Chapter 18 - Payout Policy

Chapter 18
Payout Policy

True / False Questions

 

1. A dividend does not accompany stocks that are purchased on the ex-dividend date. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

2. Anyone holding a stock before its ex-dividend date is entitled to the dividend. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

3. Investors forego the right to the dividend if they purchase after the cum-dividend date. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

18-1
Chapter 18 - Payout Policy

4. A stock split will affect the stock's price while a stock dividend will not. 
FALSE

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

5. A 50% stock dividend provides the same return to an investor as a 50% cash dividend. 
FALSE

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

6. Corporate dividends are less volatile than corporate earnings. 

TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

7. If a firm declares a stock dividend of 10%, it would send each shareholder one additional
share for each ten that are currently owned. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-2
Chapter 18 - Payout Policy

8. In a two-for-one stock split, each investor would receive one additional share for each share
already held. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

9. A two-for-one stock split is like a 200% stock dividend. 

FALSE

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

10. A two-for-one stock split results in a doubling of the number of outstanding shares, but
they do not affect the company's assets, profits, or total value. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

11. A 100% stock dividend results in a doubling of the number of outstanding shares, but they
do not affect the company's assets, profits, or total value. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-3
Chapter 18 - Payout Policy

12. The effect of a stock repurchase is not equivalent to that of a cash dividend. 

FALSE

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-07 Why Repurchases Are Like Dividends
 

13. Dividends are likely to shift up and down as earnings fluctuate so that managers can
maintain a stable payout ratio. 
FALSE

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

14. Payout policy may be defined as the trade-off between cash dividends on the one hand and
paying out cash and issuing shares on the other. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

15. MM's dividend irrelevance proposition assumes that dividends do not affect investment or
borrowing policies. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-14 The Assumptions Behind Dividend-Irrelevance
 

18-4
Chapter 18 - Payout Policy

16. According to the MM dividend-irrelevance proposition, since investors do not need

dividends to convert their shares to cash, they will not pay higher prices for firms with higher
dividend payouts. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-14 The Assumptions Behind Dividend-Irrelevance
 

17. Under current tax law, the longer an investor waits to sell an inflated stock, the lower is
the present value of the tax liability. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-19 Dividends Versus Capital Gains
 

18. Canadian corporations are likely to prefer dividends over capital gains on their own
investments. 
TRUE

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-19 Dividends Versus Capital Gains
 
 

18-5
Chapter 18 - Payout Policy

Multiple Choice Questions

 

19. Which of the following is correct for a firm with $400,000 in net earnings, 20,000 shares,
and a 30% payout ratio? 
A. retained earnings will increase by $120,000
B. each share will receive a $1.20 dividend
C. $120,000 will be spent on new investment
D. the dividend per share will equal $6.00

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

20. CormexInc. paid a dividend of $0.75 per share. It forecasted a $1.90 per share in earnings
and had a stock price of $27. Determine the stock price if Cormex declared a 10% stock
dividend. 
A. $27.55
B. $26.55
C. $25.55
D. $24.55

A 10% stock dividend increases shares outstanding by 10%. The stock dividend therefore will
reduce the stock price to $27/1.10 = $24.55.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-6
Chapter 18 - Payout Policy

21. How much should an investor pay now for a stock expected to sell for $30 one year from
now if: the stock offers a $2 dividend, dividends are taxed at 40%, capital gains are taxed at
20%, and a 15% after-tax return is expected on the investment? 
A. $25.04
B. $26.53
C. $27.09
D. $27.50

.15 = |.15 = |.15P0 = 1.20 + 24 -.8P0

|.95P0 = 25.20 | P0 = $26.53.

Blooms: Evaluate
Difficulty: Hard
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-20 Dividend Clientele Effects
 

22. ABC Corp. stock is selling for $30 per share when a 10% stock dividend is declared. If
you own 100 shares of ABC Corp. then you will receive: 
A. $3.
B. $3 times 100 shares = $300.
C. $300 plus 10 shares of ABC Corp.
D. 10 shares of ABC Corp.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-03 Some Legal Limitations on Dividends
 

18-7
Chapter 18 - Payout Policy

23. Global Inc.'s shares are selling for $36 per share. Determine the new price per share, if the
company a 4 for 6 reverse stock split. 
A. $54
B. $44
C. $34
D. $24

The stock price will rise to $36 × 6/4 = $54.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

24. Jackson Corporation paid a dividend of $1.50 per share. It forecasted a $2.50 per share in
earnings and had a stock price of $45. Determine the stock price if Cormex declared a 15%
stock dividend. 
A. $33.88
B. $36.21
C. $39.13
D. $42.28

A 15% stock dividend increases shares outstanding by 15%. The stock dividend therefore will
reduce the stock price to $45/1.15 = $39.13.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-8
Chapter 18 - Payout Policy

25. Store Wide Inc.'s shares are selling for $40 per share. Determine the new price per share,
if the company a 5 for 4 stock split. 
A. $32
B. $36
C. $40
D. $44

The stock price will fall to $40 × 4/5 = $32.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

26. With respect to the proposition that dividend policy does not matter, in order to raise an
additional $5,600 in cash by issuing stock, the stock sold must be worth: 
A. more than $5,600.
B. $2,800.
C. $5,600.
D. need to know the number of shares issued to calculate.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-14 The Assumptions Behind Dividend-Irrelevance
 

18-9
Chapter 18 - Payout Policy

27. A stock is currently priced at $65 per share and will pay a $4 dividend in one year. What
must the stock sell for in one year to meet investors' expectations of a 15% after-tax yield if
dividends are taxed at 28%? Ignore capital gains taxes due to investor timing. 
A. $70.75
B. $71.87
C. $73.63
D. $76.00

After-tax return = | 15% = | 15% =

| $9.75 = Price 1 - $62.12 | $71.87 = Price 1.

