Investors Prefer Dividends to Capital Gains: Statement Completions | CFA® Level 1 Exam Prep

Investors Prefer Dividends to Capital Gains

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Question

Which of the following statement completions is most correct? If investors prefer dividends to capital gains, then

Answers

A. dividend policy as determined by the residual dividend policy is the only dividend policy which will maximize the price per share of common stock.

B. k(s) will increase as dividends are reduced.

C. k(s) will decrease as dividends are reduced.

D. the equilibrium return, k(s), will not be affected by a change in dividend policy because tax effects will offset these preferences.

E. k(s) will decrease as the retention rate increases.

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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.

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