Distributions to Shareholders:
Dividends and Repurchases
ANSWERS TO END-OF-CHAPTER QUESTIONS
158-1 a. The optimal distribution policy is one that strikes a balance between dividend yield and capital gains so that the firm’s stock price is maximized.
b. The dividend irrelevance theory holds that dividend policy has no effect on either the price of a firm’s stock or its cost of capital. The principal proponents of this view are Merton Miller and Franco Modigliani (MM). They prove their position in a theoretical sense, but only under strict assumptions, some of which are clearly not true in the real world. The “bird-in-the-hand” theory assumes that investors value a dollar of dividends more highly than a dollar of expected capital gains because the dividend yield component, D1/P0, is less risky than the g component in the total expected return equation rS = D1/P0 + g. The tax preferencetax effect theory proposes that investors prefer capital gains over dividends, because capital gains taxes can be deferred into the future, but taxes on dividends must be paid as the dividends are received.
c. The information content of dividends is a theory which holds that investors regard dividend changes as “signals” of management forecasts. Thus, when dividends are raised, this is viewed by investors as recognition by man-agement of future earnings increases. Therefore, if a firm’s stock price increases with a dividend increase, the reason may not be investor preference for dividends, but expectations of higher future earnings. Conversely, a dividend reduction may signal that management is forecasting poor earnings in the future. The clientele effect is the attraction of companies with specific dividend policies to those investors whose needs are best served by those policies. Thus, companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income. Similarly, companies with low