Concept Checkers Dividend Policy

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1. Under the residual dividend model, firms would do all of the following EXCEPT:

A. determine their optimal capital budgets.

B. borrow money to maintain the dividend payout schedule.

C. determine the amount of equity needed to meet the capital budget.

D. pay dividends only if more earnings are available than needed to support the optimal capital budget.

2. Which of the following statements about dividends is TRUE?

A. Dividend irrelevance means that investors prefer dividends to capital gains.

B. The clientele effect suggests that firms should follow a stable dividend policy.

C. The tax preference theory suggests that a firm can increase its stock price by increasing its dividend payout ratio.

D. The bird-in-the-hand theory implies that firms can reduce their cost of equity capital by reducing their dividend payout ratios.

3. Which of the following statements about dividend policy is TRUE?

A. Academic research strongly supports the dividend irrelevance theory.

B. Current tax law encourages companies to pay large dividends to their shareholders.

C. If a company has an established clientele that prefers large dividends, the company is unlikely to adopt a residual dividend policy.

D. If a firm follows a residual dividend policy, its dividend payout will tend to rise whenever the firms investment opportunities improve.

4. Which of the following statements about dividend policy is TRUE?

A. A residual dividend policy is an effective way to stabilize dividend payout.

B. The signaling hypothesis is based on the concept that investors prefer current dividends over capital gains.

C. If Congress lowers the capital gains rate, companies will be motivated to increase their dividend payout ratios.

D. If a firm follows a residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.

5. If a firm follows a residual dividend policy and has an optimal capital budget that will require the use of all this years earnings, the firm should pay:

A. no dividends to common stockholders.

B. dividends financed by borrowing the money.

C. dividends out of newly issued common stock.

D. dividends, but only out of past retained earnings.

6. Gordon and Lintner's bird-in-the-hand dividend theory is based on the idea that:

A. ks = Dj/Pq + g is constant for any dividend policy.

B. a decrease in current dividends signals that future earnings will fall.

C. investors prefer to reinvest dividends rather than receive and spend them.

D. because of perceived differences in risk, investors value a dollar of dividends more highly than a dollar of expected capital gains.

7. An analyst gathered the following information about a company's investment plan:

• Target capital structure is 70 percent debt and 30 percent equity.

If the company follows a residual dividend policy, what portion of its net income should it pay out as dividends this year?

8. An analyst gathered the following information about a company's investment budget:

• Expected net income of $800,000 during the next year.

• Target and current capital structure is 40% debt and 60% common equity.

• Optimal capital budget for next year is $1.2 million.

If the company uses the residual dividend model to determine next year's dividend payout, how much will the company pay out? A. $80,000. B $260,000.

9. A company has provided the following financial data:

• A target capital structure that is 50% debt and 50% equity.

• Cost of retained earnings is estimated to be 13.5%.

• Cost of equity is estimated to be 14.5% if the company issues new common stock.

The company is considering the following investment projects:

Project Size pf Project RR of Project

If the company follows a residual dividend policy, what will be its payout ratio?

10. Jayco, Inc. wants to maintain its target capital structure at 30 percent debt and 70 percent equity. The company forecasts that its net income this year will be $1,000. Jayco anticipates a dividend payout ratio of 40 percent. Without raising additional external equity, what is the size of Jayco's capital budget?

A.

$600.

B.

$857.

C.

$1,000.

D.

$1,428.

Answers - Exam Flashbacks

1. D E/V = 75%. That is, the value of the new capital budget = new E / 0.75. Add 6 million of earnings or new equity. Capital spending can increase by 6/0.75 = $8 million.

Answers - Concept Checkers: Dividend Policy

1. B Under the residual dividend model, the Firm pays dividends only if earnings are available to support the optimal capital budget. The firm would not take on additional debt to pay dividends.

2. B Dividend irrelevance means investors are indifferent between dividends and capital gains; tax preference theory says investors are influenced by the higher tax rates on dividend payments compared to capital gains; bird-in-the-hand theory implies that investors prefer dividends. B is the only true statement.

3. C Academic research shows that dividend irrelevance only works in a world with no taxes or brokerage costs; current tax law encourages companies to minimize dividends in favor of capital gains; under a residual dividend, the dividend will shrink as investment opportunities improve. C is the only true statement.

4. D Under the residual dividend, the dividend payout will fluctuate with investment opportunities; signaling hypothesis is based on expected future dividends; and lowering the capital gains rates would be an incentive to favor capital gains over dividends. D is the only true statement.

5. A If all earnings are used under a residual dividend policy, the firm should not pay any dividends.

6. D The bird-in-the-hand theory is based on the fact that a dividend payment is more certain than future capital gains.

7. D 30% of $5,000 or $1,500 is equity. Income left over is 4,500 - 1,500 = $3,000, which as a % is 3,000 / 4,500 =

8. A 60% of $1,200,000 is $720,000, and income is 800,000 - 720,000 = $80,000.

9. B First, determine the WACC. Using the equation of the SML, CAPM, WACC = wd x kd(l - t) + we x ks, where ks is the required return on retained earnings. WACC = (0.5)(8) + (0.5)(13.5) = 10.75. Second, decide to accept projects A, B, and C, since they all have an IRR greater than WACC. This results in a total capital budget of $1,000 + $1,200 + $1,200 = $3,400. The equity portion is (0.5)($3,400) = $1,700. Net income = 2,500 - 1,700 is the amount used for the capital budget. $800 remains. 800 / 2,500 = 0.32 = 32%.

10. B Dividend = net income x payout ratio = 1,000 x 0.40 = 400. RE = net income - dividends = 1,000 - 400 = $600.

The following is a review of the Securities Markets principles designed to address the learning outcome statements set forth by CFA Institute. This topic is also covered in:

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