CHAPTER 13—DISTRIBUTIONS TO SHAREHOLDERS: DIVIDENDS AND

REPURCHASES

TRUE/FALSE

1. The optimal distribution policy strikes a balance between cash dividends and capital gains that
maximizes the firm’s stock price.

ANS: T PTS: 1 DIF: EASY REF: 396

OBJ: (13.1) Optimal distribution policy

2. The dividend irrelevance theory, proposed by Miller and Modigliani, says that provided a firm pays at
least some dividends, how much it pays does not affect either its cost of capital or its stock price.

ANS: F PTS: 1 DIF: EASY REF: 396–397

OBJ: (13.1) Dividend irrelevance

3. MM’s dividend irrelevance theory says that while dividend policy does not affect a firm’s value, it can
affect the cost of capital.

ANS: F PTS: 1 DIF: EASY REF: 396–397

OBJ: (13.1) Dividend irrelevance

4. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its share
price should set a low payout ratio.

ANS: T PTS: 1 DIF: EASY REF: 400

OBJ: (13.2) Investors’ dividend preferences

5. 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.

ANS: F PTS: 1 DIF: EASY REF: 401

OBJ: (13.3) Dividends and stock prices

6. Given perfect capital mobility and a global economy, dividend yields in different stock markets are
similar throughout the world.

ANS: F PTS: 1 DIF: EASY REF: 400

OBJ: (13.1) Dividend yields

7. If a firm adopts a residual distribution policy, distributions are determined as a residual after funding
the capital budget. Therefore, the better the firm’s investment opportunities, the lower its payout ratio
should be.

ANS: T PTS: 1 DIF: EASY REF: 404

OBJ: (13.5) Residual distribution policy

8. Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders’
wealth.

ANS: T PTS: 1 DIF: EASY REF: 414

 OBJ: (13.11) Stock dividends and splits

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

ANS: T PTS: 1 DIF: EASY REF: 414

OBJ: (13.11) Reverse split

10. 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.

ANS: T PTS: 1 DIF: MEDIUM REF: 397

OBJ: (13.1) Dividend irrelevance

11. One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield
must be offset by a more than proportionate increase in growth in order to keep a firm’s required
return constant, other things held constant.

ANS: T PTS: 1 DIF: MEDIUM REF: 398

OBJ: (13.1) Dividend-growth tradeoff

12. If the information content, or signalling, hypothesis is correct, then changes in dividend policy can
have an important effect on the firm’s value and capital costs.

ANS: T PTS: 1 DIF: MEDIUM REF: 401–402

OBJ: (13.3) Signalling hypothesis

13. If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory
is correct, then it must adhere to the residual distribution policy.

ANS: F PTS: 1 DIF: MEDIUM REF: 402–403

OBJ: (13.5) Residual distribution policy

14. If the shape of the curve depicting a firm’s WACC versus its debt ratio is more like a sharp “V,” as
opposed to a shallow “U,” it will be easier for the firm to maintain a steady dividend in the face of
varying investment opportunities or earnings from year to year.

ANS: F PTS: 1 DIF: MEDIUM REF: 412–403

OBJ: (13.10) WACC and dividend policy

15. Avoiding dividend cuts and maintaining target D/E ratio are the two underlying objectives in the
residual dividend policy.

ANS: T
Residual theory of dividends proposes that the dividends paid out should be the residual cash flow that
remains only after the firm has taken care of all its investment requirements.

PTS: 1 DIF: MEDIUM REF: 403 OBJ: (13.5) Residual model

16. Share repurchases result in a decrease in EPS.

ANS: F PTS: 1 DIF: MEDIUM REF: 407

OBJ: (13.7) Share repurchases
 17. Even if a stock split has no information content, and even if the dividend per share adjusted for the
split is not increased, there can still be a real benefit (i.e., a higher value for shareholders) from such a
split, but any such benefit is probably small.

