Question

Despite some theoretical assertions, many investors do care a great deal about dividends. They believe that sure dividends today (a bird in the hand) are less risky than a return in the form of capital gains in the future.

The following table lists some factors that might affect an investor’s preference for dividends. Indicate whether the given factors are likely to make an investor prefer to receive more or fewer dividends.

Factor	Investors Will Likely Prefer...
	More Dividends	Fewer Dividends
When an investor dies, his or her heirs are not liable for taxes on the capital gains generated during the investor’s life. They are only liable for the capital gains earned since the investor’s death.
Investors expect a reliable annual cash flow from their stock portfolios.
Risk-averse investors prefer to minimize uncertainty with their expectations of income from their investment.

In examining investors’ preferences for dividends, it is useful to begin with the concept of dividend irrelevance. Dividend irrelevance suggests that in a world with no taxes or brokerage (or transaction) costs, firms and investors are indifferent to the paying or receiving of dividends.

However, as these restrictions are relaxed, various factors suggest that firms should pursue high or low payouts. One such factor is:

Dividends received far into the future are significantly more uncertain than dividends received in the near future.

Based on the factor described, identify whether investors, in general, will tend to favor high or low payout ratios.

Favor a high payout

Favor a low payout

Erin and Mia are finance researchers and are discussing the Modigliani and Miller (MM) dividend irrelevance theory. Based on your understanding of MM’s argument and the impact of the assumptions applied to the argument, fill in the missing parts of their conversation.

ERIN: Modigliani and Miller (MM) dividend irrelevance theory is based on several assumptions. However, in the real world, these assumptions don’t apply.

MIA: True. If the transaction cost assumption is removed, then investors do care about how they receive their gains from their investment—capital gains or dividends.

ERIN: You are right, Mia. According to MM’s theory, investors who own low- or nondividend-paying stocks could   their holdings to satisfy current income requirements.

MIA: But in the real world, Erin, this is not a fair assumption. Transaction costs with each trade activity will   the investor’s earnings leading investors toward preferring regular dividends.

Answer 1

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Answer:

When an investor dies, his or her heirs are not liable for taxes on the capital gains generated during the investor’s life. They are only liable for the capital gains earned since the investor’s death. - less dividends

Investors expect a reliable annual cash flow from their stock portfolios

More Dividends – Annual cash flows are desired

Risk-averse investors prefer to minimize uncertainty with their expectations of income from their investment.- More dividends

Since the dividends in future are uncertain and dividends in near future are certain, investors would like to receive as much dividend as possible now since it is more certain now than in future. So answer is FAVOR A HIGH PAYOUT

nvestor in low or non-diviend paying stock could SELL A PART of their holdings to satisfy current income requirements

Transaction costs will DECREASE the investor's earnings