Question 1
Which of
the following statements is correct?
Answer
One advantage of dividend reinvestment plans
is that they enable investors to avoid paying taxes on the dividends they
receive.
If a company has an established clientele of
investors who prefer a high dividend payout, and if management wants to keep
stockholders happy, it should not
follow the
strict residual dividend policy.
If a firm follows a strict residual dividend
policy, then, holding all else constant, its dividend payout ratio will tend to
rise whenever the firm’s investment opportunities improve.
If Congress eliminates taxes on capital gains
but leaves the personal tax rate on dividends unchanged, this would motivate
companies to increase their dividend payout ratios.
Despite its drawbacks, following the residual
dividend policy will tend to stabilize actual cash dividends, and this will
make it easier for firms to attract a clientele that prefers high dividends,
such as retirees.
2
points
Question 2
In the real
world, dividends
Answer
are usually more stable than earnings.
fluctuate more widely than earnings.
tend to be a lower percentage of earnings for
mature firms.
are usually changed every year to reflect
earnings changes, and these changes are randomly higher or lower, depending on
whether earnings increased or decreased.
are usually set as a fixed percentage of
earnings, e.g., at 40% of earnings, so if EPS = $2.00, then DPS will equal $0.80. Once the percentage is set, then dividend
policy is on “automatic pilot” and the actual dividend depends strictly on
earnings.
2
points
Question 3
Which of
the following statements is correct?
Answer
Firms with a lot of good investment
opportunities and a relatively small amount of cash tend to have above average
payout ratios.
One advantage of the residual dividend policy
is that it leads to a stable dividend payout, which investors like.
An increase in the stock price when a company
decreases its dividend is consistent with signaling theory as postulated by MM.
If the “clientele effect” is correct, then for
a company whose earnings fluctuate, a policy of paying a constant percentage of
net income will probably maximize the stock price.
Stock repurchases make the most sense at times
when a company believes its stock is undervalued.
2
points
Question 4
If a firm
adheres strictly to the residual dividend policy, the issuance of new common
stock would suggest that
Answer
the dividend payout ratio has remained
constant.
the dividend payout ratio is increasing.
no dividends were paid during the year.
the dividend payout ratio is decreasing.
the dollar amount of investments has
decreased.
2
points
Question 5
You own 100
shares of Troll Brothers’ stock, which currently sells for $120 a share. The company is contemplating a 2-for-1 stock
split. Which of the following best
describes what your position will be after such a split takes place?
Answer
You will have 200 shares of stock, and the
stock will trade at or near $120 a share.
You will have 200 shares of stock, and the
stock will trade at or near $60 a share.
You will have 100 shares of stock, and the
stock will trade at or near $60 a share.
You will have 50 shares of stock, and the
stock will trade at or near $120 a share.
You will have 50 shares of stock, and the
stock will trade at or near $60 a share.
2
points
Question 6
If a firm
adheres strictly to the residual dividend policy, then if its optimal capital
budget requires the use of all earnings for a given year (along with new debt
according to the optimal debt/total assets ratio), then the firm should pay
Answer
no dividends except out of past retained
earnings.
no dividends to common stockholders.
dividends only out of funds raised by the sale
of new common stock.
dividends only out of funds raised by
borrowing money (i.e., issue debt).
dividends only out of funds raised by selling
off fixed assets.
2
points
Question 7
Which of
the following statements is correct?
Answer
Under the tax laws as they existed in 2008, a
dollar received for repurchased stock must be taxed at the same rate as a
dollar received as dividends.
One nice feature of dividend reinvestment
plans (DRIPs) is that they reduce the taxes investors would have to pay if they
received cash dividends.
Empirical research indicates that, in general,
companies send a negative signal to the marketplace when they announce an
increase in the dividend, and as a result share prices fall when dividend
increases are announced. The reason is
that investors interpret the increase as a signal that the firm has relatively
few good investment opportunities.
If a company wants to raise new equity capital
rather steadily over time, a new stock dividend reinvestment plan would make
sense. However, if the firm does not
want or need new equity, then an open market purchase dividend reinvestment
plan would probably make more sense.
