CFA Level 1 - Corporate Finance Session 11 - Reading 39 (Notes, Practice Questions, Sample Questions) 1. Paying a cash dividend is most likely to result in: A)an increase in ﬁnancial leverage ratios. B)an increase in liquidity ratios.C)the same impact on liquidity and leverage ratios as a stockdividend. Explanation: A — A cash dividend will increase leverage ratiossuch as debt-to-equity and debt-to-assets, reﬂecting adecrease in the denominator. A cash dividend should decreaseliquidity ratios such as the current ratio and cash ratio, due tothe decrease in cash in the numerator. Unlike a cash dividend, astock dividend or a stock split has no impact on liquidity orﬁnancial leverage ratios 2. A periodic payment to shareholders in the form of additional shares of stock instead of cash is a: A)dividend reinvestment plan B)stock dividend C)stock repurchase Explanation: B — Stock dividends are dividends paid out in newshares of stock instead of cash. Unlike stock dividends, dividendreinvestment plans are at the discretion of individualshareholders. In the case of stock repurchases, the company is
buying back shares so the number of shares in the investmentpublic’s hands is declining 3. Stock splits: A)do not in and of themselves a ect ﬁrm value. B)are less common than stock dividends.C)increase ﬁrm value. Explanation: A — Stock splits divide up each existing share intomultiple shares. The price of each share will dropcorrespondingly to the number of shares created, so there is nochange in the owner’s wealth. Empirical research has shownthat in the absence of a dividend yield increase, the stock pricefalls to the stock split ratio of the original price (i.e., to 25% ofthe original price in a 4-for-1 stock split). This makes sense,given that the investor’s percentage ownership of the companyhas not changed 4. Financial managers utilize stock splits and stock dividends because they perceive that: A)investors will double the share price if there is a 20% stockdividend.B)brokerage fees paid by shareholders will be reduced. C)an optimal trading range exists Explanation: C — Although there is little empirical evidence tosupport the contention, there is nevertheless a widespreadbelief in ﬁnancial circles that an optimal price range exists forstocks. “Optimal” means that if the price is within this range,the price/earnings ratio, price/sales and other relevant ratios
will be maximized. Hence, the value of the ﬁrm will bemaximized 5. What is the earliest day on which an investor can currently purchase Amex, Inc., if the investor wants to avoid receiving adividend and thereby avoid paying tax on the distribution, if thedate of record is Thursday, October 31? A)Tuesday, October 29. B)Monday, October 28.C)Thursday, October 24 Explanation: A — The ex-dividend date is now two businessdays prior to the date of record. Counting back two businessdays identiﬁes Tuesday, October 29 as the date when the sharescan be purchased without the dividend 6. The cut-o date for receiving the dividend is known as the: A)holder of record date. B)ex-dividend date. C)date of payment. Explanation: B — The cut-o date for receiving the dividend isknown as the ex-dividend date. The holder of record date is thedate on which the shareholders of record are designated. Thedate the checks are mailed out is known as the date of payment 7. Which of the following shows the key dividend dates in their proper sequence?
A)Declaration date, holder-of-record date, ex-dividend date,payment date.B)Ex-dividend date, holder-of-record date, declaration date,payment date. C)Declaration date, ex-dividend date, holder-of-record date,payment date. Explanation: C — The board of directors announce the amountof the dividend, the holder-of-record date, and payment date.The ex-dividend date is two business days prior to theholder-of-record date, giving the ﬁrm time to identify therightful owner of the dividends 8. Which justiﬁcation for repurchasing stock is the least valid? A)Repurchases o er shareholders more choices than cashdividends. B)Shareholders prefer capital gains to cash dividends. C)A cash dividend increase, in response to short-term excesscash ﬂows, may confuse investors Explanation: B — Some shareholders prefer capital gains, whileothers prefer dividends. Repurchases o er shareholders thechoice of tendering or not tendering their stock, while cashdividends represent a payment they cannot refuse. Raisingdividends is often seen as a positive signal, but an increasefunded by short-term cash ﬂows may not be sustainable,forcing the company to reduce the dividend later 9. Which of the following statements about a stock repurchase is least accurate?
A)A stock repurchase occurs when a large block of stock isremoved from the marketplace.B)Management can distribute cash to shareholders withoutsignaling about future earnings. C)Disgruntled stockholders are forced to sell their shares,improving management's position. Explanation: C — A repurchase gives stockholders a choice.They can sell or not sell 10. Jim Davis and Thurgood Owen, two equity analysts at Ferguson Capital Management, were reviewing the ﬁnancialstatements of Peregrine Foodstu s Ltd. Davis and Owen noticedthat Peregrine has been repurchasing its common shares in themarket over the past three years. Owen thought this was animportant issue to look into in greater detail. Upon completion ofhis review, Owen made the following two statements:Statement 1: Peregrine has bought back shares in the openmarket during its repurchase program. This method ofrepurchase gave the company the ﬂexibility to choose the timingof the transaction.Statement 2: Peregrine plans to buy back shares by makingtender o ers during the coming year. By making tender o ers,the company will be able to repurchase shares at a discount to theprevailing market price.With respect to Owen's statements: A)both are correct.B)both are incorrect. C)only one is correct. Explanation: C — Buying in the open market gives the companythe ﬂexibility to choose the timing of the transaction. Thus,
Statement 1 is correct. A second way is to buy a ﬁxed number ofshares at a ﬁxed price. A company may repurchase stock bymaking a tender o er to repurchase a speciﬁc number of sharesat a price that is at a premium to the current market price. Theywould not be willing to tender their shares for less than theprevailing market price, so Statement 2 is incorrect 11. Which of the following is least likely a method by which ﬁrms repurchase their shares? A)Tender o er.B)Direct negotiation. C)Exercise a call provision. Explanation: C — Call provisions are not relevant to commonstock and are not considered a repurchase in any case. There arethree repurchase methods. The ﬁrst is to buy in the openmarket. A company may repurchase stock by making a tendero er to repurchase a speciﬁc number of shares at a price that isusually at a premium to the current market price. The third wayis to repurchase by direct negotiation. Companies may negotiatedirectly with a large shareholder to buy back a block of shares,usually at a premium to the market price 12. Laura’s Chocolates, Inc. (LC), is a maker of nut-based to ees. LC is considering a share repurchase and prefers the “tendero er” method. Which of the following is also known as a “tendero er”? A)Buying a ﬁxed number of shares at a ﬁxed price. B)Buying in the open market.C)Repurchasing by direct negotiation.
Explanation: A — A tender o er refers to buying a ﬁxed numberof shares at a ﬁxed price (usually at a premium to the currentmarket price). 13. The share price of Solar Automotive Industries is $50 per share. It has a book value of $500 million and 50 million sharesoutstanding. What is the book value per share (BVPS) after ashare repurchase of $10 million? A)$10.12 B)$10.00. C)$9.84. Explanation: B — The share buyback is $10 million / $50 pershare = 200,000 shares.Remaining shares: 50 million − 200,000 = 49.8 million shares.Solar Automotive Industries’ current BVPS = $500 million / 50million = $10.Book value after repurchase: $500 million − $10 million = $490million.BVPS = $490 million / 49.8 million = $9.84.BVPS decreased by $0.16. Book value per share (BVPS) decreased because the share priceis greater than the original BVPS. If the share prices were lessthan the original BVPS, then the BVPS after the repurchasewould have increased
14. The share price of Winnipeg Auto Unlimited is $5 per share. There are 50 million shares outstanding, and Winnipeg has abook value of $900 million. What is the book value per share(BVPS) after the share repurchase of $10 million? A)$21.24. B)$18.54. C)$14.76. Explanation: B — The share buyback is $10 million / $5 pershare = 2,000,000 shares.Remaining shares: 50 million − 2 million = 48 million shares.Winnipeg Auto Unlimited’s current BVPS = $900 million / 50million = $18.Book value after repurchase: $900 million − $10 million = $890million.BVPS = $890 million / 48.0 million = $18.54.BVPS increased by $0.54. Book value per share (BVPS) increased because the share price isless than the original BVPS. If the share prices were more thanthe original BVPS, then the BVPS after the repurchase wouldhave decreased 15. What is the impact on shareholder wealth of a share repurchase versus cash dividend of equal amount when the taxtreatment of the two alternatives is the same? A)A share repurchase will sometimes lead to higher totalshareholder wealth than a cash dividend of an equal amount. B)A share repurchase is equivalent to a cash dividend of an equalamount, so total shareholder wealth will be the same.
C)A share repurchase will always lead to higher total shareholderwealth than a cash dividend of an equal amount Explanation: B — Assuming that the tax treatment of a sharerepurchase and a cash dividend of equal amount is the same, ashare repurchase is equivalent to a cash dividend payment, andshareholder wealth will be the same