Dividend Policies: Bird-in-the-Hand, Tax Preference, and Modigliani-Miller Theories

Bird-in-the-Hand, Tax Preference, and Modigliani-Miller Theories

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Question

Which of the following is/are true about dividend policies?

I. Under the Bird-in-the-Hand theory, stocks with lower pay-out ratios have higher required rates of return.

II. Under the Tax Preference theory, stocks with lower pay-out ratios have lower required rates of return.

III. Under the Modigliani-Miller theory, the price of a stock does not change with a change in the dividend policy.

Answers

Explanations

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A. B. C. D. E. F. G.

D

(II) is not necessarily true when the capital gains tax is higher than realized income tax.

Let's go through each statement one by one:

I. Under the Bird-in-the-Hand theory, stocks with lower payout ratios have higher required rates of return.

The Bird-in-the-Hand theory suggests that investors prefer to receive dividends rather than capital gains because dividends are considered more certain. According to this theory, stocks with lower payout ratios (the proportion of earnings paid out as dividends) would have higher required rates of return. This is because investors would demand a higher return to compensate for the lower dividend income they expect to receive. Therefore, statement I is true.

II. Under the Tax Preference theory, stocks with lower payout ratios have lower required rates of return.

The Tax Preference theory proposes that investors prefer capital gains over dividends because capital gains may be taxed at a lower rate. Under this theory, stocks with lower payout ratios (meaning they retain more earnings and distribute fewer dividends) would have lower required rates of return. Investors would be willing to accept a lower return since they anticipate receiving more of their return through capital gains, which are potentially taxed at a lower rate. Therefore, statement II is true.

III. Under the Modigliani-Miller theory, the price of a stock does not change with a change in the dividend policy.

The Modigliani-Miller theory, also known as the dividend irrelevance theory, states that the dividend policy of a company does not affect the value of the firm or the price of its stock. According to this theory, the value of a company is determined by its underlying cash flows and the risk associated with those cash flows, rather than the way those cash flows are distributed as dividends. Therefore, a change in the dividend policy would not impact the price of the stock. Consequently, statement III is true.

Based on the explanations above, we can conclude that statements I, II, and III are all true. Therefore, the correct answer is option C. I, II & III.

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