Save and Submit Question 1 Which of the following should not influence a firm’s dividend policy decision? Answer The firm’s ability to accelerate or delay investment projects. A strong preference by most shareholders for current cash income versus capital gains. Constraints imposed by the firm’s bond indenture. The fact that much of the firm’s equipment has been leased rather than bought and owned. The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains. 2 points Question 2 Which of the following would be most likely to lead to a decrease in a firm’s dividend payout ratio? Answer Its earnings become more stable. Its access to the capital markets increases. Its R&D efforts pay off, and it now has more high-return investment opportunities. Its accounts receivable decrease due to a change in its credit policy. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages. 2 points Question 3 If a firm adheres strictly to the residual dividend policy, the issuance of new common stock would suggest that Answer the dividend payout ratio has remained constant. the dividend payout ratio is increasing. no dividends were paid during the year. the dividend payout ratio is decreasing. the dollar amount of investments has decreased. 2 points Question 4 Which of the following statements is CORRECT? Answer 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. Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and it is illegal today. 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. 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. 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. 2 points Question 5 Which of the following statements is correct? Answer The tax code encourages companies to pay dividends rather than retain earnings. If a company uses the residual dividend model to determine its dividend payments, dividends payout will tend to increase whenever its profitable investment opportunities increase. The stronger management thinks the clientele effect is, the more likely the firm is to adopt a strict version of the residual dividend model. Large stock repurchases financed by debt tend to increase earnings per share, but they also increase the firm’s financial risk. A dollar paid out to repurchase stock is taxed at the same rate as a dollar paid out in dividends. Thus, both companies and investors are indifferent between distributing cash through dividends and stock repurchase programs. 2 points Question 6 Which of the following statements is correct? Answer Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above average payout ratios. One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like. An increase in the stock price when a company decreases its dividend is consistent with signaling theory as postulated by MM. If the “clientele effect” is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize the stock price. Stock repurchases make the most sense at times when a company believes its stock is undervalued. 2 points Question 7 Which of the following statements about dividend policies is correct? Answer 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. One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases. One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest. One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy. The clientele effect suggests that companies should follow a stable dividend policy. 2 points Question 8 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? Answer Firm M probably has a lower debt ratio than Firm N. Firm M probably has a higher dividend payout ratio than Firm N. If the corporate tax rate increases, the debt ratio of both firms is likely to decline. The two firms are equally likely to pay high dividends. Firm N is likely to have a clientele of shareholders who want to receive consistent, stable dividend income. 2 points Question 9 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. Which of the following best describes what your position will be after such a split takes place? Answer You will have 200 shares of stock, and the stock will trade at or near $120 a share. You will have 200 shares of stock, and the stock will trade at or near $60 a share. You will have 100 shares of stock, and the stock will trade at or near $60 a share. You will have 50 shares of stock, and the stock will trade at or near $120 a share. You will have 50 shares of stock, and the stock will trade at or near $60 a share. 2 points Question 10 Which of the following statements is correct? Answer One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive. 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. 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. If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this would motivate companies to increase their dividend payout ratios. 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. 2 points Question 11 Which of the following statements is NOT correct? Answer Stock repurchases can be used by a firm as part of a plan to change its capital structure. After a 3-for-1 stock split, a company’s price per share should fall, but the number of shares outstanding will rise. Investors can interpret a stock repurchase program as a signal that the firm’s managers believe the stock is undervalued. Companies can repurchase shares to distribute large inflows of cash, say from the sale of a division, to stockholders without paying cash dividends. Stockholders pay no income tax on dividends if the dividends are used to purchase stock through a dividend reinvestment plan. 2 points Question 12 Which of the following statements is correct? Answer Under the tax laws as they existed in 2008, a dollar received for repurchased stock must be taxed at the same rate as a dollar received as dividends. One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends. 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 is that investors interpret the increase as a signal that the firm has relatively few good investment opportunities. If a company wants to raise new equity capital rather 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. Dividend reinvestment plans have not caught on in most industries, and today about 99% of all companies with DRIPs are utilities. 2 points Question 13 Which of the following statements is correct? Answer If a company has a 2-for-1 stock split, its stock price should roughly double. Capital gains earned in a share repurchase are taxed less favorably than dividends; this explains why companies typically pay dividends and avoid share repurchases. 