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Questions and Answers
Which theory suggests that dividends do not affect investor preferences?
Which theory suggests that dividends do not affect investor preferences?
- Dividend Irrelevance Theory (correct)
- Tax Preference Theory
- Signaling Effect Theory
- Bird in the Hand Theory
What impact does increasing the payout ratio have on the stock price, assuming all else is equal?
What impact does increasing the payout ratio have on the stock price, assuming all else is equal?
- It increases stock price due to higher dividends. (correct)
- It increases volatility in stock prices.
- It has no impact on stock price.
- It decreases stock price due to higher retention.
What could be a consequence of increasing dividends while reducing reinvestment in growth?
What could be a consequence of increasing dividends while reducing reinvestment in growth?
- Enhanced market competitiveness.
- Improvement in shareholder satisfaction.
- Decrease in stock price due to lower growth. (correct)
- Increase in future cash flows.
Which of the following statements about investor preferences regarding dividends is true according to financial theories?
Which of the following statements about investor preferences regarding dividends is true according to financial theories?
Which factor does the optimal dividend policy depend on when maximizing the firm's stock price?
Which factor does the optimal dividend policy depend on when maximizing the firm's stock price?
According to the Bird in the Hand Theory, what do investors prefer?
According to the Bird in the Hand Theory, what do investors prefer?
What is one element that dividend policy decisions encompass?
What is one element that dividend policy decisions encompass?
Which theory states that investors might prefer lower payouts to facilitate growth?
Which theory states that investors might prefer lower payouts to facilitate growth?
What does the Bird-in-the-Hand Theory suggest about investor preferences regarding dividends?
What does the Bird-in-the-Hand Theory suggest about investor preferences regarding dividends?
According to the Tax Preference Theory, why might investors prefer firms with low payout ratios?
According to the Tax Preference Theory, why might investors prefer firms with low payout ratios?
What implication does the Irrelevance Theory suggest for managers regarding dividend payouts?
What implication does the Irrelevance Theory suggest for managers regarding dividend payouts?
Which of the following statements reflects a possible stock price effect as described in the content?
Which of the following statements reflects a possible stock price effect as described in the content?
What is a key characteristic of the Bird-in-the-Hand Theory regarding investor behavior?
What is a key characteristic of the Bird-in-the-Hand Theory regarding investor behavior?
Which statement about dividend theories reflects the current consensus among empirical research?
Which statement about dividend theories reflects the current consensus among empirical research?
What is the potential impact of a high payout on the cost of equity according to the different theories?
What is the potential impact of a high payout on the cost of equity according to the different theories?
In which situation are managers advised to set a low payout ratio?
In which situation are managers advised to set a low payout ratio?
What does the signaling hypothesis suggest about dividend increases?
What does the signaling hypothesis suggest about dividend increases?
Which type of investors prefer high dividend payouts according to the clientele effect?
Which type of investors prefer high dividend payouts according to the clientele effect?
What is the main purpose of using the residual dividend model?
What is the main purpose of using the residual dividend model?
What is implied if a company follows the residual dividend policy?
What is implied if a company follows the residual dividend policy?
How does the capital structure of a company impact its dividend policy?
How does the capital structure of a company impact its dividend policy?
What is the optimal target equity ratio given a capital budget of $800,000?
What is the optimal target equity ratio given a capital budget of $800,000?
What does a dividend cut typically signal to investors?
What does a dividend cut typically signal to investors?
Why do clientele effects complicate changes in dividend policy?
Why do clientele effects complicate changes in dividend policy?
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Study Notes
Dividend Policy Overview
- Dividend policy involves deciding how much to pay out to shareholders versus retaining earnings for reinvestment.
- Key considerations include payout level (high/low), stability of dividends, frequency of payments, and public announcement of the policy.
Theories of Investor Preferences
-
Dividends Irrelevance Theory:
- Proposed by Modigliani-Miller; suggests investors are indifferent to dividends versus capital gains.
- Assumes no taxes or brokerage costs, making empirical validation necessary.
-
Bird-in-the-Hand Theory:
- Investors perceive dividends as less risky than future capital gains, driving a preference for high payouts.
- A high payout is believed to enhance stock valuation (P0).
-
Tax Preference Theory:
- Retained earnings are taxed at lower long-term capital gains rates than dividends, leading to a preference for firms with lower payouts.
- High dividends may decrease stock valuation (P0) due to tax implications.
Implications for Financial Managers
- According to the theories:
- Irrelevance: Any payout is acceptable.
- Bird-in-the-Hand: Favor high payout ratios.
- Tax Preference: Favor low payout ratios.
Stock Price and Cost of Equity
- Stock price is influenced by payout ratios, with varying reactions according to the three theories.
- Cost of equity fluctuates depending on investor preferences related to dividend payouts.
Signaling Hypothesis
- Managers are reluctant to lower dividends; they increase them only when they expect sustained profitability.
- Dividend increases are interpreted as positive signals about a company's future performance, often corresponding with stock price rises.
Clientele Effect
- Different investor groups prefer varying dividend policies:
- High-tax investors favor low dividends.
- Low-tax investors, such as pensions, prefer higher dividends.
- This differentiation can hinder changes to dividend policies due to tax implications or transaction costs of switching.
Residual Dividend Model
- Retained earnings required for capital budgets dictate dividends, with leftover earnings paid out.
- The model aims to minimize flotation costs and equity signaling costs, thereby reducing the weighted average cost of capital (WACC).
Calculation of Dividends Using the Residual Model
- Formula:
- Net Dividends = Net Income – (Target Equity Ratio × Total Capital Budget)
- Example Data:
- Capital budget: $800,000.
- Target capital structure: 40% debt, 60% equity.
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