Answers - Reading 15 Analysis of Dividends and Share Repurchases

Question #1 of 51 Question ID: 1472722 Last year, Calfee Multimedia had earnings of $4.00 per share and paid a dividend of $0.30. In the current year, the company expects to earn $5.20 per share. Calfee has a 30% target payout ratio. If the expected dividend for this year is $0.51, what time period is Calfee most likely using in order to bring its dividend up to the target payout? A) 5 years. B) 6 years. C) 4 years. Explanation The formula to determine the expected dividend increase in a target payout approach is: Expected increase in dividends = [(expected earnings × target payout ratio) - previous dividend] × adjustment factor where the adjustment factor is 1 / number of years over which the adjustment will take place. Using the numbers given: $0.51 − $0.30 = [($5.20 × 0.30) − $0.30] × (1 / n) $0.21 = [$1.26] × (1 / n) $0.21 / $1.26 = 1 / n n = $1.26 / $0.21 n=6 (Module 15.2, LOS 15.g) Question #2 of 51 Question ID: 1472743 Global Development expects to earn $6 million next year. 40% of this amount, or $2.4 million, has been allocated for distribution to common shareholders. There are 2.4 million shares outstanding, and the market price is $30 a share. If Global uses the $2.4 million to repurchase shares at the current price of $30 per share, its share price after the repurchase will be closest to: A) $29.00. B) $31.00. C) $30.00. Explanation Market value of equity before the repurchase is $30 × 2.4 million = $72 million. Shares Repurchased = $2.4 million / $30 = 80,000 shares. Shares remaining = Shares outstanding − Shares repurchased = 2,400,000 − 80,000 = 2,320,000. Share price after the repurchase = ($72 million − $2.4 million) / 2,320,000 = $30. (Module 15.2, LOS 15.l) Question #3 of 51 Question ID: 1472719 Laura's Chocolates Inc. (LC) is a maker of nut-based toffees. LC is considering a cash dividend, but is concerned about the "double taxation" effect on their shareholders. If the corporate tax rate is 35%, and the tax on dividends is 20%, what is the effective tax rate on a dollar of corporate earnings? A) 42%. B) 48%. C) 55%. Explanation 0.35 + (1 − 0.35)(0.20) = 48% (Module 15.1, LOS 15.f) Rainham Inc. has never paid a dividend from the cash flows it generates from its projects; rather it likes to reinvest them in growing the business. Rainham Inc. has experienced a period of sustained growth but management is of the opinion that this growth rate will moderate and they have therefore decided to move to a dividend pay-out. The company's cost of equity is currently estimated to be 16%, with the industry's cost of equity at around 12%. The firm has set the objective of achieving a 70% pay-out ratio. The board of directors of Rainham Inc. is worried about the impact of moving immediately to a 70% pay-out ratio; whilst this remains their long term objective they feel that a gradual build-up of the pay-out ratio to 70% would be more appropriate. The proposal is to set an initial dividend pay-out ratio in year 1 of 30% and then increase this over the following five years to 70%. Rainham Inc. has set a growth rate in earnings consistent with their long run ROE and target pay-out ratio. The Commercial Director of Rainham Inc. believes that the board is overly concerned about investors' reaction to the change in dividend policy. He believes that dividend policy is influenced by the availability of investment opportunities, the future volatility of earnings, flotation costs and legal restrictions. Question #4 - 7 of 51 Question ID: 1472750 According to Gordon, Litner, and Graham, what will be the impact of the dividend initiation on the cost of equity of Rainham Inc.? A) Unchanged. B) It will decrease. C) It will increase. Explanation According to the dividend preference theory (bird-in-the-hand argument), dividends are perceived to be of a lower risk than potential capital gains from reinvested earnings. Dividends have certainly, whereas future capital gains do not. A company that pays dividends will, therefore, have a lower cost of equity compared to a similar non-dividend paying firm. (Module 15.1, LOS 15.b) Question #5 - 7 of 51 Question ID: 1472751 Which of the following dividend policy is consistent with the Rainham Inc.'s proposed dividend policy of setting an initial dividend payout ratio to 30% and then increase this over the following five years to 70%? A) Residual dividend model. B) Target payout ratio. C) Dividend stability. Explanation Target payout ratio is consistent with the proposed dividend policy of Rainham Inc. Under the target payout ratio approach, the management would define a target payout ratio and move toward the target payout ratio over time. (Module 15.2, LOS 15.g) Question #6 - 7 of 51 Question ID: 1472752 The Commercial Director has mentioned four out of six factors that influence dividend policy. Which of the following is least likely to be one of the remaining two factors not mentioned? A) Financial flexibility. B) Taxation. C) Clientele effect. Explanation The six factors that affect dividend policy are: Availability of investment opportunities Future earnings volatility Financial flexibility Tax considerations Flotation costs Contractual and legal restrictions (Module 15.1, LOS 15.e) Question #7 - 7 of 51 Question ID: 1472753 Rainham Inc. pays 35% taxes based on the U.S. tax laws and pays a dividend of $0.90 a share. Assuming that the investor who receives Rainham Inc.'s dividend is in the 15% tax bracket. The effective tax rate on a dollar of earnings paid out as dividends will be: A) Higher