Dividend reinvestment plans have not caught on
in most industries, and today about 99% of all companies with DRIPs are
utilities.
2
points
Question 8
Which of
the following would be most likely to lead to a decrease in a firm’s dividend
payout ratio?
Answer
Its earnings become more stable.
Its access to the capital markets increases.
Its R&D efforts pay off, and it now has
more high-return investment opportunities.
Its accounts receivable decrease due to a
change in its credit policy.
Its stock price has increased over the last
year by a greater percentage than the increase in the broad stock market
averages.
2
points
Question 9
Firm M is a
mature firm in a mature industry. Its
annual net income and net cash flows are both consistently high and
stable. However, M’s growth prospects
are quite limited, so its capital budget is small relative to its net
income. Firm N is a relatively new firm
in a new and growing industry. Its markets and products have not stabilized, so
its annual operating income fluctuates considerably. However, N has substantial growth
opportunities, and its capital budget is expected to be large relative to its
net income for the foreseeable future. Which of the following statements is
correct?
Answer
Firm M probably has a lower debt ratio than
Firm N.
Firm M probably has a higher dividend payout
ratio than Firm N.
If the corporate tax rate increases, the debt
ratio of both firms is likely to decline.
The two firms are equally likely to pay high
dividends.
Firm N is likely to have a clientele of
shareholders who want to receive consistent, stable dividend income.
2 points
Question 10
Which of
the following statements is correct?
Answer
One disadvantage of dividend reinvestment
plans is that they increase transactions costs for investors who want to
increase their ownership in the company.
One advantage of dividend reinvestment plans
is that they enable investors to postpone paying taxes on the dividends
credited to their account.
Stock repurchases can be used by a firm that
wants to increase its debt ratio.
Stock repurchases make sense if a company
expects to have a lot of profitable new projects to fund over the next few
years, provided investors are aware of these investment opportunities.
One advantage of an open market dividend
reinvestment plan is that it provides new equity capital and increases the
shares outstanding.
2
points
Question 11
Which of
the following should not influence a firm’s dividend policy decision?
Answer
The firm’s ability to accelerate or delay
investment projects.
A strong preference by most shareholders for
current cash income versus capital gains.
Constraints imposed by the firm’s bond
indenture.
The fact that much of the firm’s equipment has
been leased rather than bought and owned.
The fact that Congress is considering changes
in the tax law regarding the taxation of dividends versus capital gains.
2
points
Question 12
Which of
the following statements is correct?
Answer
If a firm repurchases some of its stock in the
open market, then shareholders who sell their stock for more than they paid for
it will be subject to capital gains taxes.
An open-market dividend reinvestment plan will
be most attractive to companies that need new equity and would otherwise have
to issue additional shares of common stock through investment bankers.
Stock repurchases tend to reduce financial
leverage.
If a company declares a 2-for-1 stock split,
its stock price should roughly double.
One advantage of adopting the residual
dividend policy is that this makes it easier for corporations to meet the
requirements of Modigliani and Miller’s dividend clientele theory.
2
points
Question 13
Which of
the following statements is NOT correct?
Answer
Stock repurchases can be used by a firm as
part of a plan to change its capital structure.
After a 3-for-1 stock split, a company’s price
per share should fall, but the number of shares outstanding will rise.
Investors can interpret a stock repurchase
program as a signal that the firm’s managers believe the stock is undervalued.
Companies can repurchase shares to distribute
large inflows of cash, say from the sale of a division, to stockholders without
paying cash dividends.
Stockholders pay no income tax on dividends if
the dividends are used to purchase stock through a dividend reinvestment plan.
2
points
Question 14
Which of
the following actions will best enable a company to raise additional equity
capital?
Answer
Refund long-term debt with lower cost
short-term debt.
Declare a stock split.
Begin an open-market purchase dividend
reinvestment plan.
Initiate a stock repurchase program.
Begin a new-stock dividend reinvestment plan.
2
points
Question 15
Which of
the following statements is correct?
Answer
The tax code encourages companies to pay
dividends rather than retain earnings.
