Ch. 16: Payout Policy

Question 1

Following the MM proposition, in a theoretical world with perfect capital markets, the payout policy (to pay dividends or repurchasing stocks) is important

True/False

Answer 1

False:

Following the MM proposition, in a theoretical world with perfect capital markets, the payout policy does not matter - i.e., it makes no difference whether surplus cash is paid out as dividend or spent on repurchase

Question 2

In the real world (imperfect markets) whether to payout surplus cash as dividends or spend them on stock repurchase can be important due to (select all correct)
A) The information content of dividends and repurchases being different
B) Cash dividends and share repurchases are typically taxed differently
C) The type of payout is unimportant as long as they do not affect cashflows

Answer 2

A) The information content of dividends and repurchases being different

B) Cash dividends and share repurchases are typically taxed differently

Question 3

When deciding whether cash is indeed surplus, the financial manager must be able to answer affirmative to three questions. Which?

Answer 3

1) Investment decision: are all real investments with positive NPVs accepted? If not, the cash is not surplus
2) Capital structure: is the firm’s debt ratio prudent and manageable? If not, FCF is better used to pay down debt
3) Rainy day money: are the company’s holdings of cash a sufficient cushion for unexpected setbacks and sufficient war chest for unexpected opportunities

Question 4

Paying out surplus cash may send a positive signal to market because?

Answer 4

Is assures shareholders that cash is not wasted on unnecessary overinvestment, excessive perks, and excessive compensation

Question 5

There are three types of dividends - which?

Answer 5

1) regular periodic (e.g., quarterly cash dividend
2) extra/ special/ unexpected dividend
3) stock dividend: not cash, but stock

Question 6

Which of the following are types of stock repurchases?
A) Tender offer
B) Dutch Auction
C) Direct negotiation with major shareholders
D) Open market transaction
D) A + B + C
E) C + B + D
F) A+B+C+D

Answer 6

F) A+B+C+D

Question 7

A firm states a series of prices at which it is prepared to repurchase stock. Shareholders then submit offers declaring how many shares they wish to sell at each price, and the company calculates the lowest price at which it can buy the desired number of shares.
This is a form of stock repurchase termed ______

Answer 7

Dutch auction

Question 8

When the firm offers to buy back a stated number of shares at a fixed price, which is typically set to be 20% above the current market level, this is a form of stock repurchase termed _____

Answer 8

Tender offer

Question 9

Generally, the announcement of an increase in dividends signals managers’ confidence in future profits (the information content of dividends) and is interpreted by investors as good news and the stock price increases. Thus, as a dividend is decrease, it sends an adverse signal to the market.

True/ False

Answer 9

True

Question 10

Stock repurchases typically happen after special events that are not expected to be recurring

True/ False

Answer 10

True

Question 11

Generally, a company announcing a share repurchase is not (necessarily) making a long-term commitment to repurchase in later years

True/ False

Answer 11

True

Question 12

Generally, the information content of a share repurchase announcement is more strongly positive than the announcement of a dividend increase
True/ False

Answer 12

False:
Generally, the information content of a share repurchase announcement is less strongly positive than the announcement of a dividend increase

Question 13

In perfect capital markets the choice between dividends and share repurchases has no effect on the market value of the firm

True/ False

Answer 13

True

Question 14

In perfect capital markets increased dividend payments financed by issuing stocks has no effect on the market value of the firm (holding the firm’s assets, investments, and borrowing policy fixed)

True/ False

Answer 14

True

Question 15

If you believe that pay-out policy matters, you simultaneously assume that the market deviates from perfection
True/ False

Answer 15

True

Question 16

One of the assumptions of Modigliani and Miller is perfect capital markets. What does this entail?

Answer 16

1) No taxes
2) No transaction costs
3) No issuance costs
4) In general no market imperfections

Question 17

Modigliani and Miller assumes that the capital budgeting decision is given - i.e., that the lhs (asset) side of the B/S is fixed

True/ False

Answer 17

True

Question 18

Modigliani and Miller assumes that the financing decision is given - i.e., that the rhs (liability) side of the B/S is fixed - often we assume that firms are fully equity financed

True/ False

Answer 18

True

Question 19

MM argues that dividend policy is value-irrelevant in perfect markets
True/ False

Answer 19

True

Question 20

According to rightists, dividends are value-destroying
True/ False

Answer 20

False:
According to rightists, dividends are good and result in higher value

Question 21

According to Rightists, investors prefer a large fraction of earnings to be paid out to shareholders as dividends: i.e., they prefer high dividend payout ratios. I.e., increased dividend payout ratios increases market value of stock
True/ False

Answer 21

True

Question 22

Rightists have two arguments for advocating high pay-out ratios. Which?