Blooms: Evaluate
Difficulty: Hard
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

28. Which of the following statements is correct about investors in Ajax Industries, which has
just announced a three-for-one stock split? 
A. investors will triple their wealth after the split
B. investors' wealth will fall by two-thirds after the split
C. %age of ownership increases for the investors
D. earnings per share will fall by two-thirds after the split

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-10
Chapter 18 - Payout Policy

29. A company has a retention ratio of 40%, net income of $17 million, and 10 million shares
outstanding. What would be the dividend per share for this company? 
A. 1.10
B. 1.02
C. .95
D. .82

Payout ratio is (1 - retention ratio). Therefore, total dividends paid would be equal to (1-.40) ×
$17,000,000 = $10,200,000. Dividends per share would be equal to $10,200,000/10,000,000 =
$1.02.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-05 Dividend Reinvestment Plans and Share Purchase Plans
 

30. Xian Inc. has 7,000,000 shares outstanding. If the company declares a 3 for 2 reverse
stock split, determine the number of shares outstanding afterwards. 
A. 10,050,000
B. 10,080,000
C. 10,200,000
D. 10,220,000

The number of shares will increase to 7,000,000 × 3/2 = 10,050,000.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-11
Chapter 18 - Payout Policy

31. What capital gain must a non-dividend-paying stock attain in order for a corporate
investor in the 35% tax bracket to be indifferent to a stock paying an 8% dividend but having
no capital gain? Assume 30% tax rate on dividends. 
A. 8.00%
B. 9.29%
C. 11.02%
D. 12.31%

After-tax return on dividend-paying stock: = 8% - (8% × .3 × .35) = 8% -.0084 = 7.16%.

After-tax return on non-dividend-paying stock: = capital gain (1 -.35). 7.16% =.65 × capital
gain. 7.16% /.65 = capital gain. 11.02% = capital gain.

Accessibility: Keyboard Navigation

Blooms: Evaluate
Difficulty: Hard
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-14 The Assumptions Behind Dividend-Irrelevance
 

32. Global Inc. has 240,000 shares outstanding. If the company declares a 4 for 6 reverse
stock split, determine the number of shares outstanding afterwards. 
A. 160,000
B. 180,000
C. 200,000
D. 220,000

The number of shares will reduce to 240,000 × 4/6 = 160,000.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-12
Chapter 18 - Payout Policy

33. An investor who currently holds 582 shares because he created a dividend by selling 18
shares has done the equivalent of a: 
A. 3% increase in dividend yield.
B. 3.5% increase in dividend yield.
C. 3% decrease in dividend yield.
D. 3% increase in ownership of the company.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-20 Dividend Clientele Effects
 

34. Corporations may have a legitimate preference for dividends over capital gains because: 
A. capital gains have a 50% tax rate.
B. dividends received by corporations are not taxable.
C. 30% of dividends received by corporations are exempt from taxation.
D. 70% of dividends received by corporations are exempt from taxation.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-14 The Assumptions Behind Dividend-Irrelevance
 

35. After the payment of a 25% stock dividend, an investor has 500 shares of stock and $400.
What did the investor have prior to the stock dividend? 
A. 300 shares of stock
B. 400 shares of stock and $400
C. 400 shares of stock
D. 625 shares of stock and $400

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-13
Chapter 18 - Payout Policy

36. An investor owns 300 shares of stock currently selling for $70 per share. What should the
investor expect to have after the stock declares a three-for-two split? 
A. 200 shares selling for $93.10 each
B. 200 shares selling for $105.00 each
C. 450 shares selling for $46.67 each
D. 450 shares selling for $93.10 each

Current wealth = 300 × $70 = $21,000. Expected wealth = 450 × $46.67 = $21,000.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

37. Which of the following signals is most likely to elicit a decrease in share price? 
A. a repurchase of 5% of the firm's stock
B. an increase in the regular quarterly dividend
C. a decrease in the regular quarterly dividend
D. borrowing funds in order to pay a cash dividend

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-11 The Information Content of Dividends and Repurchases
 

38. A dividend is declared on January 1, has a with-dividend date of January 19, and a record
date of January 26. Which of the following shareholders will not receive the dividend? 
A. A shareholder who purchases on December 31.
B. A shareholder who purchases on January 10.
C. A shareholder who purchases on January 19.
D. A shareholder who purchases on January 24.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

18-14
Chapter 18 - Payout Policy

39. High dividends may be used as __________ of a firm's __________. 

A. an indicator; high capital gains
B. an indicator; tax liability
C. a signal; return on equity
D. a signal; good prospects

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-11 The Information Content of Dividends and Repurchases
 

40. Which of the following is not a logical justification for dividend preference (versus capital
gains) in the real world? 
A. institutional restrictions involving dividends.
B. higher share prices from higher payouts.
C. a steady source of cash without transaction costs.
D. differing income tax rates.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-12 Why Payout Policy Should Not Matter
 

41. Which of the following statements regarding stock dividends and stock splits is true: 
A. a two-for-one stock split is equivalent to a 50% stock dividend.
B. a three-for-one stock split is equivalent to a 66% stock dividend.
C. a three-for-two stock split is equivalent to a 100% stock dividend.
D. a 50% stock dividend is equivalent to a three-for-two stock split.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-15
Chapter 18 - Payout Policy

42. MM's assertion that dividend policy will not affect the value of the firm requires that
dividend policy does not: 
A. alter the retained earnings of the firm.
B. affect investment and borrowing policies.
C. allow the payout ratio to change.
D. alter the number of outstanding shares.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-12 Why Payout Policy Should Not Matter
 

43. A two-for-one stock split will result in: 

A. the firm acquiring new assets.
B. a decrease in the stock price, but an increase in shareholder wealth.
C. an increase in the stock price, and an increase in shareholder wealth.
D. a decrease in the stock price, and no change to shareholder wealth.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

44. When a firm declares a stock repurchase: 

A. the number of outstanding shares falls along with the price
B. the number of outstanding shares falls and the price remains unchanged
C. an investor will receive cash in exchange for a smaller %age of ownership
D. demand drives the stock price up

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
 

18-16
Chapter 18 - Payout Policy

45. If the total assets of a firm are unaffected by a stock dividend, then: 
A. the stock should retain the same price per share.
B. stock dividends should be preferred by corporations over cash dividends.
C. an investor's wealth should not be changed.
D. only bondholders benefit from stock dividends.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

