Fin 338 Test 3 Conceptual Practice (Ch. 14 &15)

What is the Information (signaling) theory?

An increase in the dividend is often accompanied by an increase in the stock price, while a dividend cut generally leads to a stock price decline. Investors regard dividend changes as indicators of management's earnings forecasts. Managers often have better information about future prospects for dividends than public stockholders, so there's come information content in dividend announcements. A firm should consider these effects when it's contemplating a change in dividend policy.

How should the residual dividend model be used?

Because investment opportunities and earnings will vary from year to year, strict adherence to this model would result in fluctuating, unstable dividends. However, investors prefer stable, dependable dividends. Consequently, firms should use this model to help set their long-run target payout ratios, but not as a guide to payout in any one year.

Investors relied on unseen capital gains during the Internet boom. Once the Internet bubble burst, their capital gains disappeared. What investor theory follows this logic?

Bird-in-the-hand theory

(T/F) The value of operations depends on whether a firm decides to make distributions in the form of dividends or stock repurchases.

False because ignoring possible tax effects and signals, the value of a firm's operations doesn't depend on how the firms distributes its residual earnings

(T/F) The stock price of a firm increases after the firm repurchases some of its shares.

False. If stock price changes after a firm conducts its share repurchase, then there will be arbitrage opportunities. Thus, the price of the stock remains the same after a repurchase.

Corporate investors in common stock may exclude 70% of their dividend income from taxes, would corporate investors favor high or low payout ratios?

Favor a high payout

Dividends received far into the future are significantly more uncertain than dividends received in the near future. Based on the factor described, identify whether investors, in general, will tend to favor high or low payout ratios.

Favor a high payout.

Firms incur various legal and administrative costs (floatation costs) when they issue new stock. Based on this, identify whether firms will tend to favor high or low payout ratios.

Favor a low payout

When an investor dies, his or her heirs aren't liable for taxes on the capital gains generated during the investor's life. They're only liable for the capital gains earned since the investor's death. Given this information, would investors likely prefer more or fewer dividends?

Fewer dividends

What type of real option gives the firm the ability to alter operations depending on how conditions change during a project's life, which can permit the firm to change either the inputs it uses or the output it produces after operations have commenced?

Flexibility option

What type of real option creates the opportunity to make other potentially profitable investments that wouldn't otherwise be possible?

Growth option

What do high levels of participation in a DRIP suggest?

Stockholders would be better served if the firm reduced its cash dividends

What is the Optimal Dividend policy?

Strikes a balance between current dividends and future growth and maximizes the firm's stock price

Why might investors prefer capital gains to dividends?

Tax Code encourages many individual investors to prefer capital gains because taxes must be paid on dividends the year they're received, but taxes on capital gains aren't paid until stock is sold. Due to time value effects, a dollar of taxes paid in the future has a lower effective cost than a dollar of taxes paid today.

When are investors aware of the size and timing of a future dividend payment?

The Declaration Date

When are dividends actually paid?

The Payment date

When is the last date that investors can buy shares of a stock and still be entitled to the dividend date?

The With-Dividend Date

(T/F) If a firm pays a dividend of $0.59 per share, the firm's stock price will also fall by $0.59 per share

True because if a firm issues a dividend, its stock will fall by that price to avoid any arbitrage opportunities

Omni Consumer Products Co. always pays the same percentage of its annual net income as dividends. What dividend policy would this be? a.) Constant Payout Ratio b.) Low-Regular-Dividend-Plus-Extras c.) Residual Dividend d.) Stable, Predictable Dividend

a.) Constant Payout Ratio

Which of the following is a characteristic of a firm's optimal dividend policy? a.) maximizes firm's stock price b.) maximizes firm's total assets c.) maximizes return on equity d.) maximizes earnings per share

a.) maximizes firm's stock price

What is the catering theory?

Investors' preference for dividends varies over time and that corporations adapt their dividend policy to accommodate the current desires of investors

What is dividend policy?

Involves the decision to pay out earnings to shareholders, or to retain and reinvest them in the firm.

What is a stock split?

Action taken by a firm to increase the # of shares outstanding, such as doubling the # of shares outstanding by giving each shareholder two new shares for each one formerly held.

If a company whose stock price is $105 per share conducts a 4 for 1 split, what is the new price per share?