than 35%. B) Equal to the corporate tax rate of 35%. C) Equal to the investor’s tax bracket of 15%. Explanation U.S. tax rules are based on a double taxation system. As such, the effective tax rate will be higher than just the corporate tax rate of 35% as taxes paid would include both corporate tax and the tax paid on the dividend. (Module 15.1, LOS 15.f) Question #8 of 51 Question ID: 1472723 Hikaru Takei is the portfolio manager for the Reliant Dividend Focused Fund. Takei wants to add a firm to his portfolio that follows a stable dividend policy. Takei is considering investing in one of three companies: Kirk Beauty Supplies maintains a constant dividend payout of 25 to 30%. Kelley Medical Devices increases its dividend each year in accordance with the company's long run growth rate of 4%. Barrett Satellite Systems has maintained a dividend of $2.00 per share over the last 6 years. Which stock best meets Takei's criteria? A) Kelley Medical Devices. B) Kirk Beauty Supplies. C) Barrett Satellite Systems. Explanation Due to inflation considerations, a company with a stable dividend policy will have stability in the rate of increase for its dividend each year. This typically means aligning the company's dividend growth rate with its long-term growth rate. Although the company with the fixed per share dividend is a tempting choice, once inflation is considered, a fixed $2.00 per share dividend is actually declining each year in terms of spending power. (Module 15.2, LOS 15.g) Question #9 of 51 Question ID: 1472726 Which of the following is least likely a method by which firms repurchase their shares? A) Tender offer. B) Direct negotiation. C) Exercise a call provision. Explanation Call provisions are not relevant to common stock and are not considered a repurchase in any case. There are three repurchase methods. The first is to buy in the open market. A company may repurchase stock by making a tender offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price. The third way is to repurchase by direct negotiation. Companies may negotiate directly with a large shareholder to buy back a block of shares, usually at a premium to the market price. (Module 15.2, LOS 15.i) Question #10 of 51 Question ID: 1472713 At a recent conference, "Dividends − Are They Increasing?", several lecturers were discussing the signaling effect and their opinions on how changes in a company's dividend policy are often viewed by investors. Linda Travis, an equity analyst at Girthmore Capital Management and one of the guest lecturers at the conference, made the following observations: A dividend initiation is always viewed as a positive signal by investors. Observation 1: It is an indication that the company has so much cash at its disposal that it can afford to pay it out to shareholders. A dividend decrease is typically a positive signal by a company's Observation 2: management to its shareholders. It indicates that management has a variety of positive NPV projects in its capital budget and would like to finance as many of them as possible with retained earnings. With respect to Travis' observations: A) both are correct. B) only one is correct. C) both are incorrect. Explanation A dividend initiation is often viewed differently by different investors. On one hand, a dividend initiation could mean that a company is sharing its wealth with shareholders – a positive signal. On the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities – a negative signal. Dividend decreases or omissions are typically negative signals that current and future earnings prospects are not good and that management does not think the current dividend payment can be maintained. (Module 15.1, LOS 15.c) Question #11 of 51 Question ID: 1472738 Pearl City Breweries has 8 million shares outstanding that are currently trading at $34 per share. The company is choosing whether to distribute $22 million as dividends or to use the same amount to repurchase its shares. Ignoring tax effects, what will be the amount of total wealth from owning one share of Pearl City Breweries under each of these alternatives? Cash dividend Share repurchase A) $34.00 $34.00 B) $31.25 $34.00 C) $31.25 $37.00 Explanation If the company pays a cash dividend, the dividend per share will be $22 million/8 million = $2.75. The value of its shares will be: 8,000,000 ($34) − $22,000,000 8,000,000 $250,000,000 = = 8,000,000 $31.25 So the total wealth from owning one share will be $31.25 + $2.75 = $34.00. If the company repurchases shares, it can buy $22 million/$34 = 647,058 shares. The value of one share would then be: 8,000,000 ($34) − $22,000,000 8,000,000 − 647,058 $250,000,000 = 7,352,942 = $34.00 If you remember that both a cash dividend and a share repurchase for cash leave shareholder wealth unchanged, this question does not require calculations of the amounts. (Module 15.2, LOS 15.l) Question #12 of 51 When a firm pays a stock dividend, the dividend is most likely to: A) have no impact on financial leverage ratios and liquidity ratios. B) cause liquidity ratios to decrease. C) cause financial leverage ratios to increase. Question ID: 1472704 Explanation Stock dividends do not affect assets or shareholders' equity, and financial leverage ratios and liquidity ratios are unaffected. Stock dividends have no economic impact on a company and do not affect a company's capital structure. (Cash dividends, on the other hand, decrease liquidity ratios and increase financial leverage ratios.) (Module 15.1, LOS 15.a) Question #13 of 51 Question ID: 1472734 The share prices of Solar Automotive