46. What effect does a stock dividend have on the book and market values of the firm? 
A. book value increases; market value increases
B. book value increases; market value decreases
C. book value decreases; market value increases
D. book and market values remain constant

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

47. When a firm announces a two-for-one stock split (in the absence of other new
information), investors should expect that: 
A. earnings per share will fall by half but stock price will remain the same.
B. stock price will fall by half but earnings per share will remain the same.
C. both earnings per share and stock price will remain the same.
D. both earnings per share and stock price will fall by half.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-17
Chapter 18 - Payout Policy

48. Payout policy is a trade-off between ___________ and ___________. 

A. retained earnings; borrowing
B. capital budgeting; capital structure
C. cash dividend; issuing stock
D. declaring stock splits; stock dividends

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

49. Compare the after-tax returns for a corporation that invests in preferred stock with a 12%
dividend versus a common stock with no dividend but a 16% capital gain. The corporation's
tax rate is 35%. Assume 30% tax rate on dividends. The: 
A. common stock returns 2.60% more than preferred.
B. preferred stock returns 0.34% more than common.
C. common stock returns 2.32% more than preferred.
D. returns are equal on an after-tax basis.

After-tax returns: Preferred Stock: 12% - (12% × 35% × 30%) = 10.74%. Common Stock:
16% - (16% × 35%) = 10.40%. The preferred stock's after-tax return is 34 basis points higher,
although it returned 400 basis points less on a before-tax basis.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-19 Dividends Versus Capital Gains
 

18-18
Chapter 18 - Payout Policy

50. A share repurchase is said to be equivalent to the payment of a cash dividend because each
strategy: 
A. causes share price to decline.
B. causes share price to increase.
C. creates the same tax liability for the investor.
D. leaves the firm with the same amount of assets.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
 

51. What would you expect to happen to the price of a share of stock on the day it goes ex-
dividend? Ignore tax. the price should: 
A. increase by the amount of the dividend.
B. decrease by the amount of the dividend.
C. decrease by one-half the amount of the dividend.
D. remain constant.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

52. When a firm declares a special cash dividend of $1 per share, shareholders realize that
the: 
A. annual dividend will be $4 per share.
B. dividends are considered regular.
C. dividend is not likely to be repeated.
D. stock must be owned prior to the declaration date to receive the dividend.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

18-19
Chapter 18 - Payout Policy

53. A corporation's dividend payout ratio is the percentage of _____ paid out as dividends. 
A. cash
B. earnings
C. earnings before interest and taxes
D. retained earnings

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

54. The record date for a dividend is scheduled between the: 

A. declaration date and the with-dividend date.
B. with-dividend date and ex-dividend date.
C. ex-dividend date and the payment date.
D. declaration date and ex-dividend date.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

55. The date on which actual dividend cheques are mailed to shareholders or direct deposited
is the: 
A. declaration date.
B. payment date.
C. ex-dividend date.
D. with-dividend date.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-03 Some Legal Limitations on Dividends
 

18-20
Chapter 18 - Payout Policy

56. An assumption of the MM dividend irrelevance proposition is: 

A. investors are willing to pay higher prices for shares with higher payouts.
B. capital gains are offset by receiving no dividend.
C. extra cash dividends are offset by a capital gain.
D. extra cash dividends are offset by a capital loss.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-14 The Assumptions Behind Dividend-Irrelevance
 

57. Which of the following would you expect to have more impact on a dividend-based-stock-
valuation model? 
A. special dividend
B. regular dividend
C. extra dividend
D. stock dividend

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-08 Repurchases and Share Valuation
 

58. Of the following, who has tax benefits for preferring dividends? 
A. individual investors
B. corporations
C. financial institutions
D. banks

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-14 The Assumptions Behind Dividend-Irrelevance
 

18-21
Chapter 18 - Payout Policy

59. An increase in share price following an increase in dividends is logical if the: 

A. firm borrows to obtain cash for the dividend.
B. increased dividend signals higher future earnings.
C. financial markets are efficient.
D. clientele effect is not important.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-11 The Information Content of Dividends and Repurchases
 

60. When the firm has a high retention ratio, thus paying low dividends, the dividend is a by-
product of what kind of decision? 
A. borrowing
B. debt policy
C. financing
D. capital budgeting

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

61. Corporations pay regular cash dividends to their: 

A. common shareholders.
B. preferred bondholders.
C. fixed-rate bondholders.
D. convertible bondholders.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

18-22
Chapter 18 - Payout Policy

62. A corporation that has an automatic reinvestment plan: 

A. forces shareholders to automatically reinvest dividends in the company.
B. never physically pays out declared dividends.
C. helps investors plan their investment portfolio.
D. gives shareholders the option to automatically reinvest dividends in the company.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

63. A firm is said to be "smoothing" dividends if dividends: 

A. are paid through an automatic dividend reinvestment plan.
B. change more gradually than changes in earnings.
C. increase by the same dollar amount each year.
D. are paid only in even dollar amounts.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

64. A stock split and/or a stock dividend will result in an: 

A. increase in the number of shares outstanding.
B. increase in the market value of the firm.
C. increase in the total assets of the firm.
D. increase in both the number of shares outstanding and the total assets of the firm.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-23
Chapter 18 - Payout Policy

65. The Beta Corporation had 1,000 shares outstanding and a market value of $90,000 prior to
the declaration of a $5 per share dividend. To finance a new project they will issue equity and
the end result will be that the market value of the firm: 
A. drops by $1,000.
B. drops to $85,000.
C. increases by $1,000.
D. increases to $95,000.

