Session 22:Post Class tests

  1. Dividends, at least for US companies, are often described as “sticky”. Which of the following do we mean when we say that dividends are sticky?
  2. Companies are reluctant to pay dividends
  3. Companies are reluctant to change dividends per share
  4. Companies are reluctant to change dividend payout ratios
  5. Companies are reluctant to change dividend yield
  6. None of the above
  7. In the last three decades, US companies have shifted away from paying dividends to stock buybacks. Which of the following offers the best explanation for why this may have happened?
  8. Dividends are taxed at much higher rates, relative to capital gains.
  9. The proportion of stock held by institutional investors has increased.
  10. Transactions costs for trading equity have decreased
  11. Companies feel much less secure or certain about future earnings
  12. Investors are more short term than they used to be.
  13. Looking at history, which of the following best characterizes the relationship between dividends and earnings.
  14. Dividend increases tend to lead earnings increases, i.e., they happen before earnings increases
  15. Dividend increase contemporaneously with earnings
  16. Dividends increases lag earnings increases
  17. The dividend payout ratio measures the proportion of net income paid out in dividends. A company that pays out more than its earnings as dividends has a payout ratio greater than 100%. Under which of the following scenarios might this occur?
  18. A firm that is shrinking its asset base (by selling businesses)
  19. A cyclical firm during a recession year
  20. A company paying a special dividend (a one time dividend)
  21. All of the above
  22. None of the above
  23. Assume that you are looking at company that operates in a market where investors pay a 40% tax rate on dividends and only 20% in capital gains. The company’s stock trades at $20/share today and has an annual dividend of $1/share. If tomorrow is the ex-dividend day, what would you expect the stock price to be at the end of the day?
  24. $19/share
  25. $19.25/share
  26. $20/share
  27. $20.75/share
  28. $21/share
  29. None of the above
  30. Dividends are more certain that capital gains and are hence more valuable.
  31. True
  32. False

Session 20: Post class test solutions

  1. b. Companies are reluctant to change dividends per share. Companies try to maintain their dividends per share over time. They change dividends infrequently, and when they do, it is more likely to be an increase than a decrease.
  2. d. Companies feel much less secure or certain about future earnings. The tax disadvantage associated with dividends has actually decreased over the last three decades and the link between transactions costs or short termism with dividend policy is not clearly established.
  3. c. Dividend increases lag earnings increases. Companies tend to wait to make sure that earnings increases are sustainable before paying dividends.
  4. d. All of the above. Declining firms can sell assets and use the proceeds to pay more than their earnings as dividends. Cyclical firms tend to pay dividends based on average earnings over a cycle, which implies that dividends can be higher than earnings during the down cycle. Special dividends may represent cash accumulated in prior years and thus can push the dividend payout ratio over 100%.
  5. b. $19.25. The stock price will drop on the ex dividend day. The magnitude of the drop can be computed by taking the following ratio:

Price drop as % = (1- tax rate on dividends)/ (1- tax rate on capital gains)

= (1-.40) / (1-.20) = .75 or 75%

Since the dividend is $1.00, the price drop is $0.75.

  1. False. The comparison should not be between dividends today and capital gains in the future but capital gains today, since the stock price drops when the dividend is paid. Thus, if the company did not pay a dividend, I could sell the stock today at the higher price but if it does, I receive the dividend and a lower price today.