FINMAN Reviewer

The primary argument against the "marginal principle of retained earnings" is
its failure to consider stockholder preferences.
The residual theory of dividend policy asserts that

dividends are paid out of the residual remaining after internal investments by the firm.
In which phase of the life cycle would one most likely encounter stock dividends?
Phase II and Phase III
Which of the following is NOT true about the life-cycle growth and dividend policy?
In the development stage, a firm usually pays stock dividends and some low cash dividends.
In Stage II (the growth stage), sales and returns on assets will be growing at increasing rates. Which of
the following is true?
Stock dividends are common.
In the maturity stage, a firm

is growing about the same rate as the economy as a whole.
In the initial stage (Stage I), the corporation

(all of these options)
has a product yet to be accepted in the marketplace.
anticipates rapid growth in sales and earnings.
needs all its earnings for reinvestment in new assets
When a firm enters Stage III of its life cycle, which of the following is NOT likely to be observed?
Sales begin to decrease.
When a firm enters Stage IV of its life cycle,

the firm has reached maturity.
Stockholders may prefer dividends to reinvestment by the firm

because dividends may resolve some uncertainty.
because dividend payments have an information content.
because investors may prefer current cash to future cash
A convertible security is almost always

a security that can be converted into common stock at the holder's option.
A convertible bond is currently selling for $970. It is convertible into 15 shares of common stock that
presently sell for $50 per share. The conversion premium is
$220
If the price of common stock associated with a convertible bond is less than the conversion price
There is not enough information to tell what the bond price will be.
The conversion ratio is the

number of shares of common stock into which the convertible may be converted.
The conversion premium will be large

if investors have great expectations for the price of the common stock.
Which of the following is true?

As the price of common stock increases, the market price of a convertible bond and the conversion
value increase.
Expectations of a significant increase in the price of a firm's common stock will result in
large conversion premiums for the firm's convertible bonds.
A convertible bond is currently selling for $1,125. It is convertible into 20 shares of common stock that
presently sell for $40 per share. The conversion premium is
$325
A $1,000 par value bond with a conversion price of $50 has a conversion ratio of
20 shares
The theoretical floor value for a convertible bond is its

pure bond value.
Synergy is said to occur when the whole is

greater than the sum of the parts.
Synergy is
the 2 + 2 = 5 effect.
In planning mergers, there is a tendency to ___ synergistic benefits.

overestimate
Which of the following is NOT a motive for selling by the stockholders of the acquired company?
Gaining a tax advantage
Which of the following type of merger decreases competition?
A horizontal merger
Which of the following is NOT a financial motive, but rather an operating motive, for merger and
consolidation?
Synergy
An example of a horizontal merger would be

Coca-Cola and Dr Pepper.
The elimination of overlapping functions and the meshing of two firms' strong areas or products creates
the managerial incentive for mergers known as
synergy
Selling stockholders who are offered cash or another company's stock in a merger may be willing to part
with the shares they hold because
the offered shares may be more marketable.
the price they are offered for their shares may be above market value.
they can attain a greater degree of diversification as a result
Nonfinancial motives for mergers include

synergy and vertical integration.
A multinational corporation may be defined as

a company that carries on some business activity outside of its own national borders.
Multinational corporations may take several forms. An exporter could be described as

a MNC that produces a product within its own borders, but sells in a foreign market.
In a licensing agreement, the multinational corporation will very likely

allow a foreign firm to use its technology in exchange for a fee.
A form of MNC that exposes the firm to the least amount of political risk, and is therefore the preferred
arrangement by both business and foreign governments, is called
a joint venture.
Legal, political, and economic factors are most conducive to which form of multinational corporation
(MNC) organization?
Joint ventures
For a U.S. company, foreign business operations are more complex because the
host country's economy may be different from the domestic economy.
rules of taxation are different.
structure and operations of financial markets vary
A fully owned foreign subsidiary is a form of MNC in which

the MNC owns and operates the firm by itself.
A particular country's pattern of importing more than is being exported is likely to

depress that country's currency.
Which of the following is NOT an accusation made against MNCs by foreign countries?
MNCs contribute to unemployment and avoid taxes.
A proxy is
an authorization of a registered stockholder to another person to act in her place at the meeting.
Which of the following statements is true with respect to cumulative voting?

(All of these options are true)
Cumulative voting permits multiple votes for a single director.
Cumulative voting gives minority shareholders a better chance of being represented on the board of
directors.
If six directors are to be elected and you own 100 shares.
The purpose of cumulative voting is

to allow minority stockholders the possibility of a voice on the board of directors.
Under normal operating conditions, the board of directors is elected by

the common stockholders.
Given that there are 4,000,000 shares outstanding in Miller Corp., how many shares will be required for
a minority group of stockholders to elect two of the nine members on the board of directors? (Assume
cumulative voting is required.)
800,001
Sharpe Products has one million outstanding shares and seven directors to be elected. Cumulonimbus
Holdings owns 200,000 shares of Sharpe. How many directors can Cumulonimbus elect with cumulative
voting?
1
Coase Corp. has 10,000,000 outstanding shares. There are 11 directors on the firm's board. The Becker
family owns 2,300,000 shares of Coase Corp. How many directors can the Becker family be assured of
electing by themselves if Coase Corp. uses majority voting?
-Zero
A rights offer made to existing shareholders with the sole purpose of making it more difficult for another
firm to acquire the company is called
a poison pill.
A possible advantage to a rights offering is that

current shareholders are protected against dilution.
the firm has a built-in market of knowledgeable investors.
distribution costs are lower than a public offering
The effect of a rights offering on a stockholder is

to decrease his/her wealth if nothing is done.
Which of the following is not a true statement?

Common stockholders are legally entitled to some dividend
A major desire of stockholders regarding dividend policy is:

Dividend stability
Which of the following best represents the hierarchy of creditor and stockholder claims?
Senior secured debt, subordinated debt, common stock
Which of the following balance sheet accounts will be affected by a stock dividend buy not by a stock
split?
Retained Earnings
The "call" provision on some bonds allows:

The corporation to redeem the bonds earlier than maturity but usually for a premium over the par
value.
Prices of existing bonds move ________ as market interest rates move ________.
up, down
Advantages that the American Depository Receipts (ADRs) have over investing in actual shares of a
foreign stock include all but the followng:
ADR's are an effective barrier to foreign currency risk.
Which of the following is the lowest in priority of claims against a bankrupt firm?
Common stock
Which one of these conditions must be met for a lease to qualify as a capital lease?
The lease contains a bargain purchase price at the end of the lease
Which of the following is not true about the life cycle growth and dividend policy?
In the development stage, a firm usually pays stock dividends and some low cash dividend.
Bond refunding occurs when:

the sinking fund has accumulated enough money to retire the bond issue
A rights offer made to existing shareholders with the sole purpose of making it more difficult for another
firm to acquire the company is called:
a poison pill
1. Which of the following 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.
e. The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus
capital gains
d. The fact that much of the firm's equipment has been leased rather than bought and owned.
2. Which of the following statements 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 reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a
lower rate than gains on stock repurchases.
c. One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes
on the dividends that they choose to reinvest.
d. One key advantage of a residual dividend policy is that it enables a company to follow a stable
dividend policy.
e. The clientele effect suggests that companies should follow a stable dividend policy.
e. The clientele effect suggests that companies should follow a stable dividend policy
3. Trenton Publishing follows a strict residual dividend policy. All else equal, which of the following
factors 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. Congress lowers the tax rate on capital gains. The remainder of the tax code is not changed.
e. Earnings are unchanged, but the firm issues new shares of common stock
a. The firm's net income increases.
4. 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
a. no dividends to common stockholders.

b. dividends only out of funds raised by the sale of new common stock.
c. dividends only out of funds raised by borrowing money (i.e., issue debt).
d. dividends only out of funds raised by selling off fixed assets.
e. no dividends except out of past retained earnings.
a. no dividends to common stockholders.
5. Which of the following statements is correct?
a. 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.
b. One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would
have to pay if they received cash dividends.
c. 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.
d. 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.
e. Dividend reinvestment plans have not caught on in most industries, and today about
d. If a company wants to raise new equity capital rather steadily over time, a new stock dividend
reinvestment plan would make sense. firm does not want or need new equity, then an open market
purchase dividend reinvestment plan would probably make more sense
6. 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 higher dividend payout ratio than Firm N.