$26.25

After a 4-for-1 stock split, Perry Enterprises paid a dividend of $1.20 per new share, which represents a 4% increase over last year's pre-split dividend. What was last year's dividend per share? Round your answer to the nearest cent.

$4.62

What do Dividend reinvestment plans (DRIPs) do?

Allow shareholders to reinvest their dividends in the company by purchasing additional shares instead of receiving cash dividend payments

What are the 5 inputs to the Black-Scholes Option Pricing Model?

-Risk-free rate -Time to expiration of option -Strike price -Current price of the stock (in this case a proxy for the underlying asset) -Variance of the project's expected return

What does the residual dividend model assume that the optimal distribution policy is a function of? What does the firm base distributions on?

-Target Capital Structure -Investment Opportunities Available to the Firm -Availability and Cost of External Capital Firm makes distributions based on residual earnings

CHAPTER 14

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CHAPTER 15

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What is the process in which companies pay dividends?

1.) Declaration date: date on which a firm's directors issue a statement declaring a dividend 2.) With-Dividend Date: The last day that an investor can buy a share of stock and still be entitled to the dividend. 3.) Ex-Dividend date: the right to the current dividend holder no longer accompanies a stock; usually two business days prior to the holder-of-record date 4.) Holder-of-record date: company closes its stock transfer books. If company lists the stockholder as an owner on this date, then they receive the dividend. 5.) Payment date: firm mails dividend checks

What are the 3 issues to consider when distributing income to stockholders?

1.) How much should be distributed? 2.) Should the distribution be in the form of dividends or should the cash be passed on to shareholders by repurchasing stock? 3.) How stable should the distribution be?

What are the 2 opposing effects of changing the target payout ratio?

1.) If dividends are increased then taken alone this will cause the firm's stock price to increase 2.) An increase in dividends will also cause the firm's expected growth rate to decrease, which tends to cause the stock price to decrease

What year did stock repurchases become common?

1983

If a firm with 1.9 Million shares outstanding pays a 7% stock dividend, what will be the total # of shares outstanding after the stock dividend?

2,033,000 shares

Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.19 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.095 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $4.51 million. Moreover, if it waits two years, there is a 70% chance that the cash flows would be $2.281 million a year for four years, and there is a 30% chance that the cash flows will be $1.546 million a year for four years. Assume that all cash flows are discounted at a 8% WACC. If the company chooses to drill today, what is the project's net present value?

2,748,905.73

What kind of company is most likely to follow a strict residual dividend policy?

A firm with stable, predictable earnings and investment

What type of real option gives the firm the ability to shut down a project if operating cash flows turn out to be lower than expected?

Abandonment option

Why doesn't DCF analysis always lead to proper capital budgeting decisions?

Capital budgeting projects aren't passive investments like stocks and bonds. Managers can often take positive actions after the investment has been made to alter its cash flows.

Electric utility companies have historically paid high dividends to their shareholders. Many retirees include the stocks of these electric utilities in their portfolios. On the other hand, biotechnology companies typically pay little or no dividends so they can reinvest for research and development. Many of the biotech company's stockholders are in their peak income-earning years. Which of the following dividend theories best explains these results?

Clientele Effect

Modigliani and Miller pointed out that many institutional investors don't pay taxes and can buy and sell stocks with very low transaction costs. Is dividend policy more or less relevant for institutional investors than it is for an individual investor?

Dividend policy is less relevant for institutional investors

If you were to graph a firm's earnings and dividends over the past 20 years, which would you expect to be the most stable over time?

Dividends

Referring to the Residual Distribution Model, how would a reduction in forecasted capital budget affect a firm's annual dividends, assuming all other factors constant?

Dividends would increase

What does a stock dividend do? Why is it useful?

Divides the pie into smaller slices without affecting the fundamental position of the current stockholders, but shareholders receive additional shares of stock rather than cash. Used on a regular basis, stock dividends keep the stock price more or less constrained.

What does a firm's value depend on?

Expected free cash flow and cost of capital

What does dividend irrelevance suggest?

In a world with no taxes or brokerage (or transaction costs), firms and investors are indifferent to the paying or receiving of dividends.

How does the existence of real options impact projects?

Increases expected profitability, increases calculated NPVs, and decreases risk

What type of real option gives the firm flexibility as to when to begin a project?