Share price prior to declaration: = ($90,000/1,000) = $90. Share price after declaration: = $90
- $5 = $85. Market value of firm = $85 × (1,000) = $85,000.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

66. A firm's dividend policy involves a trade-off between: 

A. growth versus no growth in investment.
B. high share price versus low share price.
C. internal versus external financing of investment.
D. a large asset base and a small asset base.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

18-24
Chapter 18 - Payout Policy

67. A dividend clientele effect assumes that: 

A. investors prefer higher rather than lower dividends.
B. shareholders are indifferent regarding dividends.
C. investors have specific dividend preferences.
D. investors are making "homemade" dividends.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-20 Dividend Clientele Effects
 

18-25
Chapter 18 - Payout Policy

68. The manager of XYZ Corp. feels that a dividend increase will increase stock price
because many investors value stock with a dividend-discount model. Why might MM
disagree with this assertion? 
A. the increased dividend makes the firm much riskier.
B. future dividend growth may slow due to less retained earnings.
C. investors prefer capital gains over dividends.
D. dividend increases will increase the book value but not the market value of the firm.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-12 Why Payout Policy Should Not Matter
 

69. A policy of dividend "smoothing" refers to: 

A. maintaining a constant dividend payout ratio.
B. keeping the regular dividend at the same level indefinitely.
C. maintaining a steady progression of dividend increases over time.
D. alternating cash dividends with stock dividends.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

70. Why may a large increase in earnings not translate into a large increase in dividends? 
A. the earnings will be taxed.
B. some investors may prefer capital gains.
C. managers wish to assess the earning's persistence.
D. the earnings may already be a part of retained earnings.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

18-26
Chapter 18 - Payout Policy

71. Why are dividend changes rather than their absolute level perceived to be more important
to managers and shareholders? 
A. managers only change dividends under threatening conditions
B. dividend changes are thought to signal future expectations
C. MM states that the absolute level of dividends is irrelevant
D. changes determine whether borrowing must occur

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

72. Investors may prefer lower dividends over higher dividends because: 

A. low dividends are more predictable.
B. capital gains may be taxed less heavily than dividends.
C. of the "bird in the hand" logic.
D. low dividends indicate heavy investment for the future.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-13 Payout Policy Is Irrelevant in Efficient Financial Markets
 

73. MM's proposition concerning dividends contends that shareholders will: 

A. offer higher prices for higher dividend payouts.
B. not offer higher prices for higher dividend payouts.
C. offer higher prices for lower dividend payouts.
D. only purchase stocks that have high dividend payouts.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-12 Why Payout Policy Should Not Matter
 

18-27
Chapter 18 - Payout Policy

74. The primary purpose of laws prohibiting a firm from paying dividends that include its
legal capital is to: 
A. reduce investors' tax liability.
B. ensure that the balance sheet balances.
C. prevent managers from paying out all the firm's assets.
D. prevent managers from paying large dividends.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-03 Some Legal Limitations on Dividends
 

75. XYZ Corp. has 1,000 shares outstanding and retained earnings of $25,000. Theoretically,
what would you expect to happen to the price of their stock, currently selling for $30 per
share, if a 25% stock dividend is declared? 
A. price should increase to $44.00 per share.
B. price should increase to $37.50 per share.
C. price should decrease to $24.00 per share.
D. nothing; price should remain at $30.00.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

76. Which of the following is the order in which key dividend dates occur: 
A. declaration, with-dividend, record, ex-dividend, payment.
B. declaration, with-dividend, ex-dividend, record, payment.
C. record, declaration, with-dividend, payment, ex-dividend.
D. with-dividend, ex-dividend, record, declaration, payment.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-03 Some Legal Limitations on Dividends
 

18-28
 Chapter 18 - Payout Policy

77. What is the most likely prediction after a firm reduces its regular dividend payment? 
A. earnings are expected to decline.
B. investment is expected to increase.
C. retained earnings are expected to decrease.
D. share price is expected to increase.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

78. A firm with 2,000 outstanding shares selling for $10 each does not have the cash to pay its
dividend. In an ideal MM world, how many new shares must be sold and at what price to pay
a $2 dividend per share to old shareholders? 
A. sell 2,000 shares at a price of $2 each
B. sell 667 shares at a price of $6 each
C. sell 500 shares at a price of $8 each
D. sell 400 shares at a price of $10 each

Proof Balance Sheet Before Stock Issue:

Cash 0
Assets 20,000 Old Equity holders 20,000
20,000 20,000
Balance Sheet After Stock Issue:
Cash 0 New Equity holders 4,000
Assets 20,000 Old Equity holders 16,000
20,000 20,000

Thus, there are now 2,500 shares outstanding at a market value of $8 each.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-07 Why Repurchases Are Like Dividends
Topic: 18-12 Why Payout Policy Should Not Matter
 

18-29
Chapter 18 - Payout Policy

79. When a corporation engages in a 10% stock repurchase, it: 

A. offers shareholders 110 shares for every 100 they currently own.
B. purchases for cash 10% of the outstanding shares.
C. sells treasury stock at a 10% discount to investors.
D. purchases 10% of previously issued stock dividends.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
 

80. With a stock repurchase: 

A. no cash flow is extended from the company.
B. the company obtains some of its stock, and the value of the firm drops.
C. shareholders' ownership in the company will decrease.
D. the equity of the firm will increase.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
 

81. In regards to dividend policy, unless a firm's investment policy and borrowing remain
constant: 
A. its overall cash flows will remain the same.
B. its overall cash flows will change.
C. shareholders' risk will increase.
D. shareholders' risk will decrease.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-12 Why Payout Policy Should Not Matter
 

18-30
Chapter 18 - Payout Policy

82. Assuming no market imperfections, which of the following will not be affected by a

repurchase of shares? 
A. assets of the firm.
B. equity of the firm.
C. shares outstanding.
D. price per share.

Accessibility: Keyboard Navigation

Blooms: Evaluate
Difficulty: Hard
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
Topic: 18-12 Why Payout Policy Should Not Matter
 

83. Which statement is true concerning the one-year after-tax return on the following stocks,
assuming a 40% tax rate on dividends and a 20% tax rate on capital gains: Stock A is
purchased for $50, offers a 5% dividend yield, and is sold for $56; Stock B is purchased for
$60, offers no dividend yield, but is sold after one year for $70. 
A. Stock A's after-tax return is higher by 1.27%.
B. Stock B's after-tax return is higher by 0.73%.
C. Stock A's after-tax return is higher by 0.27%.
D. Stock B's after-tax return is higher by 0.58%.

After-tax ReturnA = = = 12.6%. After-tax ReturnB =

= = 13.33%. 13.33% - 12.6% = 0.73% difference.

