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REPURCHASES
o The optimal distribution policy strikes that balance between current dividends and capital
gains that maximizes the firm's stock price.
o True
o False
ANSWER: True
o Other things held constant, the higher a firm's target payout ratio, the higher its expected
growth rate should be.
o True
o False
ANSWER: False
RATIONALE: The higher the payout ratio, the less of its earnings the firm reinvests in the
business, and the lower the reinvestment rate, the lower the firm's growth rate.
o Miller and Modigliani's dividend irrelevance theory says that the percentage of its
earnings a firm pays out in dividends has no effect on either its cost of capital or its stock
price.
o True
o False
ANSWER: True
o Miller and Modigliani's dividend irrelevance theory says that the percentage of its
earnings a firm pays out in dividends has no effect on its cost of capital, but it does affect
its stock price.
o True
o False
ANSWER: False
o 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.
o True
o False
ANSWER: True
o A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same
effect on the firm's stock price.
o True
o False
ANSWER: True
o True
o False
ANSWER: True
o The announcement of an increase in the cash dividend should, according to MM, lead to
an increase in the price of the firm's stock, other things held constant.
o True
o False
ANSWER: False
o The federal government sometimes taxes dividends and capital gains at different rates.
Other things held constant, an increase in the tax rate on dividends relative to that on
capital gains would logically lead to an increase in dividend payout ratios.
o True
o False
ANSWER: False
o The federal government sometimes taxes dividends and capital gains at different rates.
Other things held constant, if the tax rate on dividends is high relative to that on capital
gains, then individuals with low taxable incomes should favor stocks with low payouts
and high-income individuals should favor high-payout companies.
o True
o False
ANSWER: False
o 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.
o True
o False
ANSWER: True
o 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.
o True
o False
ANSWER: True
o True
o False
ANSWER: True
o 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.
o True
o False
ANSWER: True
o 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.
o True
o False
ANSWER: True
o 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.
o True
o False
ANSWER: False
RATIONALE: MM would disagree. They would say that investors took the dividend increase as
a signal that the firm's management expected higher future earnings. MM say dividends
have information content regarding future earnings.
o True
o False
ANSWER: True
o 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.
o True
o False
ANSWER: True
o 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.
o True
o False
ANSWER: False
RATIONALE: The higher the debt ratio, the more dollars of debt will be used to fund a given
capital budget. So, the higher the debt ratio, the less equity will be needed, and this results in a
higher dividend payout ratio according to the residual dividend model.
o 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.
o True
o False
ANSWER: False
o 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.
o True
o False
ANSWER: False
RATIONALE: This is false. The stock price will drop on the ex-dividend date, which is two
days prior to the holder of record date, which is well before the actual January 31 payment date.
Also, because the dividend is taxable, the price decline is generally somewhat less than the full
amount of the dividend.
o True
o False
ANSWER: True
RATIONALE: This is true. The stock price will drop on the ex-dividend date, which is two days
prior to the holder of record date, which is well before the actual January 31 payment date. Note,
though, that because the dividend is taxable, the price decline may be somewhat less than the full
amount of the dividend.
o One advantage of dividend reinvestment plans is that they allow shareholders to delay
paying taxes on the dividends that they choose to reinvest.
o True
o False
ANSWER: False
o There are two types of dividend reinvestment plans. Under one type of plan, the firm uses
the cash that would have been paid as dividends to buy stock on the open market. Under
the other type, the company issues new stock, keeps the cash that would have been paid
out, and in effect sells new stock to those investors who choose to reinvest their
dividends.
o True
o False
ANSWER: True
o If a firm pays out all of its earnings as dividends and its stockholders then elect to have
all of their dividends reinvested, the company should reconsider its dividend policy and
possibly move to a lower dividend payout ratio.
