Brealey13e Chapter16 TB AnswerKey

Principles of Corporate Finance, 13e (Brealey)
Chapter 16 Payout Policy
1) Firms can pay out cash to their shareholders in the following way(s):
I) dividends;
II) share repurchases;
III) interest payments
A) I only
B) II only
C) I and II only
D) III only
Answer: C
Difficulty: 1 Easy
Topic: Dividends and Payout Policy
Learning Objective: 16-01 Facts About Payout.
Bloom's: Remember
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
2) Dividend policy changes are decided and announced by
I) the managers of a firm;

II) the government;
III) the board of directors
A) I only
B) II only
C) III only
D) I and II only
Answer: C
Difficulty: 1 Easy
Bloom's: Remember
3) Which of these dates, when arranged in chronological order, occurs last?

A) Dividend payment date
B) Ex-dividend date
C) Record date
D) Dividend declaration date
Answer: A
Difficulty: 2 Medium
Bloom's: Remember
4) Which of the following lists events in chronological order from earliest to latest?
A) Record date, declaration date, ex-dividend date
B) Declaration date, record date, ex-dividend date
C) Declaration date, ex-dividend date, record date
D) Record date, ex-dividend date, declaration date
Answer: C
Bloom's: Remember
5) On January 2, Michigan Mining declared a $2-per-share quarterly dividend payable on March
9th to stockholders of record on Friday, February 9. What is the latest date by which you could
purchase the stock and still get the recently declared dividend?
A) February 5
B) February 6
C) February 7
D) February 8
Answer: B
Bloom's: Understand
6) Which of the following dividends are never in the form of cash?
I) regular dividend;
II) special dividend;
III) stock dividend;
IV) liquidating dividend
A) I only
B) II only
C) III only
D) I, II, and IV only
Answer: C
Difficulty: 1 Easy
Bloom's: Understand
7) The following statements are true of dividend reinvestment plans (DRIPs):
I) They are offered by the companies to their shareholders.

II) Generally, new shares are issued at a discount.
III) The dividends are taxable as ordinary income.
A) I only
B) I and III only
C) I, II, and III
D) III only
Answer: C
Learning Objective: 16-02 The Information Content of Dividends and Repurchases.
Bloom's: Understand
8) Firms can repurchase shares in the following ways:
I) open market repurchase;

II) tender offer;
III) Dutch auction;
IV) direct negotiation with a major shareholder
A) I only
B) II only
C) III only
D) I, II, III, and IV
Answer: D
Topic: Stock Repurchases
Learning Objective: 16-03 Dividends or Repurchases? The Payout Controversy.
Bloom's: Understand
9) A Dutch auction is the same as a(n)

A) discriminatory price auction.
B) uniform price auction.
C) English auction.
D) share repurchase.
Answer: B
Bloom's: Remember
10) The par value of the outstanding shares is known as

A) retained earnings.
B) legal capital.
C) book value of equity.
D) additional paid-in capital.
Answer: B
Bloom's: Remember
11) Consider the procedure whereby the firm states a series of prices at which it is prepared to
repurchase stock. Shareholders then submit offers indicating how many shares they wish to sell
and at which price. The firm then calculates the lowest price at which it is able to buy the desired
number of shares. This procedure is known as a(n)
A) open market repurchase.
B) Dutch auction.
C) green mail.
D) tender offer.
Answer: B
Bloom's: Understand
12) What is the likely impact on a typical individual investor if a firm undertakes a stock
repurchase in lieu of a cash dividend?
A) Lower income taxes, if capital gains tax rates are less than dividend tax rates
B) Higher income taxes, if capital gains tax rates are less than dividend tax rates
C) Lower share price
D) A tax-free transaction
Answer: A
Bloom's: Understand
13) Suppose that there are no taxes, transactions costs, or other market imperfections. Which of
the following actions is most likely to make shareholders better off?
A) Increase dividends.
B) Reduce share repurchases.
C) Announce that dividends will not change for at least three years.
D) Eliminate negative-NPV projects.
Answer: D
Bloom's: Understand
14) Which of the following are true?
I) Firms have long-run target dividend payout ratios.

