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Unformatted text preview: Chapter 17 Distributions to Shareholders: Dividends and Repurchases ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 17-1 Investors who prefer a high payout policy would generally (a) need current cash income and (b) be in a low income tax bracket. Those who prefer a low payout would not need cash currently and would be in a high tax bracket. Universities and other tax-exempt institutions, and many retirees, are examples of those who prefer cash dividends, while people in their peak earning years often prefer low payouts. If someone holds a low payout stock and wants more cash income, he or she can sell the stock and buy a high payout stock, but that would result in brokerage costs and possibly capital gains taxes. If you owned a high payout stock and wanted less dividends, you could (1) sell out and switch to a low dividend stock, (2) try to get the company to lower its payout (while possibly starting a stock repurchase program), or (3) join a dividend reinvestment plan. Selling would involve brokerage costs and possibly capital gains taxes. The dividend reinvestment plan would avoid brokerage fees, but you would have to pay taxes currently even if you reinvest the dividends. You would have a good chance of getting the company to follow your advice under Point 2 if your name were Warren Buffett. 17-2 Here are the three theories, which are illustrated in the BOC model. They should be thought of as applying to investors in the aggregate and not to each individual investor, because, obviously, different individuals will certainly have different preferences. MM Indifference . Investors in the aggregate dont care. Those who like dividends are offset by those who do not want them. Bird in hand, or dividend preference . Most investors prefer cash dividends to retained earnings and possible future growth. Tax preference, or dividend dislike . Most investors prefer to have companies retain and reinvest earnings in order to generate earning growth and capital gains. MM Indifference. MM argue that argue that only a stocks earnings and business risk determine its price. Suppose stocks H and L have the same risk and the same earnings, but H pays more of its earnings out as dividends and has the higher price. MM argue that investors could sell H and buy L. Ls share price should rise faster than Hs because it is plowing back more of its earnings. Ls investors who want more dividends could sell enough of their shares to make up for the dividend shortfall. They prove that this would result in higher cash flows. They then argue that arbitrage would occur until H and L sold at the same price. Had Ls stock had the higher price, then its holders who did not want dividends could sell it, buy H, and then use the excess dividends to buy more of Hs stock....
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