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-17 Why Dividends May Reduce Firm Value
 

18-31
Chapter 18 - Payout Policy

84. Which of the following processes would not be expected to have an effect on book value
of per share? 
A. dividend declaration and payment
B. stock repurchase
C. stock dividend
D. stock split

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
Topic: 18-12 Why Payout Policy Should Not Matter
 

85. You now own 84 shares of XYZ stock, which is selling for $40 each, 4 of which you just
received from the XYZ corporation. XYZ has declared a: 
A. stock dividend of 5%.
B. cash dividend of $4.
C. stock dividend of 4%.
D. cash dividend of $160.

(4 shares/80) = 5%.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

86. When a company expects to maintain its dividend payments in the future, it will issue: 
A. regular dividends.
B. special dividends.
C. stock dividends.
D. extra dividends.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

18-32
Chapter 18 - Payout Policy

87. Conservative economists feel that high dividend payouts will increase share price
because: 
A. capital gains are less certain than dividends.
B. dividends signal higher future earnings.
C. stocks are priced using dividend discount models.
D. higher dividend payouts translate into higher investment returns.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-20 Dividend Clientele Effects
 

88. Those economists feeling that low dividend payouts will increase share price focus on: 
A. the difficulty in predicting earnings.
B. superior reinvestment opportunities.
C. tax differentials between dividends and capital gains.
D. the cost of borrowing to maintain high payouts.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-13 Payout Policy Is Irrelevant in Efficient Financial Markets
 

89. Capital gains may be preferred by investors over dividends even if their tax rates are equal
because: 
A. taxes on dividends are withheld from pay cheques.
B. taxes on capital gains are paid annually.
C. taxes on capital gains can be timed.
D. after-tax dividends are less certain than capital gains.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-19 Dividends Versus Capital Gains
 

18-33
Chapter 18 - Payout Policy

90. A company may choose to repurchase stock rather than pay out dividends when: 
A. the company wants to distribute excess cash to its investors.
B. the company wants to give its investors a bumper dividend.
C. the company does not want to make a commitment to distribute more cash.
D. the company does not want to embark on unprofitable ventures.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
 

91. Managers have been characterized as reluctant to increase dividends if: 

A. dividends were increased in the preceding year.
B. earnings have permanently increased.
C. the dividend increase cannot be sustained.
D. the dividend payout ratio exceeds 20%.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

92. Board of directors may be legally restricted in their declaration of dividends if: 

A. the cash must be borrowed for the dividend payment.
B. dividends have increased substantially over a short period of time.
C. the dividend would create a situation of insolvency.
D. the stock is selling at a low relative price.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-03 Some Legal Limitations on Dividends
 

18-34
Chapter 18 - Payout Policy

93. Which of the following statements regarding "taxation of dividends and capital gains
under current tax law" is incorrect (assuming that the marginal tax rate for a large corporation
is 35%)? 
A. For-profit corporations have a tax reason to prefer dividends.
B. Corporations pay corporate income tax on only 30% of any dividends received.
C. The effective tax rate on dividends received by large corporations is 35% of the marginal
corporate tax rate.
D. Corporations have to pay a 35% tax on the full amount of any realized capital gain.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-14 The Assumptions Behind Dividend-Irrelevance
 

94. With respect to the dividend-payment process, the price of a share of stock can logically
be expected to drop on: 
A. the payment date.
B. the date of record.
C. the ex-dividend date.
D. the declaration date.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

95. MM's proposition of dividend irrelevance depends upon: 

A. firms maintaining a constant dividend payout.
B. dividends being taxed the same as capital gains.
C. the existence of a dividend clientele.
D. the efficiency of capital markets.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-12 Why Payout Policy Should Not Matter
 

18-35
Chapter 18 - Payout Policy

96. An increase in dividends might not increase price and may actually decrease stock price
if: 
A. the dividend increase cannot be sustained.
B. the firm does not maintain an exact dividend payout ratio.
C. the firm has too much retained earnings.
D. markets are weak-form efficient.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-11 The Information Content of Dividends and Repurchases
Topic: 18-12 Why Payout Policy Should Not Matter
 

97. Research has shown all of the following to be true of the way corporations determine
dividends except: 
A. firms have short-run target payout ratios.
B. firms have long-run target payout ratios.
C. the focus is more on dividend changes rather than absolute dividends.
D. managers try to avoid dividend changes that may need to be reversed.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

98. An investor owns 5,000 shares, which is 1% of a corporation's outstanding stock before a
stock repurchase. The investor did not sell any of his stock during the 25,000 share
repurchase. Which of the following statements is correct? 
A. the investor still owns 1% of the corporation.
B. the stock's price is likely to drop by 5%.
C. the investor owns more than 1% of the corporation.
D. the investor now has 5,250 shares.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-36
Chapter 18 - Payout Policy

99. In a three for two stock split for a company that previously had 1 million shares
outstanding selling at $100 per share and a total market value of $100 million, which of the
following is true: 
A. the number of outstanding shares will drop to 666,666, and the stock price will increase to
$150.
B. the number of outstanding shares will increase to 1.5 million, and the stock price will drop
to $66.67.
C. the number of outstanding shares will increase to 1.5 million, and the stock price will rise
to $133.33.
D. the market value of the firm will increase.

1 million shares × (.15) = 1.5 million Since total market value does not change: ($100 mil/1.5
mil shares) = $66.67 = Stock price.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

100. Which of the following statements is correct for stock purchased on the last day to trade
"cum dividend"? 
A. a dividend will be declared on the next trading day.
B. a dividend will be paid on the next trading day.
C. the stock price should decline on the next trading day.
D. the stock price should have declined on the previous trading day.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

18-37
Chapter 18 - Payout Policy

101. Under the idealized conditions of MM, which statement is correct when a firm issues
new stock in order to pay a cash dividend on existing shares? 
A. the new shares are worth less than the old shares.
B. the old shares drop in value to equal the new price.
C. the value of the firm is reduced by the amount of the dividend.
D. the value of the firm is unaffected.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-07 Why Repurchases Are Like Dividends
 

102. The stock in your portfolio was selling for $40 per share yesterday, but has today
declared a three for two stock split. Which of the following statements seems to be true? 
A. there will be two-thirds as many shares outstanding, and they will sell for $60.00 each.
B. there will be four times as many shares outstanding, and they will sell for $160.00 each.
C. there will be 50% more shares outstanding, and they will sell for $26.67 each.
D. there will be one-and-one-half times as many shares outstanding, and they will sell for
$60.00 each.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

