Concept Checkers

1. The Board of Directors of Sarkel Systems Corporation is considering approving an 8-for-5 stock split for the company's common stock. The company currently has 1.5 million shares outstanding, and EPS for the prior year were $0.60. The company intends to maintain a 50% payout ratio. The company's stock price is currently $40 per share. Sarkel's CFO provided a memo to the board to help them with their decision of whether to approve the dividend. The memo contained the following statements:

(1) The stock price after the split will be $25 per share.

(2) The company's dividend yield after the split will be 1.2%.

(3) After the split, the company's price-to-earnings ratio will remain 4l.7x earnings.

How many of the statements are correct?

2. Studdard Controls (STU) recently declared a quarterly dividend of $1.25 payable on Thursday, April 25, to holders of record on Friday, April 12. What is the last day an investor could purchase STU stock and still receive the quarterly dividend?

Use the following information to answer Questions 3 through 5.

Klaatu is a country that taxes dividends based on a double-taxation system. The corporate tax rate on company profits is 35%. Barada is a country that taxes dividends based on a split-rate tax system. The corporate tax rate applied to retained earnings is 36%, while the corporate tax rate applied to earnings paid out as dividends is 20%. Nikto is a country that taxes dividends based on an imputation tax system. The corporate tax rate on earnings is 38%.

3. An investor living in KJaatu holds 100 shares of stock in the Lucas Corporation. Lucas' pretax earnings for the current year are $2.00 per share, and the company has a payout ratio of 100%. The investor's individual tax rate on dividends is 30%. The effective tax rate on a dollar of funds to be paid out as dividends is closest to:

4. An investor living in Barada holds 100 shares of Prowse, Inc. Prowse's pre-tax earnings in the current year are $1.00 per share, and Prowse pays dividends based on a target payout ratio of 40%. The individual tax rate that applies to dividends is 28%, and the individual tax rate that applies to capital gains is 15%. The effective tax rate on earnings distributed as dividends is:

5. Jenni White and Janet Langhals arc each shareholders that live in Nikto, and each owns 100 shares of OCP, Inc., which has €1.00 per share in net income. OCP pays out 100% of its earnings as dividends. White is in the 25% tax bracket, while Langhals is in the 42% tax bracket. The effective tax rate on earnings paid out as dividends is:

6. Nick Adams is recommending to the Board of Directors that they share the profits from an excellent year (totaling $56 million) with shareholders by either declaring a special cash dividend of $20 million, or using the $20 million to repurchase shares of Volksberger common stock in the open market. Selected financial information about the firm is shown below.

Shares outstanding: 40 million

Current stock price: $28.00

52-week trading range: $20.00 to $36.00

Book value of equity: $880 million

After-tax cost of borrowing: 5.5%

Adams drafts a memo to the Board of Directors detailing the financial impact of declaring a special cash dividend versus repurchasing shares. His memo includes two statements:

(1) The total shareholder wealth resulting from owning one share of stock with the special dividend option will increase to $28.50.

(2) Our company's P/E ratio after the share buyback will remain the same as before the buyback.

Which of Adams' statements are correct?

A. Both statements are correct.

B. Only one of the statements is correct.

C. Neither statement is correct.

7. Which of the following would not be a good reason for a company to repurchase shares of its own stock? Management:

A. believes a stable cash dividend is in the best interests of shareholders.

B. believes its stock is overvalued.

C. wants to increase the amount of leverage in its capital structure.

8. Arizona Seafood, Inc., plans $45 million in new borrowing to repurchase 3,600,000 shares at their market price of $12.50. The yield on the new debt will be 12%. The company has 36 million shares outstanding and EPS of $0.60 before the repurchase. The company's tax rate is 40%. The company's EPS after the share repurchase will be closest to:

9. Northern Financial Co. has a BVPS of $5.00. The company has announced a $15 million share buyback. The share price is $60 and the company has

40 million shares outstanding. After the share repurchase, the company's BVPS will be closest to:

10. Which of the following factors would encourage a company to maintain a high dividend payout ratio?

A. The double-taxation system is in place in the company's home country.

B. Most of the shares in the company are held by income-oriented mutual funds.

C. The company's debt covenants require an interest coverage ratio of at least 2.Ox.

11. Two public companies, one based in the United States and one based in Japan, unexpectedly announce decreases in the regular quarterly dividends on their common shares. What is the most likely reaction of the two firms' share prices?