Industries and Winnipeg Auto Unlimited are both $50 per share, and each company has 50 million shares outstanding. On September 30, both companies announced a $10 million stock buyback. Solar has a book value of $500 million, while Winnipeg has a book value of $900 million. How much did the book value per share (BVPS) of each company increase or decrease after the share repurchase? Solar Automotive Industries Winnipeg Auto Unlimited A) Decrease by $0.13 Decrease by $0.13 B) Increase by $0.13 Increase by $0.16 C) Decrease by $0.16 Decrease by $0.13 Explanation The share buyback for each company is $10 million / $50 per share = 200,000 shares. Remaining shares for each company = 50 million − 200,000 = 49.8 million shares. For Solar Automotive Industries: Solar Automotive Industries' current BVPS = $500 million / 50 million = $10. The market price per share of $50 is greater than the BVPS of $10. Book value after repurchase = $500 million – $10 million = $490 million BVPS = $490 million / 49.8 million = $9.84 BVPS decreased by $0.16 For Winnipeg Auto Unlimited: Winnipeg Auto Unlimited's current BVPS = $900 million / 50 million = $18. The market price per share of $50 is greater than the BVPS of $18. Book value after repurchase = $900 million – $10 million = $890 million BVPS = $890 million / 49.8 million = $17.87 BVPS decreased by $0.13. In the case of both Solar Automotive Industries and Winnipeg Auto Unlimited, book value per share (BVPS) decreased because the share price is greater than the original BVPS. If the share prices were less than the original BVPS, then the BVPS after the repurchase for each firm would have increased. (Module 15.2, LOS 15.k) Question #14 of 51 Question ID: 1472706 Which type of cash dividend is most likely to be declared by a cyclical firm during good times? A) Special dividend. B) Liquidating dividend. C) Stock dividend. Explanation Special dividends are used when favorable circumstances allow the firm to make a onetime cash payment to shareholders, in addition to any regular dividends the firm pays. Many cyclical firms (e.g., automakers) will use a special dividend to share profits with shareholders when times are good but maintain the flexibility to conserve cash when profits are down. Other names for special dividends include extra dividends and irregular dividends. Liquidating dividends occur when a company ceases to operate and distributes any equity proceeds to shareholders. Stock dividends are paid out in shares of stock rather than cash and are similar to stock splits. (Module 15.1, LOS 15.a) Question #15 of 51 Question ID: 1472729 A company is most likely to use a Dutch auction when repurchasing shares: A) with a tender offer. B) by direct negotiation. C) in the open market. Explanation In a tender offer, the company may either select a price or use a Dutch auction to determine the lowest price at which it can repurchase the number of shares desired. (Module 15.2, LOS 15.i) Question #16 of 51 Question ID: 1472709 Armsware Industries' board is debating whether to issue a cash dividend or a stock dividend. Director Jones states, "We should issue a cash dividend because our liquidity ratios will improve and the credit rating agencies will love it." Director Beane states, "A stock dividend will improve our leverage ratios by increasing contributed capital, which is what the rating agencies are looking for." Are the statements by Jones and Beane accurate? Jones Beane A) Yes Yes B) No No C) Yes No Explanation Neither statement is accurate. Cash dividends will decrease both assets and equity, causing liquidity ratios to decline (assets fall, while liabilities stay the same). Stock dividends do not affect the firm's leverage ratios. Total equity remains unchanged because a stock dividend neither raises capital nor distributes earnings to shareholders. (Module 15.1, LOS 15.a) Question #17 of 51 Question ID: 1472731 Sinclair Construction Company's Board of Directors is considering repurchasing $30,000,000 worth of common stock. Sinclair assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Sinclair decides to borrow $30 million that it will use to repurchase shares. Sinclair's Chief Executive Officer (CEO) has compiled the following information regarding the repurchase of the firm's common stock: Share price at the time of buyback = $50 Shares outstanding before buyback = 30,600,000 EPS before buyback = $3.33 Earnings yield = $3.33 / $50 = 6.7% After-tax cost of borrowing = 8.0% Planned buyback = 600,000 shares Based on the information above, Sinclair's earnings per share (EPS) after the repurchase of its common stock will be closest to: A) $3.18. B) $3.32. C) $3.23. Explanation Total earnings = $3.33 × 30,600,000 = $101,898,000 total earnings - after-tax cost of funds EPS after buyback = shares outstanding after buyback $101,898,000 - (600,000 shares x $50 x 0.08) = (30,600,000 - 600,000) shares $101,898,000 - $2,400,000 = 30,000,000 shares $99,498,000 = 30,000,000 shares = $3.32 Since the 8.0% after-tax cost of borrowing is greater than the 6.7% earnings yield (E/P) of the shares, the share repurchase reduces Sinclair's EPS. (Module 15.2, LOS 15.j) Question #18 of 51 Question ID: 1472724 Which justification for repurchasing stock is the least valid? A) Repurchases offer shareholders more choices than cash dividends. B) A cash dividend increase, in response to short-term excess cash flows, may confuse investors. C) Shareholders prefer capital gains to cash dividends. Explanation Some shareholders prefer capital gains, while others prefer dividends. Repurchases offer