Financial Statements exam template

Question: It has been argued that investors prefer high-payout companies because dividends are more certain (less risky) than the capital gains that are supposed to come from retained earnings. However, Miller and Modigliani say that this argument is incorrect, and they call it the “bird-in-the-hand fallacy.” MM base their argument on the belief that most dividends are reinvested in stocks, hence are exposed to the same risks as reinvested earnings.

Answer Choices:

Answer: B – False

Question: Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk.

Answer Choices:

Answer: A – True

Question: One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must be offset by a more than proportionate increase in growth in order to keep a firm’s required return constant, other things held constant.

Answer Choices:

Answer: B – False

Question: If a retired individual lives on his or her investment income, then it would make sense for this person to prefer stocks with high payouts so he or she could receive cash without going to the trouble and expense of selling stocks. On the other hand, it would make sense for an individual who would just reinvest any dividends received to prefer a low-payout company because that would save him or her taxes and brokerage costs.

Answer Choices:

Answer: A – True

Question: Some investors prefer dividends to retained earnings (and the capital gains retained earnings bring), while others prefer retained earnings to dividends. Other things held constant, it makes sense for a company to establish its dividend policy and stick to it, and then it will attract a clientele of investors who like that policy.

Answer Choices:

Answer: A – True

Question: Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout, announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument.

Answer Choices:

Answer: B – False

Question: If the information content, or signaling, hypothesis is correct, then a change in a firm’s dividend policy can have an important effect on its stock price and cost of equity.

Answer Choices:

Answer: A – True

Question: If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the better the firm’s investment opportunities, the lower its payout ratio will be, other things held constant.

Answer Choices:

Answer: A – True

Question: If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the higher the firm’s debt ratio, the lower its payout ratio will be, other things held constant.

Answer Choices:

Answer: B – False

Question: If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual dividend policy.

Answer Choices:

Answer: B – False

Question: If on January 3, 2015, a company declares a dividend of $1.50 per share, payable on January 31, 2015, then the price of the stock should drop by approximately $1.50 on January 31.

Answer Choices:

Answer: B – False

Question: If on January 3, 2015, a company declares a dividend of $1.50 per share, payable on January 31, 2015, to holders of record on January 17, then the price of the stock should drop by approximately $1.50 on January 15, which is the ex-dividend date.

Answer Choices:

Answer: A – True

Question: One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest.

Answer Choices:

Answer: B – False

Question: There are two types of dividend reinvestment plans. Under one type of plan, the firm uses the cash that would have been paid as dividends to buy stock on the open market. Under the other type, the company issues new stock, keeps the cash that would have been paid out, and in effect sells new stock to those investors who choose to reinvest their dividends.

Answer Choices:

Answer: A – True

Question: If a firm pays out all of its earnings as dividends and its stockholders then elect to have all of their dividends reinvested, the company should reconsider its dividend policy and possibly move to a lower dividend payout ratio.

Answer Choices:

Answer: A – True

Question: If a firm declares a 20:1 stock split, and the pre-split price was $500, then we might expect the post-split price to be $25. However, it often turns out that the post-split price will be higher than $25. This higher price could be due to signaling effects investors believe that management split the stock because they think the firm is going to do better in the future. The higher price could also be because investors like lower-priced shares.

Answer Choices:

Answer: A – True

Question: Your firm uses the residual dividend model to set dividend policy. Market interest rates suddenly rise, and stock prices decline. Your firm’s earnings, investment opportunities, and capital structure do not change. If the firm follows the residual dividend model, then its dividend payout ratio would increase.

Answer Choices:

Answer: A – True

Question: The times-interest-earned ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs.

Answer Choices:

Answer: A – True

Question: Profitability ratios show the combined effects of liquidity, asset management, and debt management on a firm’s operating results.

Answer Choices:

Answer: A – True