Can you please explain me questions 6 and 7 under section 17.6? To be honest I did not understand why the true value of the firm before the repurchase is $3000. I would assume that it is $2500 instead (since the share price before the repurchase was $25).

Chapter 17 Payout Policy 17.1 Distributions to Shareholders 1) The date on which the board authorizes the dividend is the A) declaration date. B) distribution date. C) record date. D) ex-dividend date. Answer: A Diff: 1 Skill: Definition 2) The firm will pay the dividend to all shareholders who are registered owners on a specific date, set by the board, called the A) declaration date. B) record date. C) distribution date. D) ex-dividend date. Answer: B Diff: 1 Skill: Definition 3) Anyone who purchases the stock on or after the ________ date will not receive the dividend. A) distribution B) record C) ex-dividend D) declaration Answer: C Diff: 1 Skill: Definition 4) The firm mails dividend checks to the registered shareholders on the A) ex-dividend date. B) declaration date. C) distribution date. D) record date. Answer: C Diff: 1 Skill: Definition 466 Berk/DeMarzo Corporate Finance 5) Which of the following statements is false? A) From an accounting perspective, dividends generally reduce the firm's current (or accumulated) retained earnings. B) The way a firm chooses between paying dividends and retaining earnings is referred to as its payout policy. C) Most companies that pay dividends pay them semi-annually. D) Occasionally, a firm may pay a one-time, special dividend that is usually much larger than a regular dividend. Answer: C Diff: 2 Skill: Conceptual 6) A firm can repurchase shares through a(n) ________ in which it offers to buy shares at a prespecified price during a short time period-generally within 20 days. A) tender offer B) open market share repurchases C) targeted repurchase D) Dutch auction share repurchase Answer: A Diff: 2 Skill: Definition 7) Another to method to repurchase shares is the ________, in which the firm lists different prices at which it is prepared to buy shares, and shareholders in turn indicate how many shares they are willing to sell at each price. A) tender offer B) Dutch auction share repurchase C) targeted repurchase D) open market share repurchases Answer: B Diff: 2 Skill: Definition Chapter 17 Payout Policy 467 8) A(n) ________ may occur if a major shareholder desires to sell a large number of shares but the market for the shares is not sufficiently liquid to sustain such a large sale without severely affecting the price. A) open market share repurchases B) Dutch auction share repurchase C) tender offer D) targeted repurchase Answer: D Diff: 2 Skill: Definition 9) A(n) ________ is the most common way that firms repurchase shares. A) targeted repurchase B) Dutch auction share repurchase C) tender offer D) open market share repurchases Answer: D Diff: 2 Skill: Definition 17.2 Comparison of Dividends and Share Repurchases 1) Which of the following statements is false? A) In perfect capital markets, holding fixed the investment policy of a firm, the firm's choice of dividend policy is irrelevant and does not affect the initial share price. B) In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend. C) In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the ex-dividend price if a dividend were paid instead. D) In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate either payout method on their own. Answer: C Diff: 1 Skill: Conceptual 468 Berk/DeMarzo Corporate Finance Use the information for the question(s) below. Omicron Technologies has $50 million in excess cash and no debt. The firm expects to generate additional free cash flows of $40 million per year in subsequent years and will pay out these future free cash flows as regular dividends. omicrons unlevered cost of capital is 10% and there are 10 million shares outstanding. Omicrons board is meeting to decide whether to pay out its $50 million in excess cash as a special dividend or to use it to repurchase shares of the firms stock. 2) Omicrons enterprise value is closest to: A) $500 million B) $900 million C) $450 million D) $400 million Answer: D Explanation: D) Enterprise Value = PV(Future FCF) = $40 = $400 million .10 Diff: 1 Skill: Analytical 3) Including its cash, Omicrons total market value is closest to: A) $500 million B) $900 million C) $400 million D) $450 million Answer: D Explanation: D) Enterprise Value - PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million Diff: 1 Skill: Analytical 4) Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. The amount of the special dividend is closest to: A) $5.00 B) $9.00 C) $4.00 D) $4.50 Answer: A Explanation: Diff: 1 Skill: Analytical A) Dividend = $50 million cash = $5 per share 10 million shares Chapter 17 Payout Policy 469 5) Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. The amount of the regular yearly dividends in the future is closest to: A) $4.50 B) $5.00 C) $4.00 D) $9.00 Answer: C Explanation: C) Dividend = $40 million free cash flow = $4 per share 10 million shares Diff: 1 Skill: Analytical 6) Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. Omicrons cum-dividend