6 Which of the following statements is correct? a. The tax code encourages compa

Question

6 Which of the following statements is correct?

a. The tax code encourages companies to pay dividends rather than retain earnings.

. b. If a company uses the residual dividend model to determine its dividend payments, dividends payout will tend b. to increase whenever its profitable investment opportunities increase

. c. The stronger management thinks the clientele effect is, the more likely the firm is to adopt a strict version of the c. residual dividend model.

d Large stock repurchases financed by debt tend to increase earnings per share, but they also increase the firm’s financial risk.

e A dollar paid out to repurchase stock is taxed at the same rate as a dollar paid out in dividends. Thus, both companies and investors are indifferent between distributing cash through dividends and stock repurchase programs.

Explanation / Answer

Option D is correct.

If a company is earning fair amount of income then it is advisable to buy back its shares in order to increase earnings per share as buying back shares will reduce the number of shares outstanding and hence increase amount of income to be distributed among shareholders. However, adding debt increases financial risk of the firm as interest burden gets increased.

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