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					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 2

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 3

Which of the following actions will best enable a company to raise additional equity capital?

Answer

             Refund long-term debt with lower cost short-term debt.

             Declare a stock split.

             Begin an open-market purchase dividend reinvestment plan.

             Initiate a stock repurchase program.

             Begin a new-stock dividend reinvestment plan.




2 points

Question 4

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 5

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 6

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 7

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 8

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 9

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 10

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 11

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 12

In the real world, dividends

Answer

              are usually more stable than earnings.

              fluctuate more widely than earnings.
              tend to be a lower percentage of earnings for mature firms.

              are usually changed every year to reflect earnings changes, and these changes are
              randomly higher or lower, depending on whether earnings increased or decreased.

              are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if EPS = $2.00,
              then DPS will equal $0.80. Once the percentage is set, then dividend policy is on
              “automatic pilot” and the actual dividend depends strictly on earnings.




2 points

Question 13

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 14

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 15

Which of the following statements is correct?

Answer

              One disadvantage of dividend reinvestment plans is that they increase transactions costs
              for investors who want to increase their ownership in the company.

              One advantage of dividend reinvestment plans is that they enable investors to postpone
              paying taxes on the dividends credited to their account.

              Stock repurchases can be used by a firm that wants to increase its debt ratio.

              Stock repurchases make sense if a company expects to have a lot of profitable new
              projects to fund over the next few years, provided investors are aware of these investment
              opportunities.

              One advantage of an open market dividend reinvestment plan is that it provides new
              equity capital and increases the shares outstanding.




2 points

Question 16
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 17

If debt financing is used, which of the following is CORRECT?

Answer

              The percentage change in net operating income will be greater than a given percentage
              change in net income.

              The percentage change in net operating income will be equal to a given percentage change
              in net income.

              The percentage change in net income relative to the percentage change in net operating
              income will depend on the interest rate charged on debt.

              The percentage change in net income will be greater than the percentage change in net
              operating income.

              The percentage change in sales will be greater than the percentage change in EBIT, which
              in turn will be greater than the percentage change in net income.

2 points

Question 18

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 19

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 20

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 21

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 22

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 23

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 24

Volga Publishing is considering a proposed increase in its debt ratio, which would also increase the
company’s interest expense. The plan would involve issuing new bonds and using the proceeds to buy
back shares of its common stock. The company’s CFO thinks the plan will not change total assets or
operating income, but that it will increase earnings per share (EPS). Assuming the CFO’s estimates are
correct, which of the following statements is CORRECT?

Answer
              Since the proposed plan increases Volga’s financial risk, the company’s stock price still
              might fall even if EPS increases.

              If the plan reduces the WACC, the stock price is also likely to decline.

              Since the plan is expected to increase EPS, this implies that net income is also expected to
              increase.

              If the plan does increase the EPS, the stock price will automatically increase at the same
              rate.

              Under the plan there will be more bonds outstanding, and that will increase their liquidity
              and thus lower the interest rate on the currently outstanding bonds.

2 points

Question 25

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 26

Which of the following events is likely to encourage a company to raise its target debt ratio, other things
held constant?

Answer

              An increase in the corporate tax rate.
              An increase in the personal tax rate.

              An increase in the company’s operating leverage.

              The Federal Reserve tightens interest rates in an effort to fight inflation.

              The company's stock price hits a new high.


2 points

Question 27

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 28

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.


2 points

Question 29

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 30

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

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