price is closest to: A) $50.00 B) $40.00 C) $5.00 D) $45.00 Answer: D Explanation: D) Enterprise Value - PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million Share price = Diff: 2 Skill: Analytical $450M Market value = = $45.00 10M shares outstanding 470 Berk/DeMarzo Corporate Finance 7) Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. Omicrons ex-dividend price is closest to: A) $40.00 B) $5.00 C) $50.00 D) $45.00 Answer: A Explanation: D) Enterprise Value - PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million However, once the $50 million in cash is used to pay the dividend, the new market value becomes $450 - $50 = $400 Million Share price = $400M Market value = = $40.00 10M shares outstanding Diff: 2 Skill: Analytical 8) Assume that Omicron uses the entire $50 million to repurchase shares. The number of shares that Omicron will repurchase is closest to: A) 1.0 million B) 1.2 million C) 1.1 million D) 0.9 million Answer: C Explanation: C) Enterprise Value - PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million Share price = $450M Market value = = $45.00 10M shares outstanding Number of shares repurchased = Diff: 2 Skill: Analytical $50M = 1,111,111 shares $45 Chapter 17 Payout Policy 471 9) Assume that Omicron uses the entire $50 million to repurchase shares. The number of shares that Omicron will have outstanding following the repurchase is closest to: A) 8.8 million B) 1.2 million C) 9.0 million D) 8.9 million Answer: D Explanation: C) Enterprise Value - PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million Share price = $450M Market value = = $45.00 10M shares outstanding Number of shares repurchased = $50M = 1,111,111 shares $45 Shares outstanding = 10 million - 1,111,111 = 8,888,889 shares Diff: 2 Skill: Analytical 10) Assume that Omicron uses the entire $50 million to repurchase shares. The amount of the regular yearly dividends in the future is closest to: A) $9.00 B) $5.00 C) $4.50 D) $4.00 Answer: C Explanation: A) Enterprise Value - PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million Share price = $450M Market value = = $45.00 10M shares outstanding Number of shares repurchased = $50M = 1,111,111 shares $45 Shares outstanding = 10 million - 1,111,111 = 8,888,889 shares Dividend = Diff: 3 Skill: Analytical $40 million free cash flow = $4.50 per share 8,888,889 shares 472 Berk/DeMarzo Corporate Finance 11) Assume that you own 2500 shares of Omicron stock and that Omicron uses the entire $50 million to repurchase shares. Suppose you are unhappy with Omicrons decision and would prefer that Omicron used the excess cash to pay a special dividend. The number of shares that you would have to sell in order to receive the same amount of cash as if Omicron paid the special dividend is closest to: A) 275 B) 310 C) 125 D) 250 Answer: A Explanation: A) Enterprise Value - PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million Share price = $450M Market value = = $45.00 10M shares outstanding Dividends that you wanted to receive = 2,500 shares $5 share = $12,500 Number of shares to sell = Diff: 3 Skill: Analytical $12,500 = 277.78 shares $45 per share Chapter 17 Payout Policy 473 12) Assume that you own 2500 shares of Omicron stock and that Omicron uses the entire $50 million to pay a special dividend. Suppose you are unhappy with Omicrons decision and would prefer that Omicron used the excess cash to repurchase shares. The number of shares that you would have to buy in order to undo the special cash dividend that Omicron paid is closest to: A) 125 B) 275 C) 250 D) 310 Answer: D Explanation: B) Enterprise Value - PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million However, once the $50 million in cash is used to pay the dividend, the new market value becomes $450 - $50 = $400 Million Share price = $400M Market value = = $40.00 10M shares outstanding Dividends that you did not want to receive = 2,500 shares $5 share = $12,500 Number of shares to sell = $12,500 = 312.50 shares $40 per share Diff: 3 Skill: Analytical 13) Assume that you own 4000 shares of Omicron stock and that Omicron uses the entire $50 million to repurchase shares. Suppose you are unhappy with Omicrons decision and would have preferred that Omicron used the excess cash to pay a special dividend. Detail exactly how you could create a homemade dividend that will provide you with the same combination of cash and stock that you would have received if Omicron paid the special dividend. Answer: What you have: Enterprise Value = PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million Share price = $450M Market value = = $45.00 4000 shares = $180,000 of stock. 