II) Dividend changes follow shifts in long-term, sustainable earnings.
III) Managers are reluctant to make dividend changes that might have to be reversed.
A) I only
B) II only
C) III only
D) I, II, and III
Answer: D
Bloom's: Remember
15) According to survey data, which is the least-often cited dividend policy consideration?
A) Firms want to avoid dividend reductions.
B) Firms desire a smooth dividend policy.
C) Firms avoid dividend policy reversals.
D) Firms would prefer to raise new funds rather than reduce dividends.
Answer: D
Bloom's: Remember
16) Generally, firms engage in stock repurchases during
I) boom times as firms accumulate excess cash;

II) recessions due to low stock prices;
III) times when competitors' stock prices are dropping
A) I only
B) II only
C) III only
D) II and III only
Answer: A
Bloom's: Remember
17) According to financial executives' views on dividend policy, which of the following
statements is most frequently cited?
A) We try to avoid reducing the dividend.
B) We try to maintain a smooth dividend stream.
C) We look at the current dividend level.
D) We are reluctant to make a change that may have to be reversed.
Answer: A
Bloom's: Understand
18) Generally, investors interpret the announcement of an increase in dividends as

A) bad news, and the stock price drops.
B) good news, and the stock price increases.
C) a nonevent that does not affect the stock price.
D) very bad news, and the stock price plunges.
Answer: B
Difficulty: 1 Easy
Bloom's: Understand
19) Generally, investors interpret the announcement of a decrease in dividends as
C) a nonevent that does not affect the stock prices.
D) very good news, and the stock price jumps up.
Answer: A
Bloom's: Understand
20) Generally, investors view the announcement of an open-market repurchase program as

C) a nonevent that does not affect the stock price.
D) very bad news, and the stock price plunges.
Answer: B
Bloom's: Understand
21) A key assumption of the Miller and Modigliani (MM) dividend irrelevance argument is that
A) future stock prices are certain.
B) firms have an adequate supply of Treasury shares.
C) there exists a risk-free asset.
D) new shares are sold at a fair price.
Answer: D
Bloom's: Understand
22) Miller and Modigliani's indifference proposition regarding dividend policy

A) assumes that tax rates increase at the same rate as inflation.
B) assumes that investors can sell their stock at a fair price.
C) states that investors are indifferent between stock dividends and cash dividends.
D) states that investors are indifferent between stock repurchases and cash dividends.
Answer: B
Bloom's: Understand
23) The following are indicators that the firm has a cash surplus:.
I) Free cash flow is reliably positive.

II) The firm has a low debt ratio compared to similar firms.
III) The firm has sufficient debt capacity to cover unexpected opportunities or setbacks.
A) I only
B) II only
C) III only
D) I, II, and III
Answer: D
Bloom's: Understand
24) The dividend-irrelevance proposition of Miller and Modigliani depends on the following
relationship between investment policy and dividend policy:
A) Changes in investment policy will alter dividend policy.
B) Changes in dividend policy will alter investment policy.
C) Investment policy is independent of dividend policy.
D) Dividends are tax-deductible and investments are depreciable.
Answer: C
Bloom's: Understand
25) Company X has 100 shares outstanding. It earns $1,000 per year and expects to pay all of it
as dividends. If the firm expects to maintain this dividend forever, calculate the stock price today.
(The required rate of return is 10 percent.)
A) $110
B) $100
C) $90
D) $10
Answer: B
Explanation: Dividends = 1,000/100 = $10. P = 10/0.1 = $100.
Bloom's: Apply
26) Company X has 100 shares outstanding. It earns $1,000 per year and expects to pay all of it
as dividends. If the firm expects to maintain this dividend forever, calculate the stock price after
the dividend payment. (The required rate of return is 10 percent.)
A) $110
B) $100
C) $90
D) $10
Answer: B
Explanation: Dividends = 1,000/100 = $10; P = 10/0.1 = $100.
Price before dividend payment = $110. Price after dividend payment = $100.
Bloom's: Apply
27) Company X has 100 shares outstanding. It earns $1,000 per year and announces that it will
use all $1,000 to repurchase its shares in the open market instead of paying dividends. Calculate
the number of shares outstanding at the end of year 1, after the first share repurchase, if the
required rate of return is 10 percent.
A) 110
B) 100
C) 90.91
D) 89
Answer: C
Explanation: Share price at beginning of year = [$1000/0.1]/100 = $100 per share. Share price at
$1,000/$110 = 9.09. 100 − 9.09 = 90.91 shares remain.

end of year, before repurchase, equals $100 × 1.10 = $110. Number of shares purchased =
Bloom's: Apply
28) One possible reason that shareholders often insist on higher dividends is
A) they agree with Miller and Modigliani.
B) the capital gains tax disadvantage.
C) the stock market is efficient.
D) they do not trust managers to spend retained earnings wisely.
Answer: D
Bloom's: Understand
29) The rightist position is that the market will reward firms for having
A) high dividend yield.
B) a low dividend yield
C) good management, regardless of dividend yield.
D) a zero payout policy.
Answer: A
Learning Objective: 16-04 The Rightists.
Bloom's: Understand
30) According to behavioral finance, investors prefer dividends because