103. Which of the following is not an example of market imperfections that make dividend
policy relevant? 
A. institutional restrictions on stock holdings
B. differences in dividend-payout ratios
C. transaction costs such as brokerage fees
D. differences among investors in marginal tax rates

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-12 Why Payout Policy Should Not Matter
 

18-38
Chapter 18 - Payout Policy

104. Automatic dividend reinvestment plans allow firms to: 

A. pay dividends on a more frequent schedule.
B. reduce their cash outflow to shareholders.
C. transform regular dividends into stock dividends.
D. avoid the ex-dividend date reduction in stock price.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

105. An investor who owns stock on the company's __________ date will receive the
dividends declared. 
A. ex-dividend
B. record
C. with-dividend
D. payment

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-03 Some Legal Limitations on Dividends
 

18-39
Chapter 18 - Payout Policy

Short Answer Questions

 

106. A stock of which you own 100 shares has just split three for two. Its market price before
the split was $30 per share. Now discuss what you would expect to happen with this stock and
your ownership interests. 

The three-for-two split means that you and other owners will receive one newly issued share
for every two that you currently own. Thus, your holdings will increase from 100 to 150
shares. However, the assets of the firm and its investment opportunities have not been altered.
Therefore, it would be logical to expect that the market price per share would fall to $20. This
can be seen in that three shares at the new price of $20 would precisely equal two shares at the
old price of $30. To the extent that the market price does not settle at this theoretically
expected level, the investors are "winners" or "losers." But that is the only gain or loss in this
process.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-40
Chapter 18 - Payout Policy

107. Show that a stock repurchase is conceptually the same as a cash dividend using the
following example: Repo Corp. has 1,000 shares outstanding at a market price of $20 per
share. In debating whether to declare a 5% cash dividend, the directors instead chose to
repurchase 50 of the outstanding shares. 

Ignoring any transaction costs, the corporation offers to purchase one-twentieth of each
investor's holdings. If not enough investors choose to cooperate, the Corporation can go into
the open market for purchases. The 5% cash dividend would have cost $1,000 in total ($20 ×
5% × 1,000 shares). The $1,000 can be used to purchase 50 shares from investors ($20 × 50
shares = $1,000). The corporation has $1,000 less in liquid assets but also 50 less shares
outstanding. In this ratio, share price will remain as it was at $20. If each shareholder tendered
the one-twentieth of holdings, they now hold $100 for every 100 shares that they previously
owned. Thus, each shareholder who tendered owns the same% of the company as before and
holds 5% of the previous value of his holdings in cash. If, instead of repurchasing, the firm
had paid a 5% cash dividend, each shareholder would hold 5% of the previous value of his
holdings, and would also own more shares (although the same %age of the total shares) than
with the repurchase. The difference with the cash dividend is that each share will have a
market value that is 5% lower than previously. Thus, the investors' wealth is equivalent in
either case.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
 

18-41
Chapter 18 - Payout Policy

108. Discuss the concept of dividend "smoothing." 

Managers are quite concerned with the message that may be "signaled" with each change in
the level of dividends. Thus, if management held the notion of adhering to a fixed dividend
payout, they would find themselves declaring a dividend of a different amount each quarter,
as the firm goes through the normal gyrations of business cycles and various growth phases.
The managers are especially sensitive to dividend reductions, as it signals that the future
prospects of the firm are less attractive. Therefore, management is more likely to "smooth" the
dividend, and hopefully show a stable pattern of continual growth. In periods of high
earnings, then, management may only raise the dividend a portion of the way, so as to not be
required to later reduce the regular dividend.

Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

18-42
Chapter 18 - Payout Policy

109. Miller and Modigliani proclaim that, under certain ideal conditions, dividend policy is
irrelevant.

What is it that they are specifically proclaiming to be irrelevant? Explain with the following
example. Assume that a firm has $100,000 in assets at market value, no debt, and 100 shares
outstanding. Further, $10,000 of the assets is in cash, which represents the recent net income
of the firm. Now the firm can choose whether to pay out, say, a 50% dividend, which will
necessitate the issuance of $5,000 in new shares, or to pay no dividend and plow back all
$10,000 of earnings into a project with an attractive NPV. 

The purpose of the "homemade" dividend example is to show that investors who prefer
dividends have no need to sell their shares in firms that do not pay dividends. Rather, they can
create their own dividends by selling an appropriate portion of their holdings. Firms that plow
back all of their earnings will be expected to provide attractive capital gains. Investors can
periodically sell some of the inflated shares to provide for current income such as a dividend
would provide. As long as the dividend is no greater than the appreciation in the stock price,
the investor will never reduce the investment from its original level. However, the investor's
%age ownership in the firm will decline over time. This example again assumes no
transaction costs, taxes, or other market imperfections.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-14 The Assumptions Behind Dividend-Irrelevance
 

18-43
Chapter 18 - Payout Policy

110. Discuss the concept of dividend signaling. 

Managers are assumed to be best informed about the future prospects of the firm. One way in
which they can pass this information along to the market is to "signal" with changes in their
dividend level. For example, dividends will not likely rise unless management feels that the
long-run earning potential of the firm can sustain the increase in dividend liability.
Alternatively, management will be reluctant to lower dividends since shareholders will
perceive this as a permanent reduction in future earning opportunities. Share price will thus be
bid down. Management may not signal precisely what they believe to be feasible, but rather
will smooth the dividend changes into a stable, rising level.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-11 The Information Content of Dividends and Repurchases
 

111. Ignoring the idealized world of MM, why might a higher dividend payout ratio be
considered detrimental to firm value? 

Investors are ultimately interested in after-tax returns, and to the extent that dividends are
taxed more heavily than capital gains, the stock prices of high dividend-paying firms could be
penalized. The current tax laws do favour capital gains over dividends when looking at mere
tax rates. But there is yet a more important difference with capital gains in that the timing of
the tax liability is entirely up to the investor. Thus, the present value of the tax liability may
actually be negligible when compared to the annual tax liability imposed on dividends.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-04 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.
Topic: 18-12 Why Payout Policy Should Not Matter
 

18-44
Chapter 18 - Payout Policy

112. Use your knowledge of current corporate tax laws to show that a preferred stock with a
9% dividend might be preferred to a common stock having a 13% capital gain. 