ANS: T PTS: 1 DIF: MEDIUM REF: 414

OBJ: (13.11) Stock splits

MULTIPLE CHOICE

1. Which of the following theories is supported by the argument that shareholders can transform a
company dividend policy into a different policy by means of investors buying and selling on their own
account?
a. “bird-in-the-hand” theory
b. dividend irrelevance theory
c. residual distribution model
d. tax preference theory
ANS: B PTS: 1 DIF: EASY REF: 396–398
OBJ: (13.1) Dividend irrelevance BLM: Higher Order

2. In the real world, which statement regarding dividends is true?

a. They are usually more stable than earnings.
b. They fluctuate more widely than earnings.
c. They tend to be a lower percentage of earnings for mature firms.
d. They are usually changed every year to reflect earnings changes, and these changes are
randomly higher or lower, depending on whether earnings increased or decreased.
ANS: A PTS: 1 DIF: EASY REF: 402
OBJ: (13.4) Dividend payout BLM: Higher Order

3. A company planning to pay a cash dividend in excess of the regular dividend does not want investors
to believe that such an extra dividend will be repeated. What will the firm likely call this extra
dividend?
a. a stock dividend
b. a cash-liquidating dividend
c. a special dividend
d. a residual dividend
ANS: C
Special dividends are dividends paid in addition to the regular dividend. With good reasons, firms do
not want to incorporate this amount into their regular dividend.

PTS: 1 DIF: EASY REF: 405 OBJ: (13.6) Dividend payout

BLM: Higher Order

4. What is the chronology of a dividend payment?

a. declaration date, holder-of-record date, ex-dividend date, payment date
b. declaration date, ex-dividend date, holder-of-record date, payment date
c. declaration date, holder-of-record date, payment date, ex-dividend date
d. holder-of-record date, declaration date, ex-dividend date, payment date
ANS: B PTS: 1 DIF: EASY REF: 406
OBJ: (13.6) Dividend payment procedures BLM: Remember
5. You own 100 shares of Troll Brothers stock, which currently sells for $120 a share. The company is
contemplating a 2-for-1 stock split. What will your position be after such a split takes place?
a. You will have 200 shares of stock, and the stock will trade at or near $120 a share.
b. You will have 200 shares of stock, and the stock will trade at or near $60 a share.
c. You will have 50 shares of stock, and the stock will trade at or near $120 a share.
d. You will have 50 shares of stock, and the stock will trade at or near $60 a share.
ANS: B PTS: 1 DIF: EASY REF: 413–414
OBJ: (13.11) Stock splits BLM: Higher Order

6. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend
payout ratio is decreased. On which assumption is their argument based?
a. that investors require that the dividend yield and capital gains yield equal a constant
b. that capital gains are taxed at a higher rate than dividends
c. that investors view dividends as being less risky than potential future capital gains
d. that investors value a dollar of expected capital gains more highly than a dollar of
expected dividends because of the lower tax rate on capital gains
ANS: C PTS: 1 DIF: EASY REF: 398
OBJ: (13.1) Dividends versus capital gains BLM: Remember

7. Which circumstance should NOT influence a firm’s dividend policy decision?

a. the firm’s ability to accelerate or delay investment projects
b. a strong preference by most shareholders for current cash income versus capital gains
c. Constraints imposed by the firm’s bond indenture
d. the fact that much of the firm’s equipment has been leased, rather than bought and owned
ANS: D PTS: 1 DIF: MEDIUM REF: 400 | 411 | 413
OBJ: (Comp. 13.1, 13.2, 13.9, 13.10) Optimal dividend policy BLM: Higher Order

8. Which statement about dividend policies is correct?

a. Modigliani and Miller argue that investors prefer dividends to capital gains because
dividends are more certain than capital gains. They call this the bird-in-the hand effect.
b. One advantage of dividend reinvestment plans is that they allow shareholders to avoid
paying taxes on the dividends that they choose to reinvest.
c. The key advantage of a residual dividend policy is that it enables a company to follow a
stable dividend policy.
d. The clientele effect suggests that companies should follow a stable dividend policy.
ANS: D PTS: 1 DIF: MEDIUM REF: 398 | 402 | 404 | 415
OBJ: (Comp. 13.1, 13.4, 13.5, 13.12) Dividend theories BLM: Remember

9. Which statement about dividend policies is correct?

a. Stock splits, stock dividends, and reverse splits are all designed to make the firm’s shares
more appealing to the average investor.
b. Dividend reinvestment plans are designed to aid in the distribution of stock dividends.
c. The key advantage of a residual dividend policy is that it enables a company to follow a
stable dividend policy.
d. The main goal of the share repurchases is solely to avoid taxes for investors.
ANS: A
By manipulating the number of shares, a firm can change the price per share. This may be useful if
there is an optimal trading range for the share price. At minimum, this allows the shares to be traded in
round lots at a reasonable value.
 PTS: 1 DIF: MEDIUM REF: 404 | 407 | 414 | 415
OBJ: (Comp. 13.5, 13.7, 13.11, 13.12) Dividend theories BLM: Remember