A) investors prefer the discipline that comes from spending only the dividends.
B) dividends generate lower taxes.
C) the stock market is efficient.
D) dividends provide a tax deduction.
Answer: A
Bloom's: Understand
31) If investors do not like dividends because of the additional taxes that they have to pay, how
would you expect stock prices to behave on the ex-dividend date?
A) Fall by more than the amount of the dividend
B) Fall exactly by the amount of the dividend
C) Fall by less than the amount of the dividend
D) Cannot be predicted.
Answer: C
Explanation: Relative demand for the stock will increase on the ex-dividend date since the stock
no longer trades with the dividend attached. So the stock price will fall due to the dividend, but
will increase to some extent due to its ex-dividend status. On net, it will fall less than the amount
of the dividend.
Learning Objective: 16-05 Taxes and the Radical Left.
Bloom's: Understand
32) Even if both dividends and capital gains are taxed at the same ordinary income tax rate, the
effect of each type of tax is different because
A) capital gains are actually taxed, while dividends are taxed on paper only.
B) dividends are taxed when distributed, while capital gains are deferred until the stock is sold.
C) both dividends and capital gains are taxed every year.
D) capital gains are actually taxed, while dividends are taxed on paper; and both dividends and
capital gains are taxed every year.
Answer: B
Bloom's: Understand
33) If dividends are taxed more heavily than capital gains, then investors
A) should be willing to pay more for stocks with low dividend yields.
B) should be willing to pay more for stocks with high dividend yields.
C) should be willing to pay the same for stocks regardless of their dividend yields.
D) should be willing to pay more for stocks having infrequent share repurchases.
Answer: A
Bloom's: Understand
34) Consider the payout policies of U.S. nonfinancial firms from 2011–2017. Which category
had the highest percentage of firms?
A) Firms that paid dividends and repurchased shares
B) Firms that paid dividends but did not repurchase shares
C) Firms that paid no dividends but did repurchase shares
D) Firms that paid no dividends and did not repurchase shares
Answer: D
Bloom's: Remember
35) Two corporations A and B have exactly the same risk, and both have a current stock price of
$100. Corporation A pays no dividend and will have a price of $120 one year from now.
Corporation B pays dividends and will have a price of $113 one year from now after paying the
dividend. The corporations pay no taxes and investors pay no taxes on capital gains, but pay a 30
percent income tax on dividends. What is the value of the dividend that investors expect
corporation B to pay one year from today?
A) $7
B) $13
C) $10
D) $20
Answer: C
Explanation: The after-tax returns must be the same. The return on stock A is 20 percent, or $20.
The after-tax return on stock B must also be 20 percent, or $20. Stock B will deliver $13 of
(120 − 113)/0.7 = $10.

capital gains and must therefore deliver an after-tax dividend of $7. The pre-tax dividend is =
Bloom's: Apply
36) Which of the following investors has the strongest tax reason to prefer dividends over capital
gains?
A) Pension funds
B) Financial institutions
C) Individuals
D) Corporations
Answer: D
Bloom's: Understand
37) If the corporate tax rate is 21 percent, what is the maximum effective tax rate on dividends
received by another corporation?
A) 30 percent
B) 21 percent
C) 6.3 percent
D) 63 percent
Answer: C
Explanation: Seventy percent of dividends received by another corporation is tax-exempt. Tax
rate = (0.3) × (0.21) = 0.063 = 6.3%.
Bloom's: Apply
38) Dividend policy may affect firm value because
I) there is an unsatisfied clientele that prefer dividends to capital gains;

