B .What Isthe Retention Rateor Retention Ratio? (Be Sure To Provide An Equation)
B .What Isthe Retention Rateor Retention Ratio? (Be Sure To Provide An Equation)
Pre-question: In the space below, write down the seventh and eighth commandments given
in the Ten Commandments (Ex. 20:2-17; Deut. 5:6-21). The short versions are fine.
Questions (worth 5 raw points per numerical question, and show your work):
B .What isthe retention rate or retention ratio? (be sure to provide an equation)
The retention rate or ratio is the percentage (%) of the earnings credited to retained earnings.
This is essentially (1- Dividend payout ratio)
2. A. Discuss the target payout ratio and how it is related to the optimal dividend policy.
The target payout ratio is the target percentage of net income paid out in cash dividends to
shareholders. Paying too much in dividends leads to fewer reinvestments, which means there is
less growth. An optimal dividend policy is a balance between growth and dividends. The target
payout ratio is related to the optimal dividend policy-related because the target rate is essentially
the optimal dividend policy. It is possible to maximize the shareholder wealth by paying all the
consistent dividends of what is left in the net income. Any change that occurs in the payout
policy will have two contrasting effects, so the optimal dividend policy can balance the current
dividends and future growth, which maximizes the stock price.
B. What is the clientele effect, and how might it affect dividend policy?
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The clientele effect means that different groups prefer different dividend payout policies; this
means a company tends to attract investors who prefer its dividend policy. It might affect the
dividend policy because changes in the dividend policy can cause the investors to be unsettled
and unhappy. This can eventually yield a negative change in the company’s stock price.
B. What happens to a company’s stock price when dividends are unexpectedly reduced?
When a company’s dividends are unexpectedly reduced, the company’s stock price will
decrease.
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C. How does double taxation influence the investor?
Double taxation influences the investor because this means that the investors make less money in
returns. This also creates the incentive to purchase growth companies that do not pay dividends
because this will cause tax to be calculated at the capital gains rate instead of normal income.
5. Discuss the residual dividend model and how it is connected with the concept of the
optimal capital budget and stockholder wealth maximization.
The residual dividend model is the dividends paid equals net income minus retained earnings.
The residual dividend model relates to the concept of the optimal capital budget and the
wealth maximization of a stockholder. This model looks to solve dividends paid and retained
earnings to maximize shareholder wealth.
6. Define in your own words the declaration date, the holder-of-record date, the ex-
dividend date, and the payment date.
The declaration date is when the firm’s executives, usually the Board of Directors, decide to
declare dividends to the investors. The holder-of-record date is the day when the current
holder of the stock receives the dividend. This is also the date that the firm chooses who
owns the stock at the time of the declaration date, which determines exactly who receives the
dividends to be paid. The ex-dividend date is the date that is prior to the holder-of-record
date, and this is the cut-off date(point) for who is getting paid these dividends, so this means
that if the individual purchases a stock on the ex-dividend date or after the ex-dividend date
then the seller will receive the dividend instead. The payment date is the day when the
dividends are distributed and the date the company sends out the check.
7. What is a DRIP?
A DRIP is the abbreviation form of Dividend Reinvestment Plan. This is where the
stockholder’s dividend is automatically reinvested in the company’s stock either as old or
new stock.
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8. A. List five constraints that influence dividend policies, and provide a short phrase
explaining each.
Five constraints that influence dividend policies are:
1. Bond indentures – sometimes limit dividends
2. Availability of cash – this means the company must cut a check and must have at least
cash available on hand to pay the dividends
3. Penalty tax on improperly accumulated earnings – this is another way in which the
government taxes dividends
4. Impairment of capital rule – this means that the dividends cannot exceed the retained
earnings
5. Preferred stock restrictions – usually paid first
B. List two issues relevant to investment opportunities that influence dividend policies, and
provide a short phrase explaining each.
The first issue relevant to investment opportunities that influences dividend policies is the
number of profitable investments available. The second issue is the possibility of delaying or
accelerating projects. This is the ability to slow down or speed up project production to maintain
a consistent dividend policy.
C. List three issues pertaining to alternative sources of capital that influence dividend
policies, and provide a short phrase explaining each.
1. Control issues – new shares become less favorable because of the loss of control by the firm.
2. The ability substitution of debt for equity - this leads to the capital structure to be less flexible.
3. Cost of selling a new stock – this conflict with the costs of retained earnings. Low flotation
costs mean a high payout ratio.
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B. What happens to the number of shares when a 2-for-1 stock split occurs?
When a 2-for-1 stock split occurs, the numbers of outstanding shares will double. For instance, if
I have 20 shares when the stock split occurs, I will end up with 40 shares in total.
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3) The employee stock options are connected to open market repurchases
B. List three advantages of stock repurchases. Provide a short phrase describing each.
1) Stockholders have a choice: this means that stockholders can choose to sell or buy.
2) Positive signal: stock repurchases indicate that the management believes that their
company’s shares are undervalued. Repurchases are motivated by the management’s
belief.
3) Removes the excess supply of stock: purchasing back stock has the potential to increase
the price. Repurchasing can remove excess stock that is keeping the price per share low.
C. List three disadvantages of stock repurchases. Provide a short phrase describing each.
1) The selling stockholders might be uninformed, and this can lead to lawsuits
2) Stockholder preference – stockholders could prefer dividends instead of capital gains
3) Higher prices – this means that companies will overpay for the repurchased stock. This
essentially means that companies buy these stocks above their real value price
12. A. Define the price to earnings ratio and explain what it means.
Price to earnings ratio is the current stock price divided by earnings per share (EPS). The P/E
ratio is how much an investor wants to pay per dollar of what the company earns on those
shares. This means that investors hope for a low number.
B. Do you always want to buy companies with a high P/E ratio? Why or why not?
No, because a high P/E means that the stock could be overpriced. However, this could mean that
something rare occurred to change the P/E ratio.
C. Do you always want to buy a company with a low P/E ratio? Why or why not?
No, you do not always want to buy a company with a low P/E ratio because it could mean that
the company could be in danger of going bankrupt, and it could mean there is more risk attached
to it. However, it could simply mean that it is a bargain.
D. If the P/E ratio remained constant, how could you use it to find the future share price?
(HINT: Use dimensional analysis [What are the “units” of the P/E ratio?])
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If the P/E ratio remained constant, then you can use it to find the future share price by using the
equation:
EPS1(P/E)n
13. I hereby certify that all work contained in this homework assignment is exclusively my
own. I have abided by all aspects of the Honor Code during the preparation of this
assignment, and I pledge to uphold the Honor Code by continuing to personally abide
by it and by reporting all violations that I observe. I recognize that copying another
student’s work is plagiarism and an Honor Code violation. Furthermore, I realize that
although consulting other students as I complete this assignment is permissible,
ultimately the work that I submit must be exclusively my own.
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