which of the following statements is most correct? a. the bird-in-the-hand theor
ID: 2715817 • Letter: W
Question
which of the following statements is most correct? a. the bird-in-the-hand theory implies that a company can reduce its WACC by reducing its dividend payout. b. the bird-in-the-hand theory implies that a company can increase its stock price by reducing its dividend payout. c. one problem with following a residual distribution policy( with all distributions in the form of diviends) is that it can lead to erractic diviend payouts that may prevent the firm from establishing a reliable clientele of investors who prefer a particular dividend policy. d. statements a and c are correct. e. all of the statements abore correct.
Explanation / Answer
a. the bird-in-the-hand theory implies that a company can reduce its WACC by reducing its dividend payout.
Ans. incorrect.
Reason -
Bird-in-the-hand Theory is one of the major theories concerning dividend policy in an entreprise. This theory was developed by Myron Gordon and John Lintner as a response to Modigliani and Miller's dividend irrelevance theory.
Gordon and Lintner claimed that MM made a mistake assuming lack of impact of dividend policy on firm's cost of capital. They argued that lower payouts result in higher costs of capital. They suggested that investors prefer dividend as it is more certain than capital gains that might or might not appear if they let the firm retain its earnings. The authors indicated that the higher capital gains/dividend ratio is, the larger total return is required by investors due to increased risk. In other words, Gordon and Lintner claimed that one percent drop in dividend payout has to be offset by more than one percent of additional growth.
b. the bird-in-the-hand theory implies that a company can increase its stock price by reducing its dividend payout.
Ans- incorrect
Reason -
Bird-in-the-hand” refers to the theory that a dollar of dividends in the hand is preferred by investors to a dollar retained in the business, in which case dividend policy would affect a firm’s value.The marketvalue of firm increases with higher retension ratio.If the bird-in-the-hand theory is true, then investors would regard a firm with a high payout ratio as being less risky than one with a low payout ratio, all other things equal; hence, firms with high payout ratios would have higher values than those with low. So higher the dividend payout higher the stack price.
c. one problem with following a residual distribution policy( with all distributions in the form of diviends) is that it can lead to erractic diviend payouts that may prevent the firm from establishing a reliable clientele of investors who prefer a particular dividend policy.
Ans. correct
Reason -
The term residual dividend refers to a method of calculating dividends. A dividend is a payment made by a company to its shareholders. It is essentially a portion of the company's profits that is divided amongst the people who own stock in the company. A residual dividend policy is one where a company uses residual or leftover equity to fund dividend payments. Typically, this method of dividend payment creates volatility in the dividend payments that may be undesirable for some investors.
Companies that use the residual dividend policy first use the cash flow to fullfill necessary capital expenditures and the remaining amount available (the residual) is paid out to shareholders. Also, if the company is maintaining a certain target debt to equity capital structure, then the full amount of the capital expenditure will not be paid entirely by equity but also with part debt.
Different groups, or clienteles, of stockholders prefer different dividend payout policies. For example, many retirees, pension funds, and university endowment funds are in a low (or zero) tax bracket, and they have a need for current cash income. Therefore, this group of stockholders might prefer high payout stocks. These investors could, of course, sell some of their stock, but this would be inconvenient, transactions costs would be incurred, and the sale might have to be made in a down market. Conversely, investors in their peak earnings years who are in high tax brackets and who have no need for current cash income should prefer low payout stocks.Clienteles do exist, but the real question is whether there are more members of one clientele than another, which would affect what a change in its dividend policy would do to the demand for the firm’s stock. There are also costs (taxes and brokerage) to stockholders who would be forced to switch from one stock to another if a firm changes its policy.
From the above discussion only statement (c) is correct. (a) and (b) are incorrect.
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