b. If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
c. The two firms are equally likely to pay high dividends.
d. Firm N is likely to have a clientele of shareholders who want to receive consistent, stable dividend
income.
e. Firm M probably has a lower debt ratio than Firm N
a. Firm M probably has a higher dividend payout ratio than firm N
7. Which of the following actions 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.
e. Refund long-term debt with lower cost short-term debt.
d. Begin a new-stock dividend reinvestment plan
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
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.
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 divi-dend 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
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.
10. 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
a. Investors are indifferent between dividends and capital gains.

b. Investors require that the dividend yield and capital gains yield equal a constant.
c. Capital gains are taxed at a higher rate than dividends.
d. Investors view dividends as being less risky than potential future capital gains.
e. 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.
d. investors view dividends as being less risky than potential future capital gains.
11. 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?
a. Its sales become less stable over time.

b. The costs that would be incurred in the event of bankruptcy increase.
c. Management believes that the firm's stock has become overvalued.
d. Its degree of operating leverage increases.
e. The corporate tax rate increases
e. The corporate tax rate increases
12. The firm's target capital structure should be consistent with which of the following statements?
a. Minimize the cost of debt (rd).

b. Obtain the highest possible bond rating.
c. Minimize the cost of equity (rs).
d. Minimize the weighted average cost of capital (WACC).
e. Maximize the earnings per share (EPS).
d. Minimize the weighted average cost of capital
13. Which of the following statements is CORRECT? As a firm increases the operating leverage used to
produce a given quantity of output, this will
a. normally lead to a decrease in its business risk.

b. normally lead to a decrease in the standard deviation of its expected EBIT.
c. normally lead to a decrease in the variability of its expected EPS.
d. normally lead to a reduction in its fixed assets turnover ratio.
e. normally lead to an increase in its fixed assets turnover ratio.
d. normally lead to a reduction in its fixed assets turnover ratio
14. Which of the following statements is CORRECT?
a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes
expected EPS.
b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for
maximizing the stock price.
d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the
WACC.
e. The optimal capital structure simultaneously maximizes stock price and minimizes the WACC
e. The optimal capital structure simultaneously maximizes stock

a. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always
reduce its WACC.
b. 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.
c. 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.
d. Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect
the cost of equity.
e. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always
increase its WACC.
c. Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity
financing. the company's WACC
16. 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?
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 100 shares of stock, and the stock will trade at or near $60 a share.
d. You will have 50 shares of stock, and the stock will trade at or near $120 a share.
e. You will have 50 shares of stock, and the stock will trade at or near $60 a share
b. You will have 200 shares of stock, and the stock will trade at or near $60 a share.
17. Grandin Inc. is evaluating its dividend policy. It 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%
e. 49.74%
d. 47.37%
18. In recent years Constable Inc. has suffered losses, 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. 47.50
b. 49.88
c. 50.00
d. 52.50
e. 55.13
c. 50.00
19. In the real world, dividends
a. are usually more stable than earnings.

b. fluctuate more widely than earnings.
c. tend to be a lower percentage of earnings for mature firms.
d. are usually changed every year to reflect earnings changes, and these changes are randomly higher or
lower, depending on whether earnings increased or decreased.
e. 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
a. are usually more stable than earnings
20. Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to
maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and
has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the
WACC calculation?
a. 4.35%
b. 4.58%
c. 4.83%
d. 5.08%
e. 5.33%
d. 5.08%
21. The president and CFO of Spellman Transportation are having a disagreement about whether to use
market value or book value weights in calculating the WACC. Spellman's balance sheet shows a total of
noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%.
This debt currently has a market value of $50 million. The company has 10 million shares of common
stock, and the book value of the common equity (common stock plus retained earnings) is $65 million.
The current stock price is $22.50 per share; stockholders' required return, r s , is 14.00%; and the firm's
tax rate is 40%. The CFO thinks the WACC should be based on market value weights, but the president
thinks book weights are more appropriate. What is the difference between these two WACCs?
a. 1.55%
b. 1.72%
c. 1.91%
d. 2.13%
e. 2.36%
e. 2.36%
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22. The projected capital budget of Kandell Corporation 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. $122,176
b. $128,606
c. $135,375
d. $142,500
e. $150,000
e. $150,000
23. 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?
a. The company's net income would increase.

b. The company's earnings per share would decline.
c. The company's cost of equity would increase.
d. The company's ROA would increase
c. The company's cost of equity would increase

24. Business risk is affected by a firm's operations. Which of the following is NOT associated with (or
does not contribute to) business risk?
a. Demand variability
b. Sales price variability
c. The extent to which operating costs are fixed
d. The extent to which interest rates on the firm's debt fluctuate
e. Input price variability.
d. The extent to which interest rates on the firm's debt fluctuate.
25. If debt financing is used, which of the following is CORRECT?
a. The percentage change in net operating income will be greater than a given percentage change in net
income.
b. The percentage change in net operating income will be equal to a given percentage change in net
income.
c. The percentage change in net income relative to the percentage change in net operating income will
depend on the interest rate charged on debt.
d. The percentage change in net income will be greater than the percentage change in net operating
income.
e. 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.
d. The percentage change in net income will be greater than the percentage change in net operating
income.
a. Increasing financial leverage is one way to increase a firm's basic earning power (BEP).
b. 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.
c. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price.
d. 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.)
e. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely
reduce the average corporation's debt ratio.
c. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price
27. Which of the following statements is CORRECT, holding other things constant?
a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend
to use relatively little debt.
b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely
reduce the debt ratio of the average corporation.
d. An increase in the company's degree of operating leverage is likely to encourage a company to use
more debt in its capital structure.
e. An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital
structure.
e. An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital
structure.
28. Which of the following statements best describes the optimal capital structure? The optimal capital
structure is the mix of debt, equity, and preferred stock that maximizes the company's __
a. stock price.
b. cost of equity.
c. cost of debt.
d. cost of preferred stock.
e. earnings per share (EPS).
a. stock price
29. Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its
interest expense. The company would issue new bonds and use 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?
a. If the plan reduces the WACC, the stock price is also likely to decline.
b. Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
c. If the plan does increase the EPS, the stock price will automatically increase at the same rate.
d. 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.
e. Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall
even if EPS increases.
e. Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall
even if EPS increases
30. Which of the following is NOT associated with (or does not contribute to) business risk? Recall that
business risk is affected by a firm's operations
a. Sales price variability.

b. The extent to which operating costs are fixed.
c. The extent to which interest rates on the firm's debt fluctuate.
d. Input price variability.
e. Demand variability.
c. The extent to which interest rates on the firm's debt fluctuate
31. An all-equity firm with 200,000 shares outstanding, Antwerther Inc., has $2,000,000 of EBIT, which is
expected to remain constant in the future. The company pays out all of its earnings, so earnings per
share (EPS) equal dividends per shares (DPS). Its tax rate is 40%. The company is considering issuing
$5,000,000 of 10.0% bonds and using the proceeds to repurchase stock. The risk-free rate is 6.5%, the
market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10
if the recapitalization occurs. Assuming that the shares can be repurchased at the price that existed prior
to the recapitalization, what would the price be following the recapitalization?
a. $65.77
b. $69.23
c. $72.69
d. $76.33
e. $80.14
b. $69.23
32. Morales Publishing's tax rate is 40%, its beta is 1.10, and it uses no debt. However, the CFO is
considering moving to a capital structure with 30% debt and 70% equity. If the risk-free rate is 5.0% and
the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of
equity?
a. 1.53%
b. 1.70%
c. 1.87%
d. 2.05%
e. 2.26%
b. 1.70%
33. Cartwright Communications is considering making a change to its capital structure to reduce its cost
of capital and increase firm value. Right now, Cartwright has a capital structure that consists of 20% debt
and 80% equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6% and the market
risk premium, r M - r RF , is 5%. Currently the company's cost of equity, which is based on the CAPM, is
12% and its tax rate is 40%. What would be Cartwright's estimated cost of equity if it were to change its
capital structure to 50% debt and 50% equity?
a. 13.00%
b. 13.64%
c. 14.35%
d. 14.72%
e. 15.60%
c. 14.35%
34. The major contribution of the Miller Model is that it demonstrates that
a. personal taxes increase the value of using corporate debt

b. personal taxes decrease the value of using corporate debt
c. financial distress and agency costs reduce the value of using corporate debt
d. equity costs increase with financial leverage
e. debt costs increase with financial leverage
b. personal taxes decrease the value of using corporate debt
35. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM's
original (with tax) assumptions.
c. For a given D/S, the WACC is less than the WACC under MM's original (with tax) assumptions.
d. The total value of the firm increases with the amount of debt.
e. The tax shields should be discounted at the cost of debt.
e. The tax shields should be discounted at the cost of debt.
36. Which of the following statements concerning the MM extension with growth is false ?
a. The tax shields should be discounted at the unlevered cost of equity.

