Distributions to Shareholders: Dividend Theory

A number of dividend theories have been discussed to explain how investors regard current dividends versus future growth. Professors Modigliani and Miller (MM) advanced the -Select-information contentdividend irrelevanceclientele cateringItem 1 theory that states a firm's dividend policy has no effect on either its value or its cost of capital. Under a stringent set of assumptions, they proved that a firm's value is determined only by its basic earning power and its business risk. In other words, the value of the firm depends only on the income produced by its assets, not on how that income is split between dividends and retained earnings.

Myron Gordon and John Lintner argued that the cost of equity, r_s, -Select-increasesdecreasesItem 2 as the dividend payout is increased because investors are less certain of receiving -Select-capital gainsinterest paymentsdividend paymentsItem 3 that should result from retaining earnings than they are of receiving -Select-capital gainsinterest paymentsdividend paymentsItem 4 . MM named this theory the bird-in-the-hand fallacy. MM believed that the cost of equity was independent of dividend policy, which implies that investors are indifferent between dividends and capital gains.

However, the Tax Code encourages many individual investors to prefer capital gains to dividends. Taxes must be paid on dividends the year they are received; however, taxes on capital gains are not paid until the stock is sold. Due to time value effects, a dollar of taxes paid in the future has a -Select-higherlowerItem 5 effective cost than a dollar of taxes paid today.

An increase in the dividend is often accompanied by an increase in the stock price, while a dividend cut generally leads to a stock price decline. This observation led to the -Select-dividend irrelevanceinformation (signaling)cateringItem 6 theory, which states that investors regard dividend changes as indicators of management's earnings forecasts. Managers often have better information about future prospects for dividends than public stockholders, so there is some information content in dividend announcements. A firm should consider these effects when it is contemplating a change in dividend policy.

The -Select-clienteleinformation (signaling)cateringItem 7 effect is the tendency of a firm to attract a set of investors who like its dividend policy. Firms have different groups of investors and they have different preferences, so a change in dividend policy might upset the majority group and have a negative effect on a firm's stock price. Therefore, a company should follow a stable, dependable dividend policy.

Some recent research related to behavioral finance suggests that investors' preferences for dividends vary over time. The -Select-clienteleinformation (signaling)cateringItem 8 theory suggests that investors' preference for dividends varies over time and that corporations adapt their dividend policy to accommodate the current desires of investors.

Give the correct response to the following question.

Electric utility companies have historically paid high dividends to their shareholders. Many retirees include the stocks of these electric utilities in their portfolios. On the other hand, biotechnology companies typically pay little or no dividends so they can reinvest for research and development. Many of the biotech company's stockholders are in their peak income-earning years. Which of the following dividend theories best explains these results? -Select-a. Dividend irrelevance theoryb. Tax preference theoryc. Clientele effectd. Catering theoryItem 9