o True
o False
ANSWER: True
RATIONALE: This is true, because if the company retains its earnings rather than paying them
out, investors should receive capital gains rather than dividend income, and the taxes on those
gains will be deferred until the stock is sold. Note that the money will be reinvested by the
company in either case, so the risk to stockholders under dividend reinvestment and retained
earnings should be the same.
o 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.
o True
o False
ANSWER: True
o 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.
o True
o False
ANSWER: True
RATIONALE: (1) The firm's WACC would increase, (2) this would cause fewer projects to be
accepted, (3) this would lead to a smaller capital budget, (4) thus less money would be needed to
fund the capital budget, (5) thus less equity would be needed, so (6) the dividend payout ratio
would increase.
o Suppose you plotted a curve which showed a Firm U's WACC on the vertical axis and its
debt ratio on the horizontal Then you plotted a similar curve for Firm V. The curve for
firm U resembled a shallow "U," while that for Firm V resembled a sharp "V." Both
firms have debt ratios that cause their WACCs to be minimized. Other things held
constant, it would be easier for Firm V than for Firm U to maintain a steady dividend in
the face of varying investment opportunities and earnings from year to year.
o True
o False
ANSWER: False
RATIONALE: Firm U could fund its capital budget with varying amounts of debt without
causing large changes in its WACC and thus in its value and stock price. Firm V could not vary
its debt ratio without increasing its WACC. Thus, Firm V would have to raise and lower its
dividend payout in order to obtain the equity it needed to support its capital budget. Firm U, on
the other hand, could maintain a stable, steady dividend, and let the debt ratio vary without
causing much harm to its stock price.
o In the real world, dividends
o are usually changed every year to reflect earnings changes, and these changes are
randomly higher to lower, depending on whether earnings increased or decreased.
ANSWER: a
o You own 100 shares of Troll Brothers' stock, which currently sells for $120 a share. The
company is about to declare a 2-for-1 stock split. Which of the following best describes
your likely position after the split?
o You will have 200 shares of stock, and the stock will trade at or near $120 a
share.
o You will have 200 shares of stock, and the stock will trade at or near $60 a share.
o You will have 100 shares of stock, and the stock will trade at or near $60 a share.
o You will have 50 shares of stock, and the stock will trade at or near $120 a share.
o You will have 50 shares of stock, and the stock will trade at or near $600 a share.
ANSWER: b
o Myron Gordon and John Lintner believe that the required return on equity increases as
the dividend payout ratio is Their argument is based on the assumption that
o investors view dividends as being less risky than potential future capital gains.
ANSWER: d
o Your firm adheres strictly to the residual dividend model. All else equal, which of the
following factors would be most likely to lead to an increase in the firm's dividend per
share?
o The company increases the percentage of equity in its target capital structure.
o Congress lowers the tax rate on capital gains, leaving the rest of the tax code
unchanged.
o Earnings are unchanged, but the firm issues new shares of common stock.
ANSWER: a
o 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
o dividends only out of funds raised by the sale of new common stock.
o dividends only out of funds raised by borrowing money (i.e., issuing debt).
o If a firm adheres strictly to the residual dividend model, the issuance of new common
stock would suggest that
ANSWER: c
o Which of the following does NOT normally influence a firm's dividend policy decision?
o A strong preference by most of its shareholders for current cash income versus
potential future capital gains.
o The fact that much of the firm's equipment is leased rather than bought and
owned.
o The fact that Congress is considering changes in the tax law regarding the
taxation of dividends versus capital gains.
ANSWER: d
o Which of the following would be most likely to lead to a decrease in a firm's dividend
payout ratio?
o Its research and development efforts pay off, and it now has more high-return
investment opportunities.
o Its stock price has increased over the last year by a greater percentage than the
increase in the broad stock market averages.
