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*** Level I
Question 1: If a firm adheres strictly to the residual dividend
policy, then if its optimal capital budget requires the use of
all earnings for that year (along with new debt according to the
optimal debt/total assets ratio), the firm should pay
a) none of these answers are correct.
b) dividends by borrowing the money (debt).
c) dividends, in effect, out of a new issue of common stock.
d) no dividends except out of past retained earnings.
e) no dividends to common stockholders.
Question 2: Which of the following statements is most correct?
a) If your company has established a clientele of investors who
prefer large dividends, the company is unlikely to adopt a
residual dividend policy.
b) None of these statements are correct.
c) All of these statements are correct.
d) If a firm follows a residual dividend policy, holding all else
constant, its dividend payout will tend to rise whenever the
firm's investment opportunities improve.
e) The tax code encourages companies to pay large dividends to
their shareholders.
Question 3: Which of the following statements best describes the
theories of investors' preferences for dividends?
a) One key advantage of a residual dividend policy is that it
enables a company to follow a stable dividend policy.
b) The tax preference theory suggests that a company can increase
its stock price by increasing its dividend payout ratio.
c) The clientele effect suggests that companies should follow a
stable dividend policy.
d) The bird-in-hand theory suggests that a company can reduce its
cost of equity capital by reducing its dividend payout ratio.
e) Modigliani and Miller argue that investors prefer dividends to
capital gains.
Question 4: In the real world, dividends ________.
a) are usually set as a fixed percentage of earnings
b) are usually changed every year to reflect earnings changes
c) usually exhibit greater stability than earnings
d) tend to be a lower percentage of earnings for mature firms
e) fluctuate more widely than earnings
Answer 1: e
Rationale & Reference:
The residual dividend model is a model in which the dividend paid
is set equal to the actual earnings minus the amount of retained
earnings necessary to finance the firm's optimal capital budget.
A firm follows 4 steps when using this model:
1. The optimal capital budget is determined.
2. The amount of equity needed to finance that budget, given its
target capital structure, is determined.
3. Retained earnings are used to meet equity requirements to the
extent possible.
4. Dividends are paid only if more earnings are available than
are needed to support the optimal capital budget.
As long as the firm finances with the optimal mix of debt and
equity, and provided it uses only internally generated equity
(retained earnings), then the marginal cost of each new dollar of
capital will be minimized. Internally generated equity is
available for financing some new investment, but beyond that
amount, the firm must finance through more expensive common
stock. At this point where new stock must be sold, the cost of
equity and the marginal cost of capital, increases.
Brigham & Houston, pp. 551-552
Answer 2: a
Rationale & Reference:
The clientele effect is the tendency of a firm to attract a set
of investors who like its dividend policy. The residual dividend
model is a model in which the dividend paid is set equal to the
actual earnings minus the amount of retained earnings necessary
to finance the firm's optimal capital budget. The residual
dividend policy minimizes the costs to the company of raising
outside funds, but it does not provide a stable cash flow to the
investors and most investors prefer stable dividends.
Brigham & Houston, pp. 547, 551
Answer 3: c
Rationale & Reference:
Different groups, or clientele, of stockholders prefer different
dividend payout policies. Stockholders in a low or tax-free tax
bracket generally prefer cash income, so a payout would be their
preference. On the other hand, stockholders in a high tax bracket
might prefer reinvestment of earnings because they have little
need for current investment income.
To the extent that stockholders can switch firms, a firm can
change from one dividend payout policy to another to let
stockholder who do not like the new policy sell to other
investors who do. Yet this would be costly because of brokerage
costs, the capital gains taxes that would have to be paid by the
selling stockholders, and the chance that there will be a net
loss of investors who like the firm's new dividend policy.
Management should therefore, probably not change its policy.
Several studies show that there is a clientele effect, which is
the tendency of a firm to attract a set of investors who like its
dividend policy. The existence of the clientele effect does not
necessarily imply that one dividend policy is better than
another.
Brigham & Houston, pp. 547-548
Answer 4: c
Rationale & Reference:
Most firms and stockholders expect earnings to grow over time
with dividends growing virtually the same as earnings. In the
past, a "stable dividend policy" meant a company paid the same
dollar dividend for several years in a row, but today it means
increasing the dividend at a reasonably steady rate. From an
investor's viewpoint, the most stable policy is that whose
dividend growth rate is predictable. The second most stable
policy is where stockholders can reasonably be sure that the
current dividend will not be reduced. The least stable is where
earnings and cash flows are so volatile that investors cannot
count on the company to maintain the current dividend.
Since profits and cash flow vary over time for a firm, one would
suggest that firms should vary their dividends over time,
increasing them when cash flows are large and lowering them when
cash is low relative to investment opportunities. However, many
stockholders rely on dividends and reducing dividends may send
incorrect signals, which could drive the stock price. Thus,
maximizing a firm's stock price requires a balance of its
internal fund requirements against the desires of the
stockholders
Brigham & Houston, p. 549
*** Level II
Question: Explain how buyer needs influence industry structure.
Answer:
Satisfying buyer needs is indeed a prerequisite to the
profitability of an industry, but is not sufficient to ensure
industry profitability. The crucial question in determining
profitability is whether firms can capture the value they create
for buyers, or whether this value is competed away to others.
Industry structure determines who captures the value.
The threat of entry determines the probability that new firms
will enter an industry and compete away value either passing it
on to customers through lower prices to buyers or dissipating it
by raising the costs of competing.
The power of buyers determines the extent to which they retain
most of the value created for them, leaving firms in an industry
with only modest returns.
The threat of substitutes determines the extent to which some
other product can meet the same buyer needs, and thus places a
ceiling on the amount a buyer is willing to pay for an industry's
product.
The power of suppliers determines the extent to which value
created for buyers will be appropriated by suppliers rather than
by firms in an industry.
Lastly, the intensity of rivalry acts similarly to the threat of
entry, because it determines the extent to which firms already in
an industry will compete away the value they create for buyers
amongst themselves.
Industry structure therefore, determines who keeps what
proportion of the value a product creates for buyers. If an
industry's product does not create much value for its buyers,
there is little value to be captured by firms regardless of the
other elements of structure. If the product creates much value,
structure becomes crucial. Some industries, such as heavy trucks,
may create a significant amount of value for their buyers, but
retain a small amount of it in profits. On the other hand, some
industries, such as medical equipment and bond rating services,
create high value for their buyers while retaining a significant
amount in profits.
Porter, pp. 8-9
*** Level III
Question: Learning Outcome Statement:
Explain the popularity of bond portfolio indexing and alternate
methodologies for designing index portfolios.
Answer:
Reasons for popularity of bond portfolio indexing are:
a. Performance of active bond managers has been poor.
b. Indexing reduces advisory fees charged for an indexed
portfolio compared to active management fees.
c. Lower custodian and master fees
d. Sponsors have greater control over investment advisors and
there is little divergence for the benchmark performance.
There are 3 popular strategies for portfolio design:
1. Stratified Sampling or Cell Approach
The index is divided into cells, each represents a different
characteristic of the index: duration, coupon, maturity, market
sector, credit rating, call factor, sinking fund feature.
The objective is to select 1 or more issues for each cell.
2. Optimization Approach
The cell approach is combined with the objective to maximize some
objective (yield to maturity, convexity, or total return).
Mathematical programming is used to solve the optimization
equation.
3. Variance Minimization Approach
This is the most complex. It requires using historical data to
estimate the variance of the tracking error. The objective is to
minimize the variance of the tracking error in constructing the
indexed portfolio.
Fabozzi, pp. 412-413, 419-423
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