10M shares outstanding What you want: Enterprise Value - PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million However, once the $50 million in cash is used to pay the dividend, the new market value becomes $450 - $50 = $400 Million 474 Berk/DeMarzo Corporate Finance Share price = Market value $400M = = $40.00 4,000 shares = $160,000 of stock shares outstanding 10M Dividends that you want to receive = 4,000 shares $5 share = $20,000 cash What you need to do: You have $180,000 in stock and want $160,000 in stock and $20,000 in cash, so you must sell $20,000 worth of stock. To accomplish this: Number of shares to sell = $20,000 = 444.44 shares $45 per share So by selling 444.44 shares you obtain the desired results. Diff: 3 Skill: Analytical 14) Assume that you own 4000 shares of Omicron stock and that Omicron uses the entire $50 million to pay a special dividend. Suppose you are unhappy with Omicrons decision and would have preferred that Omicron used the excess cash to repurchase stock. Detail exactly how you could undo the dividend in a way that will provide you with the same combination of cash and stock that you would have received if Omicron had not paid the special dividend. Answer: What you want: Enterprise Value = PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million Share price = $450M Market value = = $45.00 4000 shares = $180,000 of stock. 10M shares outstanding What you have: Enterprise Value = PV(Future FCF) = $40 = $400 million .10 Market value = Enterprise Value + cash = $400 + $50 = $450 million However, once the $50 million in cash is used to pay the dividend, the new market value becomes $450 - $50 = $400 Million Share price = $400M Market value = = $40.00 4,000 shares = $160,000 of stock 10M shares outstanding Dividends that you did not want to receive = 4,000 shares $5 share = $20,000 cash What you need to do: You have $160,000 in stock and $20,000 in cash and you want $180,000 in stock, so you must buy $20,000 worth of stock. To accomplish this: Chapter 17 Payout Policy 475 Number of shares to buy = $20,000 = 500 shares $40 per share So by buying 500 shares you obtain the desired results. Diff: 3 Skill: Analytical 17.3 The Tax Disadvantage of Dividends 1) Which of the following statements is false? A) Unlike with capital structure, taxes are not an important market imperfection that influence a firms decision to pay dividends or repurchase shares. B) If dividends are taxed at a higher rate than capital gains, which has been true until the most recent change to the tax code, shareholders will prefer share repurchases to dividends. C) Shareholders typically must pay taxes on the dividends they receive. They must also pay capital gains taxes when they sell their shares. D) But because long-term investors can defer the capital gains tax until they sell, there is still a tax advantage for share repurchases over dividends. Answer: A Diff: 1 Skill: Conceptual 2) Which of the following statements is false? A) When a firm pays a dividend, shareholders are taxed according to the dividend tax rate. If the firm repurchases shares instead, and shareholders sell shares to create a homemade dividend, the homemade dividend will be taxed according to the capital gains tax rate. B) When the tax rate on dividends exceeds the tax rate on capital gains, shareholders will pay lower taxes if a firm uses share repurchases for all payouts rather than dividends. C) Firms that use dividends will have to pay a lower after -tax return to offer their investors the same pre-tax return as firms that use share repurchases. D) The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all. Answer: C Diff: 2 Skill: Conceptual 476 Berk/DeMarzo Corporate Finance 3) Which of the following statements is false? A) While firms do still pay dividends, substantial evidence shows that many firms have recognized their tax disadvantage. B) The fact that firms continue to issue dividends despite their tax disadvantage is often referred to as the dividend puzzle. C) At the end of the 1990s dividend payments exceeded the value of repurchases for U.S. industrial firms. D) While evidence is indicative of the growing importance of share repurchases as a part of firms payout policies, it also shows that dividends remain a key form of payouts to shareholders. Answer: C Diff: 2 Skill: Conceptual Use the information for the question(s) below. The JRN Corporation will pay a constant dividend of $3 per share, per year, in perpetuity. Assume that all investors pay a 20% tax on dividends and that there is no capital gains tax. The cost of capital for investing in JRN stock is 12%. 4) The price of a share of JRNs stock is closest to: A) $20.00 B) $24.00 C) $25.00 D) $18.00 Answer: A Explanation: Diff: 1 Skill: Analytical A) Price = Dividend(1 - D) rE = $3.00(1 - .20) = $20.00 .12 Chapter 17 Payout Policy 477 5) Assume that management makes a surprise announcement that JRN will no longer pay dividends but will use the cash to repurchase stock instead. The price of a share of JRNs stock is now closest to: A) $20.00 B) $25.00 C) $18.00 D) $24.00 Answer: B Explanation: B) In a perfect capital market the dividend / repurchase decision does not impact firm value. Since the tax rate for repurchases is zero, the stock price would be the same as if the firm paid out the dividend and the dividends were not taxed, so: Price = Dividend $3.00 = = $25.00 .12 rE Diff: 2 Skill: Analytical 17.4 Dividend Capture and Tax Clienteles 1) Which of the following statements is false? A) Tax rates vary by income, by jurisdiction, and by whether the stock is held in a retirement account. Because of these differences, firms may attract different