The Corporation will pay tax on only 30% of the dividend from the preferred stock
investment, while it is exposed to 100% of the tax liability for capital gains. Thus, the 9%
offered by the preferred share will have an after-tax return of 8.05% (9% less (9% × 30%
taxable × 35% tax rate) = 8.05%). The common stock return of 13% pretax will be only 65%
as large after-tax, or 8.45%. Thus, the 400 basis point advantage before-tax translates into a 50
basis point disadvantage after-tax.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-19 Dividends Versus Capital Gains
 

113. Compare and contrast share repurchases with dividend payouts. 

Share repurchases are similar to an extra or bumper dividend, in that they cause large amounts
of cash to be paid to investors. However, they are not a substitute for dividends. When a
company announces a repurchase program, it is not making a long-term commitment to
distribute more cash. Thus, share repurchases are more volatile than dividends, increasing
during boom times and falling in recessions. Mature, overcapitalized companies/industries
tend to have more share repurchase programs when investment (+NPVs) opportunities are
limited. Since the 1980s, share repurchases have increased substantially and are now larger in
total value than dividend payments. Share repurchase, at market value, has the same value
impact as cash dividends.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
 

18-45
Chapter 18 - Payout Policy

114. How are dividends paid and how do companies decide on dividend payments? 

Dividends come in many forms. The most common is the regular cash dividend, but
sometimes companies pay a special cash dividend, and sometimes they pay a stock dividend.
A firm is not free to pay dividend at will. For example, it may have accepted restrictions on
dividends as a condition for borrowing money.
Most managers seem to have a target dividend payout ratio. But if firms simply applied this
target payout rate to each year's earnings, dividends could fluctuate wildly. Managers
therefore try to smooth dividends by moving only partway toward the target payout in each
year.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

115. Suppose two equally risky shares, "Div" and "Cap", offer the same expected return
before tax. Div shares pay a generous dividend but offer low expected capital gains. Cap
shares pay low dividends but offer high expected capital gains. Which of the two shares
would a pension fund prefer? An individual? A corporation? Explain your answers. 

A pension fund would not care about the dividend payout policy and therefore would be
indifferent between Div and Cap. Because the pension fund pays no taxes, it focuses only on
the total pre-tax rate of return.
An individual would have a preference for a low dividend payout policy and would therefore
prefer the Cap shares. The stated tax rate on capital gains is lower than the rate on dividend
income. Moreover, the ability to defer recognition of capital gains confers a further advantage
to a low dividend payout policy.
A corporation would prefer a high dividend payout ratio and would therefore prefer the Div
shares. The exclusion of 70% of dividend income from taxable income makes dividends more
valuable than capital gains on an after-tax basis.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-19 Dividends Versus Capital Gains
 

18-46
Chapter 18 - Payout Policy

116. You own 1,000 shares of Xytech Corporation, whose shares are currently trading at $50.
The company has disclosed that it will raise its dividend from $0.75 to $1. You would prefer
that the dividend remain at its current level. What can be done to offset the effects of the
increase in dividends? 

Your dividend income will increase from $750 to $1,000. The extra $250 can be invested in
the firm by purchasing 5 shares at $50 per share. When the stock goes ex-dividend, the share
price will fall by $1.00 instead of $.75. The number of shares held will have increased,
thereby offsetting the impact of the higher payout policy.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-03 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.
Explain why dividends may be used by management to signal the prospects of the firm.
Topic: 18-09 How Do Companies Decide on How Much to Pay Out?
 

18-47
 Chapter 18 - Payout Policy

117. Morso Corporation has declared a $5 per share in dividends. The federal tax rate is 26%
and the provincial tax rate is 13.39%. Federal and Provincial tax credits are 13.33% and 5.1%
respectively on the grossed up amount of the dividend. The gross up amount is 25%.
Determine the average tax rate for dividends. 

26.20%

Dividend Calculation
Dividend Income $5.00
Gross Up 125%
Grossed Up Dividend $6.25
Federal Tax Rate 26%
Gross Federal Tax $1.63
Federal Tax Credit 13.33%
Less: Federal Dividend Tax Credit $(0.83)
Net Federal Dividend Tax $0.79
Provincial Tax Rate 13.39%
Gross Provincial Tax $0.84
Provincial Tax Credit 5.1%
Less: Provincial Dividend Tax Credit $(0.32)
Net Provincial Dividend Tax $0.52
Net Tax on Dividend Income $1.31
After-Tax Dividend Income $3.69
Dividend Tax Rate 26.20%

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-15 Why Dividends May Increase Firm Value
 

18-48
 Chapter 18 - Payout Policy

118. Xavier Corporation has declared a $4 per share in dividends. The federal tax rate is 26%
and the provincial tax rate is 13.39%. Federal and Provincial tax credits are 13.33% and 5.1%
respectively on the grossed up amount of the dividend. The gross up amount is 25%.
Determine the after tax dividend income. 

$2.95

Dividend Calculation
Dividend Income $4.00
Gross Up 125%
Grossed Up Dividend $5.00
Federal Tax Rate 26%
Gross Federal Tax $1.30
Federal Tax Credit 13.33%
Less: Federal Dividend Tax Credit $(0.67)
Net Federal Dividend Tax $0.63
Provincial Tax Rate 13.39%
Gross Provincial Tax $0.67
Provincial Tax Credit 5.1%
Less: Provincial Dividend Tax Credit $(0.26)
Net Provincial Dividend Tax $0.41
Net Tax on Dividend Income $1.05
After-Tax Dividend Income $2.95
Dividend Tax Rate 26.20%

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-15 Why Dividends May Increase Firm Value
 

18-49
 Chapter 18 - Payout Policy

119. Thompson Inc. has just paid $2.50 in dividends. Determine the after tax dividend
received and the average tax rate given the following tax information: 25% gross up; federal
tax rate is 29%; 14% federal tax credit; 16% provincial tax rate; 6% provincial tax credit. 

after tax dividends are $1.81 and the average tax rate is 27.5%.