10. Which circumstance 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 R&D 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.
ANS: C PTS: 1 DIF: MEDIUM REF: 402–403 | 411–413
OBJ: (Comp. 13.5, 13.9, 13.10) Dividend payout BLM: Higher Order

11. Trenton Publishing follows a strict residual dividend policy. All else being equal, which circumstance
would be most likely to lead to an increase in the firm’s dividend per share?
a. The firm’s net income increases.
b. The company increases the percentage of equity in its target capital structure.
c. The number of profitable potential projects increases.
d. Earnings are unchanged, but the firm issues new shares of common stock.
ANS: A PTS: 1 DIF: MEDIUM REF: 402–404
OBJ: (13.5) Residual dividend policy BLM: Higher Order

12. Suppose a firm adheres strictly to the residual dividend policy and its optimal capital budget requires
the use of all earnings for a given year (along with new debt according to the optimal debt/total assets
ratio). What should the firm pay?
a. no dividends except out of past retained earnings
b. no dividends to common stockholders
c. dividends only out of funds raised by the sale of new common stock
d. dividends only out of funds raised by selling off fixed assets
ANS: B PTS: 1 DIF: MEDIUM REF: 403–404
OBJ: (13.5) Residual dividend policy BLM: Higher Order

13. If a firm adheres strictly to the residual dividend policy, what would the issuance of new common
stock suggest?
a. The dividend payout ratio has remained constant.
b. The dividend payout ratio is increasing.
c. No dividends were paid during the year.
d. The dividend payout ratio is decreasing.
ANS: C PTS: 1 DIF: MEDIUM REF: 403–404
OBJ: (13.5) Residual dividend policy BLM: Higher Order

14. What are automatic dividend reinvestment plans designed to do?

a. aid shareholders in creating their preferred dividend policy
b. raise new equity capital for the firm through market repurchases
c. eliminate excess illiquid shares from the open market
d. help investors avoid paying taxes on dividends
ANS: A
DRIP allows existing shareholders the use of dividends to buy new shares. These shares are then
issued by the company without any brokerage fees or purchased from market at low transaction costs.

PTS: 1 DIF: MEDIUM REF: 415–406

OBJ: (13.12) Dividend reinvestment plans BLM: Remember
15. Which of the following statements is correct?
a. One disadvantage of dividend reinvestment plans is that they increase transaction costs for
investors who want to increase their ownership in the company.
b. One advantage of dividend reinvestment plans is that they enable investors to postpone
paying taxes on the dividends credited to their account.
c. Stock repurchases can be used by a firm that wants to increase its debt ratio.
d. One advantage of an open market dividend reinvestment plan is that it provides new
equity capital and increases the shares outstanding.
ANS: C PTS: 1 DIF: MEDIUM REF: 410 | 415–416
OBJ: (Comp. 13.8, 13.12) Stock repurchases and DRIPs BLM: Higher Order

16. Which of the following statements is correct?

a. One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes
investors would have to pay if they received cash dividends.
b. Empirical research indicates that, in general, companies send a negative signal to the
marketplace when they announce an increase in the dividend, and as a result, share prices
fall when dividend increases are announced. The reason for this is that investors interpret
the increase as a signal that the firm has relatively few good investment opportunities.
c. If a company wants to raise new equity capital steadily over time, a new stock dividend
reinvestment plan would make sense. However, if the firm does not want or need new
equity, then an open market purchase dividend reinvestment plan would probably make
more sense.
d. Dividend reinvestment plans have not caught on in most industries, and today about 99%
of all companies with DRIPs are utilities.
ANS: C PTS: 1 DIF: MEDIUM REF: 401–402 | 415–416
OBJ: (Comp. 13.3, 13.12) Dividends, DRIPs, and repurchases BLM: Higher Order

17. Which of the following statements is correct?

a. Current Canadian tax law encourages companies to pay dividends rather than retain
earnings.
b. If a company uses the residual dividend model to determine its dividend payments,
dividend payouts will tend to increase whenever the company’s profitable investment
opportunities increase.
c. The stronger management thinks the clientele effect is, the more likely the firm is to adopt
a strict version of the residual dividend model.
d. Large stock repurchases financed by debt tend to increase earnings per share, but they also
increase the firm’s financial risk.
ANS: D PTS: 1 DIF: MEDIUM REF: 398 | 402–403 | 410
OBJ: (Comp. 13.1, 13.5, 13.8) Dividend policy and stock repurchases
BLM: Higher Order