b. The value of a growing tax shield is greater than the value of a constant tax shield.
c. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM's
original (with tax) assumptions.
d. For a given D/S, the WACC is greater than the WACC under MM's original (with tax) assumptions.
e. The total value of the firm is independent of the amount of debt.
e. The total value of the firm is independent of the amount of debt.
37. The market value of Firm L's debt is $200,000 and its yield is 9%. The firm's equity has a market value
of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt
has a cost of equity of 12%. Under the MM extension with growth, what would Firm L's total value be if
it had no debt?
a. 358421
b. 377286
c. 397143
d. 417000
e. 437850
c. 397143
38. The market value of Firm L's debt is $200,000 and its yield is 9%. The firm's equity has a market value
of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt
has a cost of equity of 12%. Under the MM extension with growth, what is the value of your firm's tax
shield?
a. 92571
b. 102857
c. 113143
d. 124457
e. 136903
b. 102857
39. The Kimberly corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate
tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in
the same risk class is 16%. What is the value of the firm according to MM with corporate taxes?
a. 475875
b. 528750
c. 587500
d. 646250
e. 710875
c. 587500
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40. The Kimberly corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate
tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in
the same risk class is 16%. What is the firm's cost of equity?
a. 21.0%
b. 23.3%
c. 25.9%
d. 28.8%
e. 32.0%
e. 32.0%
41. In the lease versus buy decision, leasing is often preferable
a. because it has no effect on the firm's ability to borrow to make other investments.
b. because, generally, no down payment is required, and there are no indirect interest costs.
c. because lease obligations do not affect the firm's risk as seen by investors.
d. because the lessee owns the property at the end of the least term.
e. because the lessee may have greater flexibility in abandoning the project in which the leased property
is used than if the lessee bought and owned the asset.
e. because the lessee may have greater flexibility in abandoning the project in which the leased property
is used than if the lessee bought and owned the asset
42. Sutton Corporation, which has a zero tax rate due to tax loss carry-forwards, is considering a 5-year,
$6,000,000 bank loan to finance service equipment. The loan has an interest rate of 10% and would be
amortized over 5 years, with 5 end-of-year payments. Sutton can also lease the equipment for 5 end-of-
year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease
payment? Note: Subtract the loan payment from the lease payment.
a. $177,169
b. $196,854
c. $207,215
d. $217,576
e. $228,455
c. $207,215
43. Kohers Inc. is considering a leasing arrangement to finance some manufacturing tools that it needs
for the next 3 years. The tools will be obsolete and worthless after 3 years. The firm will depreciate the
cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase
price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each
and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at
the end of the year. The firm's tax rate is 40%. Annual maintenance costs associated with ownership are
estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage
to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)
a. $96
b. $106
c. $112
d. $117
e. $123
b. $106
44. Which of the following statements is most correct?
a. Firms that use "off balance sheet" financing, such as leasing, will show lower debt ratios once the
effects of their leases are reflected in their financial statements. b. Capitalizing a lease means that the
firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support
the lease payment obligation.
c. The fixed charges associated with a lease can be as high as, but never greater than, the fixed
payments associated with a loan.
d. Capital, or financial, leases generally provide for maintenance service on the part of the lessor and can
be refinanced at the discretion of the lessee.
e. A key difference between a capital lease and an operating lease is that with a capital lease, the total
lease payments on the asset are roughly equal to the full price of the asset plus a return on the
investment in the asset.
e. A key difference between a capital lease and an operating lease is that with a capital lease, the total
lease payments on the asset are roughly equal to the full price of the asset plus a return on the
investment in the asset.
a. Financial leases are fully amortized.

b. Financial leases can be canceled.
c. Financial leases provide for maintenance services.
d. Operating leases can never be canceled.
e. All of the statements above are correct.
a. Financial leases are fully amortized.
46. Heavy use of off-balance sheet lease financing will tend to
a. Make a company appear more risky than it actually is because its stated debt ratio will appear higher.
b. Make a company appear less risky than it actually is because its stated debt ratio will appear lower.
c. Affect a company's cash flows but not its degree of risk.
d. Have no effect on either cash flows or risk because the cash flows are already reflected in the income
statement.
e. None of the statements above is correct.
b. Make a company appear less risky than it actually is because its stated debt ratio will appear lower.
47. The lease analysis should compare the cost of leasing to the
a. Cost of owning using debt.

b. Cost of owning using equity.
c. After-tax cost of debt to measure the effect of leasing on the cost of equity.
d. Average cost of all fixed charges.
e. Cost of owning using the weighted average cost of capital for the firm.
a. Cost of owning using debt.
48. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual
value, is about the same as the riskiness of the lessee's
a. equity cash flows.

b. capital budgeting project cash flows.
c. debt cash flows.
d. pension fund cash flows.
e. sales
c. debt cash flows.
49. Operating leases often have terms that include
a. maintenance of the equipment by the lessor.

b. full amortization over the life of the lease.
c. very high penalties if the lease is cancelled.
d. restrictions on how much the leased property can be used.
e. much longer lease periods than for most financial leases.
a. maintenance of the equipment by the lessor.
50. A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming
that the asset purchased
a. is financed with short-term debt.

b. is financed with long-term debt.
c. is financed with debt whose maturity matches the term of the lease.
d. is financed with a mix of debt and equity based on the firm's target capital structure, i.e., at the
WACC.
c. is financed with debt whose maturity matches the term of the lease.
51. Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is
evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year
class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at
that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on
the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm
could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning
of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could
obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment
at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the
equipment. Otherwise, it will buy it. What is the NAL? (Note: Assume MACRS rates for Years 1 to 4 are
0.3333, 0.4445, 0.1481, and 0.0741.)
a. $5,734
b. $6,023
c. $6,324
d. $6,640
e. $6,972
a. $5,734
52. Volunteer Vegetables' common stock currently sells for $33, and its 8% convertible debentures
(issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common
stock at any time before 2017. What is the conversion value of the bond?
a. $707.33
b. $744.56
c. $783.75
d. $825.00
e. $866.25
d. $825.00
53. Chocolate Factory's convertible debentures were issued at their $1,000 par value in 2007. At any
time prior to maturity on February 1, 2027, a debenture holder can exchange a bond for 25 shares of
common stock. What is the conversion price, P c ?
a. $40.00
b. $42.00
c. $44.10
d. $46.31
e. $48.62
a. $40.00
54. A decrease in a firm's willingness to pay dividends is likely to result from an increase in its
a. Earnings stability.
b. Access to capital markets.
c. Profitable investment opportunities.
d. Collection of accounts receivable.
e. Stock price.
c. Profitable investment opportunities.
55. Which of the following is likely to encourage a company to use more debt in its capital structure?
a. An increase in the corporate tax rate.

b. An increase in the personal tax rate.
c. A decrease in the company's degree of operating leverage.
d. Statements a and c are correct.
e. All of the statements above are correct.
d. Statements a and c are correct.
a. A reduction in the corporate tax rate is likely to increase the debt ratio of the average corporation.
b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely
reduce the debt ratio of the average corporation.
d. All of the statements above are correct.
e. None of the statements above is correct
e. None of the statements above is correct
57. Which of the following statements is likely to encourage a firm to increase its debt ratio in its capital
structure?
a. Its sales become less stable over time.

b. Its corporate tax rate declines.
c. Management believes that the firm's stock is overvalued.
d. Statements a and b are correct.
58. Which of the following factors is likely to encourage a corporation to increase the proportion of debt
in its capital structure?

b. An increase in the personal tax rate.
c. An increase in the company's degree of operating leverage.
d. The company's assets become less liquid.
e. An increase in expected bankruptcy costs.
59. 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, r d . However, Company HD has a higher debt
ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?
a. Company HD has a higher net income than Company LD.

b. Company HD has a lower ROA than Company LD.
c. Company HD has a lower ROE than Company LD.
d. The two companies have the same ROA.
e. The two companies have the same ROE.
b. Company HD has a lower ROA than Company LD.