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. Stock repurchases increase the number of outstanding shares. The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter. 2 points Question 14 If a firm adheres strictly to the residual dividend policy, then if 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), then the firm should pay Answer no dividends except out of past retained earnings. no dividends to common stockholders. dividends only out of funds raised by the sale of new common stock. dividends only out of funds raised by borrowing money (i.e., issue debt). dividends only out of funds raised by selling off fixed assets. 2 points Question 15 Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that Answer investors are indifferent between dividends and capital gains. investors require that the dividend yield and capital gains yield equal a constant. capital gains are taxed at a higher rate than dividends. investors view dividends as being less risky than potential future capital gains. 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. 2 points Question 16 Which of the following statements is CORRECT? Answer Since debt financing raises the firm's financial risk, increasing a company’s debt ratio will always increase its WACC. Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC. Increasing a company’s debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company’s WACC. Increasing a company’s debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company’s WACC. Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity. 2 points Question 17 An increase in the debt ratio will generally have no effect on which of these items? Answer Business risk. Total risk. Financial risk. Market risk. The firm's beta. 2 points Question 18 Which of the following statements is CORRECT? Answer As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. The optimal capital structure simultaneously maximizes stock price and minimizes the WACC. 2 points Question 19 Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will Answer normally lead to an increase in its fixed assets turnover ratio. normally lead to a decrease in its business risk. normally lead to a decrease in the standard deviation of its expected EBIT. normally lead to a decrease in the variability of its expected EPS. normally lead to a reduction in its fixed assets turnover ratio. 2 points Question 20 Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT? Answer Company HD has a higher net income than Company LD. Company HD has a lower ROA than Company LD. Company HD has a lower ROE than Company LD. The two companies have the same ROA. The two companies have the same ROE. 2 points Question 21 Reynolds Resorts is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company’s total assets, nor would it affect the firm’s basic earning power, which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan? Answer The company’s net income would increase. The company’s earnings per share would decline. The company’s cost of equity would increase. The company’s ROA would increase. The company’s ROE would decline. 2 points Question 22 Business risk is affected by a firm's operations. Which of the following is NOT associated with (or does not contribute to) business risk? Answer Demand variability. Sales price variability. The extent to which operating costs are fixed. The extent to which interest rates on the firm's debt fluctuate. Input price variability. 2 points Question 23 Based on the information below, what is Ezzel Enterprises' optimal capital structure? Answer Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00. 2 points Question 24 Blemker Corporation has $500 million of total assets, its basic earning power is 15%, and it currently has no debt in its capital structure. The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company’s common stock, paying book value. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged. Which of the following is most likely to occur as a result of the recapitalization? Answer The ROA would increase. The ROA would remain unchanged. The basic earning power ratio would decline. The basic earning power ratio would increase. The ROE would increase. 2 points Question 25 Which of the following statements is CORRECT? Answer The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WACC). The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio. Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company’s WACC. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios. 2 points Question 26 Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure? Answer Its sales become less stable over time. The costs that would be incurred in the event of bankruptcy increase. Management believes that the firm’s stock has become overvalued. Its degree of operating leverage increases. The corporate tax rate increases. 2 points Question 27 The firm’s target capital structure should be consistent with which of the following statements? Answer Maximize the earnings per share (EPS). Minimize the cost of debt (rd). Obtain the highest possible bond rating. Minimize the cost of equity (rs). Minimize the weighted average cost of capital (WACC). 2 points Question 28 Which of the following statements is CORRECT? Answer If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt. A change in the personal tax rate should not affect firms’ capital structure decisions. “Business risk” is differentiated from “financial risk” by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage. The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm’s stock, (2) minimizes its WACC, and (3) maximizes its EPS. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. 2 points Question 29 Which of the following statements is CORRECT? Answer Increasing financial leverage is one way to increase a firm’s basic earning power (BEP). If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its basic earning power ratio. (Assume that the repurchase has no impact on the company’s operating income.) If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio. 2 points Question 30 Which of the following statements is CORRECT? Answer A firm’s business risk is determined solely by the financial characteristics of its industry. The factors that affect a firm’s business risk are affected by industry characteristics and economic conditions. Unfortunately, these factors are generally beyond the control of the firm's management. One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy. A firm’s financial risk can be minimized by diversification. The amount of debt in its capital structure can under no circumstances affect a company’s business risk.
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