Choc-lattes Corp. earned $5.00 per share in 2009, and paid a dividend of $2.00 per share. If it earns

$5.50 in 2010 and follows a constant payout ratio policy, its dividend will be

a.	$3.30
b.	$3.00
c.	$2.20
d.	$2.00

1. Which of the following is NOT an example of unsystematic risk? a. IBM posts lower than expected earnings. b. Intel announces record earnings. c. The national trade deficit is higher than expected. d. None of the above. ANS: 2. Which of the following is NOT an example of systematic risk? a. IBM posts lower than expected earnings. b. The Fed raises interest rates unexpectedly. c. The rate of inflation is higher than expected. d. None of the above. ANS: 3. What is one of the most important lessons from capital market history? a. Risk does not matter. b. There is a positive relationship between risk and return. c. You are always better off investing in stock. d. T-bills are the highest yielding investment. ANS: 4. What is the purpose of diversification? a. Lower the overall risk of your portfolio. b. Increase the risk of your portfolio. c. Maximize possible returns. d. None of the above. ANS: 5. If we are able to eliminate all of the unsystematic risk in a portfolio then, what is the result? a. a risk-free portfolio b. a portfolio that contains only systematic risk c. a portfolio that has an expected return of zero d. such a portfolio cannot be constructed since there will always be unsystematic risk in any portfolio ANS: Risk and Return S1 For Question 6 - 8, use the chart below. Year Stock A 15% 25% 8% 16% 5% 1 2 3 4 5 6. Return Stock B 12% 14% 9% 25% 3% Stock C 5% -6% 10% 1% 15% What is the average return for stock C? ANS: 7. What is the standard deviation (or risk) of returns for stock C? ANS: 8. What is the coefficient of variation for stock C? ANS: 9. The additional return offered by a more risky investment relative to a safer one is called a. the risk-free rate. b. the risky return. c. the risk premium. d. the insurance premium. ANS: 10. Which statements are TRUE regarding risk and return? Statement I: Statement II: Statement III: Diversification is the process of removing systematic risk from a portfolio. In general, the greater the risk, the greater the return required by an investor. Investors should focus on real returns if they are concerned about the purchasing power of their wealth. a. Statement I only b. Statements I and III only c. Statements II and III only d. Statements I and II only ANS: Risk and Return S-2 TopicDividend Policy MULTIPLE CHOICE 1. If managers make dividend decisions only after taking all positive-NPV projects, they are following a. a constant payout ratio policy b. a low-regular-and-extra policy c. a constant nominal payment policy d. a residual payment policy ANS: D 2. Choc-lattes Corp. earned $5.00 per share in 2009, and paid a dividend of $2.00 per share. If it earns $5.50 in 2010 and follows a constant payout ratio policy, its dividend will be a. $3.30 b. $3.00 c. $2.20 d. $2.00 ANS: 3. Choc-lattes Corp. earned $5.00 per share in 2009, and paid a dividend of $2.00 per share. If it earns $5.50 in 2010 and maintains its $2.00 dividend, its payout ratio will be a. 60% b. 40% c. 64% d. 36% ANS: 4. Amazing Growth Company shares currently trade at $108 per share. There are 24 million shares outstanding. If the shares are split 3-for-1, how many shares will be outstanding, and what value per share will they have (ignoring any other market changes)? a. 8 million shares; $324 per share b. 8 million shares; $36 per share c. 48 million shares; $54 per share d. 72 million shares; $36 per share ANS: D NARRBEGIN: Bavarian Brewhouse Div. Bavarian Brewhouse Dividend Bavarian Brewhouse had earnings per share of $2.50 in 2009 and paid out a dividend per share of $1.45 that same year. Earnings per share are expected to be $3.25 in 2010. NARREND 5. What was Bavarian Brewhouse's dividend payout ratio in 2009? a. .58 b. .62 c. .35 2 Topic - Dividend Policy Topic - Dividend Policy 2 d. .42 ANS: A 1.45/2.50 = .58 6. If Bavarian Brewhouse follows a constant nominal dividend policy what will be the dividend per share in 2010? a. $1.45 b. $2.59 c. $2.12 d. $3.25 ANS: A 7. If Bavarian Brewhouse follows a constant payout ratio dividend policy, what will be the dividend per share in 2010? a. $1.45 b. $1.89 c. $2.12 d. $3.25 ANS: B d = 1.45/2.50 = .58 DPS = 3.25(.58) = $1.89 