Chapter 11.3

Question 1

What are the 3 general conditions under which capital structure policy does NOT affect firm value?

Answer 1

1. There are no taxes
2. There are not information or transaction costs
3. The real investment policy of the firm is fixed

Question 2

Who identified the 3 general conditions under which capital structure policy doesn’t affect firm value?

Answer 2

Modigliani and Miller (M&M_

Question 3

Why are the factors that cause dividends to affect firm value very closely related to the 3 conditions identified by M&M?

Answer 3

Since a dividend payment has implications for a firm’s capital structure. In fact if the conditions identified by M&M are hold, then the dividends a firm pays will not affect its value

Question 4

What happens if the 3 conditions identified by M&M are hold?

Answer 4

The dividends a firm pays will not affect its value

Question 5

Why do dividends not matter under the 3 conditions?

Answer 5

Because a stockholder can “manufacture” any dividends they want at no cost, and the total cash flows a firm produces from its real assets aren’t affected by the dividends that it pays

Question 6

Consider a retired stockholder who owns 50,000 shares of a company’s stock and needs to receive a $1 per share dividend each year on this investment to cover his or her living expenses. If the company pays such a dividend, there is no problem. But what if the company does not pay such a dividend? How can a stockholder “manufacture” their own dividend under the 3 conditions?

Answer 6

By selling $50,000 worth of stock each year. This would reduce total value of investor’s stock by $50,000, just as a $50,000 dividend would.

Question 7

Why do we assume that no taxes must be paid when “manufacturing” dividends under the 3 conditions?

Answer 7

So the decline in the vale of the shares would exactly equal the value of the dividend if one were paid

Question 8

How can a stockholder undo the dividend decisions made by managers?

Answer 8

By simply reinvesting the dividends that the company pays in new shares

Question 9

What is an example of how a stockholder can undo the dividend decisions made by managers by simply reinvesting the dividends in new shares?

Answer 9

If a company paid a $50,000 dividend, thereby reducing the value of a stockholder’s shares, that stockholder could increase his or her ownership in the company’s shares to its previous level by purchasing $50,000 worth of shares

Question 10

Just as with changes in capital structure policy, why would investors not care whether or not the company paid a dividend?

Answer 10

Investors could replicate the dividends paid by a company on their own at no cost and the managers’ dividend decisions do not affect the total cash flows the firm produces

Question 11

Why would investors not be willing to pay more/less for stock of a firm that pays a dividend than for the stock of a firm that doesn’t pay a dividend?

Answer 11

If investors could replicate the dividends paid by a company on their own at no cost and the managers’ dividend decisions do not affect the total cash flows the firm produces, investors would not care whether or not the company paid a dividend

Question 12

Do the M&M 3 assumptions apply in the real world?

Answer 12

No

Question 13

Why is M&M assumptions not applying to real world and providing companies w/ the opportunity to create value through their dividend decisions a good thing?

Answer 13

Doing so involves balancing benefits and costs, just as we do in choosing a capital structure

Question 14

Give an example of how paying a dividend is a benefit as it attracts investors who prefer to invest in stocks that pay dividends.

Answer 14

Retired stockholder: they could simply sell some stock each month to cover expenses. In real world it may be less costly and less trouble to simply receive regular cash dividend payments instead of selling each share

Under M&M conditions, there aren’t transaction costs, but in real world retiree would have to pay brokerage commisions each time they sell stock. The dividend check in contrast simply arrives each quarter

Question 15

Although under M&M conditions there are no transaction costs, in the real world what would a stockholder have to do each time they sell a stock?

Answer 15

Pay brokerage commissions

Question 16

Why would it be less costly and troublesome for a stockholder to simply receive regular cash dividend payments instead of selling each share?

Answer 16

Under the M&M conditions: no transaction costs. In the real world: have to pay brokerage commissions each time they sell stock. The dividend check, in contrast, simply arrives each quarter

Question 17

What tax considerations should a retiree evaluate regarding dividends vs stock sales?

Answer 17

Impact of taxes on value of dividend vs value of proceeds from sale of stock

Question 18

Can receiving dividends be more appealing to a retiree than selling stock?

