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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?


A) 47.50
B) 49.88
C) 50.00
D) 52.50
E) 55.13

F) A) and C)
G) B) and C)

Correct Answer

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Which of the following statements is CORRECT?


A) One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.
B) If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not adhere strictly to the residual dividend model.
C) 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.
D) 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.
E) 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.

F) C) and D)
G) A) and C)

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Which of the following statements is CORRECT?


A) 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.
B) 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.
C) 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.
D) 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.
E) 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.

F) A) and D)
G) None of the above

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


A) 25.36%
B) 28.17%
C) 31.30%
D) 34.78%
E) 38.26%

F) A) and C)
G) B) and E)

Correct Answer

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Which of the following statements is CORRECT?


A) 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.
B) Other things held constant, the higher a firm's target dividend payout ratio, the higher its expected growth rate should be.
C) 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.
D) 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.
E) 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.
Multiple Choice: Problems
These problems can be changed algorithmically, and the computer can, at times, produce combinations of variables where the residual policy results in zero dividends and a zero payout ratio. We sometimes constrain the input variables to prevent this from occurring, but we sometimes permit it. When this possibility exists, we so indicate.

F) C) and E)
G) A) and D)

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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.

A) True
B) False

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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?


A) 30.54%
B) 32.15%
C) 33.84%
D) 35.63%
E) 37.50%

F) B) and E)
G) D) and E)

Correct Answer

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


A) Its earnings become more stable.
B) Its access to the capital markets increases.
C) Its research and development efforts pay off, and it now has more high-return investment opportunities.
D) Its accounts receivable decrease due to a change in its credit policy.
E) Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages.

F) C) and E)
G) All of the above

Correct Answer

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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.

A) True
B) False

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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.

A) True
B) False

Correct Answer

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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.

A) True
B) False

Correct Answer

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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.

A) True
B) False

Correct Answer

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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.

A) True
B) False

Correct Answer

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LA Moving Company has the following data, dollars in thousands. If it follows the residual dividend model, what will its dividend payout ratio be?


A) 60.71%
B) 63.75%
C) 70.13%
D) 77.14%
E) 84.85%

F) A) and C)
G) A) and D)

Correct Answer

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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?


A) 37.2%
B) 39.1%
C) 41.2%
D) 43.3%
E) 45.5%

F) A) and B)
G) C) and E)

Correct Answer

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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.

A) True
B) False

Correct Answer

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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?


A) 6.98
B) 7.00
C) 7.35
D) 7.72
E) 8.10

F) A) and D)
G) A) and C)

Correct Answer

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

A) True
B) False

Correct Answer

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Firm M is a mature company in a mature industry. Its annual net income and cash flows are consistently high and stable. 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?


A) Firm M probably has a lower target debt ratio than Firm N.
B) Firm M probably has a higher target dividend payout ratio than Firm N.
C) If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
D) The two firms are equally likely to pay high dividends.
E) Firm N is likely to have a clientele of shareholders who want a consistent, stable dividend income.

F) D) and E)
G) B) and E)

Correct Answer

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Which of the following statements is CORRECT?


A) 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.
B) The clientele effect explains why so many firms change their dividend policies so often.
C) 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.
D) New-stock dividend reinvestment plans are similar to stock dividends because they both increase the number of shares outstanding but don't change the firm's total amount of book equity.
E) Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock dividends are received.

F) C) and E)
G) B) and C)

Correct Answer

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