ANSWER: c
o When firms are deciding on the size of stock splits--say whether to declare a 2-
for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-
for-1 split, because then the after-split price will be higher than if the 3-for-1 split
had been used.
o Back before the SEC was created in the 1930s, companies would declare reverse
splits in order to boost their stock prices. However, this was determined to be a
deceptive practice, and reverse splits are illegal today.
o Stock splits create more administrative problems for investors than stock
dividends, especially determining the tax basis of their shares when they decide to
sell them, so today stock dividends are used far more often than stock splits.
o When a company declares a stock split, the price of the stock typically declines--
for example, by about 50% after a 2-for-1 split--and this necessarily reduces the
total market value of the firm's equity.
o If a firm's stock price is quite high relative to most stocks-- say $500 per share--
then it can declare a stock split of say 20-for-1 so as to bring the price down to
something close to $25. Moreover, if the price is relatively low--say $2 per share-
-then it can declare a "reverse split" of say 1-for-10 so as to bring the price up to
somewhere around $20 per share.
ANSWER: e
o Miller and Modigliani argued that investors prefer dividends to capital gains
because dividends are more certain than capital gains. They call this the "bird-in-
the-hand" effect.
o One reason that companies tend to favor distributing excess cash as dividends
rather than by repurchasing stock is that dividends are normally taxed at a lower
rate than gains on repurchased stock.
o One key advantage of the residual dividend model is that it enables a company to
follow a stable dividend policy.
o The clientele effect suggests that companies should follow a stable dividend
policy.
ANSWER: e
o Stock repurchases can be used by a firm that wants to increase its debt ratio.
o Under the tax laws as they existed in 2011, a dollar received by an individual
taxpayer as interest income is taxed at the same rate as a dollar received as
dividends.
o One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the
taxes investors would have to pay if they received cash dividends.
o Dividend reinvestment plans have not caught on in most industries, and today
over 99% of all DRIPs are offered by utilities.
ANSWER: d
o Historically, the tax code has encouraged companies to pay dividends rather than
retain earnings.
o The more a firm's management believes in the clientele effect, the more likely the
firm is to adhere strictly to the residual dividend model.
o Large stock repurchases financed by debt tend to increase expected earnings per
share, but they also tend to increase the firm's financial risk.
o A dollar paid out to repurchase stock has the same tax benefit as a dollar paid out
in dividends. Thus, both companies and investors should be indifferent between
distributing cash through dividends and stock repurchase programs.
ANSWER: d
o If a company has a 2-for-1 stock split, its stock price should roughly double.
o Capital gains earned on shares repurchased are taxed less favorably than
dividends, which is why companies typically pay dividends and avoid share
repurchases.
o Very often, a company's stock price will rise when it announces that it plans to
commence a share repurchase Such an announcement could lead to a stock price
decline, but this does not normally happen.
o The clientele effect is the best explanation for why companies tend to vary their
dividend payments from quarter to quarter.
ANSWER: c
RATIONALE: c is correct, but perhaps the easiest way to answer this question is to eliminate
the other choices, which are obviously wrong.
o Firms with a lot of good investment opportunities and a relatively small amount
of cash tend to have above- average dividend payout ratios.
o One advantage of the residual dividend model is that it leads to a stable dividend
payout, which investors like.
o An increase in the stock price when a company cuts its dividend is consistent with
signaling theory as postulated by MM.
o If the "clientele effect" is correct, then for a company whose earnings fluctuate, a
policy of paying a constant percentage of net income will probably maximize its
stock price.
o Stock repurchases make the most sense at times when a company believes its
stock is undervalued.
ANSWER: e
o If a firm adheres strictly to the residual dividend model, then, holding all else
constant, its dividend payout ratio will tend to rise whenever its investment
opportunities improve.
o If Congress eliminates taxes on capital gains but leaves the personal tax rate on
dividends unchanged, this would motivate companies to increase their dividend
payout ratios.
o Despite its drawbacks, following the residual dividend model will tend to stabilize
actual cash dividends, and this will make it easier for firms to attract a clientele
that prefers high dividends, such as retirees.
