rgonzalez

Which of the following statements regarding dividend policies is CORRECT?

A) Companies using a longer-term residual dividend policy pay a steady dividend based on long-term forecast of their capital budget.

B) A constant payout ratio approach is likely to result in a lower risk premium assigned to a company by investors.

C) Companies following a dividend stability policy seek to pay a constant dollar amount per share over a long period of time.

---

Companies following a longer-term residual dividend approach forecast their capital budget over a longer time frame (5–10 years). Leftover earnings over this period are allocated as dividends and paid out in relatively equal amounts each year. The other statements are incorrect. With a stable dividend policy, companies seek to increase their dividend each year at a constant rate. A constant payout approach means that dividends will vary in proportion with earnings, likely resulting in volatile dividends and a higher risk premium.

rgonzalez

Which of the following dividend policies would a firm with long-term excess cash flows most likely use? A share repurchase program:

A) and no payout of dividends.

B) in conjunction with a residual dividend model.

C) and a growing dividend model.

---

The residual dividend model allows firms to pay out dividends only if more earnings are available than are needed to support the optimal capital budget. Because dividend payouts can be unstable, a firm can supplement a low, stable dividend with a share repurchase program or with an extra dividend when times are good. Stock repurchases allow management to distribute cash without signaling information about future earnings. Abnormally good years could be followed with the purchase of shares, while selling shares would provide liquidity during temporary cash shortages.

rgonzalez

Belden Engineering Corporation (BEC) is considering a share repurchase program. David Gudzanski, the firm’s executive vice president prepares a memo to the board of directors detailing reasons why a share repurchase would be favorable at this time. Reasons listed in the memo are as follows:
Reason 1: The resulting capital structure from the share repurchase would be more favorable for investors in BEC’s bonds.
Reason 2: BEC’s stock is currently selling at $37 in the marketplace. Our discounted cash flow analysis values the company at $48 per share.
Reason 3: The share repurchase could be used to offset dilution caused by the exercise of employee stock options.
Reason 4: BEC can use the repurchase to send a signal to investors that management has a positive future outlook for the company.
Reason 5: The share repurchase could be used to implement a residual dividend policy while diminishing the potential increase in perceived risk that such a policy would cause for investors.
Which of Gudzanki’s reasons in favor of the share repurchase is most accurate?

A) Reasons 2 and 3 only.

B) Reasons 2, 3, 4, and 5.

C) Reasons 1 and 3 only.

---

A share repurchase would decrease the percentage of equity in a firm’s capital structure, which would in turn increase the percentage of debt. An increase in debt would add more leverage to the firm which would be negative for the firm’s bondholders. The other reasons listed are all rationales for a share repurchase.

rgonzalez

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) Disgruntled stockholders are forced to sell their shares, improving management's position.

C) Management can distribute cash to shareholders without signaling about future earnings.

---

A repurchase gives stockholders a choice. They can sell or not sell.

rgonzalez

The following information is from the 10-k of Laura’s Chocolates, Inc.(LC), a maker of nut-based toffees.

Cash	25,000,000
Share price	40.00
Shares outstanding (prior to transaction)	20,000,000

LC decides to spend $20 million repurchasing common stock. What is the value of a share of stock after the share repurchase?

A) 40.00.

B) 35.00.

C) 45.00.

---

rgonzalez

Pearl City Breweries has 8 million shares outstanding that are currently trading at $34 per share. The company is choosing whether to distribute $22 million as dividends or to use the same amount to repurchase its shares. Ignoring tax effects, what will be the amount of total wealth from owning one share of Pearl City Breweries under each of these alternatives?

Cash dividend

Share repurchase

A) $34.00 $34.00

B) $31.25 $37.00

C) $31.25 $34.00

---

If the company pays a cash dividend, the dividend per share will be $22 million/8 million = $2.75. The value of its shares will be:

So the total wealth from owning one share will be $31.25 + $2.75 = $34.00.
If the company repurchases shares, it can buy $22 million/$34 = 647,058 shares. The value of one share would then be:

If you remember that both a cash dividend and a share repurchase for cash leave shareholder wealth unchanged, this question does not require calculations of the amounts.

rgonzalez

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.

---

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.

rgonzalez

Which of the following statements about differences observed in payout trends in US and Europe is most accurate?

A) A higher proportion of US companies pay dividends as compared to their European counterparts.

B) A lower proportion of US companies pay dividends as compared to their European counterparts.

C) The percentage of companies making stock repurchases has been trending downwards both in the US and Europe.

---

A lower proportion of US companies pay dividends as compared to their European counterparts. The percentage of companies making stock repurchases has been trending upwards in the US (since 1980s), the UK and continental Europe (since 1990s).

rgonzalez

Dan Bridges, head of equity strategies for Paca Inc. a consultant to institutional investors makes the following statement:
Globally, the developed markets have seen a decline in dividend payout ratios over time. Lately, we have also seen an increase in the proportion of companies engaging in share repurchases.
Bridges’ statement is most likely:

A) Incorrect as to dividend payout ratios.

B) Incorrect as to companies engaging in share repurchases.

C) Correct.

---

Bridges’ statement is correct.

rgonzalez

Grommetco produces plastic insulators for the electrical appliance industry. Excerpts from Grommetco’s financial results for 2010 are as follows:

Net Income (earnings)	$10
Free Cash Flow to Equity	$8
Dividends Paid	$1
Stock Repurchases	$3

Which of the following statements is most accurate? Grommetco’s:

A) dividend payout ratio is 0.4.

B) FCFE coverage ratio is 2.0.

C) dividend coverage ratio is 2.5.

---

Dividend coverage ratio = Net Income / Dividends = $10 / $1 = 10.
FCFE coverage ratio = FCFE / (dividends + share repurchases) = $8 / ($1 + $3) = 2.0.
Dividend payout ratio = Dividends / Net Income = $1 / $10 = 0.1.