CFA® Level 1: CFA® Level 1 Exam | Test Prep

CFA® Level 1 Exam

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Question

Which of the following statements is most correct?

Answers

A. An increase in the cost of equity capital when a company announces an increase in its dividend per share, would be consistent with the bird-in-the-hand theory.

B. All of these statements are correct.

C. The tax preference theory states that, all else equal, investors prefer stocks that pay low dividends because retained earnings can lead to capital gains that are taxed at a lower rate.

D. A dividend policy that involves paying a consistent percentage of net income is the best policy if the "clientele effect" is correct.

E. An increase in the stock price when a company decreases its dividend is consistent with the signaling theory.

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Explanations

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A. B. C. D. E.

The reasons investors might prefer a low dividend payout to a high payout are:

1. Long-term capital gains are taxed at a maximum 28% rate, whereas dividend income is taxed at rates up to 39.6%. Obviously, high tax-bracket investors might prefer to have firms plow back earnings into the firm, presumably leading to a higher stock price, and resulting in a lower-taxed capital gain.

2. Capital gain taxes are not paid until the stock is sold and taxes paid in the future has a lower effective cost than taxes paid today.

3. If stock is held until one dies, no capital gains tax is due because the cost basis of the stock of the beneficiaries who inherit the stock, is the stock's value on the death day, thus escaping any capital gains tax.

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