shareholders the choice of tendering or not tendering their stock, while cash dividends represent a payment they cannot refuse. Raising dividends is often seen as a positive signal, but an increase funded by short-term cash flows may not be sustainable, forcing the company to reduce the dividend later. (Module 15.2, LOS 15.i) Question #19 of 51 Question ID: 1472736 The share price of Winnipeg Auto Unlimited is $5 per share. There are 50 million shares outstanding, and Winnipeg has a book value of $900 million. What is the book value per share (BVPS) after the share repurchase of $10 million? A) $21.24. B) $18.54. C) $14.76. Explanation The share buyback is $10 million / $5 per share = 2,000,000 shares. Remaining shares: 50 million − 2 million = 48 million shares. Winnipeg Auto Unlimited's current BVPS = $900 million / 50 million = $18. Book value after repurchase: $900 million − $10 million = $890 million. BVPS = $890 million / 48.0 million = $18.54. BVPS increased by $0.54. Book value per share (BVPS) increased because the share price is less than the original BVPS. If the share prices were more than the original BVPS, then the BVPS after the repurchase would have decreased. (Module 15.2, LOS 15.k) Question #20 of 51 Question ID: 1472746 Dividend safety is most likely evidenced by: A) Increase in dividend and FCFE coverage ratios B) Increase in dividend coverage ratio but not by FCFE coverage ratio. C) Increase in FCFE coverage ratio but not be dividend coverage ratio. Explanation Both dividend and FCFE coverage ratios are indicators of dividend safety. FCFE coverage is simply more comprehensive measure and takes into account all cash distributed to shareholders. (Module 15.2, LOS 15.m) Question #21 of 51 Question ID: 1472745 Dan Bridges, head of equity strategies for Paca Inc. a consultant to institutional investors makes the following statement: Globally, the developed markets have seen a decline in proportion of companies paying cash dividends. Lately, we have also seen an increase in the proportion of companies engaging in share repurchases. Bridges' statement is most likely: A) Incorrect as to companies engaging in share repurchases. B) Correct. C) Incorrect as to dividend payout ratios. Explanation Bridges' statement is correct. (Module 15.2, LOS 15.h) Question #22 of 51 Question ID: 1472705 Paying a cash dividend is most likely to result in: A) an increase in financial leverage ratios. B) an increase in liquidity ratios. C) the same impact on liquidity and leverage ratios as a stock dividend. Explanation A cash dividend will increase leverage ratios such as debt-to-equity and debt-to-assets, reflecting a decrease in the denominator. A cash dividend should decrease liquidity ratios such as the current ratio and cash ratio, due to the decrease in cash in the numerator. Unlike a cash dividend, a stock dividend or a stock split has no impact on liquidity or financial leverage ratios. (Module 15.1, LOS 15.a) Question #23 of 51 Question ID: 1472717 Which of the following is most likely to prompt a company to increase dividend payments? A company's management foresees: A) reduced availability of credit in the market. B) continued volatility of the company's earnings. C) an immediate lack of profitable investment opportunities. Explanation When earnings are volatile, companies are more hesitant to increase dividends, as there are greater chances that a higher dividend may not be covered by future earnings. When there is reduced availability of credit in the market, a strong cash position—such as might be gained from cutting dividends—is a benefit. A company that foresees few profitable investment opportunities tends to pay out more in dividends, since these opportunities would otherwise be funded with cash flows from earnings. (Module 15.1, LOS 15.e) Question #24 of 51 Question ID: 1472707 Financial managers utilize stock splits and stock dividends because they perceive that: A) brokerage fees paid by shareholders will be reduced. B) an optimal trading range exists. C) investors will double the share price if there is a 20% stock dividend. Explanation Although there is little empirical evidence to support the contention, there is nevertheless a widespread belief in financial circles that an optimal price range exists for stocks. "Optimal" means that if the price is within this range, the price/earnings ratio, price/sales and other relevant ratios will be maximized. Hence, the value of the firm will be maximized. (Module 15.1, LOS 15.a) Question #25 of 51 Question ID: 1472744 Which of the following statements about differences observed in payout trends in US and Europe is most accurate? A) B) The percentage of companies making stock repurchases has been trending downwards both in the US and Europe. A higher proportion of US companies pay dividends as compared to their European counterparts. C) A lower proportion of US companies pay dividends as compared to their European counterparts. Explanation A lower proportion of US companies pay dividends as compared to their European counterparts. The percentage of companies making stock repurchases has been trending upwards in the US (since 1980s), the UK and continental Europe (since 1990s). (Module 15.2, LOS 15.h) Question #26 of 51 Question ID: 1472714 Which of the following statements about dividend policy and capital structure is most accurate? A) B) C) Investors view a stock repurchase as a positive signal and a stock issue as a negative signal. Monte Carlo simulation is used to estimate market risks; scenario analysis measures stand-alone risk. A