18. Which of the following statements is correct?

a. If a company has a 2-for-1 stock split, its stock price should roughly double.
b. Capital gains earned in a share repurchase are taxed less favourably than dividends; this
explains why companies typically pay dividends and avoid share repurchases.
c. Very often, a company’s stock price will rise when it announces that it plans to commence
a share repurchase program. Such an announcement could lead to a stock price decline,
but this does not normally happen.
d. The clientele effect is the best explanation for why companies tend to vary their dividend
payments from quarter to quarter.
 ANS: C PTS: 1 DIF: MEDIUM REF: 402 | 410–411 | 413–414
OBJ: (Comp. 13.4, 13.8, 13.11) Miscellaneous dividend concepts
BLM: Remember

19. Which of the following statements is correct?

a. Firms with a lot of good investment opportunities and a relatively small amount of cash
tend to have above-average payout ratios.
b. One advantage of the residual dividend policy is that it leads to a stable dividend payout,
which investors like.
c. An increase in the stock price when a company decreases its dividend is consistent with
signalling theory as postulated by MM.
d. Stock repurchases make the most sense at times when a company believes its stock is
undervalued.
ANS: D PTS: 1 DIF: MEDIUM REF: 412–413
OBJ: (13.10) Dividend theory BLM: Higher Order

20. 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 follow the strict
residual dividend policy.
c. If a firm follows a strict residual dividend policy, then, holding all else constant, its
dividend payout ratio will tend to rise whenever the firm’s investment opportunities
improve.
d. Despite its drawbacks, following the residual dividend policy 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.
ANS: B PTS: 1 DIF: MEDIUM REF: 404 | 412–413 | 415
OBJ: (Comp. 13.5, 13.10, 13.12) Dividend policy BLM: Higher Order

21. Firm M is a mature firm in a mature industry. Its annual net income and net cash flows are both
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 firm 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 debt ratio than Firm N.
b. Firm M probably has a higher dividend payout ratio than Firm N.
c. If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
d. Firm N is likely to have a clientele of shareholders who want to receive consistent, stable
dividend income.

ANS: B PTS: 1 DIF: MEDIUM REF: 413

OBJ: (13.10) Miscellaneous dividend concepts BLM: Higher Order

22. Which of the following statements best describes stock splits?

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. 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.
c. When a company declares a stock split, the price of the stock typically declines—by about
50% after a 2-for-1 split—and this necessarily reduces the total market value of the equity.
d. 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 10-for-1 so as to bring the price down to something close to
$50. Moreover, if the price is relatively low—say, $2 per share—then it can declare a
“reverse split” of, say, 1-for-25 so as to bring the price up to somewhere around $50 per
share.
ANS: D PTS: 1 DIF: MEDIUM REF: 413–415
OBJ: (13.11) Stock dividends and stock splits BLM: Remember

23. Which of the following statements is correct?

a. If a firm repurchases some of its stock in the open market, then shareholders who sell their
stock for more than they paid for it will be subject to capital gains taxes.
b. An open-market dividend reinvestment plan will be most attractive to companies that need
new equity and would otherwise have to issue additional shares of common stock through
investment bankers.
c. Stock repurchases tend to reduce financial leverage.
d. If a company declares a 2-for-1 stock split, its stock price should roughly double.
ANS: A PTS: 1 DIF: MEDIUM REF: 407 | 410 | 413–414 | 416
OBJ: (Comp: 13.7–13.12) Miscellaneous dividend concepts BLM: Higher Order

24. Which action will best enable a company to raise additional equity capital?
a. Declare a stock split.
b. Begin an open-market purchase dividend reinvestment plan.
c. Initiate a stock repurchase program.
d. Begin a new-stock dividend reinvestment plan.
ANS: D PTS: 1 DIF: MEDIUM REF: 407 | 413 | 415–416
OBJ: (Comp: 13.7–13.12) Miscellaneous dividend concepts BLM: Higher Order