groups of investors depending on their dividend policy. B) While many investors have a tax preference for share repurchases rather than dividends, the strength of that preference depends on the difference between the dividend tax rate and the capital gains tax rate that they face. C) Long-term investors are more heavily taxed on capital gains, so they would prefer dividend payments to share repurchases. D) One-year investors, pension funds, and other non-taxed investors have no tax preference for share repurchases over dividends, they would prefer a payout policy that most closely matches their cash needs. Answer: C Diff: 2 Skill: Conceptual 478 Berk/DeMarzo Corporate Finance 2) Which of the following statements is false? A) Individuals in the highest tax brackets have a preference for stocks that pay high dividends, whereas tax-free investors and corporations have a preference for stocks with no or low dividends. B) To compare investor preferences, we must quantify the combined effects of dividend and capital gains taxes to determine an effective dividend tax rate for an investor. C) The dividend-capture theory states that absent transaction costs, investors can trade shares at the time of the dividend so that non-taxed investors receive the dividend. D) Differences in tax preferences create clientele effects, in which the dividend policy of a firm is optimized for the tax preference of its investor clientele. Answer: A Diff: 2 Skill: Conceptual 3) Consider the following equation: Pcum - Pex = Div 1 - d - g 1 - g The term Pcum is A) the personal tax rate for capital gains. B) the price per share after a dividend is paid. C) the price per share before a dividend is paid. D) the personal tax rate for dividend. Answer: C Diff: 1 Skill: Analytical 4) Consider the following equation: Pcum - Pex = Div 1 - d - g 1 - g The term g is A) the personal tax rate for dividend. B) the personal tax rate for capital gains. C) the price per share before a dividend is paid. D) the price per share after a dividend is paid. Answer: B Diff: 1 Skill: Analytical Chapter 17 Payout Policy 479 5) Consider the following equation: Pcum - Pex = Div 1 - d - g 1 - g The term Pex is A) the personal tax rate for dividend. B) the price per share before a dividend is paid. C) the price per share after a dividend is paid. D) the personal tax rate for capital gains. Answer: C Diff: 1 Skill: Analytical 6) Consider the following equation: Pcum - Pex = Div 1 - d - g 1 - g The term d is A) the price per share after a dividend is paid. B) the price per share before a dividend is paid. C) the personal tax rate for capital gains. D) the personal tax rate for dividend. Answer: D Diff: 1 Skill: Analytical 7) Which of the following equations is incorrect? d - g A) Pcum - Pex = Div 1 - 1 - g B) Pcum - Pex = Div 1 - d 1 - g d - g * C) d = 1 - g D) (Pcum - Pex )(1 - d ) = Div(1 - g ) Answer: D Explanation: Diff: 2 Skill: Analytical D) Correct formula (Pcum - Pex )(1 - g ) = Div(1 - d ) 480 Berk/DeMarzo Corporate Finance Use the information for the question(s) below. Consider the following tax rates: Year 1997-2000 2001-2002 2003- Capital Gains Rate 20% 20% 15% Ordinary Income Rate 40% 39% 35% Dividend Rate 40% 39% 15% *The current tax rates are set to expire in 2008 unless Congress extends them. The tax rates shown are for financial assets held for one year. For assets held less than one year, capital gains are taxed at the ordinary income tax rate (currently 35% for the highest bracket); the same is true for dividends if the assets are held for less than 61 days. 8) The effective dividend tax rate for a buy and hold individual investor in 2006 is closest to: A) 0% B) 35% C) 15% D) 20% Answer: C Explanation: C) d = 15%, g = 0% (Buy and Hold) d - g .15 - 0 * d = = = .15 1 - g 1 - 0 Diff: 1 Skill: Analytical 9) The effective dividend tax rate for a one-year individual investor in 2006 is closest to: A) 20% B) 15% C) 35% D) 0% Answer: D Explanation: D) d = 15%, g = 15% (one year) d - g .15 - .15 * d = = = 0 1 - g 1 - .15 Diff: 1 Skill: Analytical Chapter 17 Payout Policy 481 10) The effective dividend tax rate for a pension fund in 2006 is closest to: A) 20% B) 0% C) 25% D) 15% Answer: B Explanation: B) d = 0%, g = 0% (pension fund) d - g .15 - .15 * d = = = 0 1 - g 1 - .15 Diff: 1 Skill: Analytical 11) The effective dividend tax rate for a buy and hold individual investor in 1999 is closest to: A) 25% B) 0% C) 20% D) 40% Answer: D Explanation: D) d = 40%, g = 0% (buy and hold) d - g .40 - 0 * d = = = .40 1 - g 1 - 0 Diff: 2 Skill: Analytical 12) The effective dividend tax rate for a one-year individual investor in 1999 is closest to: A) 0% B) 20% C) 25% D) 40% Answer: C Explanation: C) d = 40%, g = 20% (one year) d - g .40 - .20 * d = = = .25 1 - g 1 - ..20 Diff: 2 Skill: Analytical 482 Berk/DeMarzo Corporate Finance 13) The effective dividend tax rate for a pension fund in 1999 is closest to: A) 40% B) 20% C) 0% D) 25% Answer: C Explanation: C) d = 0%, g = 0% (pension fund) d - g 0 - 0 * d = = = 0 1 - g 1 - 0 Diff: 2 Skill: Analytical 14) Using the available tax information for 2002, calculate the effective dividend tax rate for a: (1) one-year