1:Aresidualdividendpolicyissimplefor thecompany touseandeasy toimplement.
Point 2:Theresidualdividendapproachallowsmanagement todetermineinvestment opportunities without having to take dividendsintoconsideration.
Point 3:Because thefirmismaximizing itspositivenet present valueopportunities witharesidualdividendmodel, investors arelikely toperceive thefirmashaving lessrisk.
WhichofDonaldson'spointsdescribing advantagesof theresidualdividendapproacharemostaccurate?
Points 1,2, and 3. Point 2 only. Points1and 2 only.
Explanation
Theresidualdividendapproachiseasyforacompany touseandimplement - thecompanysimplyreinvestsearningsneeded tomaintainand grow the business, andpaysout anyleft overearningsout asdividends.Theresidualdividendapproachalso allowsmanagement todetermineinvestment opportunities without having to takedividendsintoconsideration. Note that the residualdividendapproachislikely tolead todividends that fluctuatedramaticallyfromyear toyear.Sinceinvestorsprefer stabledividends, theyarelikely toperceiveafirmfollowing aresidualdividendapproachashaving greaterrisk, whichisoneof thedisadvantagesof theapproach.
Whichof thefollowing statementsabout differencesobservedinpayout trendsin USand Europeismostaccurate? The percentage of companies making stock repurchases has been trending
downwards both in the US and Europe.
Alowerproportionof UScompaniespaydividendsascompared to their European counterparts.
Ahigherproportionof UScompaniespaydividendsascompared to their European counterparts.
Explanation
Alowerproportionof UScompaniespaydividendsascompared to their Europeancounterparts.Thepercentageof companiesmaking stock repurchaseshas been trending upwardsin the US (since1980s), the UK andcontinental Europe (since1990s).
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Question #17 of 45
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A high dividend payout ratio compared to the industry average. Issuing new debt tofundprojectsandcovercapitalexpenditures. Alow dividendyieldcompared to thecompany'shistoricaverage.
Explanation
Highdividendyieldscomparedtothecompany'srecordsuggestthatinvestorsareexpecting dividendsto becut. Net borrowingsarenotsustainable, and willeventuallyrequireacutinsharerepurchasesanddividends.Ahigher-than-average dividendpayoutratiocreatestherisk thatdividendsmay becutifearningsdecline.
If Modiglianiand Miller'sdividendirrelevancytheoryiscorrect, whatistheimpactonafirm'scostofcapitalandsharepriceif itsdividendpayoutincreases?
CostofCapital Share Price
None A decrease
None None
Anincrease Adecrease
Explanation
Ifinvestorsdonotconsiderdividendsto berelevant, thedividendpayout willnotaffecttherequiredrateofreturn.Ifthe requiredrateofreturndoesnotchange, thevalueofafirm will beunchangeddespitethechangeinitsdividendpayoutrate.
FaltysAsset Management (FAM)followsadividend growthinvestmentstrategy.The FaltysDividend Growth Fundonlyinvests incompaniesthathaveadividendyield greaterthantheS&P 500andhavethepotentialtoincreasethatdividendeachyear ataratethatexceedsinflation. WarrenBerlin, Directorof Marketing for FAM has beendeveloping apresentation book to presentthefundtoprospectiveclients.Theseprospectiveclientsincluderetiredindividuals who wantdividendincomeand trustcompanies whomanagetrustaccounts whichprovideincometo bedistributedto beneficiaries. Whichofthefollowing dividendtheoriesbestdescribestheinvestmentstrategyandthemarketing strategyofthefund?
Investment
Strategy Marketing Strategy
Bird-in-the-hand Modigliani and Miller
Stabledividend Clienteleeffect Signaling effect Bird-in-the-hand
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Theinvestmentstrategy would best bedescribedasastabledividendstrategy.Astabledividendpolicymeansthata company'sdividendpayoutisaligned withcompany'slong-term growthratesuchthatthereisstabilityintherateofincrease forthedividend.Themarketing strategy wouldbest bedescribedastheclienteleeffect.Berlinispursuing specific groupsof investorsthatpreferdividends. Notethatthe bird-in-in-the-handtheorystatesthatinvestorspreferthecertaintyofdividends now touncertaincapital gainsinthefuture, while Modiglianiand Millerproposedthatdividendpolicyhasnoimpactonthe priceofafirm'sstock.