8. You own stock in a company that just announced a 3-1 stock split. If shares currently trade at $15 a share, what should the stock price be after the stock split? a. $15 b. $5 c. $45 d. $30 ANS: B 15/3 = 5 9. You own stock in a company that just announced a 1-3 reverse stock split. If shares currently trade at $15 a share, what should the stock price be after the reverse stock split? a. $15 b. $5 c. $45 d. $30 ANS: C 15(3) = 45 10. Bavarian Brewhouse had aftertax earnings of $1,500,000 in 2009. The company needs $2,500,000 for new investments and plans to finance 60% of those investments with debt. If Bavarian Brew follows a residual dividend policy, what total dividend will be paid? a. $1,500,000 b. $500,000 c. $2,500,000 ANS: d. $0 B ANS: B Topic - Dividend Policy 3 amount of debt to be raised: 2,500,000(.6) = 1,500,000 equity needed: 1,000,000 amount available for dividends = 1,500,000 - 1,000,000 = 500,000 11. Smith Enterprises reports earnings per share for 2009 of $3.75 and dividends per share for the same year of $1.65. What is Smith's dividend payout ratio? a. 44% b. 56% c. 36% d. 64% ANS: A 1.65/3.75 = .44 12. Smith Enterprises reports earnings per share for 2009 of $3.75 and dividends per share for the same year of $1.65. What percentage of earnings will be kept in the company as retained earnings? a. 44% b. 56% c. 32% d. 68% ANS: B 1.65/3.75 = .44 retention = 1-.44 = .56 13. Smith Enterprises just paid a 10% stock dividend. If the market price of the stock was $18 per share before the stock dividend, what do you expect it to be afterwards? a. $18.00 b. $16.36 c. $19.80 d. $17.20 ANS: B 18/(1+.1) = 16.36 14. Smith Enterprises declares a 4-1 stock spilt. If you own 600 shares of Smith stock, how many share do you own after the split? a. 600 b. 150 c. 2400 d. 1200 ANS: C 600(4) = 2400 15. Smith Enterprises declares a 1-4 reverse stock split. If you own 600 shares of Smith stock, how many shares do you own after the split? a. 600 b. 150 c. 2400 d. 1200 ANS: B 4 Topic - Dividend Policy Topic - Dividend Policy 4 600/4 = 150 16. The board of directors of Smith Enterprises announced a dividend of $1.75 per share on August 2. The dividend will be paid out to all shareholders of record as of August 10. If you bought 100 shares of Smith Enterprises stock on August 10, how much dividend are you going to receive? a. $0 b. $175 c. $1.75 d. $350 ANS: A since you bought on the holder of record date you are not eligible for dividend payments 17. The board of directors of Smith Enterprises announced a dividend of $1.75 per share on August 2. The dividend will be paid out to all shareholders of record as of August 10. If you bought 100 shares of Smith Enterprises stock on August 3, how much total dividend are you going to receive? a. $0 b. $1.75 c. $175 d. $350 ANS: C 1.75(100) = 175 18. A firm's dividend policy refers to all of the following except to its choice of a. whether to pay shareholders a cash dividend. b. how large the cash dividend should be. c. how frequently a cash dividend should be distributed. d. who should receive a cash dividend. ANS: D 19. Which of the following are methods to distribute cash to shareholders? a. cash dividends b. stock dividends c. share repurchases d. a and c ANS: D 20. CashOut, Inc. has a current share price of $50. If CashOut plans to pay a $1 dividend, then if we ignore the effect of taxes we would expect the price of CashOut shares to change by what amount on the ex dividend date? a. no change since prices will reflect dividend payments on the announcement date b. a drop of $1 c. an increase of $1 d. no change since prices are not a function of cash paid to investors ANS: B Topic - Dividend Policy 5 21. You notice that a company has consistently paid a dividend of $.20 per quarter except for the quarter one year ago when it paid $.52 when it had an unusually high level of earnings that the company did not believe was going to be sustainable into the future. Such a pattern is most indicative of what kind of dividend policy? a. constant payout ratio dividend policy b. constant nominal payout dividend policy c. target dividend payout ratio dividend policy d. low-regular-and-extra policy dividend policy ANS: D 22. Which of the following firms is most likely to pay out a larger portion of their earnings to shareholders? a. a small company b. a mature company c. a young company