Answer 18

Yes, after considering taxes, receiving dividends can sometimes be more attractive financially than selling stock.

Question 19

What is another type of investor that might prefer income-paying stocks?

Answer 19

An institutional investor

Question 20

What are examples of institutional investors and why might they prefer income-paying stocks?

Answer 20

An institutional investor such as an endowment or foundation might prefer income paying stocks because of their investment guidelines

Question 21

What investment guidelines are in place for institutional investors in which they might prefer income-paying stocks?

Answer 21

Some institutional investors are only allowed to spend proceeds that are received as income from their investments. These institutions face limitations on their ability to sell shares to replicate a dividend

Question 22

Why is is the ability to appeal to certain investors not a very compelling reason for paying dividends?

Answer 22

While retirees and some institutional investors might prefer dividends, investors with no current need for income from their investment portfolios might prefer not to receive dividends

Question 23

Who might investors with no current need for income from their investment portfolios actually choose to avoid stocks that pay high dividends?

Answer 23

Since they might have to pay taxes on the dividends and would face transaction costs when they reinvest the dividends they receive

Question 24

Does the preference of some investors to receive dividends mean a company can increase its stock value by paying them?

Answer 24

No, investors preferring to receive dividends doesn’t necessarily mean that an individual company can increase the value of its stock by paying dividends

Question 25

Why does the preference of some investors to receive dividends not mean a company can increase its stock value by paying them?

Answer 25

A wide range of dividend-paying stocks is already available on the market. The addition of one more such stock is unlikely to markedly increase the options available for investors looking for dividends. Therefore, these investors will not be willing to pay a higher price for that stock

Question 26

What have some people argued that large regular dividends indicate about a company?

Answer 26

That a company is financially strong. The "signal" of strength, they say, can result in a higher stock price

Question 27

What assumption is the argument that a large regular dividend indicates that a company is financially strong based on?

Answer 27

The assumption that a company that's able to pay a large dividend, rather than holding on to cash for future investments, is a company that's doing so well that is has more money than it needs to fund its available investments

Question 28

What is the problem with the line of reasoning that a company that's able to pay large dividends is strong because it has money to spare instead of using it to fund investments?

Answer 28

Such a company might have more than enough money for all its future investment opportunities because it doesn't have many future investment opportunities. In this situation, the fact that the company doesn't need cash would be a bad signal, not a good one.

Question 29

How is What seemingly contradictory practice highlights a potential benefit of paying dividends?

Answer 29

Many companies pay regular cash dividends while routinely selling new shares

Question 30

What is an example of a company who pays regular cash dividends while routinely selling new shares?

Answer 30

FPL Group pays a regular dividend and occasionally raises capital by issuing new equity

Question 31

Why might FPL reduce its equity by paying a dividend and then turn around and increase it by selling new shares?

Answer 31

- Management may just be trying to appeal to investors who prefer dividends - But this practice helps to align the incentives of managers and stockholders

Question 32

How does a company paying dividends while also selling shares help align incentives of managers and stockholders?

Answer 32

By distributing excess cash through dividends, companies limit the funds available for managers to spend on unproductive or self-serving activities, encouraging more efficient use of resources.

Question 33

What risk do stockholders face when a highly profitable company doesn’t need external capital?

Answer 33

Managers may become less disciplined, investing in negative NPV projects or neglecting the business, reducing overall company performance and stock value.

Question 34

Why might stockholders lower the price they are willing to pay for a company's stock in the context of bad management?

Answer 34

If they believe managers are using excess profits inefficiently or prioritizing personal benefits over shareholder value, they will discount the stock to reflect this risk.

Question 35

What are examples of negative NPV assets managers might invest in for personal benefit?

Answer 35

What are examples of negative NPV assets managers might invest in for personal benefit?

Question 36

Why might managers at very profitable firms be less efficient?

Answer 36

Without the need to raise external capital, they face less financial discipline and may pursue personal perks or distractions instead of maximizing firm value.

Question 37

What happens if a company's board of directors votes to pay dividends that amount to more than the excess cash that the company is producing from its operations?