HikaruTakeiistheportfoliomanagerfortheReliantDividend Focused Fund.Takei wantstoaddafirmtohisportfoliothat followsastabledividendpolicy.Takeiisconsidering investing inoneofthreecompanies:
Kirk BeautySuppliesmaintainsaconstantdividendpayoutof 25to30%.
Kelley MedicalDevicesincreasesitsdividendeachyearinaccordance withthecompany'slong run growthrateof4%. BarrettSatelliteSystemshasmaintainedadividendof $2.00pershareoverthelast 6 years.
Whichstock bestmeetsTakei'scriteria?
Kirk Beauty Supplies. BarrettSatelliteSystems.
Kelley MedicalDevices.
Explanation
Duetoinflationconsiderations, acompany withastabledividendpolicy willhavestabilityintherateofincreaseforitsdividend eachyear.Thistypicallymeansaligning thecompany'sdividend growthrate withitslong-term growthrate.Althoughthe company withthefixedpersharedividendisatempting choice, onceinflationisconsidered, afixed $2.00persharedividend isactuallydeclining eachyearintermsofspending power.
Tecnolotronix isanequipmentmanufacturerinavolatile, cyclicalindustrythatemploysalong-termresidualdividend
approach.Asurpriseincreasein quarterlyprofits would bemostlikelytohave whichofthefollowing immediateeffectsonthe actualmeasuredpayoutratio?
A decrease in the ratio. Anincreaseintheratio.
Nochangeintheratio.
Explanation
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QuestionID:462708Laura'sChocolatesInc. (LC)isamakerofnut-basedtoffees. LCisconsidering acashdividend, butisconcernedaboutthe "doubletaxation" effectontheirshareholders.Ifthecorporatetax rateis35%, andthetax ondividendsis 20%, whatisthe effectivetax rateonadollarofcorporateearnings?
48%. 42%. 55%.
Explanation
0.35 + (1 − 0.35)(0.20) = 48%
Oneyearago, Makato Omurapurchaseda 6.50% fixedcoupon bondfor98.50.Recently, shesoldthe bondfor99.25and calculatedherreturnat7.4%.Herfriend, TakaninoTakemiya, CFA, reminds Omurathatthisisthenominalreturnandthatto calculatetherealreturn, sheneedstofactorintheinflationrateovertheholding period.Ifthepriceindex forthecurrentyear is118.5andthepriceindex oneyearago was115.9, Omura'srealreturnisclosestto:
9.6%. 5.2%. 6.3%.
Explanation
Omura'srealreturnisapproximated bysubtracting theinflationratefromthecalculated (nominal)return.Theinflationrateis calculatedusing theformula:
Inflation = (PriceIndex - PriceIndex ) / PriceIndex
Here, inflation = (118.5 - 115.9) / 115.9 = 0.0224, orapproximately 2.2%. Thus, therealreturn = 7.4% - 2.2% = 5.2%.
Belden Engineering Corporation (BEC)isconsidering asharerepurchaseprogram.David Gudzanski, thefirm'sexecutivevice presidentpreparesamemotothe boardofdirectorsdetailing reasons whyasharerepurchase would befavorableatthis time.Reasonslistedinthememoareasfollows:
Reason1:Theresulting capitalstructurefromthesharerepurchase would bemorefavorableforinvestorsinBEC's bonds. Reason 2:BEC'sstock iscurrentlyselling at $37inthemarketplace. Ourdiscountedcashflow analysisvaluesthecompanyat $48 pershare.
Reason3:Thesharerepurchasecould beusedtooffsetdilutioncaused bytheexerciseofemployeestock options. Reason4:BECcanusetherepurchasetosendasignaltoinvestorsthatmanagementhasapositivefutureoutlook forthe
ᅚ A) ᅞ B) ᅞ C)
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QuestionID:462609ᅞ A) ᅞ B) ᅚ C) company.
Reason5:Thesharerepurchasecould beusedtoimplementaresidualdividendpolicy whilediminishing thepotential increaseinperceivedrisk thatsuchapolicy wouldcauseforinvestors.
Whichof Gudzanki'sreasonsinfavorofthesharerepurchaseismostaccurate?
Reasons 2, 3, 4, and 5. Reasons1and3only.
Reasons 2 and3only.
Explanation
Asharerepurchase woulddecreasethepercentageofequityinafirm'scapitalstructure, which wouldinturnincreasethe percentageofdebt.Anincreaseindebt wouldaddmoreleveragetothefirm which would benegativeforthefirm's bondholders.Theotherreasonslistedareallrationalesforasharerepurchase.