individual investor (2) buy and hold individual investor (3) pension fund Answer: (1) d = 39%, g = 20% (one year) d - g .39 - .20 * = = .2375 d = 1 - .20 1 - g (2) d = 39%, g = 0% (buy and hold) d - g .39 - 0 * d = = = .39 1 - g 1 - 0 (3) d = 0%, g = 0% (pension fund) d - g 0 - 0 * d = = = 0 1 - g 1 - 0 Diff: 2 Skill: Analytical Chapter 17 Payout Policy 483 17.5 Payout Versus Retention of Cash 1) Which of the following statements is false? A) In perfect capital markets, buying and selling securities is a zero-NPV transaction, so it should not affect firm value. B) Making positive-NPV investments will create value for the firm's investors, whereas saving the cash or paying it out will not. C) In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm's choice of payout versus retention is irrelevant and does not affect the initial share price. D) After adjusting for investor taxes, there remains a substantial tax advantage for the firm to retain excess cash. Answer: D Diff: 1 Skill: Conceptual 2) Which of the following statements is false? A) A firm must therefore balance the tax costs of holding cash with the potential benefits of having to raise external funds in the future. B) Paying out excess cash through dividends or share repurchases can boost the stock price by reducing managers' ability and temptation to waste resources. C) If there is a reasonable likelihood that future earnings will be insufficient to fund future positive-NPV investment opportunities, a firm may start accumulating cash to make up the difference. D) According to the managerial entrenchment theory of payout policy, managers pay out cash only when pressured to do so by the firm's investors. Answer: A Diff: 2 Skill: Conceptual 3) Which of the following formulas is incorrect? (1 - i )(1 - g ) A) *retain = 1 - (1 - c) B) Pretain = Div (1 - d ) rf (1 - i ) C) Pretain = Pcum (1 - c)(1 - g) (1 - i) D) Pretain = Pcum (1 - *retain) Answer: A Explanation: Diff: 2 Skill: Analytical A) *retain = 1 - (1 - C)(1 - g ) (1 - i) 484 Berk/DeMarzo Corporate Finance 4) Consider the following equation: Pretain = Pcum (1 - c)(1 - g ) (1 - i) The term i in this equation represents A) the corporations tax rate on interest income. B) the investors tax rate on capital gains. C) the investors tax rate on interest income. D) the investors tax rate on cumulative dividends. Answer: C Diff: 1 Skill: Analytical 5) Consider the following equation: Pretain = Pcum (1 - c)(1 - g ) (1 - i) The term Pretain in this equation represents A) the price of the stock if it retains and invests the cash. B) the percentage of net income retained or reinvested back into the firm. C) the percentage of net income paid out as a cash dividend. D) the price of the stock if it retains cash to use in a share repurchase. Answer: A Diff: 1 Skill: Analytical 6) Consider the following equation: Pretain = Pcum (1 - c)(1 - g ) (1 - i) The term c in this equation represents A) the corporations tax rate on interest income. B) the investors tax rate on interest income. C) the investors tax rate on cumulative dividends. D) the investors tax rate on capital gains. Answer: A Diff: 1 Skill: Analytical Chapter 17 Payout Policy 485 Use the information for the question(s) below. Luther Industries has $5 million in excess cash and 1 million shares outstanding. Luther is considering investing the cash in one-year treasury bills that are currently paying 5% interest, and then using the cash to pay a dividend next year. Alternatively, Luther can pay the cash out as a dividend immediately and the shareholders can invest in the treasury bills themselves. Assume that capital markets are perfect. 7) If Luther invests the excess cash in treasury bills, then the dividend per share next year will be closest to: A) $5.00 B) $5.25 C) $4.75 D) $1.05 Answer: B Explanation: B) $5M (1.05) = $5,250,000 / 1,000,000 shares = $5.25 Diff: 1 Skill: Analytical 8) If Luther decides to pay the dividend immediately the dividend per share will be closest to: A) $1.05 B) $5.25 C) $5.00 D) $4.75 Answer: C Explanation: Diff: 1 Skill: Analytical C) $5,000,000 / 1,000,000 shares = $5.00 486 Berk/DeMarzo Corporate Finance Use the information for the question(s) below. Consider the following tax rates: Year 1997-2000 2001-2002 2003- Corporate Tax Rate 35% 35% 35% Capital Gains Rate 20% 20% 15% Ordinary Income Rate 40% 39% 35% Dividend Rate 40% 39% 15% *The current tax rates are set to expire in 2008 unless Congress extends them. The tax rates shown are for financial assets held for one year. For assets held less than one year, capital gains are taxed at the ordinary income tax rate (currently 35% for the highest bracket); the same is true for dividends if the assets are held for less than 61 days. 9) In 2006, Luther Incorporated paid a special dividend of $5 per share for the 100 million shares outstanding. If Luther has instead retained that cash permanently and invested it into treasury bills earning 6%, then the present value of the additional taxes paid by Luther would be closest to: A) $35 million B) $290 million C) $175 million D) $585 million Answer: C Explanation: C) PV = cash rf Tc = $5 100M shares .35 = $175 million