DIVIDEND POLICY
1) In response to a temporary decline in earnings per share, most companies would

A) decrease their cash dividend.
B) not decrease their cash dividend.
C) suspend their cash dividend.
D) substitute a stock dividend for the cash dividend.
2) The ex-dividend date is ________ the holder of record date.

A) five days before
B) two weeks before
C) two days before
D) three days after
3) Assume that Home Depot's annual dividend is $1.60 per share. This dividend would most
likely be paid as
A) $0.80 twice a year.
B) $1.60 once a year.
C) whenever the company had extra cash.
D) $0.40 four times per year.
4) ZZZ Corporation has declared a stock dividend that pays one share of stock for every 10
shares owned. What will happen to EPS immediately upon the distribution of the stock
dividend?
A) There is not enough information to know.
B) EPS will increase by 10%.
C) EPS will not be affected by the stock dividend.
D) EPS will decrease by 10%.
5) Which of the following describes the effect of a stock dividend?

A) A stock dividend immediately increases the market price of a share of stock.
B) A stock dividend immediately decreases the paid-in capital account.
C) A stock dividend immediately increases the number of shares outstanding.
D) A stock dividend indicates that the company must be short on cash.
6) Trendy Corp. recently declared a 10% stock dividend. As of the date of the announcement,
Trendy had 10 million shares outstanding which were selling on the NYSE for $50 per share. An
accounting entry is required on the balance sheet in order to transfer an amount from retained
earnings to the common stock and additional paid-in capital accounts. What is the dollar amount
of retained earnings that will be transferred from retained earnings to the common stock account
as the result of the stock dividend? Assume that the par value of Trendy is $2 per share.
A) $2 million
B) $50 million
C) $45.45 million
D) $12.5 million
7) A stock dividend will cause changes in the dollar value of which of the below capital
accounts?
A) Common stock
B) Additional paid-in capital
C) Retained earnings
D) All of the above
8) Which of the following is the most likely reason for a corporation to cut its dividend?
A) To keep the firm's price within its optimal range.
B) Because the company believes that existing dividend levels are no longer sustainable.
C) To make the firm more attractive to growth oriented investors.
D) To shelter the shareholders from double taxation.
9) Which of the following motivates corporations to split their common stock?

A) To keep the price of the firm's common stock within an optimum price range
B) To increase retained earnings
C) To reallocate capital to shareholders
D) To narrow ownership of the firm
10) If a firm's EPS are $8.33, and the firm is paying a dividend of $1.25 per share, what is the
firm's dividend payout ratio?
A) 33%
B) 6%
C) 15%
D) 25%
E) 66%
11) Most stock splits

A) increase the number of shares outstanding.
B) increase the value of the company.
C) tend to raise the price of the stock.
D) all of the above.
12) A stock split will cause changes in the dollar value of which of the following?
A) The par value of the stock
B) The book value of common equity
C) The market value of common equity
D) The per share price of the stock
13) Assume that on January 1 a firm announces that on June 30 they will pay a dividend of
$2.50 per share to holders of record on March 30. When does the stock sell ex-dividend?
A) January 5
B) April 5
C) March 28
D) July 5
E) June 25
14) For accounting purposes, a stock split has been defined as a stock dividend exceeding
A) 25%.
B) 35%.
C) 45%.
D) 55%.
15) The final approval of a dividend payment comes from the

A) controller.
B) president of the company.
C) board of directors.
D) Chief Financial Officer.
16) The only definite result from a stock dividend or a stock split is
A) an increase in the P/E ratio.
B) an increase in the common stock's market value.
C) an increase in the number of shares outstanding.
D) cannot be determined from the above.
17) Five years ago, Mr. Martinez purchased 1000 shares of JPM stock at $50 per share. If Mr.
Martinez ' tax rate is 25%, would he prefer that the company pay a $5.00 per share dividend or
offer to repurchase 100 shares at $50 per share?
A) Pay the dividend because he would have no transaction costs.
B) It would make no difference because he would receive $5,000 either way.
C) Repurchase the stock because he would owe no taxes.
D) It would make no difference because the tax rate on dividends is the same as the tax rate on
capital gains.
18) The ________ designates the date on which the stock transfer books are closed in regard to
a dividend payment.
A) declaration date
B) ex-dividend date
C) date of record
D) payment date
Use the following information to answer the following question(s).
Your firm is planning to pay a 15% stock dividend. The market price for the stock has been $84.
The table below presents the equity portion of your firm's balance sheet before the dividend.
Common stock
Par value
(1 million shares
outstanding; $4 par value) $ 4,000,000
Paid-in capital 16,000,000
Retained earnings 30,000,000
Total equity $50,000,000
19) Which of the following would result from payment of the stock dividend?
A) Total equity would remain at $50,000,000.
B) Total equity would increase to $57,500,000.
C) Total equity would decrease to $43,478,261.
D) The effect on the equity account would depend on the market's reaction to the dividend.
20) If instead of a stock dividend, your firm decided to split the stock 2-1, then the number of
shares outstanding and their par value per share would be
A) 1 million; $4.
B) 1 million; $8.
C) 2 million; $2.
D) 2 million; $4.
21) Five years ago, Mr. Martinez purchased 1000 shares of JPM stock at $50 per share. The
market price of the stock is now $55. If Mr. Martinez ' tax rate is 25%, would he prefer that the
company pay a $5.00 per share dividend or offer to repurchase 100 shares at the market price?
Assume that after the ex-dividend date, the price would return to $50 per share.
A) Pay the dividend because he would have no transaction costs.
B) As long as the tax rate on capital gains and dividends is the same, Martinez' wealth is the
same under either alternative.
C) Repurchase the stock because he would owe less taxes.
D) He would be better off to sell the stock in the open market.
22) EG's board of directors announced a quarterly dividend of 25 cents. The ex-dividend date is
November 3. On November 2, EG's stock closed at $40.00 per share. What is the most likely
opening price on November 3?
A) $40.25
B) $39.75
C) $41.00
D) $39.00
Use the following information to answer the following question(s).
Your firm is planning a 2 for 1 stock split. The market price for the stock has been $84. The
table below presents the equity portion of your firm's balance sheet before the split.
Common stock
Par value
(1 million shares
outstanding; $4 par value) $ 4,000,000
Paid-in capital 16,000,000
Retained earnings 30,000,000
Total equity $50,000,000
23) After the stock split, the number of shares outstanding, their par value and the total common
stock account will stand at
A) 2,000,000; $4.00; $8,000,000.
B) 500,000; $8.00; $4,000,000.
C) 2,000,000; $2.00; $4,000,000.
D) 500,000; $2.00, $2,000,000.
24) Immediately after the stock split, the stock price will be approximately
A) $42.
B) $84.
C) $2.00.
D) $8.00.
25) Immediately after the stock split, an investor who owned 100 share before the split will own
A) 100 shares worth a total of $4200.
B) 200 shares worth a total of $8400.
C) 200 shares worth a total of $16,800.
D) 200 shares with a par value of $8.00 each.
26) A firm's payout is calculated as the ratio of retained earnings to earnings before interest and
taxes (EBIT).
Answer: FALSE
27) If a firm were to unexpectedly omit payment of its quarterly dividend, that firm's stock price
would probably drop.
Answer: TRUE
28) The dividend declaration date is the date at which the stock transfer books are to be closed
for determining the investor to receive the next dividend payment.
Answer: FALSE
29) There is absolutely no difference on an economic basis between a stock dividend and a
stock split.
Answer: TRUE
30) Firms can use stock repurchases as a dividend substitute.