Dividendpaymentsaremostlikelyto beassociated with:
increased agency conflict between bondholders and shareholders. increasedagencyconflict betweenshareholdersandmanagers.
increasedagencyconflict between bondholdersandmanagers.
Explanation
Paying dividendscan behelpfulinreducing agencyconflicts betweenshareholdersandmanagers becausedividendpayouts constrainmanagers' abilitytoinvestinnegative NPV projectsthat benefitthemanagersattheexpenseofshareholders. Paying dividendsislikelytointensifytheagencyconflict between bondholdersandshareholders, asitrepresentsatransferof wealthfrom bondholderstoshareholders.
Thereisnoagencyconflict between bondholdersandmanagers.
GlobalDevelopmentexpectstoearn $6 millionnextyear.40% ofthisamount, or $2.4million, has beenallocatedfor
distributiontocommonshareholders.Thereare 2.4millionsharesoutstanding, andthemarketpriceis $30ashare.If Global usesthe $2.4milliontorepurchasesharesatthecurrentpriceof $30pershare, itssharepriceaftertherepurchase will be closestto:
$29.00. $31.00. $30.00.
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Marketvalueofequity beforetherepurchaseis $30 × 2.4million = $72 million. SharesRepurchased = $2.4million / $30 = 80,000shares.
Sharesremaining = Sharesoutstanding − Sharesrepurchased = 2,400,000 − 80,000 = 2,320,000. Sharepriceaftertherepurchase = ($72 million − $2.4million) / 2,320,000 = $30.
DanBridges, headofequitystrategiesfor PacaInc.aconsultanttoinstitutionalinvestorsmakesthefollowing statement: Globally, thedevelopedmarketshaveseenadeclineindividendpayoutratiosovertime. Lately, wehavealsoseenan increaseintheproportionofcompaniesengaging insharerepurchases.
Bridges' statementismostlikely:
Incorrect as to dividend payout ratios. Correct.
Incorrectastocompaniesengaging insharerepurchases.
Explanation
Bridges' statementiscorrect.
Peter Lung istheCFO for MooreIndustries. Lung isnew tothecompanyandhas beentasked bythecompany's boardof directorstoreview thecompany'sdividendpolicy.Thereasonforthisrequestisthattwo boardmembershavesuggested changes bemadetothedividendpolicy, buttheirsuggestedchangesareinoppositedirections.
Oneofthe boardmembers, Al Gormus, hassuggestedthatthefirmincreasedividendssothatthedividendpayoutratio will be higher, butHarold Leehassuggestedthatthefirmdecreasedividends.The boardhasasked Lung toidentifytheeffectsof thesesuggestedchangesonthecompany'sstock.
Toinvestigatethefirm'sabilitytopaydividends, Lung decidestolook atthedividendcoverageratios basedonearningsand cashflow. Lung has gatheredthefinancialdata below forthemostrecenttwoyears.Additionally, henotesthatthestock price was $23.20in 20X7and $20.08 in 20X6.Thesharesoutstanding were1.45 billionin 20X7and1.50 billionin 20X6.
(in $millions) 20X7 20X6
Netincome 1,783 2,195
Cashflow from
operations 4,054 4,122
Capitalexpenditures 1,799 3,266
Net borrowing (1,034) (615)
Dividendspaid 1,691 1,585
Stock repurchases (176) 166
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QuestionID:462674 thedividendpayoutincreases.Investorsaremorecertainaboutdividendpaymentsrelativetocapital gains, andrequirea lowerrateofreturnforstocksthathaveahigherdividendpayoutratio. (StudySession9, LOS 28.b)Ifthecompanyimplements Lee'ssuggesteddividendchange, assuming thatthechange wasnotanticipated bythemarket, thesignalthatthischange wouldsendtoinvestors wouldmostlikely be:
that the company's business prospects are weak. ambiguousandindiscernibletoinvestors.
thatthecompany's businessprospectsarestrong.
Explanation
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Basedontheinformationcollected by Lung, the 20X6 dividendpayoutratioisclosestto: 0.7.
1.4.
0.1.
Explanation
Thedividendpayoutratioiscomputedasdividendspaiddivided bynetincome.Thedividendpayoutratiofor 20X6 is:
(StudySession 8, LOS31.i)
Basedontheinformationcollected by Lung, the FCFE coverageratiofor 20X7isclosestto: 0.8.
