Reading 31: Dividends and Share Repurchases: Analysis-LOS c 习 likely, company, following, 2011, class

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Session 8: Corporate Finance
Reading 31: Dividends and Share Repurchases: Analysis

LOS c: Illustrate how clientele effects and agency issues may affect a company's payout policy.

 

 

According to the “clientele effect” of dividend policy, which of the following groups is most likely to be attracted to low dividend payouts?

A) High-income individual investors.

B) Corporations.

C) Pension funds.

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High-income individuals in high tax brackets would prefer capital gains over dividends as they have the greatest benefit from deferral of taxes.

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Which of the following statements about dividend policy and capital structure is most accurate?

A) Investors view a stock repurchase as a positive signal and a stock issue as a negative signal.

B) A person who believes in the clientele effect and a proponent of the "bird-in-hand" theory would have similar views on dividend payout policy.

C) Monte Carlo simulation is used to estimate market risks; scenario analysis measures stand-alone risk.

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Investors view a stock repurchase as a positive signal and a stock issue as a negative signal. A repurchase may mean that management believes the stock is undervalued. To understand why a stock issue is viewed negatively, consider the following circumstances: A biotech company has a new blockbuster drug that will increase its profitability, but to produce and market the drug, the company needs to raise capital. If the company sells new stock, then as sales (and thus profits) occur, the price of the stock will rise. The current shareholders will do well but not as well as they would have had the company not sold more stock before the share price increased. Thus, it is assumed that management will prefer to finance growth with non-stock sources.

The other statements are false. A person who believes in the clientele effect and a proponent of the “bird-in-hand” theory would not have similar views on dividend policy. The clientele effect suggests that different groups of investors want different dividend levels (often based on tax status), and through the law of supply and demand, investors will select companies that meet their needs. Thus, dividend payout policy does not matter. According to the “bird-in-hand” theory, investors prefer dividends to capital appreciation because they view the former (D₁ / P₀) as less risky than the latter (g, or growth rate).

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Faltys Asset Management (FAM) follows a dividend growth investment strategy. The Faltys Dividend Growth Fund only invests in companies that have a dividend yield greater than the S& 500 and have the potential to increase that dividend each year at a rate that exceeds inflation. Warren Berlin, Director of Marketing for FAM has been developing a presentation book to present the fund to prospective clients. These prospective clients include retired individuals who want dividend income and trust companies who manage trust accounts which provide income to be distributed to beneficiaries. Which of the following dividend theories best describes the investment strategy and the marketing strategy of the fund?

Investment Strategy

Marketing Strategy

A) Signaling effect Bird-in-the-hand

B) Bird-in-the-hand Modigliani and Miller

C) Stable dividend Clientele effect

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The investment strategy would best be described as a stable dividend strategy. A stable dividend policy means that a company’s dividend payout is aligned with company’s long-term growth rate such that there is stability in the rate of increase for the dividend. The marketing strategy would best be described as the clientele effect. Berlin is pursuing specific groups of investors that prefer dividends. Note that the bird-in-in-the-hand theory states that investors prefer the certainty of dividends now to uncertain capital gains in the future, while Modigliani and Miller proposed that dividend policy has no impact on the price of a firm’s stock.

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The clientele effect predicts that investors with high marginal tax rates and low desire for current income will be attracted to companies whose dividend policies promote:

A) low dividends levels.

B) low levels of share repurchase.

C) low reinvestment of earnings.

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The clientele effect states that companies with low dividends will attract a clientele of investors with high marginal tax rates and low desires for current income.

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Dividend payments are least likely to be associated with:

A) reduced agency conflict between shareholders and managers.

B) increased agency conflict between bondholders and managers.

C) increased agency conflict between bondholders and shareholders.

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Paying dividends is likely to intensify the agency conflict between bondholders and shareholders, as it represents a transfer of wealth from bondholders to shareholders. Paying dividends can be helpful in reducing agency conflicts between shareholders and managers because dividend payouts constrain managers’ ability to invest in negative NPV projects that benefit the managers at the expense of shareholders. A dividend payment is not usually associated with an increase in agency conflict between bondholders and managers.