Answer 37

Since the money to pay dividends will have to come from somewhere, the board is effectively forcing management to sell equity periodically in the public markets

Question 38

Why will the need to raise equity in capital markets help align the incentives of managers with those of stockholders by voting on paying dividends that amount to more than excess cash that the company is producing from its operations?

Answer 38

Because it increases the cost to managers of operating the business inefficiently. In order to raise equity at a reasonable cost, the managers must be careful how efficiently they are operating the business

Question 39

What kind of audit does the process of raising new equity involve?

Answer 39

A special audit that's more detailed than an annual audit and invites the close attention of lawyers, investment bankers, and outside experts

Question 40

What do the outside parties involved in a special audit for the process of raising new equity provide?

Answer 40

A certification function that increases the amount of public information about the firm's activities

Question 41

How can receiving a special audit and a certification function ultimately lead to better company performance?

Answer 41

Voluntarily submitting to such outside certification by paying a dividend and issuing equity rather than just keeping cash inside the firm can ultimately lead to better company performance and the willingness of investors to pay higher price for company stock

Question 42

How can paying dividends be useful in managing the capital structure of a company?

Answer 42

The trade-off theory of capital structure tells us that there's a optimal mix of debt and equity that maximizes the value of a firm

Question 43

What happens if a firm generates more internal equity than it can invest profitably?

Answer 43

The fraction of debt in its capital structure will always be decreasing over time unless the company borrows more money (which it doesn't need) or distributes cash to stockholders

Question 44

How can paying dividends help maintain a firm’s optimal capital structure?

Answer 44

By distributing excess equity to stockholders, dividends prevent the equity ratio from rising too far above the optimal level.

Question 45

What are what of the important costs associated with dividends?

Answer 45

Taxes

Question 46

Why do stockholders have to pay taxes if they want to own the stock?

Answer 46

Dividends are taxable, and the stockholders of firms that pay dividends have no choice but to receive the dividends and pay the associated taxes

Question 47

Before 2003, how were dividends taxed by the federal government in the U.S.?

Answer 47

As ordinary income

Question 48

Why were tax laws changed in 2003 so dividends wouldn't have to be taxed as personal income?

Answer 48

Before: as much as 39.6 percent of the dividend would be paid to the federal government in taxes After: Lowered top rate to 15% making it the same top rate on capital gains

Question 49

What tax rate was given to dividends after tax law changes were made in 2003?

Answer 49

15%, same as capital gains

Question 50

What increased tax rates were given to both dividends and capital gains in 2013?

Answer 50

Increased from 15% in 2003 to 23.8% in 2013

Question 51

What tax rates are some government officials working to make for dividends once again?

Answer 51

To be the same as that for ordinary income again

Question 52

How can the total tax rate for dividends be even higher depending depending on where you live?

Answer 52

Since dividends are also taxed by a number of states

Question 53

What taxes do stockholders have to pay if they decide to sell shares to "manufacture" their own dividends?

Answer 53

Only on the profit on the sale

Question 54

Are profits from selling shares to "manufacture" dividends lower or higher than the amount an actual dividend would be?

Answer 54

Unless the stockholder received the stock for free, the profit from selling is a smaller amount than the amount a dividend would be

Question 55

How has the U.S. tax system typically treated capital gains differently from dividends?

Answer 55

If you own a stock for some specified period of time (currently 12 months), any gain on the sale of that stock is treated as a capital gain

Question 56

Until 2003, dividends were taxed as ordinary income. Was the ordinary income tax rate for most taxpayers higher or lower than the capital gains tax rate?

Answer 56

Higher, thus before 2003, if you sold shares rather than receiving dividends, you not only paid taxes on a smaller amount, but you also paid a lower rate on the amount that was taxable

Question 57

Since when have tax rates been the same for dividends and capital gains?

Answer 57

2003

Question 58

Are tax rates on dividends going to stay the same as capital gains forever?

Answer 58

No, the rate on dividends will be higher again not too far into the future

Question 59

In addition to paying taxes on dividends, what else do owners of stocks that pay dividends often have to pay if they want to reinvest the proceeds?

Answer 59

Brokerage fees

Question 60

What do some companies offer to eliminate the costs of brokerage fees for investors who want to reinvest their proceeds?