person who believes in the agency cost effect and a proponent of the "bird-inhand" theory would have opposite views on dividend payout policy. Explanation Investors view a stock repurchase as a positive signal and a stock issue as a negative signal. A repurchase may mean that management believes the stock is undervalued. To understand why a stock issue is viewed negatively, consider the following circumstances: A biotech company has a new blockbuster drug that will increase its profitability, but to produce and market the drug, the company needs to raise capital. If the company sells new stock, then as sales (and thus profits) occur, the price of the stock will rise. The current shareholders will do well but not as well as they would have had the company not sold more stock before the share price increased. Thus, it is assumed that management will prefer to finance growth with non-stock sources. The other statements are false. A person who believes in the clientele effect and a proponent of the "bird-in-hand" theory would not have similar views on dividend policy. Under the agency cost theory, dividends reduce free cash flow that managers can use for empire building and hence, a high payout is preferred. According to the "bird-in-hand" theory, investors prefer dividends to capital appreciation because they view the former (D1 / P0) as less risky than the latter (g, or growth rate). Both approaches have similar (and not opposite) views on dividend policy. (Module 15.1, LOS 15.d) Question #27 of 51 Question ID: 1472710 In a world with taxes and brokerage costs: A) Modigliani and Miller say that dividend policy is relevant. B) dividend policy may be relevant. C) Modigliani and Miller say that dividend policy is irrelevant. Explanation Modigliani and Miller assume a world without taxes and transaction costs. They (correctly) claim that the validity of their theory should be judged on empirical tests, not the realism of their assumptions. Myron Gordon and John Lintner have championed the "bird-in-thehand" theory, which gives greater value to firms with high dividend yields because investors perceive dividends to be less risky than capital gains. (Module 15.1, LOS 15.b) Question #28 of 51 Question ID: 1472741 The following information is from the 10-k of Laura's Chocolates, Inc.(LC), a maker of nutbased toffees. Cash 25,000,000 Share price 40.00 Shares outstanding (prior to transaction) 20,000,000 LC decides to spend $20 million repurchasing common stock. What is the value of a share of stock after the share repurchase? A) 35.00. B) 40.00. C) 45.00. Explanation 20,000,000 × 40 − 20,000,000 20,000,000 − 500,000 (Module 15.2, LOS 15.l) 780,000,000 = 19,500,000 = 40.00 Question #29 of 51 Question ID: 1472711 If Modigliani and Miller's dividend irrelevancy theory is correct, what is the impact on a firm's cost of capital and stockholder wealth if its dividend payout increases? Cost of Capital Stockholder wealth A) An increase A decrease B) None A decrease C) None None Explanation If investors do not consider dividends to be relevant, the dividend payout will not affect the required rate of return. If the required rate of return does not change, stockholder wealth will be unchanged despite the change in its dividend payout rate. (Module 15.1, LOS 15.b) Question #30 of 51 Question ID: 1472740 Which of the following statements about a stock repurchase is least accurate? A) A stock repurchase occurs when a large block of stock is removed from the marketplace. B) Management can distribute cash to shareholders at a favorable after-tax rate. C) Disgruntled stockholders are forced to sell their shares, improving management's position. Explanation A repurchase gives stockholders a choice. They can sell or not sell. Stock repurchase is also more tax-efficient as only those shareholders that choose to sell their shares would potentially have a tax liability. (Module 15.2, LOS 15.l) Question #31 of 51 Question ID: 1472748 Which of the following is most likely to be a symptom of a company that is able to sustain its cash dividend? A) A low dividend yield compared to the company's historic average. B) A high dividend payout ratio compared to the industry average. C) Issuing new debt to fund projects and cover capital expenditures. Explanation High dividend yields compared to the company's record suggest that investors are expecting dividends to be cut. Net borrowings are not sustainable, and will eventually require a cut in share repurchases and dividends. A higher-than-average dividend payout ratio creates the risk that dividends may be cut if earnings decline. (Module 15.2, LOS 15.n) Question #32 of 51 Question ID: 1472733 Pants R Us Inc.'s Board of Directors is considering repurchasing $30,000,000 worth of common stock. Pants R Us assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Pants R Us decides to borrow $30 million that it will use to repurchase shares. Pants R Us' Chief Investment Officer (CIO) has compiled the following information regarding the repurchase of the firm's common stock: Share price at the time of buyback = $50 Shares outstanding before buyback = 30,600,000 EPS before buyback = $3.33 Earnings yield = $3.33 / $50 = 6.7% After-tax cost of borrowing = 6.7% Planned buyback = 600,000 shares Based on the information above, what will be Pants R Us' earnings per share (EPS) after the repurchase of its common stock? A) $3.28. B) $3.40. C) $3.33. Explanation Total earnings = $3.33 × 30,600,000 = $101,898,000 total earnings - after-tax cost of funds EPS after buyback = shares outstanding after buyback $101,898,000 - (600,000 shares x $50 x 0.067) = (30,600,000 - 600,000) shares $101,898,000 - $2,010,000 = 30,000,000 shares $99,888,000 = 30,000,000 shares = $3.33 Since the after-tax cost of borrowing of 6.7%% is equal to the 6.7% earnings yield (E/P) of the shares, the share repurchase has no effect on Pants R Us' EPS. (Module 15.2, LOS 15.j) Question #33 of 51 Question ID: 1472728 Laura's Chocolates, Inc. (LC), is a maker of nut-based toffees. LC is considering a share repurchase and prefers the "tender offer" method. Which of the following is also known as a "tender offer"? A) Repurchasing by direct negotiation. B) Buying a fixed number of shares at a fixed price. C) Buying in the open market. Explanation A tender offer refers to buying a fixed number of shares at a fixed price (usually at a premium to the current market price). (Module 15.2, LOS 15.i) Question #34 of 51 Stock splits: Question ID: 1472703 A) do not in and of themselves affect firm value. B) increase firm value. C) are less common than stock dividends. Explanation Stock splits divide up each existing share into multiple shares. The price of each share will drop correspondingly to the number of shares created, so there is no change in the owner's wealth. Empirical research has shown that in the absence of a dividend yield increase, the stock price falls to the stock split ratio of the original price (i.e., to 25% of the original price in a 4-for-1 stock split). This makes sense, given that the investor's percentage ownership of the company has not changed. (Module 15.1, LOS 15.a) Question #35 of 51 Question ID: 1472742 What is the impact on shareholder wealth of a share repurchase versus cash dividend of equal amount when the tax treatment of the two alternatives is the same? A) B) C) A share repurchase will always lead to higher total shareholder wealth than a cash dividend of an equal amount. A share repurchase will sometimes lead to higher total shareholder wealth than a cash dividend of an equal amount. A share repurchase is equivalent to a cash dividend of an equal amount, so total shareholder wealth will be the same. Explanation Assuming that the tax treatment of a share repurchase and a cash dividend of equal amount is the same, a share repurchase is equivalent to a cash dividend payment, and shareholder wealth will be the same. (Module 15.2, LOS 15.l) Question #36 of 51 Question ID: 1472747 Grommetco produces plastic insulators for the electrical appliance industry. Excerpts from Grommetco's financial results for 2010 are as follows: Net Income (earnings) $10 Free Cash Flow to Equity $8 Dividends Paid $1 Stock Repurchases $3 Which of the following statements is most accurate? Grommetco's: A) dividend coverage ratio is 2.5. B) FCFE coverage ratio is 2.0. C) dividend payout ratio is 0.4. Explanation Dividend coverage ratio = Net Income / Dividends = $10 / $1 = 10. FCFE coverage ratio = FCFE / (dividends + share repurchases) = $8 / ($1 + $3) = 2.0. Dividend payout ratio = Dividends / Net Income = $1 / $10 = 0.1. (Module 15.2, LOS 15.m) Question #37 of 51 Question ID: 1472708 When a firm pays a cash dividend, the dividend payment is most likely to: A) cause liquidity ratios to increase. B) cause financial leverage ratios to increase. C) have no impact on financial leverage ratios and liquidity ratios. Explanation All else equal, the result of a cash dividend is that financial leverage ratios (such as the debt-to-equity ratio) should increase, while liquidity ratios (such as the cash ratio) should decrease. Cash dividends reduce assets (as cash is paid out) and reduce shareholders' equity (by lowering retained earnings). (Stock dividends, on the other hand, do not impact liquidity ratios or financial leverage ratios.) (Module 15.1, LOS 15.a) Question #38 of 51 Question ID: 1472715 Dividend payments are most likely to be associated with: A) increased agency conflict between bondholders and shareholders. B) increased agency conflict between shareholders and managers. C) increased agency conflict between bondholders and managers. Explanation Paying dividends can be helpful in reducing agency conflicts between shareholders and managers because dividend payouts constrain managers' ability to invest in negative NPV projects that benefit the managers at the expense of shareholders. Paying dividends is likely to intensify the agency conflict between bondholders and shareholders, as it represents a transfer of wealth from bondholders to shareholders. There is no agency conflict between bondholders and managers. (Module 15.1, LOS 15.d) Question #39 of 51 Question ID: 1472739 Belden Engineering Corporation (BEC) is considering a share repurchase program. David Gudzanski, the firm's executive vice president prepares a memo to the board of directors detailing reasons why a share repurchase would be favorable at this time. Reasons listed in the memo are as follows: Reason 1: Reason 2: Reason 3: Reason 4: The resulting capital structure from the share repurchase would be more favorable for investors in BEC's bonds. BEC's stock is currently selling at $37 in the marketplace. Our discounted cash flow analysis values the company at $48 per share. The share repurchase could be used to offset dilution caused by the exercise of employee stock options. BEC can use the repurchase to send a signal to investors that management has a positive future outlook for the company. The share repurchase could be used to implement a residual dividend Reason 5: policy while diminishing the potential increase in perceived risk that such a policy would cause