0.7.
1.4.
Explanation
The FCFE coverageratioiscomputedasfreecashflow toequitydivided bythesumofdividendsandsharerepurchases.The firststepistocompute FCFE:
FCFE = cashflow fromoperations − FCInv + net borrowings = 4,054 − 1,799 + (1,034) = 1,221 where:
FCInv = fixedcaptialinvestment The FCFE coverageratioisthen:
(StudySession 8, LOS31.i)
Ifthefirm'snetincomein 20X8 is $1,500andthefirmfollowsaresidualdividendpolicy, thedividendcoverageratio would be: 1.67.
2.50. undefined.
Explanation
Thefirststepistocomputethe WACCasfollows:
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Question #33 of 45
QuestionID:462702ᅞ A)
Thefirm willonlyinvestinprojects withIRRsthatexceedthe WACC (Projects1, 2, and3).Thetotalinvestmentis $1,500 million, andtheportionthat will befundedfromequityis $900 (= $1,500 × 0.60).Theremaining portionofnetincome, $600 (= $1,500 − $900), will bepaidoutasdividends.
Thedividendcoverageratio, whichiscomputedasnetincomedivided bydividends, is 2.50 (= $1,500 / $600). (StudySession 8, LOS31.f, i)
Are Lung'sstatementsregarding sharerepurchasesCORRECT? Yes,both statements are correct.
No, onlyoneofthestatementsiscorrect. No, bothstatementsareincorrect.
Explanation
Statement1isincorrect.Inyears withmoreprofitableprojects, thefirm'srepurchases will belowerasthefirm willhaveless residualcash.Inyears withfewerprofitableprojects, repurchases would behigher.
Statement 2 isincorrect.Sharerepurchases willonlyincreasethecompany's EPSiftheafter-tax costof borrowing islessthan thefirm'searningsyield.Inthiscase, thefirmsafter-tax costof borrowing is 6.5%, andthefirm'searningsyieldforthemost recentperiodis5.3%.Therefore, sharerepurchases willactuallydecrease EPS.
EPS = $1,783M / 1.45Bshares = $1.2297pershare
earningsyield = EPS / shareprice = $1.2297 / $23.20 = 5.3% (StudySession9, LOS 28.g)
Theclienteleeffectpredictsthatinvestors withhighmarginaltax ratesandlow desireforcurrentincome will beattractedto companies whosedividendpoliciespromote:
low dividends levels.
low levelsofsharerepurchase. low reinvestmentofearnings.
Explanation
Theclienteleeffectstatesthatcompanies withlow dividends willattractaclienteleofinvestors withhighmarginaltax ratesand low desiresforcurrentincome.
Acompanyisallequityfinanced, hasacapital budgetof $2.0millionandearningsof $1.8 million.Ifthecompanyfollowsa residualdividendpolicy, theamountit willpayoutindividendsisclosestto:
ᅞ B) ᅚ C)
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Question #35 of 45
QuestionID:462685ᅞ A) ᅚ B) ᅞ C)
$0.1million. $0.
Explanation
Intheresidualdividendmodel, dividendsare basedonearningslessfundsthefirmretainstofinancetheequityportionofits capital budget.Themodelis basedonthefirm's (1)investmentopportunityschedule (IOS), (2)targetcapitalstructure, and (3) accesstoandcostofexternalcapital.Inthiscase, thecapital budgetexceedsearningssothereisnoresidual.
Dividendsafetyismostlikelyevidenced by:
Increase in dividend and FCFE coverage ratios
Increasein FCFE coverageratio butnot bedividendcoverageratio. Increaseindividendcoverageratio butnot by FCFE coverageratio.
Explanation
Bothdividendand FCFE coverageratiosareindicatorsofdividendsafety. FCFE coverageissimplymorecomprehensive measureandtakesintoaccountallcashdistributedtoshareholders.
Atarecentconference, "Dividends − AreTheyIncreasing?", severallecturers werediscussing thesignaling effectandtheir opinionsonhow changesinacompany'sdividendpolicyareoftenviewed byinvestors. LindaTravis, anequityanalystat GirthmoreCapital Managementandoneofthe guestlecturersattheconference, madethefollowing observations:
Observation1:Adividendinitiationisalwaysviewedasapositivesignal byinvestors.Itisanindicationthatthecompanyhas somuchcashatitsdisposalthatitcanaffordtopayitouttoshareholders.