ANSWER: b
o Firm M is a mature company in a mature industry. Its annual net income and cash flows
are consistently high and However, M's growth prospects are quite limited, so its capital
budget is small relative to its net income. Firm N is a relatively new company in a new
and growing industry. Its markets and products have not stabilized, so its annual
operating income fluctuates considerably. However, N has substantial growth
opportunities, and its capital budget is expected to be large relative to its net income for
the foreseeable future. Which of the following statements is CORRECT?
o Firm M probably has a higher target dividend payout ratio than Firm N.
o If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
ANSWER: b
o If a firm repurchases some of its stock in the open market, then shareholders who
sell their stock for more than they paid for it will be subject to capital gains taxes.
o If a company declares a 2-for-1 stock split, its stock price should roughly double.
o One advantage of adopting the residual dividend model is that this makes it easier
for corporations to meet the requirements of Modigliani and Miller's dividend
clientele theory.
ANSWER: a
o Which of the following actions will best enable a company to raise additional equity
capital, other things held constant?
ANSWER: e
o Stock repurchases can be used by a firm as part of a plan to change its capital
structure.
o After a 3-for-1 stock split, a company's price per share should fall, but the number
of shares outstanding will rise.
o Investors may interpret a stock repurchase program as a signal that the firm's
managers believe the stock is undervalued, or, alternatively, as a signal that the
firm does not have many good investment opportunities.
o A company can repurchase stock to distribute a large one-time cash inflow, say
from the sale of a division, to stockholders without having to increase its regular
dividend.
ANSWER: e
o If a firm follows the residual dividend model, then a sudden increase in the
number of profitable projects would be likely to lead to a reduction of the firm's
dividend payout ratio.
o The clientele effect explains why so many firms change their dividend policies so
often.
o One advantage of adopting the residual dividend model is that this policy makes it
easier for a corporation to attract a specific and well-identified dividend clientele.
o Investors who receive stock dividends must pay taxes on the value of the new
shares in the year the stock dividends are received.
ANSWER: a
o 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.
o Other things held constant, the higher a firm's target dividend payout ratio, the
higher its expected growth rate should be.
o Miller and Modigliani's dividend irrelevance theory says that the percentage of its
earnings that a firm pays out in dividends has no effect on its cost of capital, but it
does affect its stock price.
o The federal government sometimes taxes dividends and capital gains at different
rates. Other things held constant, an increase in the tax rate on dividends relative
to that on capital gains would logically lead to a decrease in dividend payout
ratios.
o If investors prefer firms that retain most of their earnings, then a firm that wants
to maximize its stock price should set a high dividend payout ratio.
ANSWER: d
o Portland Plastics Inc. has the following data. If it follows the residual dividend model,
what is its forecasted dividend payout ratio?
Capital budget $12,500
% Debt 40%
o 25.36%
o 28.17%
o 31.30%
o 34.78%
o 38.26%
ANSWER: d
RATIONALE:
% Debt 40%
o $36.10
o $38.00
o $40.00
o $42.00
o $44.10
ANSWER: c
RATIONALE:
o 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?
o $30.00
o $31.50
o $33.08
o $34.73
o $36.47
ANSWER: a
RATIONALE:
o Mid-State BankCorp recently declared a 7-for-2 stock split. Prior to the split, the stock
sold for $80 per share. If the firm's total market value is unchanged by the split, what will
the stock price be following the split?
o $20.63
o $21.71
o $22.86
o $24.00
o $25.20
ANSWER: c
RATIONALE:
o 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?
o $584,250
o $615,000
o $645,750
o $678,038
o $711,939
ANSWER: b
RATIONALE:
% Equity 60%
o 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?
o $ 904,875
o $ 952,500
o $1,000,125
o $1,050,131
o $1,102,638
ANSWER: b
RATIONALE:
o Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target
capital structure of 45% debt and 55% equity, and she also wants to pay a dividend of
$500,000. If the company follows the residual dividend model, how much income must it
earn, and what will its dividend payout ratio be?
o $ 898,750; 55.63%
o $ 943,688; 58.41%
o $ 990,872; 61.34%
o $1,040,415; 64.40%
o $1,092,436; 67.62%
ANSWER: a RATIONALE:
o Banerjee Inc. wants to maintain a target capital structure with 30% debt and 70% equity.