Investment timing option

Suppose a firm generates a lot of cash, but has limited investment opportunities. Is this stock more likely to be a utility stock or a technology stock? In addition, is the stock more likely to provide a high or low dividend yield?

Mature utilities are likely to have a lot of cash on hand and limited investment opportunities, whereas tech companies usually have a large number of potentially profitable investment opportunities but limited cash to invest. A firm with a lot of available cash and limited investment opportunities will be able to pay a high dividend yield. If a firm can't invest the cash and earn high rates of return for its investors, it should pay out the cash as dividends. Therefore, the firm described in the problem is more likely to be utility stock that pays a high dividend yield.

What is the firm's objective?

Maximize shareholder value

What does the belief that there exists an optimal price range for stocks mean?

Means that within this range the P/E ratio and therefore the firm's value will be maximized. Two such tools to use for this purpose are stock dividends and stock splits. They are often used to lower a firm's stock price, and at the same time, to conserve the firm's cash resources.

Would an investor on a fixed income who depends on returns from investment likely prefer more or fewer dividends?

More dividends

Would an investor who believes in the bird-in-the-hand theory prefer more or less dividends?

More dividends. The certainty of a dividend received now and the uncertainty of possible capital gains is what some academics call the bird-in-the-hand fallacy. Nevertheless, many investors, especially risk-averse investors, see this relationship as a very real factor and prefer stocks that pay higher dividends now.

What is the bird-in-the-hand fallacy? Why did Modigliani and Miller believe this was a fallacy?

Myron Gordon and John Lintner argued that the cost of equity decreases as the dividend payout increases because investors are less certain of receiving capital gains that should result from retaining earnings than they are of receiving dividend payments. MM argued it was a fallacy because they believed that the cost of equity was independent of the dividend policy, which implies that investors are indifferent between dividends and capital gains.

Who advanced the dividend irrelevance theory? What does the theory state?

Professors Modigliani and Miller (MM). The theory states that a firm's dividend policy has no effect on either its value or its cost of capital. They proved that a firm's value is determined only by its basic earning power and business risk. In other words, the value of a firm depends only on the income produced by its assets, not on how that income is split between dividends and retained earnings.

What does a new stock dividend reinvestment program do?

Raises new capital for the firm by investing dividends in newly issued stock

What is the residual dividend model? What is its significance?

Sets the dividend paid equal to net income minus the amount of retained earnings necessary to finance the firm's optimal capital budget. This minimizes flotation and equity signaling costs, hence minimizing the WACC. Dividends = net income - (Target equity ratio x Total capital budget)

When should income be retained instead of distributed? Why?

Since the firm's cash flows belong to the shareholders, income shouldn't be retained unless management can reinvest those earnings at higher rates of return than shareholders can earn themselves. This is because the overriding objective is to maximize shareholder value.

When are stock splits used? How are they viewed in recent years?

Stock splits are generally used after a sharp price run-up to produce a large price reduction. Stock splits have become a lot less popular in recent years because individual investors have moved from purchasing individual company shares to purchasing shares in mutual funds. Institutional investors are less likely to value stock splits.

What do low levels of participation in a DRIP suggest?

Stockholders are content with the amount of cash dividends the firm is paying out

(T/F) Even though most firms have earnings that vary considerably year to year and required investment may change often, most firms can still use the concepts behind a residual dividend policy to make long-run decisions about dividends

True

(T/F) Modigliani and Miller argued that each shareholder can construct his or her own dividend policy.

True

(T/F) The presence of real options increases the value of an investment project.

True

What does an old stock reinvestment plan do?

The company gives any cash dividends that investors would've received to a bank, which acts as a trustee. The bank then uses the money to repurchase the company's existing stock in the stock market and then allocates the shares purchased to the participating stockholders' accounts on a pro rata (proportional) basis

What is the target payout ratio?

The percentage of net income distributed as cash dividends, and it should be based on investors' preferences for dividends versus capital gains

What is the clientele effect?

The tendency of a firm to attract a set of investors who like its dividend policy. Firms have different groups of investors and they have different preferences, so a change in dividend policy might upset the majority group and have a negative effect on a firm's stock price. Therefore, a company should follow a stable, dependable dividend policy.