25. Which of the following statements is NOT true?

a. Stock repurchases can be used by a firm as part of a plan to change its capital structure.
b. After a 3-for-1 stock split, a company’s price per share should fall, but the number of
shares outstanding will rise.
c. Investors can interpret a stock repurchase program as a signal that the firm’s managers
believe the stock is undervalued.
d. Stockholders pay no income tax on dividends if the dividends are used to purchase stock
through a dividend reinvestment plan.
ANS: D PTS: 1 DIF: MEDIUM REF: 410 | 414–415
OBJ: (Comp: 13.8, 13.11, 13.12) Stock repurchases, stock splits, and DRIPs
BLM: Remember

26. Which of the following statements is correct?

a. If a firm follows the residual dividend policy, then a sudden increase in the number of
profitable projects is likely to reduce the firm’s dividend payout.
b. The clientele effect can explain why so many firms change their dividend policies so
often.
c. One advantage of adopting the residual dividend policy is that this policy makes it easier
for corporations to develop 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.
ANS: A PTS: 1 DIF: MEDIUM | HARD
REF: 412–413 | 414 | 416 OBJ: (Comp: 13.10, 13.11, 13.12)) Dividend policy
BLM: Higher Order

27. Brammer Corp.’s projected capital budget is $1,000,000, its target capital structure is 60% debt and
40% equity, and its forecasted net income is $550,000. If the company follows a residual dividend
policy, what total dividends, if any, will it pay out?
a. $128,606
b. $135,375
c. $142,500
d. $150,000
ANS: D
Capital budget $1,000,000
% Equity 40%
Net income (NI) $550,000
Dividends paid = NI – [% Equity(Capital budget)] $150,000

PTS: 1 DIF: EASY REF: 403

OBJ: (13.5) Residual model—divs paid, divs always positive BLM: Higher Order

28. Blease Inc. has a capital budget of $625,000, and it wants to maintain a target capital structure of 60%
debt and 40% equity. The company forecasts a net income of $475,000. If it follows the residual
dividend policy, what is its forecasted dividend payout ratio?
a. 40.61%
b. 42.75%
c. 45.00%
d. 47.37%
ANS: D
Capital budget $625,000
Equity ratio 40%
Net income (NI) $475,000
Dividends paid = NI – (Equity ratio)(Capital budget) $225,000
Dividend payout ratio = Dividends paid/NI 47.37%

PTS: 1 DIF: EASY REF: 403

OBJ: (13.5) Residual dividend model—dividend payout ratio BLM: Higher Order

29. P&D Co. has a capital budget of $1,000,000. The company wants to maintain a target capital structure
of 30% debt and 70% equity. The company forecasts that its net income this year will be $800,000. If
the company follows a residual dividend policy, what will be its total dividend payment?
a. $100,000
b. $200,000
c. $300,000
d. $400,000
ANS: A
The amount of new investment that must be financed with equity is
$1,000,000  70% = $700,000.

Since the firm has $800,000 of net income only $100,000 will be left for dividends.
 PTS: 1 DIF: EASY REF: 403
OBJ: (13.5) Residual dividend policy—nonalgorithmic BLM: Higher Order

30. Pate & Co. has a capital budget of $3,000,000. The company wants to maintain a target capital
structure that is 15% debt and 85% equity. The company forecasts that its net income this year will be
$3,500,000. If the company follows a residual dividend policy, what will be its total dividend
payment?
a. $205,000
b. $500,000
c. $950,000
d. $2,550,000
ANS: C
The amount of new investment that must be financed with equity is
$3,000,000  85% = $2,550,000.

Since the firm has $3,500,000 of net income, $950,000 = $3,500,000 – $2,550,000 will be left for
dividends.

PTS: 1 DIF: EASY REF: 403

OBJ: (13.5) Residual dividend policy—nonalgorithmic BLM: Higher Order

31. D&P Co. has a capital budget of $2,000,000. The company wants to maintain a target capital structure
that is 35% debt and 65% equity. The company forecasts that its net income this year will be
$1,800,000. If the company follows a residual dividend policy, what will be its total dividend
payment?
a. $200,000
b. $300,000
c. $400,000
d. $500,000
ANS: D
The amount of new investment that must be financed with equity is
$2,000,000  65% = $1,300,000.

Since the firm has $1,800,000 of net income only $500,000 = $1,800,000 – $1,300,000 will be left for
dividends.