d. a growth company ANS: B 23. A firm has just instituted a regular dividend for the first time in its history. That action might be interpreted in the market as a. a signal the it believes that it will be able to permanently sustain the future dividends b. a signal that its growth opportunity set might be slowing c. a signal that it is a high quality firm d. all of the above ANS: D Topic - Dividend Policy 6 1. If a firm increases its use of financial leverage, then what would we generally expect for the shareholders of that firm to a. lower their demand for return on their investment. b. remain indifferent with respect to their return on investment. c. increase their demand for return on their investment. d. it is not possible to tell what will happen. ANS: 2. Firm X plans to increase its financial leverage by issuing debt and using the proceeds to repurchase equity. If you assume that the Modigliani and Miller assumptions hold then the effect of this increasing financial leverage transaction should a. increase the market value of Firm X's shares. b. have no effect on the market value of Firm X's shares. c. decrease the market value of Firm X's shares. d. it is not possible to tell what will happen. ANS: 3. Which statement is TRUE regarding a firm that increases financial leverage? a. Average earnings per share increases, while shareholder risk increases. b. Average earnings per share increases, while shareholder risk decreases. c. Average earnings per share decreases, while shareholder risk decreases. d. Average earnings per share decreases, while shareholder risk increases. ANS: 4. From the information below, select the optimal capital structure for Minnow Entertainment Company. a. b. c. d. e. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00. ANS: **5. A consultant has collected the following information regarding Young Publishing: Total assets Operating income (EBIT) expense Interest $3,000 $800 million $0 million Tax rate Debt ratio WACC 40% 0% 10% Topic - Dividend Policy 7 2 Topic - Capital Structure Net income Share price $480 million $32.00 M/B ratio EPS = DPS 1.00 $3.20 The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). Young's stock price can be calculated by simply dividing earnings per share by the required return on equity capital, which currently equals the WACC because the company has no debt. The consultant believes that the company would be much better off if it went to a capital structure of 40% debt and 60% equity. After meeting with investment bankers, the consultant concludes that the company could issue $1,200 million of debt at a beforetax cost of 7%, leaving the company with interest expense of $84 million. The $1,200 million raised from the debt issue would be used to repurchase stock at $32 per share. The repurchase will have no effect on the firm's EBIT; however, after the repurchase, the cost of equity will increase to 11%. If the firm follows the consultant's advice, what will be its estimated stock price after the capital structure change? a. b. c. d. e. $32.00 $33.48 $31.29 $32.59 $34.72 ANS : E Step 1: Find the current number of shares outstanding: Shares = NI/EPS = $480 million/$3.20 = 150 million shares. Step 2: Find the number of shares after the repurchase: New shares = 150 - $1,200/$32 = 150 - 37.5 = 112.5 million shares. Step 3: Find the new EPS after the repurchase: EPS = [(EBIT - INT)(1 - T)]/New shares = [($800 - $84) 0.6]/112.5 = $3.818667. Step 4: Find the new stock price: Stock price = EPS/New WACC = $3.818667/0.11 = $34.72. 6. Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20% debt and 80% equity. (Its D/E ratio is 0.25.) The risk-free rate is 6% and the market risk premium is 5%. Currently the company's cost of equity is 12% and its tax rate is 40%. What would be Simon's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity? a. b. c. d. e. 14.35% 30.00% 14.72% 15.60% 13.64% Topic - Dividend Policy 8 Topic 12 - Capital Structure 3 ANS: A Facts given: rs = 12%; D/E = 0.25; rRF = 6%; RPM = 5%; T = 40%. Step 1: Step 2: Step 3: Step 4: Find the firm's current levered beta using the CAPM: rs = rRF + RPM(b) 12%= 6% + 5%(b) b = 1.2. Find the firm's unlevered beta using the Hamada equation: b = bU[1 + (1 - T)(D/E)] 1.2 = bU[1 + (0.6)(0.25)] 1.2 = 1.15bU 1.0435 = bU. Find the new levered beta given the new capital structure using the Hamada