Answer 22

1) Market imperfection: deviating from MM’s proposition 1 assumptions
2) Pay-out policy have impact on management incentives

Question 23

Rightists argue for the existence of a natural clientele for high dividend pay-out stocks - i.e., some investors have a clear preference for dividend payments, incl. which?
A) financial institutions legally restricted from holding stocks lacking established dividend records
B) Trusts and endowment funds, because dividends are regarded as spendable income, giving rise to preference
C) Shareholders who are able to save on transaction costs and save considerable inconvenience in trading to meet liquidity needs
D) Pension funds

Answer 23

A) financial institutions legally restricted from holding stocks lacking established dividend records
B) Trusts and endowment funds, because dividends are regarded as spendable income, giving rise to preference
C) Shareholders who are able to save on transaction costs and save considerable inconvenience in trading to meet liquidity needs

Question 24

The rightists challenges MM’s assumption of the asset side (capital budgeting) of the balance sheet being fixed/ given

True/ False

Answer 24

True

Question 25

According to rightists, increase in dividend payout or share repurchase may lead to rise in stock price. Why?

Answer 25

Not because dividends are necessarily valuable in themselves, but because they signal a more careful, value-oriented investment policy with no money wasted on unwise spending/ investment

Question 26

Which of the following statements is/ are not in coherence with the radical left school of thought?
A) If dividends are taxed more heavily than capital gains, firms should pay the lowest cash dividend they can get away with
B) Available cash should rather be spent on stock repurchase than dividend payments for tax-saving reasons
C) Increased dividend payments reduce market value of stock
D) In the US, the most obvious and serious market imperfection has been the different tax treatment of dividends and capital gains
E) taxes alone can explain the payout policy adopted by firms

Answer 26

False:
E) taxes alone can explain the payout policy adopted by firms

Question 27

Assuming that the radical left are correct in their view, stocks with high dividend yields will have higher/lower market value of equity than stocks with low dividend yield

Answer 27

Assuming that the radical left are correct in their view, stocks with high dividend yields will have lower market value of equity than stocks with low dividend yield

Bc. shareholders prefer capital gains rather than dividends due to tax reasons

Question 28

Assuming that the radical left are correct in their view, stocks with high dividend yields will have higher/lower pre-tax risk-adjusted rate of return

Answer 28

Assuming that the radical left are correct in their view, stocks with high dividend yields will have higher pre-tax risk-adjusted rate of return

Bc. shareholders will demand a higher premium from holding high dividend stocks, wherefore required rate of return for such stocks is higher

Question 28

Assuming that the radical left are correct in their view, stocks with high dividend yields will have higher/lower pre-tax risk-adjusted rate of return

Answer 28

Assuming that the radical left are correct in their view, stocks with high dividend yields will have higher pre-tax risk-adjusted rate of return

Bc. shareholders will demand a higher premium from holding high dividend stocks, wherefore required rate of return for such stocks is higher

Question 29

Assuming that the radical left are correct in their view, stocks with high dividend yields will have higher/lower/equal after-tax risk-adjusted rate of return

Answer 29

Assuming that the radical left are correct in their view, stocks with high dividend yields will have EQUAL after-tax risk-adjusted rate of return

After adjusting for tax, all else equal, the two stocks should be equivalent since it is assumed that taxes gives rise to preferences for one over the other

Question 30

In young firms’ payout decisions, following statements are true (select all correct)
A) Young firms with plenty of profitable capital budgeting proposals and growth opportunities should retain and reinvest all operating cash flows
B) there is no point in paying out cash to investors if the firm has to replace the cash by borrowing or issuing new shares
C) retaining cash helps avoid costs of issuing securities and minimizes shareholders’ taxes
D) Investors are less worried about unnecessary overinvestment because growth opportunities are plenty
E) investments are financed as much as possible with internally generated CFs

Answer 30

All are true

Question 31

The older and more mature the firm becomes, the more/less of cash is paid out as dividends or spent on repurchase rather than retained

Answer 31

The older and more mature the firm becomes, the MORE of cash is paid out as dividends or spent on repurchase rather than retained

Question 32

Share repurchase is more/less flexible than dividends

Answer 32

MORE

Once a firm announces a regular cash dividend, investors expect the cash dividend to continue unless the firm encounters serious financial trouble. The same strong assumption is not the case for repurchases

Question 33

Generally, the announcement of an increase in dividends leads to stock increase/ decrease in practice

Answer 33

Generally, the announcement of an increase in dividends leads to stock increase in practice

Note that this is opposite to the argument by radical left

Question 34

Increased dividend pay-out ratios increase market value of stock. This is argued by:
A) Modigliani and Miller
B) Rightists
C) Radical left

Answer 34

B) Rightists

Question 35

Increased dividend payments reduce market value of stock.
This is argued by:
A) Modigliani and Miller
B) Rightists
C) Radical left

Answer 35

C) Radical left