Reading 47: Dividends and Share Repurchases: Basics-LOS a 习 2011, including, expected, regular, company

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Session 11: Corporate Finance
Reading 47: Dividends and Share Repurchases: Basics

LOS a: Explain regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder's wealth and a company's financial ratios.

 

 

A periodic payment to shareholders in the form of additional shares of stock instead of cash is a:

A) stock dividend

B) dividend reinvestment plan

C) stock repurchase

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Stock dividends are dividends paid out in new shares of stock instead of cash. Unlike stock dividends, dividend reinvestment plans are at the discretion of individual shareholders. In the case of stock repurchases, the company is buying back shares so the number of shares in the investment public’s hands is declining.

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Paying a cash dividend is most likely to result in:

A) an increase in liquidity ratios.

B) the same impact on liquidity and leverage ratios as a stock dividend.

C) an increase in financial leverage ratios.

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A cash dividend will increase leverage ratios such as debt-to-equity and debt-to-assets, reflecting a decrease in the denominator. A cash dividend should decrease liquidity ratios such as the current ratio and cash ratio, due to the decrease in cash in the numerator. Unlike a cash dividend, a stock dividend or a stock split has no impact on liquidity or financial leverage ratios.

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Financial managers utilize stock splits and stock dividends because they perceive that:

A) investors will double the share price if there is a 20% stock dividend.

B) an optimal trading range exists.

C) brokerage fees paid by shareholders will be reduced.

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Although there is little empirical evidence to support the contention, there is nevertheless a widespread belief in financial circles that an optimal price range exists for stocks. “Optimal” means that if the price is within this range, the price/earnings ratio, price/sales and other relevant ratios will be maximized. Hence, the value of the firm will be maximized.

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Stock splits:

A) are less common than stock dividends.

B) do not in and of themselves affect firm value.

C) increase firm value.

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Stock splits divide up each existing share into multiple shares. The price of each share will drop correspondingly to the number of shares created, so there is no change in the owner’s wealth. Empirical research has shown that in the absence of a dividend yield increase, the stock price falls to the stock split ratio of the original price (i.e., to 25% of the original price in a 4-for-1 stock split). This makes sense, given that the investor’s percentage ownership of the company has not changed.