rf Diff: 2 Skill: Analytical 10) The effective tax disadvantage for retaining cash in 2006 is closest to: A) 14.75% B) 12.50% C) 35.00% D) 15.00% Answer: D Explanation: Diff: 2 Skill: Analytical (1 - c)(1 - g ) (1 - .35)(1 - .15) * D) retain = 1 - = 1 - = .15 (1 - i ) (1 - .35) Chapter 17 Payout Policy 487 11) The effective tax disadvantage for retaining cash in 2002 is closest to: A) 15.00% B) 14.75% C) 30.00% D) 35.00% Answer: B Explanation: (1 - c)(1 - g ) (1 - .35)(1 - .20) * B) retain = 1 - = 1 - = .1475 (1 - i ) (1 - .39) Diff: 2 Skill: Analytical 12) The effective tax disadvantage for retaining cash in 2000 is closest to: A) 15.00% B) 13.35% C) 14.75% D) 35.00% Answer: B Explanation: (1 - C)(1 - g ) (1 - .35)(1 - .20) * B) retain = 1 - = 1 - = .13333 (1 - i ) (1 - .40) Diff: 2 Skill: Analytical Use the information for the question(s) below. Iota Industries is an all-equity firm with 50 million shares outstanding. Iota has $200 million in cash and expects future free cash flows of $75 million per year. Management plans to use the cash to expand the firms operations, which in turn will increase future free cash flows by 12%. Iotas cost of capital is 10% and assume that capital markets are perfect. 13) The value of Iota if they use the $200 million to expand is closest to: A) $825 million B) $688 million C) $840 million D) $950 million Answer: C Explanation: Diff: 2 Skill: Analytical C) value = $75(1.12) = $840 million .10 488 Berk/DeMarzo Corporate Finance 14) The value of Iota if they not to use the $200 million to expand and hold the cash instead is closest to: A) $840 million B) $825 million C) $950 million D) $688 million Answer: C Explanation: A) value = $75 = $750 million + $200 million cash = $950 million .10 Diff: 2 Skill: Analytical 15) The price per share of Iota if they use the $200 million to expand is closest to: A) $13.75 B) $16.50 C) $19.00 D) $16.80 Answer: D Explanation: D) Value = $75(1.12) = $840 million .10 Price per share = $840 million = $16.80 50 million shares Diff: 2 Skill: Analytical 16) The price per share of Iota if they not to use the $200 million to expand and hold the cash instead is closest to: A) $16.50 B) $16.80 C) $19.00 D) $13.75 Answer: C Explanation: C) Value = $75 = $750 million + $200 million cash = $950 million .10 Price per share = Diff: 2 Skill: Analytical $950 million = $19.00 50 million shares Chapter 17 Payout Policy 489 17) The NPV of Iotas expansion project is closest to: A) -$110 million B) -$137.5 million C) $0 D) $75 million Answer: A Explanation: A) NPV = -200 + $75(.12) = -$110 million .10 Diff: 2 Skill: Analytical 18) A member of Iotas board of directors suggests that Iotas stock price would be higher if they used the $200 million to repurchase shares instead of funding the expansion. If you were advising the board, what course of action would you recommend, expansion or repurchase? Which provides the higher stock price? Answer: Value with expansion: $75(1.12) Value = = $840 million .10 Price per share = $840 million = $16.80 50 million shares Value with repurchase (since capital markets are perfect we know that the stock price with the repurchase will be identical to the stock price before the repurchase takes place): $75 Value = = $750 million + $200 million cash = $950 million .10 Price per share = $950 million = $19.00 50 million shares The other way to show that the expansion is a bad idea is to calculate the NPV of the project: $75(.12) = -$110 million NPV = -200 + .10 So, you should recommend that they use the cash for a share repurchase. Diff: 3 Skill: Analytical 490 Berk/DeMarzo Corporate Finance 19) Suppose that Iota is able to invest the $200 million in excess cash into a project that will increase future free cash flows by 30% If you were advising the board, what course of action would you recommend, investing the $200 million in an expansion project that will raise future free cash flows by 30% or use the $200 million to repurchase shares? Which provides the higher stock price? Answer: Value with expansion: $75(1.30) = $975 million Value = .10 Price per share = $975 million = $19.50 50 million shares Value with repurchase (since capital markets are perfect we know that the stock price with the repurchase will be identical to the stock price before the repurchase takes place): $75 Value = = $750 million + $200 million cash = $950 million .10 Price per share = $950 million = $19.00 50 million shares The other way to show that the expansion is a good idea is to calculate the NPV of the project: $75(.30) = $25 million NPV = -200 + .10 So, you should recommend that they invest in the expansion project that offers the 30% increase in FCF. Diff: 2 Skill: Analytical Chapter 17 Payout Policy 491 Use the information for the question(s) below. Consider the following tax rates: Year 1997-2000 2001-2002 2003- Corporate Tax Rate 35% 35% 35% Capital Gains Rate 20% 20% 15% Ordinary Income Rate 40% 39% 35% Dividend Rate 40% 39% 15% *The current tax rates are set to expire in 2008 unless Congress extends them. The tax rates shown are for financial assets held for one year. For assets held less than one year, capital gains are taxed at