JoeyDVivre

Last year, Calfee Multimedia had earnings of $4.00 per share and paid a dividend of $0.30. In the current year, the company expects to earn $5.20 per share. Calfee has a 30% target payout ratio. If the expected dividend for this year is $0.39, what time period is Calfee most likely using in order to bring its dividend up to the target payout?

A) 4 years.

B) 8 years.

C) 3 years.

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The formula to determine the expected dividend in a target payout approach is:
Expected dividend = (previous dividend) + [(expected increase in EPS) × (target payout ratio) × (adjustment factor)], where the adjustment factor is 1 / number of years over which the adjustment will take place.
Using the numbers given:
$0.39 = $0.30 + [($5.20 - $4.00) × (0.30) × (1 / n)]
$0.39 = $0.30 + [($1.20) × (0.30) × (1 / n)]
$0.09 = $0.36 × (1 / n)
0.25 = (1 / n)
n = 4

JoeyDVivre

David Drakar and Leslie O’Rourke both own 100 shares of stock in a German corporation that makes €1.00 per share in pre-tax income. The corporation pays out all of its income as dividends. Drakar is in the 30% individual tax bracket while O’Rourke is in the 40% individual tax bracket. The tax rate applicable to the corporation is 30%. Drakar and O’Rourke live in the United Kingdom, which uses an imputation tax system for corporate dividends. What is the effective tax rate on the dividend for each shareholder, assuming no effects from the exchange rate?

Drakar

O’Rourke

A) 40% 48%

B) 30% 40%

C) 38% 44%

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Under an imputation tax system, taxes are paid at the corporate level, but are attributed to the shareholder, so that all taxes are effectively paid at the shareholder rate.

JoeyDVivre

International Pulp, a Swiss-based paper company, has annual pretax earnings (in Swiss francs) of SF 600. The corporate tax rate on retained earnings is 55%, and the corporate tax rate that applies to earnings paid out as dividends is 30%. Furthermore, International Pulp pays out 30% of its earnings as dividends, and the individual tax rate that applies to dividends is 40%.
What is the effective tax rate on corporate earnings paid out as dividends?

A) 70%.

B) 48%.

C) 58%.

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This is an example of a split-rate corporate tax system. The calculation of the effective tax rate on a Swiss franc of corporate income distributed as dividends is based on the corporate tax rate for distributed income.

The effective tax rate on income distributed as dividends = 30% + [(1 − 30%) × 40%] = 58%.

JoeyDVivre

Laura’s Chocolates Inc. (LC) is a maker of nut-based toffees. LC is considering a cash dividend, but is concerned about the “double taxation” effect on their shareholders. If the corporate tax rate is 35%, and the tax on dividends is 20%, what is the effective tax rate on a dollar of corporate earnings?

A) 55%.

B) 48%.

C) 42%.

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0.35 + (1 − 0.35)(0.20) = 48%

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.

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

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 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

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

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.