Question

The term clientele effect refers to the tendency of firms to attract investors who like their dividend policies. Three potential investors are described in the table.

Indicate which type of firms they are most likely to be attracted to.

Potential Investors	Types of Firms
Stockholders in their peak earning years	(high dividend payout, low dividend payout)
Investors who have a preference for current investment income	(high dividend payout, low dividend payout)
Retired individuals, pension funds, and university endowment funds	(high dividend payout, low dividend payout)

Defense Dynamics Co. is a typical company that is very concerned with meeting investors’ expectations and keeping investors happy. Its earnings tend to fluctuate from year to year because of the nature of the business the company is in. Which of these statements most likely describes Defense Dynamics Co.’s dividend policy?

Defense Dynamics Co. will be willing to increase its dividend only if it believes that it will be able to maintain the dividend increase in future years.

Defense Dynamics Co. will increase its dividends in years when it has high earnings so that it can distribute excess free cash flows to investors, even if it means that the firm will have to reduce its dividend in subsequent years.

Answer 1

The stockholders in their peak earnings years will prefer a low dividend payout policy, as they will have to pay higher taxes with higher dividends paid out to them. They are not in the need for a current income and they prefer dividend reinvestment plans, where the dividends received by them are reinvested into the firm.

Investors who have a preference for current investment income : these investors will prefer a higher dividend payout policy. As , a higher dividend payout will provide them with the current investment income they are looking for.

Retired individuals, pension, university endowment funds will prefer a higher dividend payout policy as the income of this category of investors is generally low. These people belong to the very low tax bracket, so taxes is not a major concern for them ,they prefer a cash income. hence they prefer higher dividend payouts

Defense dynamics will increase its dividends when it has high earnings so that it can distribute the excess cash flow to investors, even if it means the firm will have to reduce its dividend in subsequent years.

The company can distribute dividends in times of higher earnings and reduce dividends during the slowdown period.

So, the correct option is option 2.