Cost of Common Stock and Dividend Payout Relationship

Financial Theories: Determinants of Stock Prices

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Question

Consider the following argument: "The cost of common stock should decrease as the dividend payout is increased because investors are more certain of receiving these dividends than the capital gains which are supposed to be derived from retained earnings." This statement applies best to which of the following financial theories? Choose the best answer.

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Explanations

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A. B. C. D. E.

E

The Bird-in-the-Hand Theory came about as a refutation of Modigliani and Miller's Dividend Irrelevance Theory. The founders of the Bird-in-the-Hand Theory,

Myron Gordon and John Lintner, stated that investors are more confident in the fact that they will receive dividends versus capital gains. So said, the cost of common stock should decrease as the payout ratio is increased.

The Tax Preference Theory states that investors prefer capital gains to dividends, and this is due to the structure of tax rates. Specifically, dividends are typically taxed at a higher rate than capital gains, and are in this respect less attractive.

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