Question

Which of the following statements is CORRECT? If the "clientele effect" is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize the stock price. An increase in the stock price when a company decreases its dividend is consistent with signaling theory. Firms with a large number of investment opportunities and a relatively small amount of cash tend to have above average dividend payout ratios. One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like. Stock repurchases make the most sense at times when a company believes that its stock is undervalued.

Answer 1

Ans:

The correct statement is Stock repurchases make the most sense at times when a company believes that its stock is undervalued.

Clientele effect is a theory that affirms the stock market price of a company could increase or decrease depending on the taxation, the distribution of the dividends and other company policies. A policy of paying a constant percentage of net income for a company whose earnings is fluctuating may not be welcome by the investor. Due to the fluctuating nature of dividends as its a constant percentage of net income, the share price may fall down.

As per signaling theory, increases in a company's dividend payout generally forecast a positive future performance of the company's stock.

Firms with large no of investment opportunities and a relatively small amount of cash tend to have a very low dividend payout ratio due to lake of liquidity and other high return investment opportunities.

Companies that maintain a residual dividend policy invest in growth opportunities from profits before paying shareholders their dividends. Hence the distribution of dividends is volatile in nature which depends on investment opportunities. Due to this a variable dividend policy may send conflicting signals to investors. It also represents an increased level of risk for investors, as dividend income remains uncertain.