Dividend Calculation
Dividend Income $2.50
Gross Up 125%
Grossed Up Dividend $3.13
Federal Tax Rate 29%
Gross Federal Tax $0.81
Federal Tax Credit 14.00%
Less: Federal Dividend Tax Credit $(0.44)
Net Federal Dividend Tax $0.38
Provincial Tax Rate 16.00%
Gross Provincial Tax $0.50
Provincial Tax Credit 6.0%
Less: Provincial Dividend Tax Credit $(0.19)
Net Provincial Dividend Tax $0.31
Net Tax on Dividend Income $0.69
After-Tax Dividend Income $1.81
Dividend Tax Rate 27.50%

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-15 Why Dividends May Increase Firm Value
 

18-50
 Chapter 18 - Payout Policy

120. Investors require an after-tax rate of return of 10% on their stock investments. The tax
rate on dividends is 28%, while capital gains escape taxation. A firm will pay $2 per share in
dividends one year from now, after which the stock is expected to be at a price of $20.
Determine the current stock price and the expected before tax rate of return for a one-year
holding period. 

DATA
Investor return 10%
Dividend amount $2.00
Tax rate 28%
Future price prediction $20.00

Current price = PV(after-tax dividend plus final share price)

Current price = $2.00 * (1 - 0.28 ) + $20.00
1.10
Current price = $19.49
Before tax return = $2.00 + ( $20.00 - $19.49 )
19.49
Before tax return = 12.87%

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-19 Dividends Versus Capital Gains
 

18-51
 Chapter 18 - Payout Policy

121. Investors require an after-tax rate of return of 12% on their stock investments. The tax
rate on dividends is 28%, while capital gains escape taxation. A firm will pay $3 per share in
dividends one year from now, after which the stock is expected to be at a price of $15.
Determine the current stock price and the expected before tax rate of return for a one-year
holding period. 

DATA
Investor return 12%
Dividend amount $3.00
Tax rate 28%
Future price prediction $15.00

Current price = PV(after-tax dividend plus final share price)

Current price = $3.00 * (1 - 0.28 ) + $15.00
1.12
Current price = $15.32
Before tax return = $3.00 + ( $15.00 - $15.32 )
15.32
Before tax return = 17.48%

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-19 Dividends Versus Capital Gains
 

18-52
 Chapter 18 - Payout Policy

122. Investors require an after-tax rate of return of 9% on their stock investments. The tax rate
on dividends is 26%, while capital gains escape taxation. A firm will pay $2.50 per share in
dividends one year from now, after which the stock is expected to be at a price of $30.
Determine the current stock price and the expected before tax rate of return for a one-year
holding period. 

DATA
Investor return 9%
Dividend amount $2.50
Tax rate 26%
Future price prediction $30.00

Current price = PV(after-tax dividend plus final share price)

Current price = $2.50 * (1 - 0.26 ) + $30.00
1.09
Current price = $29.22
Before tax return = $2.50 + ( $30.00 - $29.22 )
29.22
Before tax return = 11.22%

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-05 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect
payout policy.
Topic: 18-19 Dividends Versus Capital Gains
 

18-53
Chapter 18 - Payout Policy

123. List several advantages and disadvantages of dividend reinvestment plans and stock
repurchase plans. 

Some advantages include:

> Savings to investors on brokerage commissions.

> Some investors may have an option to purchase additional shares.
> Shares bought through these plans are often at a discount.
> These plans enable investors to accumulate their holdings in the particular stocks carrying
such plans.

Disadvantages include the following:

> Dividends reinvested through such plans may typically represent taxable income.
> These plans enable purchases at specific intervals (for instance, monthly or quarterly) and
may not be suitable to those investors who need the flexibility to be able to be able to buy or
sell stocks quickly.
> These plans are typically useful as long-term investment vehicles.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-02 Explain how share repurchases are used to distribute cash to shareholders.
Topic: 18-06 Share Repurchase
 

18-54
Chapter 18 - Payout Policy

124. Briefly discuss each of the chronological "steps" in the process of paying a dividend. 

The first step in the process of paying a dividend is for the board of directors to declare the
dividend. Boards can declare either a regular cash dividend, an extra (or special) dividend, or
stock rather than cash dividends. The board will also state a record date and a payment date.
The record date is the date at which the corporate records will be searched to discover who the
eligible shareholders are to receive the dividend that will be paid on the payment date, which
is typically about two weeks after the record date. There are two more important
chronological steps in the dividend payment process, namely, the with-dividend date and the
ex-dividend date. The with-dividend date occurs five business days prior to the date of record.
This is the last day that the stock trades with the rights to receive the newly declared dividend.
The ex-dividend day is the next day, or, more correctly, the next business day. It would be
anticipated that the stock price would drop by approximately the value of the dividend on the
ex-dividend day. An efficient market will ensure that this is approximately correct.

Accessibility: Keyboard Navigation

Blooms: Understand
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-02 Cash Dividends
 

125. How will your investment in Acme Corp. change if you currently own 100 shares valued
at $10 each and Acme has just declared a 10% stock dividend? Before the stock dividend
there were 2,000 shares outstanding. 

Before the stock dividend your ownership represented 100/2,000 = 5% of the firm. After the
stock dividend you will hold 110 shares and a total of 2,200 shares will be outstanding. Thus,
110/2,200 still equals a 5% ownership interest. And, since nothing has changed in regard to
asset value since the stock dividend, you would expect all shares to now sell for $9.09. This
can be verified by dividing the total market value of the firm (2,000 × $10 = $20,000) by the
new number of shares outstanding: $20,000/2,200 = $9.09. Only in the case that the market
value of stock does not settle in at $9.09 have investors actually experienced a change in
wealth as a result of the stock dividend.

Accessibility: Keyboard Navigation

Blooms: Apply
Difficulty: Medium
Learning Objective: 18-01 Describe how dividends are paid and how companies decide on dividend payments.
Topic: 18-04 Stock Dividends, Stock Splits, and Reverse Splits
 

18-55