Level 1 CFA Exam: Most Correct Statement

CFA Level 1: Exam Statement Analysis

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Question

Which of the following statements is most correct?

Answers

A. One advantage of adopting a residual dividend policy is that it makes it easier for corporations to maintain dividend clienteles.

B. None of these answers are correct.

C. The clientele effect can explain why firms often change their dividend policies.

D. The bird-in-hand theory would predict that companies could decrease their cost of equity financing by raising their dividend payout.

E. All of these answers are correct.

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Explanations

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A. B. C. D. E.

The main conclusion of MM's irrelevance theory is that dividend policy does not affect the required rate of return on equity. Gordon-Lintner disagreed stating that k

(s) decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which should result from retaining earnings than they are of receiving dividends. They said that investors value expected dividends more highly than expected capital gains because the dividend yield is less risky than the growth component in the total expected return equation, k(s) = D1/Po + g. MM disagreed and theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains. MM called the Gordon-Lintner's study the bird-in-the- hand fallacy, because MM thought the riskiness of the firm's cash flows to investors in the long run is determined by the riskiness of the operating cash flows, not by dividend policy.

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