JoeyDVivre

David Johnson, Karim Baghwani, and Marlon Fitzpatrick are equity research associates at Carp National Investments. Over lunch in the cafeteria, they began discussing the information content of dividends. Baghwani made the following statements to his colleagues:
Statement 1: There is no doubt that shareholders perceive changes in dividend policy as conveying important information about the firm. However, it is viewed differently in the U.S. and in Japan. In the U.S., investors infer that even a small change in a dividend sends a major signal about a company’s prospects.
Statement 2: In Japan, however, investors are less likely to assume that even a large change in dividend policy signals anything about a company’s prospects. Thus, Japanese companies are more free to increase and decrease their dividends than their U.S. counterparts without concerns over investor reactions. With respect to Baghwani's statements:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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Both statements are correct. In the U.S., investors infer that even small changes in a dividend send a major signal about a company’s future prospects. However, in Asian countries such as Japan, investors are less likely to assume that even a large change in dividend policy signals anything about a company’s future prospect.

JoeyDVivre

Faltys Asset Management (FAM) follows a dividend growth investment strategy. The Faltys Dividend Growth Fund only invests in companies that have a dividend yield greater than the S&P 500 and have the potential to increase that dividend each year at a rate that exceeds inflation. Warren Berlin, Director of Marketing for FAM has been developing a presentation book to present the fund to prospective clients. These prospective clients include retired individuals who want dividend income and trust companies who manage trust accounts which provide income to be distributed to beneficiaries. Which of the following dividend theories best describes the investment strategy and the marketing strategy of the fund?

Investment Strategy

Marketing Strategy

A) Stable dividend Clientele effect

B) Signaling effect Bird-in-the-hand

C) Bird-in-the-hand Modigliani and Miller

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The investment strategy would best be described as a stable dividend strategy. A stable dividend policy means that a company’s dividend payout is aligned with company’s long-term growth rate such that there is stability in the rate of increase for the dividend. The marketing strategy would best be described as the clientele effect. Berlin is pursuing specific groups of investors that prefer dividends. Note that the bird-in-in-the-hand theory states that investors prefer the certainty of dividends now to uncertain capital gains in the future, while Modigliani and Miller proposed that dividend policy has no impact on the price of a firm’s stock.

JoeyDVivre

According to the “clientele effect” of dividend policy, which of the following groups is most likely to be attracted to low dividend payouts?

A) High-income individual investors.

B) Corporations exempt from taxes on 85% of dividend income.

C) Tax exempt pension funds.

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High-income individuals in high tax brackets would prefer capital gains over dividends as they have the greatest benefit from deferral of taxes.

JoeyDVivre

Which of the following statements about dividend policy and capital structure is most accurate?

A) Investors view a stock repurchase as a positive signal and a stock issue as a negative signal.

B) A person who believes in the clientele effect and a proponent of the "bird-in-hand" theory would have similar views on dividend payout policy.

C) Monte Carlo simulation is used to estimate market risks; scenario analysis measures stand-alone risk.

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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. The clientele effect suggests that different groups of investors want different dividend levels (often based on tax status), and through the law of supply and demand, investors will select companies that meet their needs. Thus, dividend payout policy does not matter. 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).

JoeyDVivre

The clientele effect predicts that investors with high marginal tax rates and low desire for current income will be attracted to companies whose dividend policies promote:

A) low levels of share repurchase.

B) low dividends levels.

C) low reinvestment of earnings.

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The clientele effect states that companies with low dividends will attract a clientele of investors with high marginal tax rates and low desires for current income.

JoeyDVivre

Dividend payments are least likely to be associated with:

A) increased agency conflict between bondholders and managers.

B) increased agency conflict between bondholders and shareholders.

C) increased agency conflict between shareholders and managers.

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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.
A dividend payment is not usually associated with an increase in agency conflict between bondholders and managers, but can be.

JoeyDVivre

Which of the following is most likely to prompt a company to increase dividend payments? A company’s management foresees:

A) an immediate lack of profitable investment opportunities.

B) reduced availability of credit in the market.

C) continued volatility of the company's earnings.

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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.

JoeyDVivre

Tecnolotronix is an equipment manufacturer in a volatile, cyclical industry that employs a long-term residual dividend approach. A surprise increase in quarterly profits would be most likely to have which of the following immediate effects on the actual measured payout ratio?

A) A decrease in the ratio.

B) An increase in the ratio.

C) No change in the ratio.

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If a profit increase is seen by management to be a temporary increase, it is unlikely to prompt an increase in the level of dividend payout: a firm using the long-term residual dividend approach would not generally raise dividends in response to a short-run profit increase. Since the payout ratio is calculated as Dividend / Earnings, and earnings have temporarily increased, the calculated payout ratio should fall in the short term.

JoeyDVivre

Which of the following would be least likely to prompt a decline in a company’s overall payout ratio?

A) A decrease in the capital gains tax rate.

B) A permanent decrease in company profitability.

C) An increase in interest rates.

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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

JoeyDVivre

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) shareholders are primarily tax-exempt institutions.

C) flotation costs are high.

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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.