3. 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.

Blue Water Producers Inc. is an oil drilling company. The company paid a dividend of $2.80 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 $3.75 this year, and its share price rose from $35 per share to $38 per share immediately after the announcement.

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

Dividend irrelevance theory

The clientele effect

The signaling hypothesis

Which of the following statements is true?

Taxes on dividend income are paid in the year that they are received.

Taxes on dividend income are paid when the stock is sold.

As a result, the U.S. tax code encourages many individual investors to prefer to receive capital gains or dividens .

Some researchers and analysts have noticed a trend in which firms that increase their dividends see an increase in their stock price. The theory of clientele effect or information content explains this phenomenon.

In some cases, analysts notice that groups of similar investors tend to flock to stocks that have dividend policies consistent with their needs. This circumstance is an illustration of the clientele effect or information content effect.