If a company uses the residual dividend model
to determine its dividend payments, dividends payout will tend to increase
whenever its profitable investment opportunities increase.
The stronger management thinks the clientele
effect is, the more likely the firm is to adopt a strict version of the
residual dividend model.
Large stock repurchases financed by debt tend
to increase earnings per share, but they also increase the firm’s financial
risk.
A dollar paid out to repurchase stock is taxed
at the same rate as a dollar paid out in dividends. Thus, both companies and investors are
indifferent between distributing cash through dividends and stock repurchase
programs.
2
points
Question 16
Based on
the information below, what is Ezzel Enterprises' optimal capital structure?
Answer
Debt = 40%; Equity = 60%; EPS = $2.95; Stock
price = $26.50.
Debt = 50%; Equity = 50%; EPS = $3.05; Stock
price = $28.90.
Debt = 60%; Equity = 40%; EPS = $3.18; Stock
price = $31.20.
Debt = 80%; Equity = 20%; EPS = $3.42; Stock
price = $30.40.
Debt = 70%; Equity = 30%; EPS = $3.31; Stock
price = $30.00.
2
points
Question 17
Which of
the following events is likely to encourage a company to raise its target debt
ratio, other things held constant?
Answer
An increase in the corporate tax rate.
An increase in the personal tax rate.
An increase in the company’s operating
leverage.
The Federal Reserve tightens interest rates in
an effort to fight inflation.
The company's stock price hits a new high.
2
points
Question 18
If debt
financing is used, which of the following is CORRECT?
Answer
The percentage change in net operating income
will be greater than a given percentage change in net income.
The percentage change in net operating income
will be equal to a given percentage change in net income.
The percentage change in net income relative
to the percentage change in net operating income will depend on the interest
rate charged on debt.
The percentage change in net income will be
greater than the percentage change in net operating income.
The percentage change in sales will be greater
than the percentage change in EBIT, which in turn will be greater than the
percentage change in net income.
2
points
Question 19
Which of
the following statements is CORRECT? As
a firm increases the operating leverage used to produce a given quantity of
output, this will
Answer
normally lead to an increase in its fixed
assets turnover ratio.
normally lead to a decrease in its business
risk.
normally lead to a decrease in the standard
deviation of its expected EBIT.
normally lead to a decrease in the variability
of its expected EPS.
normally lead to a reduction in its fixed
assets turnover ratio.
2
points
Question 20
Business
risk is affected by a firm's operations.
Which of the following is NOT associated with (or does not contribute
to) business risk?
Answer
Demand variability.
Sales price variability.
The extent to which operating costs are fixed.
The extent to which interest rates on the
firm's debt fluctuate.
Input price variability.
2
points
Question 21
Firms U and
L each have the same amount of assets, and both have a basic earning power
ratio of 20%. Firm U is unleveraged,
i.e., it is 100% equity financed, while Firm L is financed with 50% debt and
50% equity. Firm L’s debt has a
before-tax cost of 8%. Both firms have
positive net income. Which of the
following statements is CORRECT?
Answer
The two companies have the same times interest
earned (TIE) ratio.
Firm L has a lower ROA than Firm U.
Firm L has a lower ROE than Firm U.
Firm L has the higher times interest earned
(TIE) ratio.
Firm L has a higher EBIT than Firm U.
2
points
Question 22
Which of
the following statements is CORRECT, holding other things constant?
Answer
Firms whose assets are relatively liquid tend
to have relatively low bankruptcy costs, hence they tend to use relatively
little debt.
An increase in the personal tax rate is likely
to increase the debt ratio of the average corporation.
If changes in the bankruptcy code make
bankruptcy less costly to corporations, then this would likely reduce the debt
ratio of the average corporation.
An increase in the company’s degree of
operating leverage is likely to encourage a company to use more debt in its
capital structure.
An increase in the corporate tax rate is
likely to encourage a company to use more debt in its capital structure.
2
points
Question 23
Which of
the following statements is CORRECT?
Answer
Since debt financing raises the firm's
financial risk, increasing a company’s debt ratio will always increase its
WACC.
Since debt financing is cheaper than equity
financing, raising a company’s debt ratio will always reduce its WACC.