Which of the following statements is correct? a.) Having the option to abandon a project could increase the expected NPV of a project but could not decrease a project's risk. b.) Having the option to abandon a project could both increase the expected NPV of a project and decrease a project's risk by limiting downside losses. c.) Having the option to abandon a project could decrease a project's risk but not increase the expected NPV of a project. d.) None of the statements above is correct.

b.) Having the option to abandon a project could both increase the expected NPV of a project and decrease a project's risk by limiting downside losses.

ABCDE Telecom has volatile earnings and cash flows, so it pays a small dividend every year and then pays additional dividends in good years. What dividend policy would this be? a.) Constant payout ratio b.) Low-Regular-Dividend-Plus-Extras c.) Residual Dividend d.) Stable, Predictable Dividend

b.) Low-Regular-Dividend-Plus-Extras

Business Logistics Corp. uses a policy that allows it to pay a small, consistent dividend in years when earnings are low or large capital investments are required. In some years, the firm pays an extra dividend when excess funds are available. What dividend policy would this be? a.) Constant payout ratio b.) Low-Regular-Dividend-Plus-Extras c.) Residual Dividend d.) Stable, Predictable Dividend

b.) Low-Regular-Dividend-Plus-Extras

Globo-Chem Co. sets its dividend rather conservatively, but supplemental dividends are periodically issued when it finds itself with excess funds. What dividend policy would this be? a.) Constant payout ratio b.) Low-Regular-Dividend-Plus-Extras c.) Residual Dividend d.) Stable, Predictable Dividend

b.) Low-Regular-Dividend-Plus-Extras

Which of the following explains why stock price rises when dividends increase more than expected? a.) the clientele effect b.) the signaling hypothesis c.) Dividend irrelevance theory

b.) the signaling hyposthesis

Mainway Toys Co.'s dividends represent the portion of earnings left after it's made all profitable investments. What dividend policy would this be? a.) Constant payout ratio b.) Low-Regular-Dividend-Plus-Extras c.) Residual Dividend d.) Stable, Predictable Dividend

c.) Residual Dividend

St. Mildred's Brewing Co. pays dividends only iff more earnings are available than needed to support the optimal capital budget. What dividend policy would this be? a.) Constant payout ratio b.) Low-Regular-Dividend-Plus-Extras c.) Residual Dividend d.) Stable, Predictable Dividend

c.) residual dividend

Seller sells Indigo Company stock to Buyer on the ex-dividend date. Which of the following statements is correct? a.) Neither the Buyer or the Seller will receive the dividend. Dividend rolls over to special account for the next quarter's dividend. b.) Buyer receives the stock, so Buyer now receives the dividend. c.) Because the stock was sold on the ex-dividend date, a special rule applies where the dividend is split between the Buyer and Seller. d.) Because the stock was sold on the ex-dividend date, Seller would still be considered the owner of the stock and would receive the dividend.

d.) Because the stock was sold on the ex-dividend date, Seller would still be considered the owner of the stock and would receive the dividend.

If Victor buys 10 shares of LeBron Development Inc. stock from Susan, by which business date must Victor inform the company that he owns the shares so that he's eligible to receive the recently announced dividend payment? a.) Declaration Date b.) With-Dividend Date c.) Ex-Dividend Date d.) Holder-of-record Date e.) Payment Date

d.) Holder-of-record Date Must inform LeBron Development Inc. before 5:00 PM, otherwise the business day is technically over and Susan will receive the dividend

Which of the following statements is correct? a.) Once a firm analyzes a project and determines that it is advantageous to waiting (indicating a higher NPV than doing the project today), it has no other considerations to factor into the analysis. b.) If a firm decides to wait to undertake a project, it must consider the loss of the strategic advantage of being the first to enter a new business or market. c.) If a firm decides to wait to undertake a project, it must consider that costs may increase which would lower the calculated NPV. d.) Previous two statements are correct. e.) None of the statements above is correct.

d.) Previous two statements are correct.

Spentworth Industries Inc's investors like the firm's dividend policy because the firm pays the same dividend every year no matter how the firm performs. What dividend policy would this be? a.) Constant payout ratio b.) Low-Regular-Dividend-Plus-Extras c.) Residual Dividend d.) Stable, Predictable Dividend

d.) Stable, Predictable Dividend