PTS: 1 DIF: EASY REF: 403

OBJ: (13.5) Residual dividend policy—nonalgorithmic BLM: Higher Order

32. Becker Financial recently completed a 7-for-2 stock split. Prior to the split, its stock sold for $90 per
share. If the total market value was unchanged by the split, what was the price of the stock following
the split?
a. $23.21
b. $24.43
c. $25.71
d. $27.00
ANS: C
Number of new shares 7
Number of old shares 2
Old (pre-split) price $90
New price = Old price  (Old shrs/New shrs) $25.71
 PTS: 1 DIF: EASY REF: 414
OBJ: (13.11) Stock splits—fractional splits BLM: Higher Order

33. Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $150
per share. The firm’s total market value was unchanged by the split. Other things held constant, what
is the best estimate of the stock’s post-split price?
a. $50.00
b. $52.50
c. $55.13
d. $57.88
ANS: A
Number of new shares 3
Number of old shares 1
Pre-split stock price $150
Post-split stock price: P0/New per old = $50.00

PTS: 1 DIF: EASY REF: 414

OBJ: (13.11) Stock splits—simple splits BLM: Higher Order

34. Ting Technology has a capital budget of $850,000, it wants to maintain a target capital structure of
35% debt and 65% equity, and it also wants to pay a dividend of $400,000. If the company follows a
residual dividend policy, how much net income must it earn to meet its capital budgeting requirements
and pay the dividend, all while keeping its capital structure in balance?
a. $904,875
b. $952,500
c. $1,000,125
d. $1,050,131
ANS: B
Capital budget $850,000
Equity ratio 65%
Dividends to be paid $400,000
Required net income = Dividends + (Capital budget  % Equity) $952,500

PTS: 1 DIF: EASY | MEDIUM REF: 403

OBJ: (13.5) Residual dividend model—find net income BLM: Higher Order

35. Fauver Worldwide forecasts a capital budget of $650,000, and it wants to maintain a target capital
structure of 40% debt and 60% equity. It also wants to pay a dividend of $225,000. If the company
follows the residual dividend policy, how much net income must it earn to meet its capital
requirements, pay the dividend, and keep the capital structure in balance?
a. $584,250
b. $615,000
c. $645,750
d. $711,939
ANS: B
Capital budget $650,000
% Equity 60%
Dividends to be paid $225,000
Required net income = Dividends + (Capital budget  % Equity) $615,000

PTS: 1 DIF: EASY | MEDIUM REF: 403

 OBJ: (13.5) Residual dividend model—find net income BLM: Higher Order

36. Brooks Corp.’s projected capital budget is $2,000,000, its target capital structure is 60% debt and 40%
equity, and its forecasted net income is $600,000. If the company follows a residual dividend policy,
what total dividends, if any, will it pay out?
a. $228,000
b. $216,600
c. $205,770
d. $0
ANS: D
Capital budget $2,000,000
% Equity 40%
Net income (NI) $600,000
Dividends paid = NI – [% Equity(Capital Budget)] $0

PTS: 1 DIF: MEDIUM REF: 403

OBJ: (13.5) Residual model—divs paid, divs are zero BLM: Higher Order

37. D. Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target capital
structure of 45% debt and 55% equity, and it also wants to pay dividends of $500,000. If the company
follows the residual dividend policy, how much income must it earn, and what will its dividend payout
ratio be?

Net Income Payout

W. $898,750 55.63%
X. $943,688 58.41%
Y. $990,872 61.34%
Z. $1,040,415 64.40%

a. Choice W
b. Choice X
c. Choice Y
d. Choice Z
ANS: A
Capital budget $725,000
Equity ratio 55%
Dividends paid $500,000
NI=Divs + (Eq %  Cap Bud) $898,750
Payout = Dividends/NI 55.63%

PTS: 1 DIF: MEDIUM REF: 403

OBJ: (13.5) Residual model—find NI, then divs and payout BLM: Higher Order

38. Banerjee Inc. wants to maintain a target capital structure with 30% debt and 70% equity. Its forecasted
net income is $550,000, and its board of directors has decreed that no new stock can be issued during
the coming year. If the firm follows the residual dividend policy, what is the maximum capital budget
that is consistent with maintaining the target capital structure?
a. $673,652
b. $709,107
c. $746,429
d. $785,714
 ANS: D
% Debt 30%
% Equity 70%
Net income $550,000
Max capital budget = NI/% Equity $785,714
Check: Is calculated max cap bud  % Equity = NI? $550,000 = net income

PTS: 1 DIF: MEDIUM REF: 403

OBJ: (13.5) Residual dividend policy BLM: Higher Order

39. Dentaltech Inc. projects the following data for the coming year. If the firm follows the residual
dividend policy and also maintains its target capital structure, what will its payout ratio be?