Observation 2:Adividenddecreaseistypicallyapositivesignal byacompany'smanagementtoitsshareholders.Itindicates thatmanagementhasavarietyofpositive NPV projectsinitscapital budgetand wouldliketofinanceasmanyofthemas possible withretainedearnings.
WithrespecttoTravis' observations:
both are correct. bothareincorrect. onlyoneiscorrect.
Explanation
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Which of the following statementsabout astock repurchaseisleastaccurate?
Management can distribute cash to shareholders at a favorable after-tax rate.
A stock repurchaseoccurs whena large block of stock isremoved from themarketplace.
Disgruntledstockholdersare forced tosell theirshares, improving management's position.
Explanation
A repurchase givesstockholdersachoice. They cansell ornot sell. Stock repurchaseisalsomore tax-efficient asonly those
shareholders that choose tosell theirshares would potentially havea tax liability.
According to Modiglianiand Miller'sdividendirrelevancytheory, aninvestorinafirmthatdoesnotpayadividendcanstillearn a "dividend" onthatcompany by:
selling a portion of the company's stock each year. buying additionalshareseachyear.
contacting thefirmandasking foradividendpayment.
Explanation
Millerand Modigliani'sdividendirrelevancytheorystatesthatshareholderscanintheoryconstructtheirowndividendpolicy.If afirmdoesnotpaydividends, ashareholder who wantsa4% dividendcan "create" it byselling 4% ofhisorherstock. Note that Modiglianiand Miller'stheorydoesnotallow fortransactioncostsortaxes.Inactuality, shareholders willhavetopaya brokeragecommissiononthesaleandtax onanycapital gains.
Whatistheimpactonshareholder wealthofasharerepurchaseversuscashdividendofequalamount whenthetax treatment ofthetwoalternativesisthesame?
A share repurchase is equivalent to a cash dividend of an equal amount, so total shareholder wealth will be the same.
Asharerepurchase willalwaysleadtohighertotalshareholder wealththanacash dividendofanequalamount.
Asharerepurchase willsometimesleadtohighertotalshareholder wealththanacash dividendofanequalamount.
Explanation
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Question #40 of 45
Question ID: 462697ᅞ A) ᅞ B) ᅚ C)
Thefollowing financialdatarelatestotheCarmichaelBeverageCompanyfor 2005:
Thetargetcapitalstructureis 65% equityand35% debt. After-tax costofdebtis7%.
Costofretainedearningsisestimatedto be12%.
Costofequityisestimatedto be13.5% ifthecompanyissuesnew commonstock. Netincomeis $4,000,000.
CarmichaelBeverageCompanyisconsidering thefollowing investmentprojects:
P
ro
j
ec
t A: $2,500,000
va
lu
e
; IRR
o
f 11.50%
P
ro
j
ec
t B: $1,000,000
va
lu
e
; IRR
o
f 13.00%
P
ro
j
ec
t C: $2,000,000
va
lu
e
; IRR
o
f 9.50%
P
ro
j
ec
t D: $500,000
va
lu
e
; IRR
o
f 10.50%
P
ro
j
ec
t E: $1,500,000
va
lu
e
; IRR
o
f 8.00%
Ifthecompanyfollowsaresidualdividendpolicy, itspayoutratio will beclosestto: 0%.
12%. 35%.
Explanation
Firstdeterminethe WACC. WACC = w × k (1 − t) + w × k , where k istherequiredreturnonretainedearnings. WACC = (0.65)(0.12) + (0.35)(0.07) = 0.078 + 0.0245 = 0.1025 = 10.25%.Second, decidetoacceptprojectsA, B, andDsincetheyare all greaterthanthe WACC.Accepting theseprojects willresultinatotalcapital budgetof ($2,500,000 + $1,000,000 +
$500,000) = $4,000,000.Theequityportionis 65% × 4,000,000 = $2,600,000. FromCarmichael'snetincome, $4,000,000 − $2,600,000 = $1,400,000 will beleftoverfordividends, whichimpliesapayoutratioof $1,400,000 / $4,000,000 = 35%.
DavidDrakarand Leslie O'Rourke bothown100sharesofstock ina Germancorporationthatmakes 1.00pershareinpre-tax income.Thecorporationpaysoutallofitsincomeasdividends.Drakarisinthe30% individualtax bracket while O'Rourkeisin the40% individualtax bracket.Thetax rateapplicabletothecorporationis30%.Drakarand O'Rourkeliveinthe United Kingdom, whichusesanimputationtax systemforcorporatedividends. Whatistheeffectivetax rateonthedividendforeach shareholder, assuming noeffectsfromtheexchangerate?