for investors. Which of Gudzanski's reasons in favor of the share repurchase is most accurate? A) Reasons 2 and 3 only. B) Reasons 2, 3, 4, and 5. C) Reasons 1 and 3 only. Explanation A share repurchase would decrease the percentage of equity in a firm's capital structure, which would in turn increase the percentage of debt. An increase in debt would add more leverage to the firm which would be negative for the firm's bondholders. The other reasons listed are all rationales for a share repurchase. (Module 15.2, LOS 15.l) Question #40 of 51 Question ID: 1472732 Francis Investment Inc.'s Board of Directors is considering repurchasing $30,000,000 worth of common stock. Francis assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Francis decides to borrow $30 million that it will use to repurchase shares. Francis' Chief Financial Officer (CFO) has compiled the following information regarding the repurchase of the firm's common stock: Share price at the time of buyback = $50 Shares outstanding before buyback = 30,600,000 EPS before buyback = $3.33 Earnings yield = $3.33 / $50 = 6.7% After-tax cost of borrowing = 4.0% Planned buyback = 600,000 shares Based on the information above, after the repurchase of its common stock, Francis' EPS will be closest to: A) $3.41. B) $3.36. C) $3.39. Explanation Total earnings = $3.33 × 30,600,000 = $101,898,000 total earnings - after-tax cost of funds EPS after buyback = shares outstanding after buyback $101,898,000 - (600,000 shares x $50 x 0.04) = (30,600,000 - 600,000) shares $101,898,000 - $1,200,000 = 30,000,000 shares $100,698,000 = 30,000,000 shares = $3.36 Since the after-tax cost of borrowing of 4% is less than the 6.7% earnings yield (E/P) of the shares, the share repurchase will increase Francis's EPS. (Module 15.2, LOS 15.j) Question #41 of 51 Question ID: 1472720 International Pulp, a Swiss-based paper company, has annual pretax earnings (in Swiss francs) of SF 600. The corporate tax rate on retained earnings is 55%, and the corporate tax rate that applies to earnings paid out as dividends is 30%. Furthermore, International Pulp pays out 30% of its earnings as dividends, and the individual tax rate that applies to dividends is 40%. What is the effective tax rate on corporate earnings paid out as dividends? A) 70%. B) 48%. C) 58%. Explanation This is an example of a split-rate corporate tax system. The calculation of the effective tax rate on a Swiss franc of corporate income distributed as dividends is based on the corporate tax rate for distributed income. The effective tax rate on income distributed as dividends = 30% + [(1 − 30%) × 40%] = 58%. (Module 15.1, LOS 15.f) Question #42 of 51 Question ID: 1472737 The share price of Solar Automotive Industries is $50 per share. It has a book value of $500 million and 50 million shares outstanding. What is the book value per share (BVPS) after a share repurchase of $10 million? A) $10.12. B) $10.00. C) $9.84. Explanation The share buyback is $10 million / $50 per share = 200,000 shares. Remaining shares: 50 million − 200,000 = 49.8 million shares. Solar Automotive Industries' current BVPS = $500 million / 50 million = $10. Book value after repurchase: $500 million − $10 million = $490 million. BVPS = $490 million / 49.8 million = $9.84. BVPS decreased by $0.16. Book value per share (BVPS) decreased because the share price is greater than the original BVPS. If the share prices were less than the original BVPS, then the BVPS after the repurchase would have increased. (Module 15.2, LOS 15.k) Question #43 of 51 Question ID: 1472721 David Drakar and Leslie O'Rourke both own 100 shares of stock in a German corporation that makes €1.00 per share in pre-tax income. The corporation pays out all of its income as dividends. Drakar is in the 30% individual tax bracket while O'Rourke is in the 40% individual tax bracket. The tax rate applicable to the corporation is 30%. Drakar and O'Rourke live in the United Kingdom, which uses an imputation tax system for corporate dividends. What is the effective tax rate on the dividend for each shareholder, assuming no effects from the exchange rate? Drakar O'Rourke A) 38% 44% B) 30% 40% C) 40% 48% Explanation Under an imputation tax system, taxes are paid at the corporate level, but are attributed to the shareholder, so that all taxes are effectively paid at the shareholder rate. (Module 15.1, LOS 15.f) Question #44 of 51 Question ID: 1472735 The current stock price of Westkirk is $50.00 per share. Book value of equity is $200 million and 10 million shares are outstanding. If Westkirk repurchases $25 million of their stock, the change in book value per share after the repurchase is closest to a(n): A) decrease of $2.50. B) increase of $1.10. C) decrease of $1.60. Explanation Book value per share before the repurchase = $200 million / 10 million shares = $20.00 per share. Shares repurchased = $25 million / $50.00 = 500,000 shares. Remaining shares = 10 million – 500,000 = 9.5 million shares. After the repurchase, book value = $200 million – $25 million = $175 million. Book value per share after the repurchase = $175 million / 9.5 million shares = $18.42. Difference = $18.42 – $20.00 = –$1.58 per share. (Module 15.2, LOS 15.k) Question #45 of 51 Question ID: 1472712 According to Modigliani and Miller's dividend irrelevancy theory, an investor in a firm that does not pay a dividend can still earn a "dividend" on that company by: A) slowly liquidating the fixed income portion of the investor’s portfolio. B) writing covered call options on the underlying stock. C) selling a portion