A. Both shares decrease.

B. Only US shares decrease.

C. Only Japanese shares increase.

12. Firms that use a residual dividend model are least likely to:

A. determine their optimal capital budgets.

B. issue common stock to maintain the dividend payout schedule.

C. determine the amount of equity needed to meet the capital budget.

13. If a firm follows a residual dividend policy and has an optimal capital budget that will require the use of all this year's earnings, the firm would most likely pay:

A. no dividends to common stockholders.

B. dividends financed by borrowing the money.

C. dividends but only out of past retained earnings.

14. The dividend preference theory is based on the idea that:

A. rs = D|/P0 + g is constant for any dividend policy.

B. a decrease in current dividends signals that future earnings will fall.

C. because of perceived differences in risk, investors value a dollar of dividends more highly than a dollar of expected capital gains.

Srudy Session 8

Cross-Reference to CFA Institute Assigned Reading #30— Dividends and Dividend Policy

15. An analyst gathered the following information about a company's investment plan:

• Target capital structure is 70% debt and 30% equity.

If the company follows a residual dividend policy, the portion of its net income it will pay out as dividends this year is closest to:

16. An analyst gathered the following information about a company's investment budget:

• Expected net income of $800,000 during rhe next year.

• Target and current capital structure is 40% debt and 60% common equity.

• Optimal capital budget for next year is $1.2 million.

If the company uses the residual dividend model to determine next year's dividend payout, the company payout is closest to:

17. Last year, Wolverine Shoes and Boots had earnings of $4.00 per share and paid a dividend of $0.20. In rhe current year, the company expects to earn $4.40 per share. The company has a 30% target payout ratio and plans to bring its dividend up to the target payout ratio over an 8-year period. Nexr year's expected dividend is closest to:

18. A company has provided the following financial data:

Target capital structure is 50% debt and 50% equity. • After-tax cost of debt is 8%.

Cost of retained earnings is estimated to be 13.5%.

Cost of equity is estimated to be 14.5% if the company issues new common stock.

Net income is $2,500.

The company is considering the following investment projects: Project Size of project 1RR of project

If the company follows a residual dividend policy, its payout ratio will be closest to:

19. The Board of Directors at Saturn Networks, a company specializing in computer hardware, is considering implementing the firm's first annual dividend. Saturn currently trades at a price per share of $77.76, which is a P/£ ratio of 18 times its current earnings. The cost of equity applied to the firm is 14%, and the company is growing at a constant rate of 11% per year. The directors on Saturn's board believe that a dividend payout of 30% will reduce the marker's perceived risk of the firm, and the cost of equity will go down to 12.5%. The firm's growth rate is expected to remain the same. Two of the board members make statements about the impact of the dividend initiation on the firm. • Statement 1: The P/E ratio based on next year's earnings will increase by

• Statement 2: The price of the stock next year based on the newly calculated P/E ratio and next year's earnings should be $96.00 per share.

Are rhe statements made by the board members accurate?

A. Both statements are correct.

B. Only one of the statements is correct.

C. Neither statement is correct.

20. Bee Heaven management believes the company's stock is undervalued at $50 a share and is interested in repurchasing three million shares. Which of the following share repurchasing methods is Bee Heaven least likely to consider?

A. Make a tender offer to repurchase three million shares at $55-

B. Contact major shareholders and buy large blocks of shares.

C. Declare a reverse split that will reduce shares outstanding by three million

Project A $1,000

Project B $1,200

Project C $1,200

Project D $1,200

Project E $1,000

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