Question

3. Dividend policy

A firm’s 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 firm’s value and the investors in different ways.

Suppose a firm generates a lot of cash but has limited investment opportunities. Is this stock more likely to be a utility stock or a technology stock? In addition, is the stock more likely to provide a high or low dividend yield?

A utility stock that has a high dividend yield

A utility stock that has a low dividend yield

A technology stock that has a low dividend yield

A technology stock that has a high dividend yield

Modigliani and Miller argued that each shareholder can construct his or her own dividend policy. This statement is:

False

True

Modigliani and Miller also pointed out that many institutional investors do not pay taxes and can buy and sell stocks with very low transaction costs. For these investors, dividend policy is   relevant than it is for an individual investor.

Some researchers and analysts have noticed a trend in which firms that increase their dividends see an increase in their stock price. The theory of   explains this phenomenon.

In some cases, analysts notice that groups of similar investors tend to flock to stocks that have dividend policies consistent with their needs. This circumstance is an illustration of:

The clientele effect

The information content effect

Answer 1

Solution

1)

If the firm generates a lot of cash but does not have many investment opportunities thenn it is most likely to be a utilities company. Since technology companies have to invest a lot in the research and development of new technologies thus the y always have enough investment opportunities to keep the future growth expectations alive. In case of a utilities firm the investment period is usually followed by reaping benefits of those investments i.e. the cash from the operations. Thus it is more likely a utility stock.

The stock is expected to have a high dividend yield as the major amount of cash generated goe to the shareholders and it makes sense to keep back cash enough to meet operations an contingencies.

Thus it is a utility stock with high dividend yield

2)

3)

4)

When a group of similar investors tend to flock to stocks that have dividend policy consistent with their needs, it is an illustration of clientele effect.

5)

The clientele effect