of the company's stock each year. Explanation Miller and Modigliani's dividend irrelevancy theory states that shareholders can create their own dividend policy. If a firm does not pay dividends, a shareholder who wants a 4% dividend can "create" it by selling 4% of his or her stock. Note that Modigliani and Miller's theory assumes zero transaction costs or taxes. In actual practice, shareholders will have to pay transaction costs, and tax on any capital gains. (Module 15.1, LOS 15.b) Question #46 of 51 Question ID: 1472727 Jim Davis and Thurgood Owen, two equity analysts at Ferguson Capital Management, were reviewing the financial statements of Peregrine Foodstuffs Ltd. Davis and Owen noticed that Peregrine has been repurchasing its common shares in the market over the past three years. Owen thought this was an important issue to look into in greater detail. Upon completion of his review, Owen made the following two statements: Peregrine has bought back shares in the open market during its Statement 1 repurchase program. This method of repurchase gave the company the flexibility to choose the timing of the transaction. Peregrine plans to buy back shares by making tender offers during the Statement 2 coming year. By making tender offers, the company will be able to repurchase shares at a discount to the prevailing market price. With respect to Owen's statements: A) both are correct. B) only one is correct. C) both are incorrect. Explanation Buying in the open market gives the company the flexibility to choose the timing of the transaction. Thus, Statement 1 is correct. A second way is to buy a fixed number of shares at a fixed price. A company may repurchase stock by making a tender offer to repurchase a specific number of shares at a price that is at a premium to the current market price. They would not be willing to tender their shares for less than the prevailing market price, so Statement 2 is incorrect. (Module 15.2, LOS 15.i) Question #47 of 51 Question ID: 1472702 A periodic payment to shareholders in the form of additional shares of stock instead of cash is a: A) stock dividend B) stock repurchase C) dividend reinvestment plan Explanation Stock dividends are dividends paid out in new shares of stock instead of cash. Unlike stock dividends, dividend reinvestment plans are at the discretion of individual shareholders. In the case of stock repurchases, the company is buying back shares so the number of shares in the investment public's hands is declining. (Module 15.1, LOS 15.a) Question #48 of 51 Question ID: 1472730 Compared to a Dutch auction tender offer, when a firm uses a fixed price tender offer it is more likely that the fixed price tender offer will: A) result in a lower buyback price. B) send a positive signal to investors. C) require a greater amount of time to complete. Explanation The premium offered in a fixed price tender offer provides a positive signal to investors about management's view of the stock's value. Dutch auctions can be accomplished quickly, but usually not as quickly as fixed price tender offers. Dutch auctions generally enable a company to do the buyback at a lower price than with a fixed price tender offer. (Module 15.2, LOS 15.i) Question #49 of 51 Question ID: 1472716 Which of the following is least likely to discourage a company from making high dividend payouts? The company's: A) bondholders are protected by strong debt covenants. B) flotation costs are high. C) shareholders are primarily tax-exempt institutions. Explanation Taxes on dividends are one factor that sometimes discourages companies from paying dividends, however if most shareholders are tax exempt, tax considerations are unlikely to discourage a company from making dividend payouts. A company with high flotation costs is less likely to pay out high dividends, to ensure that projects can be financed through earnings and to thus avoid the expense of issuing new shares. Bondholders are often contractually protected from high dividend payouts; strong debt covenants are likely to prevent the company from making high dividend payouts. (Module 15.1, LOS 15.e) Question #50 of 51 Question ID: 1472718 Which of the following would be least likely to prompt a decline in a company's overall payout ratio? A) An increase in interest rates. B) A permanent decrease in company profitability. C) A decrease in the capital gains tax rate. Explanation A permanent decrease in profits is expected to result in a decrease in the dividend payment level; however this would probably not lead to a decrease in the payout ratio. If interest rates were to increase, it would make retained earnings a more attractive way of financing new investment; as a result, the payout ratio would be more likely to decline. A decrease in the capital gains tax rate would (for investors that pay tax) make capital gains more appealing; accordingly, aggregate payout ratios would be expected to decline. (Module 15.1, LOS 15.e) Question #51 of 51 Question ID: 1472725 Which of the following statements about a stock repurchase is least accurate? A) A stock repurchase occurs when a large block of stock is removed from the marketplace. B) Management can distribute cash to shareholders at a favorable after-tax rate. C) Disgruntled stockholders are forced to sell their shares, improving management's position. Explanation A repurchase gives stockholders a choice. They can sell or not sell. Stock repurchase is also more tax-efficient as only those shareholders that choose to sell their shares would potentially have a tax liability. (Module 15.2, LOS 15.i)