Its forecasted net income is $550,000, and its board of directors has decreed that no new
stock can be issued during the coming year. If the firm follows the residual dividend
model, what is the maximum capital budget that is consistent with maintaining the target
capital structure?
o $673,652
o $709,107
o $746,429
o $785,714
o $825,000
ANSWER: d
RATIONALE:
% Debt 30%
% Equity 70%
Check: Is calculated Max. capital budget % Equity = NI? $550,000 = Net income
o 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?
o 37.2%
o 39.1%
o 41.2%
o 43.3%
o 45.5%
ANSWER: d
RATIONALE:
EBIT $2,000,000
o Mortal Inc. expects to have a capital budget of $500,000 next year. The company wants
to maintain a target capital structure with 30% debt and 70% equity, and its forecasted net
income is $400,000. If the company follows the residual dividend model, how much in
dividends, if any, will it pay?
o $45,125
o $47,500
o $50,000
o $52,500
o $55,125
ANSWER: c
RATIONALE:
% Debt 30%
% Equity 70%
o Torrence Inc. has the following data. If it uses the residual dividend model, how much
total dividends, if any, will it pay out?
% Debt 60%
ANSWER: e
RATIONALE:
Capital budget $1,000,000
% Debt 60%
Equity needed to support the capital budget = % Equity Capital budget $400,000
o NY Fashions has the following data. If it follows the residual dividend model, how much
total dividends, if any, will it pay out?
% Debt 65%
o $20,363
o $21,434
o $22,563
o $23,750
o $25,000
ANSWER: e
RATIONALE:
Equity needed to support the capital budget = % Equity Capital budget $525,000
o Chicago Brewing has the following data, dollars in thousands. If it follows the residual
dividend model, what will its dividend payout ratio be?
% Debt 45%
o 48.11%
o 50.52%
o 55.57%
o 61.13%
o 67.24%
ANSWER: a
RATIONALE:
o LA Moving Company has the following data, dollars in thousands. If it follows the
residual dividend model, what will its dividend payout ratio be?
% Debt 45%
o 60.71%
o 63.75%
o 70.13%
o 77.14%
o 84.85%
ANSWER: a
RATIONALE:
% Debt 45%
o New Orleans Builders Inc. has the following data. If it follows the residual dividend
model, what is its forecasted dividend payout ratio?
% Debt 35%
o 18.23%
o 20.25%
o 22.50%
o 25.00%
o 27.50%
ANSWER: d
RATIONALE:
Capital budget $7,500
% Debt 35%
o Ross-Jordan Financial has suffered losses in recent years, and its stock currently sells for
only $0.50 per share. Management wants to use a reverse split to get the price up to a
more "reasonable" level, which it thinks is $25 per share. How many of the old shares
must be given up for one new share to achieve the $25 price, assuming this transaction
has no effect on total market value?
o 47.50
o 49.88
o 50.00
o 52.50
o 55.13
ANSWER: c
RATIONALE:
o Keys Financial has done extremely well in recent years, and its stock now sells for $175
per share. Management wants to get the price down to a more typical level, which it
thinks is $25 per share. What stock split would be required to get to this price, assuming
the transaction has no effect on the total market value? Put another way, how many new
shares should be given per one old share?
o 6.98
o 7.00
o 7.35
o 7.72
o 8.10
ANSWER: b
RATIONALE:
No. of new shares per 1 old share = Current price/Target price = 7.00
o Whited Products recently completed a 4-for-1 stock split. Prior to the split, its stock sold
for $120 per share. If the firm's total market value increased by 5% as a result of
increased liquidity and favorable signaling effects, what was the stock price following the
split?
