Dividend Policy Paper 3

Answer (B) is correct. A reverse stock split decreases the number of shares outstanding, thereby increasing the market price per share. A reverse stock split may be desirable when a stock is selling at such a low price that management is concerned that investors will avoid the stock because it has an undesirable image.

Answer (C) is correct. EPS equals $2.50 ($500,000 NI ÷ 200,000 pre-split shares). Thus, 100 shares had a value of $2,000 (100 shares × $2.50 EPS × 8 P/E ratio) before the split. This value is unchanged by the stock split. Although the stockholder has more shares, the total value of the investment is the same.

Answer (A) is correct. A reverse stock split, like a regular stock split, does not change the corporation’s market capitalization. Thus, if there are 1/10 as many shares outstanding as previously, they should be worth 10 times as much. Thus, the price after the reverse split would be $13.75 (10 × $1.375).

Answer (C) is correct. The total market capitalization of 1,000 shares is $50,000. That should remain about the same following the issuance of the 200 shares of stock dividend. Thus, dividing $50,000 by 1,200 shares equals $41.67 per share.

Answer (D) is correct. Under the residual theory of dividends, the amount (residual) of earnings paid as dividends depends on the available investment opportunities and the debt-equity ratio at which cost of capital is minimized. The rational investor should prefer reinvestment of retained earnings when the return exceeds what the investor could earn on investments of equal risk. However, the firm may prefer to pay dividends when investment opportunities are poor and the use of internal equity financing would move the firm away from its ideal capital structure.

Answer (C) is correct. A stock split does not involve any accounting entries. Instead, a larger number of new shares are issued to replace and retire all outstanding shares.

Answer (C) is correct. Lower dividend payout ratios will be favored by investors if dividends are taxed at a higher rate than capital gains. The cost of equity for the company will be lower under the lower dividend payout policy because more retained earnings will be available for reinvestment.

Answer (B) is correct. Dividends are recorded on their declaration date by a debit to retained earnings and a credit to dividends payable. The dividend is the amount payable to all shares outstanding. Treasury stock is not eligible for dividends because it is not outstanding. Thus, the December 1 entry is to debit retained earnings and credit dividends payable for $50,000 (50,000 × $1).

Answer (A) is correct. Under the residual theory of dividends, the firm prefers to pay dividends when investment opportunities are poor and internal financing would move the firm away from its ideal capital structure. Thus, a company with less-attractive investment opportunities will have a lower optimal capital budget. Under a residual dividend policy, a lower optimal capital budget will result in a higher dividend payout ratio, other factors being constant.

Answer (B) is correct. The ex-dividend date is 4 days before the date of record. Unlike the other relevant dates, it is not established by the corporate board of directors but by the stock exchanges. The period between the ex-dividend date and the date of record gives the stock exchange members time to process any transactions in time for the new shareholders to receive the dividend to which they are entitled. An investor who buys a share of stock before the ex-dividend date will receive the dividend that has been previously declared. An investor who buys after the ex-dividend date (but before the date of record or payment date) will not receive the declared dividend.