Answer 60

Dividend reinvestment program (DRIPs)

Question 61

What is a dividend reinvestment program (DRIP)?

Answer 61

A program in which a company sells new shares, commission-free, to dividend recipients who elect to automatically reinvest their dividends in the company's stock

Question 62

While DRIPS eliminate transaction costs, what do they not affect in terms of costs associated to dividends?

Answer 62

The taxes that must be paid on the dividends

Question 63

How do Dividend Reinvestment Plans (DRIPs) shift costs among stockholders?

Answer 63

Since DRIPs are costly to administer, they transfer the reinvestment costs from individual stockholders to the firm—effectively making all stockholders share the expense, even those who don’t use the program.

Question 64

How is the total value of assets affected when a dividend is paid?

Answer 64

Total value of assets in a company goes down

Question 65

How can paying dividends increase the cost of debt for a highly leveraged company?

Answer 65

If the payment of dividends reduces the value of the assets underlying debt holder claims on the cash flows from the firm

Question 66

Why do debt holders charge higher interest rates when a firm’s assets become less valuable?

Answer 66

Because lower asset value increases the risk of default, debt holders demand higher rates to compensate for the additional risk.

Question 67

How can we think about the market's reaction to a dividend announcement?

Answer 67

In the context of what we call the cash flow identity

Question 68

What is cash flow identity?

Answer 68

A term which means that during any period, the sources of cash must equal the uses of cash in a firm

Question 69

What is the equation for cash flow identity?

Answer 69

Sources = Uses CFOAₜ + Equityₜ + Debtₜ = Divₜ + Repurchasesₜ + Interestₜ + Principalₜ + Invₜ Where CFOAₜ= cash flow to investors from operating activity in period t Equityₜ = proceeds from the sale of stock in period t Debtₜ= proceeds from the sale of debt in period t Divₜ = dividends paid in period t Repurchasesₜ = cash used to repurchase stock in period t Interestₜ = interest payments to debt holders in period t Principalₜ = principal payments on debt in period t Invₜ = investments in net working capital and fixed assets period t

Question 70

What are the sources of cash in the cash flow identity equation?

Answer 70

CFOAₜ + Equityₜ + Debtₜ Where CFOAₜ= cash flow to investors from operating activity in period t Equityₜ = proceeds from the sale of stock in period t Debtₜ= proceeds from the sale of debt in period t

Question 71

What are the uses of cash in the cash flow identity equation?

Answer 71

Divₜ + Repurchasesₜ + Interestₜ + Principalₜ + Invₜ Where Divₜ = dividends paid in period t Repurchasesₜ = cash used to repurchase stock in period t Interestₜ = interest payments to debt holders in period t Principalₜ = principal payments on debt in period t Invₜ = investments in net working capital and fixed assets period t

Question 72

How can the cash flow identity help us to understand how investors use dividend announcements to infer what management thinks the firm's future performance will be?

Answer 72

If dividends increase while all other components (Equity, Debt, Repurchases, Interest, Principal, Investment) remain unchanged, the identity implies an expected increase in CFOAₜ, suggesting stronger future operating performance.

Question 73

What assumption must hold for investors to infer rising CFOAₜ from a dividend increase?

Answer 73

That there is no change in financing (Equityₜ, Debtₜ), no repurchases, and no change in investment or debt service—leaving CFOAₜ as the only possible rising source.

Question 74

Why might a stock’s price rise after an unexpected dividend increase?

Answer 74

Investors interpret the increase as a signal that management expects future operating cash flows to rise, which increases expected cash returns to shareholders.

Question 75

Is evidence of stock price reactions to dividend announcements consistent with the cash flow identity? What does this evidence indicate?

Answer 75

Yes, this evidence indicates that when a company announces that it will begin paying a regular cash dividend, its stock price increases by an avg of ~3.5%

Question 76

What % increase in avg stock price are announcements that a company will increase in regular cash dividends associated with?

Answer 76

1-2%

Question 77

What % decrease in avg stock price are announcements that a company will reduce its regular cash dividend associated with?

Answer 77

A 3.5% decrease

Question 78

What % increase in avg stock price are announcements that a company will pay a special dividend associated with?

