12. Dividend policy

A firms value depends on its expected free cash flow and its cost of capital. Distributions made in the form of dividends or stock repurchases impact the firms value and the investors in different ways.

Some analysts have argued that a firms value should solely be determined by its basic earning power and the business risk of the firm. Which of these concepts would support these analysts argument?

The signaling hypothesis

The clientele effect

Dividend irrelevance theory

The residual dividend model

Consider the case of Blue Water Producers Inc., and answer the question that follows:

Blue Water Producers Inc. is an oil-drilling company. The company paid a dividend of $1.75 last year, and, in the past, its dividend has increased steadily by about 4% a year. Blue Water just announced that its dividend will increase to $2.50 this year, and its share price rose from $30 per share to $33 per share immediately after the announcement.

Which of the following best explains why Blue Waters stock price increased as it did?

The signaling hypothesis

The clientele effect

Dividend irrelevance theory

Modigliani and Miller argued that each shareholder can construct his or her own dividend policy. This statement is:

False

True

Modigliani and Miller also pointed out that many institutional investors do not pay taxes and can buy and sell stocks with very low transaction costs. For these investors, dividend policy is relevant than it is for an individual investor.

Another firm, called Cheatum Power & Water, an established public utility company, has been paying dividends for the past 20 years. This year Cheatum also announced that it will increase its dividends by 10%. Which class of investors is more likely to be pleased by Cheatums dividend announcement?

Investors with low tax rates who depend on current dividend income for living expenses

Investors with high tax rates who dont depend on current dividend income for living expenses

A firms dividend policy determines its current clientele of investors.