Achieving Desired Dividend: Modigliani and Miller Assumptions

D

Suppose the investor is holding stocks worth $100. The company then pays $8 as dividends. To reduce his dividend income to $4, the investor must buy stocks worth $4.

In the given scenario, we are assuming the Modigliani and Miller assumptions, which include no taxes and transaction costs. This implies that the payment of dividends does not affect the value of the firm or the stock price.

The firm has a policy of paying out 8% of the stock price as dividends, but the investor would like to receive only a 4% dividend. To achieve this, the investor needs to adjust their holdings in a way that they receive the desired 4% dividend.

Let's consider the options provided:

A. None of these answers: This option implies that none of the other options is correct. We will evaluate the other options to determine if any of them are valid.

B. Liquidate 8% of his stock holding after receiving the dividend: This option suggests that the investor should sell 8% of their stock holdings after receiving the dividend. However, this approach does not guarantee that the investor will receive a 4% dividend going forward. Selling 8% of the holdings does not change the dividend payout ratio set by the firm.

C. Liquidate 4% of his stock holding after receiving the dividend: This option suggests that the investor should sell 4% of their stock holdings after receiving the dividend. By doing so, the investor reduces their stock holdings, which would result in a lower dividend amount in the future. This option does not align with the investor's objective of receiving a 4% dividend.

D. Use half of the dividend amount to buy stock after receiving the dividend: This option suggests that the investor should reinvest half of the dividend amount by buying more stock after receiving the dividend. Since the investor wants to receive a 4% dividend, reinvesting half of the dividend amount would increase their stock holdings, which may lead to a higher dividend payout in the future. This option aligns with the investor's objective of receiving a 4% dividend.

Therefore, the correct answer is D. The investor should use half of the dividend amount to buy stock after receiving the dividend. By doing so, the investor increases their stock holdings and potentially increases the dividend amount in the future, helping them achieve their desired 4% dividend.