Answer: TRUE
31) The ex-dividend date occurs prior to the declaration date.

Answer: FALSE
32) Dividends tend to be higher for firms with stable earnings.

Answer: TRUE
33) Dividend payout ratios are generally much lower for small or newly established firms than
for large, publicly owned firms.
Answer: TRUE
34) After a stock split of 2-1, each investor will have one-half of the percentage ownership in the
firm that he had before the split.
Answer: FALSE
35) A reverse stock split, 1 for 10 for example, should result in a higher price per share.
Answer: TRUE
36) Managers avoid cutting dividends even in response to short-term fluctuations in earnings.
Answer: TRUE
37) A reasonable conclusion about dividend policy is that management should avoid surprising
investors when it comes to the firm's dividend decision.
Answer: TRUE
38) Due to the strengthening of the stock market over the past 50 years, stock splits and stock
dividends are more common than cash dividends.
Answer: FALSE
39) The financial crisis of 2008-2009 caused an unusually large number of companies to cut
their dividends.
Answer: TRUE
40) A stock dividend increases a firm's retained earnings.

Answer: FALSE
41) Kelly owns 10,000 shares in McCormick Spices, which currently has 500,000 shares
outstanding. The stock sells for $86 on the open market. McCormick's management has
decided on a 2-1 split.
a. Will Kelly's financial position alter after the split, assuming that the stocks will fall
proportionately?
b. Assuming only a 35% fall on each stock, what will be Kelly's value after the split?
Answer:
McCormick Spices Corporation - Stock Split
Market price $86.00
Split multiple 2
Shares outstanding 500,000
a.
Investor's shares = 10,000
Position before split $860,000 = 10,000 shares × $86 per share
Price after split $43.00 = $86/2
Kelly's shares after split 20,000 = 10,000 × 2
Position after split $860,000 = 20,000 shares × $43 per share
Net gain $0
b.
Price fall 0.35
Price after split $55.90 = $86.00(1 - .35)
Position after split $1,118,000 = 20,000 shares × $55.90 per share
Net gain $258,000 = $1,118,000 - $860,000
42) Why has the popularity of stock repurchases been growing faster than the cash dividends
as a method for companies to distribute cash to their stockholders.
Answer: Stock repurchases allow investors to tailor the timing of cash flows to their individual
needs and tax situations. An investor with high current income can refuse the distribution,
thereby "reinvesting" the money, postponing taxes, and avoiding transaction fees. An investor
who wants or needs the income can sell shares back to the firm with no or very low transaction
fees and often at a price that is slightly higher than the market value.
From the firm's point of view, the effect on stock price of omitting a dividend is often devastating,
while there seems to be no equivalent penalty for not offering to repurchase shares.
43) Explain the significance of each of the following:

a. announcement date
b. ex-dividend date
c. record date
d. payment date
Answer:
a. announcement date: Date at which the Board of Directors announces that a dividend will be
paid.
b. ex-dividend: date Date after which the stock trades ex-dividend. Investors who buy the
stock on or after the ex-dividend date do not receive the dividend. The previous owner does.
c. record date: Date on which the company examines its records to determine who is entitled
to the dividend.
d. payment date: The date at which cash is actually distributed to eligible shareholders (those
who purchased before the ex-dividend date.)
44) What are the effects of stock splits and stock dividends? Why are they popular?
Answer: Economically, the only effect of a stock split or stock dividend is to increase the
number of shares in existence. Since these shares bring no additional cash into the firm, it is
obvious that neither book equity nor market equity increase as a result. Of necessity, the price
per share must fall to adjust for the number of additional shares.
A company whose shares sell for a relatively high price, say $200, might decide to split the
shares 4 for 1 creating 4 shares valued at $50 for every 1 share in existence. This action is
based on the belief that investors will prefer the lower price because a typical 100 share "round
lot" would then be more affordable.
It also assumes that the price of a stock is influenced by supply and demand for the stock rather
than just future cash flows. In view of the importance of large institutional investors who are not
concerned with whether they buy 100,000 $50 shares or 50,000 $100 shares, this argument
seems dubious.
It is also possible that managers use stock splits to hint at future good news concerning the
company's cash flows.
45) XYZ Corporation has 400,000 shares of common stock outstanding, a P/E ratio of 8, and
$500,000 available for common stockholders. The board of directors has just voted a 3-2 stock
split.
a. If you had 100 shares of stock before the split, how many shares will you have after the
split?
b. What was the total value of your investment in XYZ stock before the split?
c. What should be the total value of your investment in XYZ stock after the split?
d. In view of your answers to (b) and (c) above, why would a firm's management want to have
a stock split?
Answer:
a. Number of shares after split = 3/2 × 100 = 150
b. EPS before split = ($500,000/400,000) = $1.25
Price per share before split = 8 × $1.25 = $10
Total value of investment = $10 × 100 = $1,000
c. Total number of shares after split = 3(400,000/2) = 600,000
EPS after split = ($500,000/600,000) = $.8333
Price per share after split = 8 × $.833 = $6.67
Total value of investment after split = $6.67 × 150 = $1,000
d. (1) Stock splits are believed to have favorable information content. Splits are often
associated with growth companies.
(2) Splits can conserve corporate cash if the firm has cash flow problems or needs
additional funds for attractive investment opportunities.
16.2 Does Dividend Policy Matter?
1) Which of the following might cause dividend policy to affect shareholder wealth?
A) Taxes
B) Transaction costs
C) Changes in the firm's investment policies
D) All of the above
Answer: D
2) A stock repurchase increases the

A) retention ratio of earnings.
B) number of shares outstanding.
C) EPS.
D) both B and C.
3) Transaction costs
A) encourage firms to retain earnings rather than pay dividends.
B) encourage firms to pay large dividends. rather than retain earnings.
C) are encountered whenever a firm pays a dividend.
D) are incurred when investors fail to cash their dividend check.
4) The Modigliani and Miller dividend irrelevancy theorem states that

A) dividends are preferable to stock repurchases.
B) the timing of cash distributions is important.
C) the timing of cash distributions is unimportant.
D) stock repurchases are preferable to dividends.
5) Assume that as the result of a firm announcing a large unexpected increase in its dividend
payment, the price of the firm's common stock rises. This event would be consistent with which
of the following?
A) The dividend irrelevance theory
B) The tax preference theory
C) The information effect
D) The beta effect
6) Millbury Gas and Oil's rate of return on equity is 12%. It can either pay a dividend of $5.00
today or reinvest the money and pay a dividend of $5.60 at the end of the year. From a
shareholder's point of view, the value of the dividend paid now is ________ and the value of the
dividend paid a year from now is ________.
A) $5.00, $4.46
B) $5.00, $5.00
C) $4.46, $5.00
D) $5.60, $5.00
7) In the absence of taxes, transaction costs, or changes in a firm's operating or investment

policies
A) the greater the payout ratio, the greater the share price of the firm.
B) the price of a share of stock is not affected by dividend policy.
C) the firm should retain earnings so stockholders will receive a capital gain.
D) the firm should pay a dividend only after current equity financing needs have been met.
8) Assume that investors' have a 10% required rate of return on MTA stock. According to the
Modigliani and Miller dividend indifference theorem, if investors could choose between a $1.00
dividend today and $1.10 dividend one year from today
A) they would prefer $1.00 today.
B) they would prefer $1.10 one year from today.
C) neither alternative would satisfy them.
D) they would have no preference.
9) What might an investor reasonably expect from a company with excess cash and few internal
investment growth opportunities?
A) The company will buy Treasury bills with all the excess cash.
B) The company will split its stock.
C) The company will declare a stock dividend.
D) The company will pay a cash dividend or repurchase some of its own shares.
10) If dividends and capital gains are taxed at the same rate, should investors prefer cash
dividends or stock repurchases?
A) They would prefer to have neither a dividend nor a stock repurchase.
B) It would not matter. Either cash dividends or stock repurchases would result in the same
after-tax cash flow.
C) They should prefer cash dividends to stock repurchases.
D) They should prefer stock repurchases to cash dividends.
11) Which of the following describes the clientele effect concept of dividend policy?
A) The clientele effect looks at investor preferences for dividends compared to share
repurchase programs.
B) The clientele effect defines the relationship between the shareholder and a stockbroker.
C) The clientele effect focuses entirely on the stability of dividends.
D) Modern corporations do not consider shareholders to be "clients."
12) In the absence of taxes or transaction costs, investors