II) there are sufficient loopholes in the tax system that wealthy shareholders can avoid taxes on
dividends;
III) well-managed companies prefer to signal their worth by paying high dividends
A) I only
B) I and II only
C) I and III only
D) II and III only
Answer: C
Bloom's: Apply
39) A firm in Australia earns a pretax profit of $A10 per share. Suppose that it pays a corporate
tax of $3 per share (30 percent tax rate) in taxes. The firm pays the remaining $A7 in dividends
to a shareholder in the 30 percent marginal tax bracket. What is the amount of additional tax paid
by the shareholder under an imputation tax system?
A) $A2.10
B) $A0.00
C) $A3.00
D) $A5.10
Answer: B
Bloom's: Apply
40) A firm in Australia earns a pretax profit of $A10 per share. Suppose that it pays a corporate
tax of $3 per share (30 percent tax rate) in taxes. The firm pays the remaining $A7 in dividends
to a shareholder in the 40 percent marginal tax bracket. What is the amount of additional tax paid
by the shareholder under an imputation tax system?
A) $A1.00
B) $0.00
C) $A4.00
D) $A5.80
Answer: A
Bloom's: Apply
41) Companies using a tender offer to repurchase shares typically offer a stock price greater than
the current stock price.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Remember
42) Firms can pay out cash to their shareholders in two ways: cash dividends and stock
dividends.
Answer: FALSE
Difficulty: 1 Easy
Bloom's: Remember
43) In 2009, JPMorgan Chase cut its dividend down to $0.05 per share and the bank's share price
increased in response.
Answer: TRUE
Bloom's: Remember
44) Adoption of Rule 10b-18 by the SEC has protected firms from being prosecuted for
manipulating their share price through share repurchases.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Remember
45) A high-dividend policy is more difficult for a weak firm than a strong firm because it likely
will not have the cash to support it.
Answer: TRUE
Bloom's: Understand
46) Healy and Palepu found that the stock price of firms that stopped paying a dividend declined
by 9.5 percent on average upon announcement.
Answer: TRUE
Difficulty: 3 Hard
Bloom's: Remember
47) Many companies have automatic dividend reinvestment plans (DRIPs).
Answer: TRUE
Bloom's: Remember
48) An equivalent alternative to paying cash dividends is to pay stock dividends.
Answer: FALSE
Bloom's: Understand
49) Dividend payments are used to change the firm's capital structure by replacing equity with
debt.
Answer: FALSE
Difficulty: 3 Hard
Bloom's: Understand
50) Most firms have long-run target dividend payout ratios.
Answer: TRUE
Bloom's: Remember
51) Stock repurchases are like bumper dividends, but they do not typically substitute for regular
cash dividends.
Answer: TRUE
Topic: Share Repurchases
Bloom's: Understand
52) Managers are reluctant to make dividend changes that they may have to reverse.
Answer: TRUE
Bloom's: Understand
53) Managers try to avoid reducing their stock's dividend.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Understand
54) Miller and Modigliani's argument for dividend irrelevance assumes an efficient market.
Answer: TRUE
Bloom's: Understand
55) Australia follows an imputation tax system for the payment of taxes on dividends.
Answer: TRUE
Bloom's: Understand
56) The Miller and Modigliani dividend irrelevance argument assumes that the firm's investment
policy and debt policy are both settled (fixed).
Answer: TRUE
Bloom's: Understand
57) The Miller and Modigliani dividend irrelevance argument assumes that the firm can issue
new shares at a fair price.
Answer: TRUE
Bloom's: Understand
58) Briefly describe the sequence of events of a firm's dividend payment.
Answer: The board of directors sets the dividend for a firm. The date on which the board of
directors announces the dividend is called the declaration date. Dividends will be paid to those
who are registered shareholders as of the record date. Two business days prior to the record date
is the ex-dividend date. Shares bought on the ex-dividend date or later do not come with the
dividend. Dividend checks are mailed to shareholders on the payment date.
Difficulty: 1 Easy
Bloom's: Remember
59) What is SEC Rule 10b-18?
Answer: SEC Rule 10b-18 was adopted in 1982. Prior to adoption of this rule, firms that
repurchased their shares were liable for prosecution for manipulating their share price. SEC Rule
10b-18 has provisions that protect firms against such prosecution.
Difficulty: 1 Easy
Bloom's: Remember
60) Briefly discuss different ways in which a firm can pay dividends to its shareholders.
Answer: Firms that pay dividends typically pay a regular cash dividend each quarter.
Occasionally, firms pay extra or special dividends. Occasionally, firms declare stock dividends.
That is, shareholders receive additional shares of stock instead of cash. Many times firms might
repurchase their own stock. This is in lieu of paying dividends.
Difficulty: 1 Easy
Bloom's: Remember
61) What information does a share repurchase convey to investors?
Answer: Firms repurchase shares when they have accumulated cash that they are not able to
invest profitably. Share repurchases may indicate an underpriced stock. Share repurchase may
also be used to signal management's confidence in the future of the firm.
Bloom's: Understand
62) Describe Miller and Modigliani's proposition on dividend irrelevance.
Answer: Miller and Modigliani state that in a world without taxes, transaction costs, or other
market imperfections, the firm's choice of dividend policy is irrelevant to the value of the firm.
Difficulty: 3 Hard
Bloom's: Understand
63) Rightists argue that increasing a firm's dividend will increase its value. Review some of the
key points in their assertion.
Answer: Investors prefer cash to capital gains as cash dividends are certain and capital gains are
uncertain; many investors prefer cash, as they need it for living expenses; investors see the
information contained within dividend payments as objective evidence of a firm's good
performance.
Bloom's: Understand
64) Briefly describe the leftists' point of view on dividends and taxes.
Answer: If dividends are taxed at a higher rate than capital gains, firms should pay the lowest
cash dividends. By shifting their distribution policy, corporations can transform dividends into
capital gains. Leftists favor low dividend payouts.
Bloom's: Understand
65) Briefly describe the middle-of-the-roaders' position on dividend policy.
Answer: Middle-of-the-roaders hold that a firm's value is not affected by its dividend policy.
Bloom's: Understand
66) Briefly explain how shareholders' returns are taxed twice in the United States.
Answer: Shareholders' returns are taxed at the corporate level as corporate tax. Distributions of
the remaining earnings are taxed a second time at the shareholders' level as either tax on
dividends tax or as capital gains tax.
Bloom's: Understand
67) Briefly describe an imputation tax system.
Answer: In an imputation tax system, shareholders are taxed on dividends, but they receive a tax
deduction, which is equal to their share of the corporate tax that the company has paid. This is
followed in Australia.
Bloom's: Understand
68) Briefly explain how shareholders are taxed twice in the United States by providing an
example.
Answer:
Operating Income $ 100