Answer 78

Increase of ~2%

Question 79

Why is it important that we can't interpret studies as proof that changes in dividends cause changes in stock prices?

Answer 79

Rather the cash flow identity suggests that managers change dividends when something fundamental has changed in the business. It is this fundamental change that causes the stock price to change. The dividend announcement is really just the means by which investors find out about the fundamental change.

Question 80

Why is there no evidence that its possible to increase firm value by increasing dividends?

Answer 80

Dividend changes only provide a signal concerning a fundamental change at the firm. In this sense, they are only by-products of the change.

Question 81

What are stock repurchases an alternative to?

Answer 81

Dividends as a way of distributing value

Question 82

What advantages do stock repurchases have over dividends?

Answer 82

- Give stockholders the ability to choose when they receive the distribution (affects the timing of the taxes they must pay + the cot of reinvesting funds that aren't immediately needed) - Stockholders who sell shares back to company pay taxes only on the gains they realize (historically these gains taxed @ lower rate than dividends)

Question 83

From management's perspective, how do stock repurchases provide greater flexibility in distributing value?

Answer 83

Even when company publicly announces ongoing open-market stock repurchase program, as opposed to regular cash dividend, investors know that mngmnt can always quietly cut back/end repurchases at any time

Question 84

Why do dividend programs represent a stronger commitment to distribute value in the future?

Answer 84

Because they can't be quietly ended. For this reason, investors know that managers will initiate regular cash dividends only when they're quite confident that they will be able to continue them for the long run

Question 85

How do open-market share repurchases provide flexibility for managers when future cash flows are uncertain?

Answer 85

Managers can distribute extra cash without committing to ongoing payments, and if future cash flows decline, they can reduce repurchases without significantly impacting the stock price—unlike dividend cuts, which often send negative signals.

Question 86

What is the notable disadvantages of stock repurchases compared to dividends?

Answer 86

Flip side of the signalling benefit of dividends; Since most ongoing stock repurchase programs aren't visible as dividend programs, they can't be used as effectively to send positive signal about the company's prospects to investors

Question 87

What is a more subtle issue concerning stock repurchase programs?

Answer 87

The fact that managers can choose when to repurchase shares.

Question 88

Why are managers being able to choose when to repurchase shares in a stock repurchase program an issue?

Answer 88

Just like other investors, they prefer purchasing shares when they believe that they're undervalued in the market. Problem: since managers have better info about the company's prospects than other investors, can take advantage of this info to detriment of other investors

Question 89

What happens if managers are taking advantage of superior information in stock repurchases?

Answer 89

Their repurchases are effectively transferring value from stockholders who choose to sell their shares (maybe bc they simply need $ to live on) to stockholders who choose to remain invested in the company Transfer of wealth from one group of stockholders to another is a problem

Question 90

Why is the transfer of wealth from one group of stockholders to another a problem in the context of managers taking advantage of insider info in stock repurchases?

Answer 90

Management is supposed to act in the best interest of ALL of the firm's stockholders

Question 91

Companies in what country have historically distributed more value through dividend payments than through stock repurchases?

Answer 91

In the US

Question 92

What does companies in the US having historically distributed more value through dividend payments than through stock repurchases suggest?

Answer 92

That managers have on balance, found dividends more attractive.

Question 93

How have the popularity of stock repurchases increased in recent years?

Answer 93

2005-2007: total $ value distributed thru stock repurchases exceeded value distributed thru dividends for the first time While $ value of stock repurchases has been below that of dividends since 2008, it has remained at historically high lvls

Question 94

How have the way companies payed dividends and how much they pay changed substantially?

Answer 94

1978-2000: # of public industrial companies in the US that paid dividends declined from ~2,250 to 926 The total value of dividends paid has actually increased since 1978 even after adjusting for inflation. The net result is that the firms that pay dividends on avg, paying larger dividends

Question 95

What type of companies are most likely to stop paying dividends?

Answer 95

Companies that had been paying relatively small dividends are the ones most likely to stop doing so.

Question 96

How has the fraction of total equity value being distributed to stockholders (total value of dividends and stock repurchases as a percentage of market cap) of U.S. firms changed?

Answer 96

Has declined