A) would prefer immediate dividends to future capital gains.
B) who did not want a dividend could use dividends to purchase more shares.
C) could create their own dividends by selling the appropriate number of shares.
D) Both B and C are correct.
13) Which of the following statements is most plausible?

A) Increases in stock price associated with a dividend increase are likely due to information
conveyed by the increase.
B) Increases in stock price associated with a dividend increase are likely due to changes in the
company's capital structure.
C) Increases in stock price associated with a dividend increase are likely due to investors'
preference for dividends over capital gains.
D) Increases in stock price associated with a dividend increase are likely due to the favorable
tax treatment of dividends over capital gains.
14) Chandler Corporation has 1 million shares outstanding. The current price per share is $20. If
the company decides to pay a $2 million dollar dividend, the company will have ________
shares outstanding worth approximately ________.
A) 900,000, $20 per share
B) 1,000,000, $20 per share
C) 900,000, $22.22 per share
D) 1,000,000, $18 per share
15) Chandler Corporation has 1 million shares outstanding. The current price per share is $20. If
the company decides to use $2 million dollars to repurchase shares at the market price, the
company will have ________ shares outstanding worth approximately ________. Assume that
the price does not change during the repurchase period.
A) 900,000, $20 per share
B) 1,000,000, $20 per share
C) 900,000, $22.22 per share
D) 1,000,000, $18 per share
16) Which of the following reasons is used to justify stock repurchases?

A) The repurchase narrows ownership.
B) The repurchase modifies the firm's capital structure.
C) The repurchase reduces the firm's costs associated with servicing small stockholders.
D) All of the above.
17) Dividend policy is influenced by

A) a company's investment opportunities.
B) a firm's capital structure mix.
C) a company's availability of internally generated funds.
D) all of the above.
18) M. Camus bought 1000 shares of Oran Co. at $60 per share and 100 shares of Gitane Co.
at $40 per share. Both stocks are now worth $50 per share. Both companies have offered to
repurchase their shares. If M. Camus would like to have about $5,000 in cash, should he sell
the Oran or Gitane?
A) Oran, because a tax deduction on the loss will leave him with more than $5,000 and taxes on
the capital gain from Gitane would leave him with less than $5,000.
B) Gitane because the price is rising.
C) He should sell equal amounts of each so that his gains cancel out his losses.
D) there is no difference, he makes $5,000 either way.
19) Which of the following typically would NOT affect the dividend policy of the firm?
A) Today's dividend policy is affected by future dividend expectations among investors.
B) Managers are afraid to decrease their voting control of the company by issuing stock
dividends.
C) The failure of so many high-tech and dot.com companies showed that dividends are
important to long-term investors.
D) The current and future cash flow expectations of the company affect dividend policy.
20) Apple Computers decided to raise a large amount of money by selling bonds (previously the
company had little or no debt) and use the proceeds to repurchase billions of dollars worth of
the company's stock. The decision was made after Apple stock lost more than 40% of its value
in a six month period when most stock prices were rising.
A) Apple wanted to lower its cost of capital by substituting debt for equity.
B) Apple wanted to appease disappointed investors by offering them cash for their stock.
C) Apple wanted to increase earning per share by reducing the number of shares outstanding.
D) All of the above are reasonable explanations for Apple's decision.
21) If investor's expect a 15% rate of return on their investment, they will be indifferent between
a $1.00 dividend received immediately or
A) $1.15 received at the end of the year.
B) $1.00 received later.
C) $0.87 received at the end of the year.
D) $1.00 increase in the stock price a year later.
22) Which of the following is a reason that a company would repurchase its own shares of stock
in the market?
A) To reduce cash and the number of shares outstanding
B) To increase outstanding equity shares
C) To have shares available to offer a merger target
D) Both A and B
23) Since 2003 for most investors the tax rate on dividends has been ________ and the tax rate
on capital gains has been ________.
A) 28%, 15%
B) 15%, 15%
C) 25%, 25%
D) 20%, 34%
24) Which of the following is the most probable way in which a shareholder will benefit from a
stock split?
A) The immediately lower share price will attract enough increased interest in the stock to cause
the market price to increase on a more consistent basis.
B) The immediately higher number of shares that an investor owns immediately increases the
investor's wealth.
C) The shareholder can use the immediately increased wealth to borrow more money to buy
even more shares at the immediately lower market price.
D) A shareholder can lose money after a stock split if the market believes that the split was an
artificial way of attracting attention to a company that is not well managed.
25) Brimfield Corp. has total cash available of $1 million, but decides to match last year's
dividend payout of $1.5 million. If the company raises the extra $500,000 by selling stock, the
decision to pay out more than its available cash in dividends should
A) cause the stock price to increase.
B) have no effect on the value of the stock.
C) cause the stock price to decrease.
D) a company cannot use money raised by selling to stock to pay a dividend to existing
stockholders.
26) Fred Handel owns 2000 shares of Haydn Inc. stock which is currently selling for $18 per
share. If the company repurchases 10% of its outstanding shares at $18 per share and Fred
chooses to sell back 200 shares
A) his investment in the company and his percentage of ownership will each decrease by 10%.
B) his investment in the company and his percentage of ownership will stay the same.
C) his investment in the company will decrease by $3,600 and his percentage of ownership will
stay the same.
D) the value of his remaining shares will increase to $20 per share and his percentage of
ownership will fall by 10%.
27) Fred Handel owns 2000 shares of Haydn Inc. stock which is currently selling for $18 per
share. If the company repurchases 10% of its outstanding shares at $18 per share and Fred
chooses not to sell any shares back to the company
A) the value of his shares will stay the same and his percentage ownership of the company will
increase by 10%.
B) his investment in the company and his percentage of ownership will stay the same.
C) his investment in the company will decrease by $3,600 and his percentage of ownership will
stay the same.
D) the value of his remaining shares will stay the same and his percentage of ownership will
increase by 11.11%.
28) ZZZ Corporation had net income of $100 million last year and 50 million common shares
outstanding. They declared an 8% stock dividend. Calculate EPS before and after the stock
dividend.
A) EPS before would be $2; after the dividend, EPS would be $1.85.
B) There is not enough information to make this calculation.
C) EPS before would be $0.50; after the dividend, EPS would be $0.46.
D) Since they made $100 million in net income, the EPS cannot change.
29) Information asymmetry takes into account the higher stock price that can be achieved due
to certainty from the accessibility of information between management and investors.
Answer: FALSE
30) According to the Modigliani & Miller dividend indifference theorem, if a company decreased
its dividend per share, an investor would be forced to sell his common stock at a depressed
price.
Answer: FALSE
31) Dividend payouts have the effect of lowering the company's debt to equity ratio.
Answer: FALSE
32) As a firm's investment opportunities increase, the dividend payout ratio should increase.
Answer: FALSE
33) The timing of dividend payments will not matter if the firm's rate of return on equity and the
investor's required rate of return are the same.
Answer: TRUE
34) Although the rates have changed from time to time, dividends and capital gains have always
been taxed at the same rate in the U.S.
Answer: FALSE
35) Empirical evidence is conclusive that dividend policy matters.

Answer: FALSE
36) When a firm begins to pay dividends, it is signalling that it always expects to have enough
cash flow to maintain and increase its dividend payout.
Answer: TRUE
37) The clientele effect suggests that a firm's dividend policy will be affected by the needs of the
shareholders.
Answer: TRUE
38) The clientele effect suggests that firms can change their dividend policy frequently with no
potential adverse effect on the firm.
Answer: FALSE
39) A firm with high profitability will always have the cash flow necessary to pay high dividends.
Answer: FALSE
40) When a firm makes the decision to pay dividends, it also makes the decision not to reinvest
the cash in the firm.
Answer: TRUE
41) Dividends per share divided by earnings per share (EPS) equals the dividend retention date.
Answer: FALSE
42) Under what conditions would the Modigliani and Miller dividend indifference theorem be
literally true.
Answer: The Modigliani and Miller dividend indifference theorem requires that investors be able
to buy and sell stock without incurring any transaction costs, such as brokerage costs. In
addition, companies can issue stock without incurring any cost in doing so. It assumes that
there are no personal or corporate taxes. Complete information about the firm is readily
available, and there are no conflicts of interest between management and stockholders. Lastly,
financial distress and bankruptcy costs are nonexistent.
43) In 2013, Apple Computers decided to raise a large amount of money by selling bonds
(previously the company had little or no debt) and use the proceeds to repurchase billions of
dollars worth of the company's stock. The decision was made after Apple stock lost more than
40% of its value in a six month period when most stock prices were rising. What were the
company's intentions?
Answer: Apple may have been trying to appease disappointed shareholders by offering them
cash for their shares, essentially saying: "If you think you can do better with another investment,
go ahead." By substituting debt for equity, it would be lowering its cost of capital. By reducing
the number of shares outstanding, Apple hopes to increase earning per share, giving a boost to
its languishing stock price. Apple may also have been reluctantly signalling that it expects
slower growth and diminished investment opportunities in the future.
44) Georges Bizet owns 10,000 shares of Pearl Co. purchased at an average price of $15 per
share. The tax rate on both dividends and capital gains is 15%. Would Bizet prefer a $2.00 per
share dividend or to sell 1,000 shares back to the company at $20 per share? Compute his
after-tax income from each option.
Answer: If Bizet receives the dividend, his tax will be $20,000 × .15 = $3,000 and he would
have $17,000 in after-tax income. If the company repurchases the share, he will have a capital
gain of $20 - $15=$5 per share.
Of the $20,000 he receives by selling back the shares, only $5,000 would be taxable. His tax
would be $5,000 × .15 = $750, so his after-tax income would be $20,000 - $750 = $19,250. He
would be better off by $2,250.
45) Because money has a time value investors should prefer that dividends be paid sooner
rather than later. Agree or disagree. Explain your answer with a numerical example.
Answer: When investors buy a company's shares, they assume that the company will earn a
rate of return on equity that equals or exceeds their required rate of return. If an investor
requires a 10% rate of return and the company decides to defer a $100 dividend for a year, the
company will reinvest the $100 at its ROE and it will grow to $110.
Reinvesting the money will allow the firm to pay a later dividend that is large enough to provide
the investor with her required rate of return. In other words, if an investor requires 10%, she
should be indifferent between a $100 dividend now and a $110 dividend a year from now. Note
that the 10% includes compensation for the risk of the future cash flow, the same risk the
investor was willing to take when she bought the stock.
46) What is meant by "dividend clienteles"? Give specific examples.
Answer: Some investors purchase stocks with a record of paying stable dividends as a higher
yielding alternative to bonds or certificates of deposits. Such investors could be retirees or
institutions who need the dividends for their operating budgets.
Other investors prefer that the company reinvest all available funds in growth and would rather
not receive dividends. These investors are often high income individuals who would have to pay
high taxes. Such investors prefer to build wealth for the future rather than increase their current
income.
47) Pettry, Inc. expects EPS this year to be $5.25. If EPS grows at an average annual rate of
10%, and if Pettry pays 60% of its earnings as dividends, what will the expected dividend per
share be in 10 years?
Answer:
$5.25 (1 + 0.10)10 = 13.62 = EPS in 10 years
$13.62 × 0.6 = $8.17 = Expected dividends per share
48) You are considering the stock of two firms to add to your portfolio. The companies differ
only with respect to their dividend policies. For both firms, investors expect EPS for each of the
next two years to be $7 and dividends and ending price for each of the next two periods to be:
D1 D2 P2
Firm A $2 $2 $60.70
Firm B 4 4 56.42
The required rate of return for the stock of Firm A is 14%. Ignore taxes or transaction fees.
a. How much would investors pay for the stock of Firm A?
b. How much would investors pay for the stock of Firm B?
c. For a less-than-perfect world, provide an argument for each of the following:
(1) Investors prefer the dividend policy of Firm A.
(2) Investors prefer the dividend policy of Firm B.
(3) Firms prefer the dividend policy of Firm A.
Answer:
a. Po = ($2.00/1.14) + [($2.00 + $60.72)/(1.14)2]
Po = $50
b. Exactly the same in the perfect capital market environment.
Po = ($4.00/1.14) + (($4.00 + $56.42)/(1.14)2)
Po = $50
c. (1) Investors can pay a lower capital gains tax on the growth.
(2) Investors in this firm may need current income.
(3) Firms need additional equity to finance growth.
49) Noblesville Auto Supply Company's stock is trading ex-dividend at $5 per share. The
company just paid a 10% stock dividend. The P/E ratio for the stock is 10. What was the price of
the stock prior to trading ex-dividend?
Answer: EPS after stock dividend = ($5.00/10.00) = $.50

EPS after stock dividend = (EPS before stock dividend)/(1.10)
($.50)(1.10) = $.55 = EPS before stock dividend
Stock price prior to stock dividend = (10)($.55) = $5.50
50) Trevor Co.'s future earnings for the next four years are predicted below. Assuming there are
500,000 shares outstanding, what will the yearly dividend per share be if the dividend policy is
as follows?
a. A constant payout ratio of 40%
b. Stable dollar dividend targeted at 40% of the average earnings over the four-year period
c. Small, regular dividend of $0.75 plus a year-end extra of 40% of profits exceeding $1
million
Trevor Co.
Year 1 $ 900,000
Year 2 1,200,000
Year 3 850,000
Year 4 1,350,000
Answer:
a. .40($900,000)/500,000 = $0.72
.40($1,200,000)/500,000 = $0.96
.40($850,000)/500,000 = $0.68
.40($1,350,000)/500,000 = $1.08
b. .40($1,075,000) = $430,000/500,000 = $0.86
c. Year 1 $0.75 = $0.75
Year 2 $0.75 + $0.16 = $0.91
Year 3 $0.75 = $0.75
Year 4 $0.75 + $0.28 = $1.03
16.3 Cash Distribution Policies in Practice
1) According to the residual dividend payout policy, dividends are considered a residual after
A) investment financing needs have been met.
B) preferred stock is issued.
C) EPS is allocated.
D) retained earnings are financed.
2) Common stock dividends tend to be more stable than

A) cash flow.
B) earnings.
C) preferred stock dividends.
D) bond interest.
3) Which of the following dividend policies would cause dividends per share to fluctuate the
most?
A) Residual dividend policy
B) Stable dollar dividend
C) Small, low, regular dividend plus a year-end extra
D) Small, low, regular dividend
4) All of the following might influence a firm's dividend payment EXCEPT

A) investment opportunities.
B) investor transaction costs.
C) common stock par value.
D) flotation costs.
5) Which of the following would influence a firm's decision about dividends for large firms?
A) Ownership control
B) Liquidity position
C) Earnings predictability
D) Both B and C
6) A firm that maintains stable cash dividends will generally not increase the dividend unless
A) a stock split occurs.
B) the firm merges with another profitable firm.
C) the firm is sure that a higher dividend level can be maintained.
D) the price-earnings (P/E) ratio increased steadily over the past five years.
7) From the firm's point of view, a major advantage of stock repurchases over cash dividends is
A) a commitment to maintain or increase repurchases every year.
B) a stronger signal about the firm's financial strength.
C) that they restrain agency costs.
D) that the repurchases imply no commitment to pay the same amount or more every year.
8) The problem with the residual dividend policy ratio is

A) investors might come to expect a specified amount.
B) the dollar amount of the dividend fluctuates from year to year.
C) management is reluctant to cut the dividend even if there are low profits in a year.
D) all of the above are possible problems.
9) Which of the following statements about the residual dividend theory is FALSE?
A) The firm will maintain its optimum debt ratio in financing future investments.
B) Dividend policy by itself has no direct influence on the market price of the firm's common
stock.
C) The firm will issue new common stock to finance investment opportunities in order to ensure
that some dividend will be paid.
D) The firm's investment opportunities, capital structure, and profitability all influence the firm's
dividend policy.
10) Which of the following motivates corporations to enter into stock repurchase programs?
A) Favorable impact on EPS
B) Expected favorable impact on stock price
C) To modify the firm's capital structure
D) All of the above
11) Which of the following is the most important factor motivating dividend policy for large
American corporations?
A) Changes in EPS
B) Maintain constant dividend payout ratio
C) Avoiding flotation costs of selling new stock
D) Avoid reducing dividends per share
12) Which of the following is most likely to have a negative impact on stock price?
A) Omitting a stock repurchase offer
B) Failure to increase the dividend at the same rate as previous years
C) Cutting the dividend per share in dollar terms
D) Reducing the dividend payout ratio
13) Which of the following is least important to repurchase decisions of large American
corporations?
A) The previous level of dividends.
B) The tax consequences to shareholders.
C) Lack of good investment opportunities for cash retained in the firm.
D) The company is holding more cash than it would like.
14) In practice, firms tend to increase their dividend

A) when the stock seems to be underpriced in the market.
B) reducing cash to force executives to focus on efficient investment decisions.
C) only when they believe they can sustain the increased payout indefinitely.
D) when company is holding more cash than it would like.
15) Which of the following statements is true?

A) The stable dividend payout ratio keeps the dollar amount of the dividend stable.
B) Dividends usually do not increase unless management is convinced that the higher dividend
can be maintained in the future.
C) The dividend policy which allows for an extra dividend at year-end in prosperous years
includes a fairly large regular dividend payment per share every year.
D) All of the above are true.
16) Which of the following is more true of cash dividends than of repurchase offers?
A) The amount of cash to be returned to shareholders is flexible on a year to year basis.
B) External funds would be raised before reducing stock repurchase offers but not before cutting
cash distributions.
C) Cash distribution decisions would take priority over investment decisions.
D) The stock price would be severely penalized if the cash distribution is reduced.
17) For a company with unpredictable investment needs and opportunities, the best way to
distribute cash to shareholders would be
A) a residual dividend policy.
B) to repurchase company stock.
C) to issue preferred rather than common stock.
D) to pay dividends on an irregular basis.
18) According to the residual theory of dividends

A) dividends are to be paid out only after investment financing needs have been met.
B) earnings remaining after payment of preferred stock dividends should be paid to common
stockholders.
C) dividend payments are a constant percentage of EPS.
D) a dividend is the residual above the payout ratio.
19) Franklin Electric is presently generating earnings available to common shareholders of
$7.25 per share. The firm's income tax rate is 40%. Franklin is paying a dividend to the
preferred shareholders of $2.10 per share. The firm's dividend payout ratio on common stock is
20%. What is the amount per share that Franklin will pay in dividends to common shareholders?
A) $0.58
B) $1.45
C) $3.12
D) $0.42
E) $2.20
20) Which of the following policies would appeal to an investor using dividends to increase her
retirement income?
A) Maintaining smoothly increasing dividends from year to year.
B) A residual dividend policy.
C) Maintaining a constant dividend payout ratio.
21) The dividend policy that states smoothing of the dividend stream in order to minimize the
effect of company reversals is called the
A) increasing-stream hypothesis of dividend policy.
B) stable dividend policy.
C) clientele effect policy.
D) residual payout policy.
22) Which of the following considerations would be expected to influence a firm's decision
regarding the payment of dividends?
A) Earnings predictability
B) Legal restrictions
C) Liquidity position
D) All of the above
23) Groups of investors who prefer one distribution method over another are known as
A) pressure groups.
B) return chasers.
C) dividend clienteles.
D) retirees.
24) We typically expect to find rapidly growing firms to have high payout ratios.
Answer: FALSE
25) Reducing dividends will usually have a negative impact on the stock price.
Answer: TRUE
26) The residual dividend theory suggests that dividends should be paid to stockholders first,
and then, what is left can be reinvested by the firm.
Answer: FALSE
27) Company managers strive to gradually increase dividend series over the long-term future.
Answer: TRUE
28) Unexpected dividend changes would cause investors to reassess their perceptions about a
firm's stock.
Answer: TRUE
29) Managers are prohibited from using dividend changes and repurchase offers to
communicate information concerning their future expectations concerning the firm's cash flows.
Answer: FALSE
30) European firms tend to pay out more dividends than U. S. firms.
Answer: TRUE
31) The stable dividend policy is the most common.

Answer: TRUE
32) The residual dividend theory indicates that a firm would never pay dividends unless the
firm's profits were larger than its equity financing needs.
Answer: TRUE
33) Share repurchases convey information to investors that the shares are underpriced.
Answer: TRUE
34) Compare management's motives for preferring either stock repurchases or cash dividends.
Answer: Cash dividends and repurchase offers are both ways to return cash to shareholders
and both tend to convey positive information about the company's stock price and future
earnings. Once a company begins paying cash dividends, it is under considerable pressure to at
least match and preferably increase dividends each year.
Repurchase offers put less pressure on management to pay out cash each year. They are more
like the "residual dividend policy" in that the company only needs to pay out cash when all other
demands have been met.
35) Compare the Stable Dividend Payout to the Residual Dividend Policy.
Answer: A stable dividend payout policy tries to avoid unpleasant surprises to the company's
shareholder clientele who may depend on the dividends to meet their income needs.
Companies who follow this policy consider the predictability of dividends more important than
the size or payout ratio and only increase dividends when they are quite certain that they can
maintain the increased payout.
A company that followed a residual dividend policy would only pay a dividend after all
operational and investment needs had been met. Such a policy would lead to large year to year
fluctuations in the dollar amount of dividends. The residual dividend policy is much less popular
with investors and therefore with managers as well.

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The residual theory of dividend policy asserts that

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If six directors are to be elected and you own 100 shares.

The purpose of cumulative voting is

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A major desire of stockholders regarding dividend policy is:

The "call" provision on some bonds allows:

ADR's are an effective barrier to foreign currency risk.

Bond refunding occurs when:

a. The firm's ability to accelerate or delay investment projects.

2. Which of the following statements about dividend policies is CORRECT?

a. The firm's net income increases.

a. The firm's net income increases.

a. no dividends to common stockholders.

a. no dividends to common stockholders.

5. Which of the following statements is correct?

a. Firm M probably has a higher dividend payout ratio than Firm N.

a. Firm M probably has a higher dividend payout ratio than firm N

a. Declare a stock split.

d. Begin a new-stock dividend reinvestment plan

8. Which of the following statements is correct?

9. Which of the following statements is correct?

a. Investors are indifferent between dividends and capital gains.

a. Its sales become less stable over time.

e. The corporate tax rate increases

a. Minimize the cost of debt (rd).

d. Minimize the weighted average cost of capital

a. normally lead to a decrease in its business risk.

d. normally lead to a reduction in its fixed assets turnover ratio

14. Which of the following statements is CORRECT?

e. The optimal capital structure simultaneously maximizes stock

15. Which of the following statements is CORRECT?

19. In the real world, dividends

a. are usually more stable than earnings.

a. are usually more stable than earnings

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a. The company's net income would increase.

c. The company's cost of equity would increase

d. The extent to which interest rates on the firm's debt fluctuate.

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