Drakar O'Rourke
40% 48%
38% 44%
30% 40%
Question #41 of 45
Question ID: 462713ᅚ A) ᅞ B) ᅞ C)
Question #4
2
of 45
Question ID: 462693ᅚ A) ᅞ B) ᅞ C)
Question #43 of 45
Question ID: 462700Explanation
Underanimputationtax system, taxesarepaidatthecorporatelevel, butareattributedtotheshareholder, sothatalltaxes areeffectivelypaidattheshareholderrate.
Grommetcoproducesplasticinsulatorsfortheelectricalapplianceindustry. Excerptsfrom Grommetco'sfinancialresultsfor 2010areasfollows:
Net Income (earnings) $10 Free Cash Flow to Equity $8 Dividends Paid $1 Stock Repurchases $3
Whichofthefollowing statementsismostaccurate? Grommetco's:
FCFE coverage ratio is 2.0. dividendpayoutratiois0.4.
dividendcoverageratiois 2.5.
Explanation
Dividendcoverageratio = NetIncome / Dividends = $10 / $1 = 10.
FCFE coverageratio = FCFE / (dividends + sharerepurchases) = $8 / ($1 + $3) = 2.0. Dividendpayoutratio = Dividends / NetIncome = $1 / $10 = 0.1.
Whichofthefollowing would beleastlikelytopromptadeclineinacompany'soverallpayoutratio? A permanent decrease in company profitability.
Adecreaseinthecapital gainstax rate. Anincreaseininterestrates.
Explanation
Apermanentdecreaseinprofitsisexpectedtoresultinadecreaseinthedividendpaymentlevel; howeverthis wouldprobably notleadtoadecreaseinthepayoutratio.Ifinterestrates weretoincrease, it wouldmakeretainedearningsamoreattractive wayoffinancing new investment; asaresult, thepayoutratio would bemorelikelytodecline.Adecreaseinthecapital gains tax rate would (forinvestorsthatpaytax)makecapital gainsmoreappealing; accordingly, aggregatepayoutratios would be expectedtodecline.
ᅞ A) ᅞ B) ᅚ C)
Question #44 of 45
QuestionID:462709ᅚ A) ᅞ B) ᅞ C)
Question #45 of 45
QuestionID:434350ᅞ A) ᅚ B) program:
and a growing dividend model. andnopayoutofdividends.
inconjunction witharesidualdividendmodel.
Explanation
Theresidualdividendmodelallowsfirmstopayoutdividendsonlyifmoreearningsareavailablethanareneededtosupport theoptimalcapital budget.Becausedividendpayoutscan beunstable, afirmcansupplementalow, stabledividend witha sharerepurchaseprogramor withanextradividend whentimesare good.Stock repurchasesallow managementtodistribute cash withoutsignaling informationaboutfutureearnings.Abnormally goodyearscould befollowed withthepurchaseof shares, whileselling shares wouldprovideliquidityduring temporarycashshortages.
Thefollowing informationisfromthe10-k of Laura'sChocolates, Inc.(LC), amakerofnut-basedtoffees.
Cash 25,000,000
Shareprice 40.00
Sharesoutstanding (priorto transaction)
20,000,000
LCdecidestospend $20millionrepurchasing commonstock. Whatisthevalueofashareofstock aftertheshare repurchase?
40.00. 45.00.
35.00.
Explanation
PearlCityBrewerieshas 8 millionsharesoutstanding thatarecurrentlytrading at $34pershare.Thecompanyischoosing whethertodistribute $22 millionasdividendsortousethesameamounttorepurchaseitsshares.Ignoring tax effects, what will betheamountoftotal wealthfromowning oneshareof PearlCityBreweriesundereachofthesealternatives?
Cashdividend Share
repurchase
ᅞ C) $31.25 $34.00
Explanation
Ifthecompanypaysacashdividend, thedividendpershare will be $22 million/8 million = $2.75.Thevalueofitsshares will be:
Sothetotal wealthfromowning oneshare will be $31.25 + $2.75 = $34.00.
Ifthecompanyrepurchasesshares, itcan buy $22 million/$34 = 647,058 shares.Thevalueofoneshare wouldthen be: