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Free CMA Exam Braindumps (page: 145)

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The Dawson Corporation projects the following for the year Earrings before interest and taxes $35 million
Interest expense $5 million
Preferred stock dividends $4 million

Common stock dividend-payout ratio 30%
Common shares outstanding 2 million
Effective corporate income tax rate 40%
The expected common stock dividend per share for Dawson Corporation is The company's net income is $18,000,000 [($35,000,000 EBIT - $5,000,000 interest) x (1.0 ­ .4 tax rate)]. Thus, the earnings available to common shareholders equal $14,000,000 ($18,000,000 - $4,000,000 preferred dividends), and EPS is $7 ($14,000,000 ÷ 2,000,000 common shares). Given a dividend-payout ratio of 30%, the dividend to common shareholders is expected to be $2.10 per share ($7 x 30%).

  1. $2.34
  2. $2.70
  3. $1.80
  4. $2.10

Answer(s): D



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In practice, dividends

  1. Usually exhibit greater stability than earnings.
  2. Fluctuate more widely than earnings.
  3. Tend to be a lower percentage of earnings for mature firms.
  4. Are usually changed every year to reflect earnings changes.

Answer(s): A

Explanation:

Dividend policy determines the portion of net income distributed to stockholders. Corporations normally try to maintain a stable level of dividends, even though profits may fluctuate considerably, because many stockholders buy stock with the expectation of receiving a certain dividend every year. Thus, management tends not to raise dividends if the payout cannot be sustained. The desire for stability has led theorists to propound the information content or signaling hypothesis a change in dividend policy is a signal to the market regarding management's forecast of future earnings. This stability often results in a stock that sells at a higher market price because stockholders perceive less risk in receiving their dividends.



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Residco; Inc expects net income of $800,000 for the next fiscal year. Its targeted and current capital structure is 40% debt and 60% common equity. The director of capital budgeting has determined that the optimal capital spending for next year is $1 2 million. If Residco follows a strict residual dividend policy, what is the expected dividend-payout ratio for next year'?

  1. 90.0%
  2. 66.7%
  3. 40.0%
  4. 10.0%

Answer(s): D

Explanation:

Under the residual theory of dividends, the residual of earnings paid as dividends depends on the available investments 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 returns are poor and the internal equity financing would move the firm away from its ideal capital structure. If Residco wants to maintain its current structure, 60% of investments should be financed from equity. Hence, it needs $720,000 ($1,200,000 x 60%) of equity funds, leaving $80,000 of net income ($800,000 NI - $720,000) available for dividends. The dividend-payout ratio is therefore 10% ($80,000 --$800,000 NI)



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A firm's dividend policy may treat dividends either as the residual part of a financing decision or as an active policy strategy. Treating dividends as the residual part of a financing decision assumes that

  1. Earnings should be retained and reinvested as long as profitable projects are available.
  2. Dividends are important to shareholders, and any earnings left over after paying dividends should be invested in high-return assets
  3. Dividend payments should be consistent.
  4. Dividends are relevant to a financing decision.

Answer(s): A

Explanation:

According to 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.






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