Increasing a company’s debt ratio will
typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the
company’s WACC.
Increasing a company’s debt ratio will
typically increase the marginal cost of both debt and equity financing. However, this action still may lower the
company’s WACC.
Since a firm's beta coefficient it not
affected by its use of financial leverage, leverage does not affect the cost of
equity.
2
points
Question 24
Volga
Publishing is considering a proposed increase in its debt ratio, which would
also increase the company’s interest expense.
The plan would involve issuing new bonds and using the proceeds to buy
back shares of its common stock. The
company’s CFO thinks the plan will not change total assets or operating income,
but that it will increase earnings per share (EPS). Assuming the CFO’s estimates are correct,
which of the following statements is CORRECT?
Answer
Since the proposed plan increases Volga’s
financial risk, the company’s stock price still might fall even if EPS
increases.
If the plan reduces the WACC, the stock price
is also likely to decline.
Since the plan is expected to increase EPS,
this implies that net income is also expected to increase.
If the plan does increase the EPS, the stock
price will automatically increase at the same rate.
Under the plan there will be more bonds
outstanding, and that will increase their liquidity and thus lower the interest
rate on the currently outstanding bonds.
2
points
Question 25
The firm’s
target capital structure should be consistent with which of the following
statements?
Answer
Maximize the earnings per share (EPS).
Minimize the cost of debt (rd).
Obtain the highest possible bond rating.
Minimize the cost of equity (rs).
Minimize the weighted average cost of capital
(WACC).
2
points
Question 26
Which of
the following statements is CORRECT?
Answer
If corporate tax rates were decreased while
other things were held constant, and if the Modigliani-Miller tax-adjusted
tradeoff theory of capital structure were correct, this would tend to cause
corporations to decrease their use of debt.
A change in the personal tax rate should not
affect firms’ capital structure decisions.
“Business risk” is differentiated from
“financial risk” by the fact that financial risk reflects only the use of debt,
while business risk reflects both the use of debt and such factors as sales
variability, cost variability, and operating leverage.
The optimal capital structure is the one that
simultaneously (1) maximizes the price of the firm’s stock, (2) minimizes its
WACC, and (3) maximizes its EPS.
If changes in the bankruptcy code make
bankruptcy less costly to corporations, then this would likely reduce the debt
ratio of the average corporation.
2
points
Question 27
Companies
HD and LD have identical tax rates, total assets, and basic earning power
ratios, and their basic earning power exceeds their before-tax cost of debt,
rd. However, Company HD has a higher
debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?
Answer
Company HD has a higher net income than
Company LD.
Company HD has a lower ROA than Company LD.
Company HD has a lower ROE than Company LD.
The two companies have the same ROA.
The two companies have the same ROE.
2
points
Question 28
Which of
the following statements is CORRECT?
Answer
As a rule, the optimal capital structure is
found by determining the debt-equity mix that maximizes expected EPS.
The optimal capital structure simultaneously
maximizes EPS and minimizes the WACC.
The optimal capital structure minimizes the
cost of equity, which is a necessary condition for maximizing the stock price.
The optimal capital structure simultaneously
minimizes the cost of debt, the cost of equity, and the WACC.
The optimal capital structure simultaneously
maximizes stock price and minimizes the WACC.
2
points
Question 29
Which of
the following would increase the likelihood that a company would increase its
debt ratio, other things held constant?
Answer
An increase in costs incurred when filing for
bankruptcy.
An increase in the corporate tax rate.
An increase in the personal tax rate.
The Federal Reserve tightens interest rates in
an effort to fight inflation.
The company's stock price hits a new low.
2
points
Question 30
Which of
the following statements is CORRECT?
Answer
The capital
structure that maximizes expected EPS also maximizes the price per share of
common stock.
The capital
structure that minimizes the interest rate on debt also maximizes the expected
EPS.
The capital structure that minimizes the
required return on equity also maximizes the stock price.
The capital
structure that minimizes the WACC also maximizes the price per share of common
stock.
The capital
structure that gives the firm the best credit rating also maximizes the stock
price.