equation: b = bU[1 + (1 - T)(D/E)] b = 1.0435[1 + (0.6)(1)] b = 1.6696. Find the firm's new cost of equity given its new beta and the CAPM: rs = rRF + RPM(b) rs = 6% + 5%(1.6696) rs = 14.35%. Topic - Dividend Policy 9 . If a firm increases its use of financial leverage, then what would we generally expect for the shareholders of that firm to a. lower their demand for return on their investment. b. remain indifferent with respect to their return on investment. c. increase their demand for return on their investment. d. it is not possible to tell what will happen. ANS: 2. Firm X plans to increase its financial leverage by issuing debt and using the proceeds to repurchase equity. If you assume that the Modigliani and Miller assumptions hold then the effect of this increasing financial leverage transaction should a. increase the market value of Firm X's shares. b. have no effect on the market value of Firm X's shares. c. decrease the market value of Firm X's shares. d. it is not possible to tell what will happen. ANS: 3. Which statement is TRUE regarding a firm that increases financial leverage? a. Average earnings per share increases, while shareholder risk increases. b. Average earnings per share increases, while shareholder risk decreases. c. Average earnings per share decreases, while shareholder risk decreases. d. Average earnings per share decreases, while shareholder risk increases. ANS: 4. From the information below, select the optimal capital structure for Minnow Entertainment Company. a. b. c. d. e. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00. ANS: **5. A consultant has collected the following information regarding Young Publishing: Total assets Operating income (EBIT) Interest expense $3,000 million $800 million $0 million Tax rate Debt ratio WACC 40% 0% 10% Topic - Dividend Policy 10 2 Topic - Capital Structure Net income Share price $480 million $32.00 M/B ratio EPS = DPS 1.00 $3.20 The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). Young's stock price can be calculated by simply dividing earnings per share by the required return on equity capital, which currently equals the WACC because the company has no debt. The consultant believes that the company would be much better off if it went to a capital structure of 40% debt and 60% equity. After meeting with investment bankers, the consultant concludes that the company could issue $1,200 million of debt at a beforetax cost of 7%, leaving the company with interest expense of $84 million. The $1,200 million raised from the debt issue would be used to repurchase stock at $32 per share. The repurchase will have no effect on the firm's EBIT; however, after the repurchase, the cost of equity will increase to 11%. If the firm follows the consultant's advice, what will be its estimated stock price after the capital structure change? a. b. c. d. e. $32.00 $33.48 $31.29 $32.59 $34.72 ANS : E Step 1: Find the current number of shares outstanding: Shares = NI/EPS = $480 million/$3.20 = 150 million shares. Step 2: Find the number of shares after the repurchase: New shares = 150 - $1,200/$32 = 150 - 37.5 = 112.5 million shares. Step 3: Find the new EPS after the repurchase: EPS = [(EBIT - INT)(1 - T)]/New shares = [($800 - $84) 0.6]/112.5 = $3.818667. Step 4: Find the new stock price: Stock price = EPS/New WACC = $3.818667/0.11 = $34.72. 6. Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20% debt and 80% equity. (Its D/E ratio is 0.25.) The risk-free rate is 6% and the market risk premium is 5%. Currently the company's cost of equity is 12% and its tax rate is 40%. What would be Simon's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity? a. b. c. d. e. 14.35% 30.00% 14.72% 15.60% 13.64% Topic - Dividend Policy 11 Topic 12 - Capital Structure 3 ANS: A Facts given: rs = 12%; D/E = 0.25; rRF = 6%; RPM = 5%; T = 40%. Step 1: Step 2: Step 3: Step 4: Find the firm's current levered beta using the CAPM: rs = rRF + RPM(b) 12%= 6% + 5%(b) b = 1.2. Find the firm's unlevered beta using the Hamada equation: b = bU[1 + (1 - T)(D/E)] 1.2 = bU[1 + (0.6)(0.25)] 1.2 = 1.15bU 1.0435 = bU. Find the new levered beta given the new capital structure using the Hamada equation: b = bU[1 + (1 - T)(D/E)] b = 1.0435[1 + (0.6)(1)] b = 1.6696. Find the firm's new cost of equity given its new beta and the CAPM: rs = rRF + RPM(b) rs = 6% + 5%(1.6696) rs = 14.35%