LOS m: Differentiate among the schools of thought on dividends (dividend irrelevance, dividend preference, and tax aversion), and discuss their implications for shareholder value and the price-to-earnings ratio.

Q1. The bird-in-the-hand argument is based on the assumption that:

A)   investors value expected capital gains more highly than expected dividends because of the lower tax rate on capital gains.

B)   investors are indifferent between dividends and capital gains.

C)   investors view dividends as being less risky than expected capital gains.

Q2. According to Modigliani and Miller’s dividend irrelevancy theory, an investor in a firm that does not pay a dividend can still earn a “dividend” on that company by:

A)   selling a portion of the company's stock each year.

B)   contacting the firm and asking for a dividend payment.

C)   buying additional shares each year.

Q3. In a world with taxes and brokerage costs:

A)   Modigliani and Miller say that dividend policy is irrelevant.

B)   dividend policy may be relevant.

C)   Modigliani and Miller say that dividend policy is relevant.

Q4. If Modigliani and Miller’s dividend irrelevancy theory is correct, what is the impact on a firm’s cost of capital and share price if its dividend payout increases?

          Cost of Capital                        Share Price

A)  An increase                            A decrease

B)  None                                       A decrease

C)  None                                       None

LOS m: Differentiate among the schools of thought on dividends (dividend irrelevance, dividend preference, and tax aversion), and discuss their implications for shareholder value and the price-to-earnings ratio. fficeffice" />

Q1. The bird-in-the-hand argument is based on the assumption that:

A)   investors value expected capital gains more highly than expected dividends because of the lower tax rate on capital gains.

B)   investors are indifferent between dividends and capital gains.

C)   investors view dividends as being less risky than expected capital gains.

Correct answer is C)         

The Gordon/Lintner argument is called the bird-in-the-hand theory. Myron Gordon and John Lintner, argue that k_s decreases as the dividend payout increases. Why? Because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current certain dividend payments. Gordon/Lintner argue that investors value a dollar of expected dividends more highly than a dollar of expected capital gains because the dividend yield component (D₁/P_o) is less risky than the growth component (g) in the total expected return equation:

 k_s =D₁/P_o + g.

Q2. According to Modigliani and Miller’s dividend irrelevancy theory, an investor in a firm that does not pay a dividend can still earn a “dividend” on that company by:

A)   selling a portion of the company's stock each year.

B)   contacting the firm and asking for a dividend payment.

C)   buying additional shares each year.

Correct answer is A)

Miller and Modigliani’s dividend irrelevancy theory states that shareholders can in theory construct their own dividend policy. If a firm does not pay dividends, a shareholder who wants a 4% dividend can “create” it by selling 4% of his or her stock. Note that Modigliani and Miller’s theory does not allow for transaction costs or taxes. In actuality, shareholders will have to pay a brokerage commission on the sale and tax on any capital gains.

Q3. In a world with taxes and brokerage costs:

A)   Modigliani and Miller say that dividend policy is irrelevant.

B)   dividend policy may be relevant.

C)   Modigliani and Miller say that dividend policy is relevant.

Correct answer is B)

Modigliani and Miller assume a world without taxes and transaction costs. They (correctly) claim that the validity of their theory should be judged on empirical tests, not the realism of their assumptions. Myron Gordon and John Lintner have championed the “bird-in-the-hand” theory, which gives greater value to firms with high dividend yields because investors perceive dividends to be less risky than capital gains.

Q4. If Modigliani and Miller’s dividend irrelevancy theory is correct, what is the impact on a firm’s cost of capital and share price if its dividend payout increases?

          Cost of Capital                        Share Price

A)  An increase                            A decrease

B)  None                                       A decrease

C)  None                                       None

Correct answer is C)

If investors do not consider dividends to be relevant, the dividend payout will not affect the required rate of return. If the required rate of return does not change, the value of a firm will be unchanged despite the change in its dividend payout rate.

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