the ordinary income tax rate (currently 35% for the highest bracket); the same is true for dividends if the assets are held for less than 61 days. 20) Calculate the effective tax disadvantage for retaining cash in 1999, 2001, and 2005. (1 - c)(1 - g ) (1 - .35)(1 - .20) * Answer: 1999: retain = 1 - = 1 - = .13333 (1 - i) (1 - .40) (1 - c)(1 - g ) (1 - .35)(1 - .20) * 2001: retain = 1 - = 1 - = .1475 (1 - i) (1 - .39) (1 - c)(1 - g ) (1 - .35)(1 - .15) * 2005: retain = 1 - = 1 - = .15 (1 - i) (1 - .35) Diff: 2 Skill: Analytical 17.6 Signaling with Payout Policy 1) Which of the following statements is false? A) Firms adjust dividends relatively infrequently, and dividends are much less volatile than earnings. This practice of maintaining relatively constant dividends is called dividend signaling. B) When a firm increases its dividend, it sends a positive signal to investors that management expects to be able to afford the higher dividend for the foreseeable future. C) The average size of the stock price reaction increases with the magnitude of the dividend change, and is larger for dividend cuts. D) When managers cut the dividend, it may signal that they have given up hope that earnings will rebound in the near term and so need to reduce the dividend to save cash. Answer: A Diff: 2 Skill: Conceptual 492 Berk/DeMarzo Corporate Finance 2) Which of the following statements is false? A) If firms smooth dividends, the firm's dividend choice will contain information regarding management's expectations of future earnings. B) Because of the increasing popularity of repurchases, firms cut dividends much more frequently than they increase them. C) Announcing a share repurchase today does not necessarily represent a long-term commitment to repurchase shares. D) While cutting the dividend is costly for managers in terms of their reputation and the reaction of investors, it is by no means as costly as failing to make debt payments. Answer: B Diff: 2 Skill: Conceptual 3) Which of the following statements is false? A) Managers are much less committed to dividend payments than to share repurchases. B) Share repurchases are a credible signal that the shares are under -priced, because if they are over-priced a share repurchase is costly for current shareholders. C) While an increase of a firm's dividend may signal management's optimism regarding its future cash flows, it might also signal a lack of investment opportunities. D) Managers will clearly be more likely to repurchase shares if they believe the stock to be under-valued. Answer: A Diff: 2 Skill: Conceptual Chapter 17 Payout Policy 493 Use the information for the question(s) below. Rockwood Industries has 100 million shares outstanding, a current share price of $25, and no debt. Rockwoods management believes that the shares are under-priced, and that the true value is $30 per share. Rockwood plans to pay $250 million in cash to its shareholders by repurchasing shares. Management expects that very soon new information will come out that will cause investors to revise their opinion of the firm and agree with Rockwoods assessment of the firms true value. 4) If Rockwood is able to repurchase shares prior to the market becoming aware of the new information regarding Rockwoods true value, then the number of shares outstanding following the repurchase is closest to: A) 92 million B) 10 million C) 75 million D) 90 million Answer: D Explanation: D) Number of shares repurchased = $250 Million Cash = 10 million shares $25 per share So, total shares outstanding after repurchase = 100 million initial - 10 million repurchased = 90 million remaining. Diff: 1 Skill: Analytical 5) Assume that Rockwood is not able to repurchase shares prior to the market becoming aware of the new information regarding Rockwoods true value. If Rockwood repurchases the shares following the release of the new information, then the number of shares outstanding following the repurchase is closest to: A) 92 million B) 90 million C) 75 million D) 10 million Answer: A Explanation: A) Number of shares repurchased = $250 Million Cash = 8,333,333 shares $30 per share So, total shares outstanding after repurchase = 100,000,000 million initial - 8,333,333 repurchased = 91,666,667 total shares outstanding Diff: 1 Skill: Analytical 494 Berk/DeMarzo Corporate Finance 6) Assume that Rockwood is able to repurchase shares prior to the market becoming aware of the new information regarding Rockwoods true value. After the repurchase, and following the release of the new information regarding the true value of Rockwood, the firms share price is closest to: A) $30.00 B) $31.50 C) $28.75 D) $30.60 Answer: D Explanation: D) Number of shares repurchased = $250 Million Cash = 10 million shares $25 per share So, total shares outstanding after repurchase = 100 million initial - 10 million repurchased = 90 million remaining. True value of the firm before repurchase = $30 100 million shares = 3,000 million. True value after repurchase = $3,000 million - $250 million in cash spent on repurchase = $2,750 million $2,750M Price per share = = $30.56 90M shares Diff: 2 Skill: Analytical 7) Assume that Rockwood is not able to