CFA Level 1 - Corporate Finance Session 11 - Reading 39

CFA Level 1 - Corporate Finance Session 11 - Reading 39 (Notes, Practice Questions, Sample Questions) 1. 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 — 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 2. A periodic payment to shareholders in the form of additional shares of stock instead of cash is a: A)dividend reinvestment plan B)stock dividend C)stock repurchase Explanation: B — 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 3. Stock splits: A)do not in and of themselves affect firm value. B)are less common than stock dividends. C)increase firm value. Explanation: A — 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 4. Financial managers utilize stock splits and stock dividends because they perceive that: A)investors will double the share price if there is a 20% stock dividend. B)brokerage fees paid by shareholders will be reduced. C)an optimal trading range exists Explanation: C — 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 5. What is the earliest day on which an investor can currently purchase Amex, Inc., if the investor wants to avoid receiving a dividend and thereby avoid paying tax on the distribution, if the date of record is Thursday, October 31? A)Tuesday, October 29. B)Monday, October 28. C)Thursday, October 24 Explanation: A — The ex-dividend date is now two business days prior to the date of record. Counting back two business days identifies Tuesday, October 29 as the date when the shares can be purchased without the dividend 6. The cut-off date for receiving the dividend is known as the: A)holder of record date. B)ex-dividend date. C)date of payment. Explanation: B — The cut-off date for receiving the dividend is known as the ex-dividend date. The holder of record date is the date on which the shareholders of record are designated. The date the checks are mailed out is known as the date of payment 7. Which of the following shows the key dividend dates in their proper sequence? A)Declaration date, holder-of-record date, ex-dividend date, payment date. B)Ex-dividend date, holder-of-record date, declaration date, payment date. C)Declaration date, ex-dividend date, holder-of-record date, payment date. Explanation: C — The board of directors announce the amount of the dividend, the holder-of-record date, and payment date. The ex-dividend date is two business days prior to the holder-of-record date, giving the firm time to identify the rightful owner of the dividends 8. Which justification for repurchasing stock is the least valid? A)Repurchases offer shareholders more choices than cash dividends. B)Shareholders prefer capital gains to cash dividends. C)A cash dividend increase, in response to short-term excess cash flows, may confuse investors Explanation: B — 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 9. 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 without signaling about future earnings. C)Disgruntled stockholders are forced to sell their shares, improving management's position. Explanation: C — A repurchase gives stockholders a choice. They can sell or not sell 10. 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: Statement 1: Peregrine has bought back shares in the open market during its repurchase program. This method of repurchase gave the company the flexibility to choose the timing of the transaction. Statement 2: Peregrine plans to buy back shares by making tender offers during the 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)both are incorrect. C)only one is correct. Explanation: C — 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 11. 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: C — 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 12. 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)Buying a fixed number of shares at a fixed price. B)Buying in the open market. C)Repurchasing by direct negotiation. Explanation: A — A tender offer refers to buying a fixed number of shares at a fixed price (usually at a premium to the current market price). 13. 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: B — 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 14. 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: B — 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 15. 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)A share repurchase will sometimes lead to higher total shareholder wealth than a cash dividend of an equal amount. B)A share repurchase is equivalent to a cash dividend of an equal amount, so total shareholder wealth will be the same. C)A share repurchase will always lead to higher total shareholder wealth than a cash dividend of an equal amount Explanation: B — 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