o $29.93
o $31.50
o $33.08
o $34.73
o $36.47
ANSWER: b
RATIONALE:
% value increase 5%
Post-split stock price = (P0/[(New shares per old shares) (1 + % Value increase)] = $31.50
o 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?
o $1,093,500
o $1,215,000
o $1,350,000
o $1,485,000
o $1,633,500
ANSWER: c
RATIONALE:
Old New
%
Debt 15%
60%
% Equity = 1.0 %
Debt 85%
40%
o Purcell Farms Inc. has the following data, and it follows the residual dividend model.
Currently, it finances with 15% debt. Some Purcell family members would like for the
dividend payout ratio to be increased. If Purcell increased its debt ratio, which the firm's
treasurer thinks is feasible, by how much could the dividend payout ratio be increased,
holding other things constant?
Capital budget $3,000,000
o 38.6%
o 40.5%
o 42.5%
o 44.7%
o 46.9%
ANSWER: a
RATIONALE:
Old New
%
Debt 15%
60%
% Equity = 1.0 %
Debt 85%
40%
o Whitman Antique Cars Inc. has the following data, and it follows the residual dividend
model. Some Whitman family members would like more dividends, and they also think
that the firm's capital budget includes too many projects whose NPVs are close to zero. If
Whitman reduced its capital budget to the indicated level, by how much could dividends
be increased, holding other things constant?
% Debt 40%
o $486,000
o $540,000
o $600,000
o $660,000
o $726,000
ANSWER: c
RATIONALE:
Old New
%
Debt 40%
40%
% Equity = 1.0 %
Debt 60%
60%
o Pavlin Corp.'s projected capital budget is $2,000,000, its target capital structure is 40%
debt and 60% equity, and its forecasted net income is $900,000. If the company follows
the residual dividend model, how much dividends will it pay or, alternatively, how much
new stock must it issue?
o $462,983; $244,352
o $487,350; $257,213
o $513,000; $270,750
o $540,000; $285,000
o $ 0; $300,000
ANSWER: e
RATIONALE:
Capital budget $2,000,000
% Equity 60%
o Grullon Co. is considering a 7-for-3 stock split. The current stock price is $75.00 per
share, and the firm believes that its total market value would increase by 5% as a result of
the improved liquidity that should follow the split. What is the stock's expected price
following the split?
o $32.06
o $33.75
o $35.44
o $37.21
o $39.07
ANSWER: b
RATIONALE:
% Increase in value 5%
o 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?
% Debt 35%
Net income; it will not change this year even if dividends increase $3,500,000
o $2,741,538
o $3,046,154
o $3,384,615
o $3,723,077
o $4,095,385
ANSWER: c
RATIONALE:
Old New
%
Debt 35%
35%
% Equity = 1.0 %
Debt 65%
65%
o 30.54%
o 32.15%
o 33.84%
o 35.63%
o 37.50%
ANSWER:
RATIONALE:
EPS $3.00
DPS $2.00
o Del Grasso Fruit Company has more positive NPV projects than it can finance under its
current policies without issuing new stock, but its board of directors had decreed that it
cannot issue any new shares in the foreseeable future. Your boss, the CFO, wants to
know how the capital budget would be affected by changes in capital structure policy
and/or the target dividend payout policy. You obtained the following data, which shows
the firm's projected net income (NI), its current capital structure and dividend payout
policies, and three possible new policies. Projected net income for the coming year will
not be affected by a policy change. How much larger could the capital budget be if (1) the
target de ratio were raised to the indicated amount, other things held constant, (2) the
target payout ratio were lowered to the indicated amount, other things held constant, or
(3) the debt ratio and dividend payout were both changed by the indicated amounts?
RATIONALE:
Dividends
Ret. earnings, RE
Percentage increase: