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FIN 534 Quiz 8 wek 9

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Question 1

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

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 3

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 4

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 5

You own 100 shares of Troll Brothers’ stock, which currently sells for $120 a share. The company is contemplating a 2-for-1 stock split. 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 6

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 7

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 8

Which of the following would be most likely to lead to a decrease in a firm’s dividend payout ratio?

Answer

Its earnings become more stable.

Its access to the capital markets increases.

Its R&D efforts pay off, and it now has more high-return investment opportunities.

Its accounts receivable decrease due to a change in its credit policy.

Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages.

2 points

Question 9

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 10

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 11

Which of the following should not influence a firm’s dividend policy decision?

Answer

The firm’s ability to accelerate or delay investment projects.

A strong preference by most shareholders for current cash income versus capital gains.

Constraints imposed by the firm’s bond indenture.

The fact that much of the firm’s equipment has been leased rather than bought and owned.

The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains.

2 points

Question 12

Which of the following statements is correct?

Answer

If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes.

An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional shares of common stock through investment bankers.

Stock repurchases tend to reduce financial leverage.

If a company declares a 2-for-1 stock split, its stock price should roughly double.

One advantage of adopting the residual dividend policy is that this makes it easier for corporations to meet the requirements of Modigliani and Miller’s dividend clientele theory.

2 points

Question 13

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 14

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 15

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 16

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 17

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 18

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 19

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

Answer

normally lead to an increase in its fixed assets turnover ratio.

normally lead to a decrease in its business risk.

normally lead to a decrease in the standard deviation of its expected EBIT.

normally lead to a decrease in the variability of its expected EPS.

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

2 points

Question 20

Business risk is affected by a firm’s operations. Which of the following is NOT associated with (or does not contribute to) business risk?

Answer

Demand variability.

Sales price variability.

The extent to which operating costs are fixed.

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

Input price variability.

2 points

Question 21

Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L’s debt has a before-tax cost of 8%. Both firms have positive net income. Which of the following statements is CORRECT?

Answer

The two companies have the same times interest earned (TIE) ratio.

Firm L has a lower ROA than Firm U.

Firm L has a lower ROE than Firm U.

Firm L has the higher times interest earned (TIE) ratio.

Firm L has a higher EBIT than Firm U.

2 points

Question 22

Which of the following statements is CORRECT, holding other things constant?

Answer

Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.

An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.

If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.

An increase in the company’s degree of operating leverage is likely to encourage a company to use more debt in its capital structure.

An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.

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

The firm’s target capital structure should be consistent with which of the following statements?

Answer

Maximize the earnings per share (EPS).

Minimize the cost of debt (rd).

Obtain the highest possible bond rating.

Minimize the cost of equity (rs).

Minimize the weighted average cost of capital (WACC).

2 points

Question 26

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 27

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?

Answer

Company HD has a higher net income than Company LD.

Company HD has a lower ROA than Company LD.

Company HD has a lower ROE than Company LD.

The two companies have the same ROA.

The two companies have the same ROE.

2 points

Question 28

Which of the following statements is CORRECT?

Answer

As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.

The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.

The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.

The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.

The optimal capital structure simultaneously maximizes stock price and minimizes the WACC.

2 points

Question 29

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

Answer

An increase in costs incurred when filing for bankruptcy.

An increase in the corporate tax rate.

An increase in the personal tax rate.

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

The company’s stock price hits a new low.

2 points

Question 30

Which of the following statements is CORRECT?

Answer

The capital structure that maximizes expected EPS also maximizes the price per share of common stock.

The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.

The capital structure that minimizes the required return on equity also maximizes the stock price.

The capital structure that minimizes the WACC also maximizes the price per share of common stock.

 

The capital structure that gives the firm the best credit rating also maximizes the stock price.

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