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.

1. In some cases, analysts notice that groups of similar investors tend to flock to stocks that have dividend policies consistent with their financial needs. This circumstance is an illustration of:
   1. dividend irrelevance theory.
   2. the clientele effect.
   3. the residual dividend policy.
   4. the signaling hypothesis.

Consider the case of Purple Sage Producers Inc., and answer the question that follows:

Purple Sage Producers Inc. is an oil drilling company and has some free cash flow that is not expected to be used to finance future growth or potential investment projects. The company plans to distribute its free cash flow to its shareholders but is still deciding whether the distribution should take the form of a stock repurchase or the payment of a cash dividend.

2. Which of the following is a characteristic of a firms optimal dividend policy?

a. It maximizes the firms total assets.

b. It maximizes the firms return on equity.

c. It maximizes the firms stock price.

d. It maximizes the firms earnings per share.

3. Which of the following statements is true?

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

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

4. As a result, the U.S. tax code encourages many individual investors to prefer to receive _____.

5. 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?

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

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

6. A firms _____ dividend policy determines its current clientele of investors.