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

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

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

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

At a recent conference, “Dividends − Are They Increasing?”, several lecturers were discussing the signaling effect and their opinions on how changes in a company’s dividend policy are often viewed by investors. Linda Travis, an equity analyst at Girthmore Capital Management and one of the guest lecturers at the conference, made the following observations:
Observation 1: A dividend initiation is always viewed as a positive signal by investors. It is an indication that the company has so much cash at its disposal that it can afford to pay it out to shareholders.
Observation 2: A dividend decrease is typically a positive signal by a company’s management to its shareholders. It indicates that management has a variety of positive NPV projects in its capital budget and would like to finance as many of them as possible with retained earnings.
With respect to Travis' observations:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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A dividend initiation is often viewed differently by different investors. On one hand, a dividend initiation could mean that a company is sharing its wealth with shareholders – a positive signal. On the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities – a negative signal. Dividend decreases or omissions are typically negative signals that current and future earnings prospects are not good and that management does not think the current dividend payment can be maintained.

JoeyDVivre

In a recent lecture at a seminar titled “Dividends – Do They Really Matter?”, Matthew Janowski, CFA, made the following two statements regarding the information content in dividend policy changes across countries:
Statement 1: In the U.S., investors infer that small changes in dividends do not send a major signal about a company’s future prospects to existing and potential shareholders.
Statement 2: In Asian countries such as Japan, investors are unlikely to assume that even a large change in dividend policy signals anything about a company’s future prospect.
With respect to Janowski's statements:

A) only one is correct.

B) both are correct.

C) both are incorrect.

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The information content in dividend policy changes is viewed differently across countries. In the U.S., investors infer that even small changes in a dividend send a major signal about a company’s future prospects. Thus, Statement 1 is incorrect. 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. As a result, Asian companies are freer to raise and lower their dividends as circumstances change without concerns over how investor reactions may affect the stock price. Therefore, Statement 2 is correct.

JoeyDVivre

One year ago, Makato Omura purchased a 6.50% fixed coupon bond for 98.50. Recently, she sold the bond for 99.25 and calculated her return at 7.4%. Her friend, Takanino Takemiya, CFA, reminds Omura that this is the nominal return and that to calculate the real return, she needs to factor in the inflation rate over the holding period. If the price index for the current year is 118.5 and the price index one year ago was 115.9, Omura’s real return is closest to:

A) 9.6%.

B) 6.3%.

C) 5.2%.

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Omura’s real return is approximated by subtracting the inflation rate from the calculated (nominal) return. The inflation rate is calculated using the formula:Inflation = (Price Indexthis year – Price Indexlast year) / Price Indexlast year
Here, inflation = (118.5 – 115.9) / 115.9 = 0.0224, or approximately 2.2%.
Thus, the real return = 7.4% - 2.2% = 5.2%.

JoeyDVivre

According to Modigliani and Miller’s dividend irrelevancy theory, an investor in a firm that does not pay a dividend can still earn a “dividend” on that company by:

A) contacting the firm and asking for a dividend payment.

B) selling a portion of the company's stock each year.

C) buying additional shares each year.

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Miller and Modigliani’s dividend irrelevancy theory states that shareholders can in theory construct their own dividend policy. If a firm does not pay dividends, a shareholder who wants a 4% dividend can “create” it by selling 4% of his or her stock. Note that Modigliani and Miller’s theory does not allow for transaction costs or taxes. In actuality, shareholders will have to pay a brokerage commission on the sale and tax on any capital gains.

JoeyDVivre

In a world with taxes and brokerage costs:

A) dividend policy may be relevant.

B) Modigliani and Miller say that dividend policy is irrelevant.

C) Modigliani and Miller say that dividend policy is relevant.

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Modigliani and Miller assume a world without taxes and transaction costs. They (correctly) claim that the validity of their theory should be judged on empirical tests, not the realism of their assumptions. Myron Gordon and John Lintner have championed the “bird-in-the-hand” theory, which gives greater value to firms with high dividend yields because investors perceive dividends to be less risky than capital gains.

JoeyDVivre

If Modigliani and Miller’s dividend irrelevancy theory is correct, what is the impact on a firm’s cost of capital and share price if its dividend payout increases?

Cost of Capital

Share Price

A) An increase A decrease

B) None None

C) None A decrease

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If investors do not consider dividends to be relevant, the dividend payout will not affect the required rate of return. If the required rate of return does not change, the value of a firm will be unchanged despite the change in its dividend payout rate.