Question

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.

Cloudy Skies Production Company’s CFO has stated that the firm will pay dividends only after all acceptable capital budgeting projects have been financed using retained earnings to the extent possible. Which concept did the CFO most likely base her decision on?

The residual dividend model

The signaling hypothesis

The clientele effect

Dividend irrelevance theory

Consider the case of Blue Water Producers Inc., and answer the question that follows:

Blue Water Producers Inc. is an oil-drilling company. The company paid a dividend of $2.80 last year, and, in the past, its dividend has increased steadily by about 4% a year. Blue Water just announced that its dividend will increase to $3.75 this year, and its share price rose from $35 per share to $38 per share immediately after the announcement.

Which of the following best explains why Blue Water’s stock price increased as it did?

The signaling hypothesis

The clientele effect

Dividend irrelevance theory

Which of the following statements is true?

Taxes on dividend income are paid in the year that they are received.

Taxes on dividend income are paid when the stock is sold.

As a result, the U.S. tax code encourages many individual investors to prefer to receive   .

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 information content effect.

the clientele effect.

Answer 1

Question wise answers are given below:

1.

Correct answer: The residual dividend model ( As under this model, a firm pays dividends only if more earnings are available than are needed to support the optimal capital budget.)

2.

Which of the following best explains why Blue Water’s stock price increased as it did?

Correct answer: The signaling hypothesis. Since the company has announced a dividend which is much more than its usual trend of 4% annual increase (which would have been $2.91) so it serves as a signal to investors that management forecasts good future earnings.

3.

Correct answer: Taxes on dividend income are paid in the year that they are received. (This is the true statement)

4. As a result, the U.S. tax code encourages many individual investors to prefer to receive  Capital gains ( because taxes must be paid on dividends the year they are received, but taxes on capital gains are not paid until the stock is sold.)

5. The theory of the Signaling Hypothesis explains this phenomenon.

6. This circumstance is an illustration of: the clientele effect. ( For e.g. retired individuals generally prefer regular cash income so they like to invest in stocks that pay regular dividends.)