repurchase shares prior to the market becoming aware of the new information regarding Rockwoods true value. After the release of the new information regarding the true value of Rockwood, and following the repurchase, the firms share price is closest to: A) $30.00 B) $30.60 C) $28.75 D) $31.50 Answer: A Explanation: A) Number of shares repurchased = $250 Million Cash = 8,333,333 shares $30 per share So, total shares outstanding after repurchase = 100,000,000 million initial - 8,333,333 repurchased = 91,666,667 total shares outstanding True value of the firm before repurchase = $30 100 million shares = 3,000 million. True value after repurchase = $3,000 million - $250 million in cash spent on repurchase = $2,750 million $2,750M Price per share = = $30.00 91,666,667 Diff: 2 Skill: Analytical Chapter 17 Payout Policy 495 8) Calculate Rockwoods stock price following the market becoming aware of the new information regarding Rockwoods true value, if (1) Rockwood completed the repurchase prior to the market becoming aware of the information and (2) Rockwood completed the repurchase following the market becoming aware of the new information. Answer: (1) Rockwood completed the repurchase prior to the market becoming aware of the information $250 Million Cash = 10 million shares Number of shares repurchased = $25 per share So, total shares outstanding after repurchase = 100 million initial - 10 million repurchased = 90 million remaining. True value of the firm before repurchase = $30 100 million shares = 3,000 million. True value after repurchase = $3,000 million - $250 million in cash spent on repurchase = $2,750 million $2,750M Price per share = = $30.56 90M shares (2) Rockwood completed the repurchase following the market becoming aware of the new information $250 Million Cash = 8,333,333 shares Number of shares repurchased = $30 per share So, total shares outstanding after repurchase = 100,000,000 million initial - 8,333,333 repurchased = 91,666,667 total shares outstanding True value of the firm before repurchase = $30 100 million shares = 3,000 million. True value after repurchase = $3,000 million - $250 million in cash spent on repurchase = $2,750 million $2,750M Price per share = = $30.00 91,666,667 Diff: 3 Skill: Analytical 17.7 Stock Dividends, Splits, and Spin-offs 1) Which of the following statements is false? A) Stocks generally trade in lots of 1000 shares, and in any case do not trade in units less than one share. B) Non-cash special dividends are commonly used to spin off assets or a subsidiary as a separate company. C) The typical motivation for a stock split is to keep the share price in a range thought to be attractive to small investors. D) If a company declares a 10% stock dividend, each shareholder will receive one new share of stock for every 10 shares already owned. Answer: A Diff: 1 Skill: Conceptual 496 Berk/DeMarzo Corporate Finance 2) Which of the following statements is false? A) With a stock dividend, a firm does not pay out any cash to shareholders. As a result, the total market value of the firm's assets and liabilities, and therefore of its equity, is unchanged. B) If the price of the stock falls too low, a company can engage in a reverse split and reduce the number of shares outstanding. C) Stock dividends of 50% or higher are generally referred to as stock splits. D) Rather than pay a dividend using cash or shares of its own stock, a firm can also distribute shares of a subsidiary in a transaction referred to as a off-shoot. Answer: D Diff: 1 Skill: Conceptual Use the information for the question(s) below. Luther Industries currently has 5 million shares outstanding and it stock is currently trading at $40 per share. 3) Assuming Luther issues a 25% stock dividend, then Luthers new share price is closest to: A) $24.00 B) $30.00 C) $16.00 D) $32.00 Answer: D Explanation: D) New share price = $40 = $32 1.25 Diff: 1 Skill: Analytical 4) Assuming Luther issues a 5:2 stock split, then Luthers new share price is closest to: A) $32.00 B) $16.00 C) $24.00 D) $30.00 Answer: B Explanation: Diff: 2 Skill: Analytical B) New share price = $40 = $16 5 2 Chapter 17 Payout Policy 497 5) Assuming Luther issues a 5:2 stock split, then the number of shares Luther will have outstanding following the split is closest to: A) 25.0 million B) 12.5 million C) 2.0 million D) 16.0 million Answer: B Explanation: A) New share price = $40 = $16 5 2 B) shares outstanding following split = current shares outstanding split 5 = 5 million = 12.5 million 2 Diff: 1 Skill: Analytical 6) Delta Products has decided to spin-off one of its subsidiaries, Gamma Technologies. Each Delta shareholder will receive 0.125 shares of Gamma for each share of Delta they own. Deltas price is $35.00 cum-dividend and immediately after the spin-off Gamma Technologies was trading for $24.00 per share. In a perfect capital market, what would Delta Products ex -dividend share price be after this transaction? Answer: The value of the special dividend is: 0.125 Gamma shares $24.00 per share = $3.00 So we expect Deltas stock price to drop by $3.00 per share. So final stock price = $35.00 - $3.00 = $32.00 Diff: 2 Skill: Analytical