EBIT $2,000,000 Capital budget $850,000

Interest rate 10% % Debt 40%
Debt outstanding $5,000,000 % Equity 60%
Shares outstanding $5,000,000 Tax rate 40%

a. 37.2%
b. 39.1%
c. 41.2%
d. 43.3%
ANS: D
EBIT $2,000,000 Capital budget $850,000
Interest rate 10% % Debt 40%
Debt outstanding $5,000,000 % Equity 60%
Shares outstanding $5,000,000 Tax rate 40%

EBIT $2,000,000
?2- Interest expense = interest rate  debt 500,000
Taxable income $1,500,000
?2- Taxes = Tax rate  income 600,000
Net income (NI) $900,000
?2- Equity needed for capital budget = % Equity(capital budget) = 510,000
Dividends = NI ?2- Equity needed $390,000
Payout ratio = Dividends/NI 43.33%

PTS: 1 DIF: MEDIUM REF: 403

OBJ: (13.5) Residual dividend policy BLM: Higher Order

40. Mortal Inc. expects to have a capital budget of $500,000 next year. The company wants to maintain a
target capital structure with 30% debt and 70% equity, and its forecasted net income is $400,000. If the
company follows the residual dividend policy, how much in dividends, if any, will it pay?
a. $42,869
b. $45,125
c. $47,500
d. $50,000
ANS: D
% Debt 30%
% Debt 70%
Capital budget $500,000
Net income $400,000
 Equity requirement = Cap Bud  % Equity = $350,000
Dividends = NI - 2- Equity requirement = $50,000

PTS: 1 DIF: MEDIUM REF: 403

OBJ: (13.5) Residual dividend policy; dividend may be zero BLM: Higher Order

41. Ross 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. 24.50
b. 25.00
c. 50.00
d. 52.50
ANS: C
Current price $0.50
Target price $25.00
Old shares surrendered per 1 new share = Target price/Old price 50.00

PTS: 1 DIF: MEDIUM REF: 414

OBJ: (13.11) Stock splits—reverse split BLM: Higher Order

42. 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. 5.00
b. 6.00
c. 7.00
d. 8.00
ANS: C
Current price $175.00
Target price $25.00
No. of new shares per 1 old share = Current price/Target price 7.00

PTS: 1 DIF: MEDIUM REF: 414

OBJ: (13.11) Stock splits—optimal stock split BLM: Higher Order

43. Whited Products recently completed a 4-for-1 stock split. Prior to the split, its stock sold for $120 per
share. If the firm’s total market value increased by 5% as a result of increased liquidity caused by the
split, what was the stock price following the split?
a. $24.00
b. $30.00
c. $31.50
d. $33.50
ANS: C
New shares per 1 old share 4
Pre-split stock price $120
% value increase 5%
Post-split stock price = (P0/New per old)(% Value increase) $31.50

PTS: 1 DIF: MEDIUM REF: 414

 OBJ: (13.11) Stock splits—positive market reaction BLM: Higher Order

44. 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. 32.15%
b. 33.84%
c. 35.63%
d. 37.50%
ANS: D
EPS $3.00
Shares outstanding 500,000
DPS $2.00
Capital budget $800,000
Net income = EPS  Shares outstanding = $1,500,000
Dividends paid = DPS  Shares outstanding = $1,000,000
Retained earnings available $500,000
Capital budget - 2- Retained earnings = Debt needed $300,000
Debt needed/Capital budget = % Debt financing 37.5%

PTS: 1 DIF: MEDIUM | HARD REF: 403

OBJ: (13.5) Residual dividend model—req’d debt ratio BLM: Higher Order

45. Grullon Co. is considering a 7-for-3 stock split. The current stock price is $75.00 per share, and the
firm believes that its total market value would increase by 5% as a result of the improved liquidity that
it thinks would follow the split. What is the stock’s expected price following the split?
a. $32.06
b. $33.75
c. $35.44
d. $37.21
ANS: B
Number of new shares 7
Number of old shares 3
Old (pre-split) price $75.00
% Increase in value 5%
New price before value increase = Old price/(Old shares/New shares) $32.14
New price after value increase = Prior  (1 + % Value increase) $33.75

PTS: 1 DIF: MEDIUM | HARD REF: 414

OBJ: (13.11) Stock splits—positive market reaction BLM: Higher Order

46. Pavlin Corp.’s projected capital budget is $2,000,000, its target capital structure is 40% debt and 60%
equity, and its forecasted net income is $1,000,000. If the company follows a residual dividend policy,
how much will it pay in dividends or, alternatively, how much new stock must it issue?

