Question of the Week

Which of the following statements is least accurate with respect to the various theories that exist about dividend policies?

a) The clientele effect asserts that a change in dividend policy would simply substitute one set of investors with another, and thus leaving the stock price largely unchanged.
b) The tax preference theory argues that interest is tax deductible and thus the lower the proportion of equity and thus dividends, the greater will be each share value.
c) The bird in the hand theory argues that dividends are the more certain component of total return, and hence, the higher this component, the more valuable the share will be.
d) The dividend irrelevance theory argues that dividends are simply how the firm's cash flows are distributed and thus should have no impact on stock price.


Answer:

The correct answer is: b)

The tax preference theory simply argues that capital gain return results in a higher after tax return than would dividends. Thus, firms that reinvest earnings as opposed to paying them out as dividends, would be valued more.

2005 LOS: 11.1.G.a - 11.1.G.g