5. Dividend preference theory (bird-in-the-hand theory)

Despite some theoretical assertions, many investors do care a great deal about dividends. They believe that sure dividends today (a bird in the hand) are less risky than a return in the form of capital gains in the future.

The following table lists some factors that might affect an investors preference for dividends. Indicate whether the given factors are likely to make an investor prefer to receive more or fewer dividends.

Factor	Investors Will Likely Prefer...
	More Dividends	Fewer Dividends
With capital gains, shareholders in high tax brackets have the ability to defer taxes into the future.
When investors receive dividends today, they may choose to reinvest or to consume goods.
The value of a dividend received today is known, but the value of a capital gain received in the future is uncertain.

In examining investors preferences for dividends, it is useful to begin with the concept of dividend irrelevance. Dividend irrelevance suggests that in a world with no taxes or brokerage (or transaction) costs, firms and investors are indifferent to the paying or receiving of dividends.

However, as these restrictions are relaxed, various factors suggest that firms should pursue high or low payouts. One such factor is:

Taxes on capital gains are deferred until the capital gain is realized, whereas taxes on dividends are due in the year in which they are received.

Based on the factor described, identify whether investors, in general, will tend to favor high or low payout ratios.

a) Favor a low payout

b) Favor a high payout

Erin and Mia are finance researchers and are discussing the Modigliani and Miller (MM) dividend irrelevance theory. Based on your understanding of MMs argument and the impact of the assumptions applied to the argument, fill in the missing parts of their conversation.

ERIN: Modigliani and Miller (MM) dividend irrelevance theory is based on several assumptions. However, in the real world, these assumptions dont apply.

MIA: Yes, Erin. Along with the assumptions not applying to the real world, there are other factors that affect the companies dividend policy such as agency costs.

ERIN: Absolutely. The_______________ helps to reduce agency costs between shareholders and management.

MIA: Raising funding by issuing new stock requires companies to meet several regulatory requirements, which helps to_____________ managerial performance.