Dividends Stock Issued

W. $514,425 $162,901
X. $541,500 $171,475
Y. $570,000 $180,500
Z. $0 $200,000
 a. Choice W
b. Choice X
c. Choice Y
d. Choice Z
ANS: D
Capital budget $2,000,000
% Equity 60%
Net income (NI) $1,000,000

Dividends paid = NI - [% Equity(Cap. Bud)], stock issued if dividends zero or neg $0 $200,000

PTS: 1 DIF: MEDIUM | HARD REF: 403

OBJ: (13.5) Residual model—divs paid or stock issued BLM: Higher Order

47. DeAngelo Corp.’s projected net income is $150.0 million, its target capital structure is 25% debt and
75% equity, and its target payout ratio is 65%. DeAngelo has more positive NPV projects than it can
finance without issuing new stock, but its board of directors has decreed that it cannot issue any new
shares in the foreseeable future. The CFO now wants to determine how the maximum capital budget
would be affected by changes in capital structure policy and/or the target dividend payout policy.
Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were
raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things
held constant, and (3) the debt ratio and payout were both changed by the indicated amounts.

Increase in Capital Budget

Increase Debt to Lower Payout
75% to 20% Do Both
W. $120.0 $77.2 $351.5
X. $126.4 $81.2 $370.0
Y. $133.0 $85.5 $389.5
Z. $140.0 $90.0 $410.0

a. Choice W
b. Choice X
c. Choice Y
d. Choice Z
ANS: D
New Maximums:
Current If increase If lower If do
maximum debt payout both
NI $150.0 $150.0 $150.0 $150.0
% Debt 25.0% 75.0% 25.0% 75.0%
% Equity 75.0% 25.0% 75.0% 25.0%
% Payout 65.0% 65.0% 20.0% 20.0%
Dividends $97.5 $97.5 $30.0 $30.0
Retained earnings $52.5 $52.5 $120.0 $120.0
Max. capital budget = RE/% Equity $70.0 $210.0 $160.0 $480.0
Increase over current: Changed amt - Current max. NA $140.0 $90.0 $410.0

PTS: 1 DIF: HARD REF: 403

OBJ: (13.5) Residual model—divs paid or stock issued BLM: Higher Order
48. The following data apply to Grullon-Ikenberry Inc.:

Net income (NI) expected for the coming year $625,000

Currently outstanding shares 100,000
Current stock price $40.00

The company is in a mature industry. Therefore, it plans to distribute all of its income at year end, and
its earnings are not expected to grow. The CFO is now deciding whether to distribute income to
stockholders as dividends or to use the funds to repurchase common stock. She believes the P/E ratio
will not be affected by a repurchase. Moreover, she believes that the stock can be repurchased at the
end of the year at the then-current price, which is expected to be the now-current price plus the
dividend that would otherwise be received at year end. Disregarding any possible tax effects, how
much would a stockholder who owns 100 shares gain if the firm used its net income to repurchase
stock rather than for dividends?
a. $564.06
b. $593.75
c. $625.00
d. $656.25
ANS: C
NI $625,000
No. of shares outstanding 100,000
Expected EPS $6.25
Current stock price $40.00
P/E ratio 6.40
Expected DPS if pay dividend = EPS $6.25
Expected stock price end of year = Current price + expected DPS $46.25
Shares repurchased if use repurchase plan = NI/Expected Price 13,514
New shares outstanding after repurchase 86,486
New EPS if use repurchase plan = NI/New shares $7.227
New price = P/E  New EPS $46.25
Gain, 100 share owner, dividends = 100  DPS $625.00
Gain, 100 share owner, repurchase = 100  (new price – current price) $625.00

PTS: 1 DIF: HARD REF: 407–409

OBJ: (13.7) Repurchases versus dividends BLM: Higher Order