Corporate tax rate 30% 30
After-tax income (paid out as dividends) 70
Income tax paid by the investor at 15% 10.5
Income to shareholders 59.5
Difficulty: 3 Hard
Bloom's: Apply
69) Briefly explain how the imputation tax system works in Australia by providing an example.
Assume a 30 percent corporate tax rate and a 15 percent marginal tax rate for the investor.
Answer:
Operating Income $ 100

Corporate tax rate 30% 30
After-tax income (paid out
as dividends) 70
Grossed-up dividend 100
Income tax paid by the
investor at 15% 15
−30
Tax credit for corporate
−15
payment
Tax due from shareholder
Income to shareholders 85
Difficulty: 3 Hard
Bloom's: Apply
70) A retiree believes that investing in a nondividend paying growth firm, which requires the
periodic sale of stock for income, will eventually lead to a loss of all shares. Explain the flaw in
this logic.
Answer: A growth firm, by definition, will have an increasing share price. Over time, the firm
will either have stock splits to maintain a stock price within a certain trading range or the price
will go up substantially over time. In the case of stock splits, the retiree will get an ever
increasing number of shares. In the case of an increasing share price, the retiree will need to
liquidate a decreasing quantity of shares. In either case, the investor's investment will not
disappear any faster than it would through dividend payments.
Difficulty: 3 Hard
Bloom's: Understand

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Principles of Corporate Finance, 13e (Brealey)

Chapter 16 Payout Policy

2) Dividend policy changes are decided and announced by

I) the managers of a firm;

3) Which of these dates, when arranged in chronological order, occurs last?

6) Which of the following dividends are never in the form of cash?

7) The following statements are true of dividend reinvestment plans (DRIPs):

I) They are offered by the companies to their shareholders.

8) Firms can repurchase shares in the following ways:

I) open market repurchase;

9) A Dutch auction is the same as a(n)

10) The par value of the outstanding shares is known as

14) Which of the following are true?

I) Firms have long-run target dividend payout ratios.

16) Generally, firms engage in stock repurchases during

I) boom times as firms accumulate excess cash;

18) Generally, investors interpret the announcement of an increase in dividends as

20) Generally, investors view the announcement of an open-market repurchase program as

22) Miller and Modigliani's indifference proposition regarding dividend policy

I) Free cash flow is reliably positive.

$1,000/$110 = 9.09. 100 − 9.09 = 90.91 shares remain.

30) According to behavioral finance, investors prefer dividends because

(120 − 113)/0.7 = $10.

38) Dividend policy may affect firm value because

I) there is an unsatisfied clientele that prefer dividends to capital gains;

47) Many companies have automatic dividend reinvestment plans (DRIPs).

48) An equivalent alternative to paying cash dividends is to pay stock dividends.

50) Most firms have long-run target dividend payout ratios.

53) Managers try to avoid reducing their stock's dividend.

58) Briefly describe the sequence of events of a firm's dividend payment.

59) What is SEC Rule 10b-18?

61) What information does a share repurchase convey to investors?

62) Describe Miller and Modigliani's proposition on dividend irrelevance.

65) Briefly describe the middle-of-the-roaders' position on dividend policy.

67) Briefly describe an imputation tax system.

Operating Income $ 100

Operating Income $ 100

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