FM12_Ch_18_Tool_Kit

FM12_Ch_18_Tool_Kit - 1/2/2007 Chapter 18. Tool Kit for...

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Chapter 18. Tool Kit for Distributions to Shareholders: Dividends and Repurchases THE LEVEL OF DISTRIBUTIONS AND FIRM VALUE (Section 18.1) DIVIDEND THEORIES MM Dividend Irrelevance Theory Bird-In-The-Hand Theory Tax Preference Theory Proposed by Merton Miller and Franco Modigliani, this theory argues that dividend policy has no effect on either the price of a firm's stock or its cost of capital. Firm value, they contended, is determined by basic earning power and business risk. Therefore, a firm's value is based only on fundamental factors, and dividend policy is irrelevant. Others, including Myron Gordon, who developed the DCF stock valuation model, disagreed. They argued that investors regard capital gains as being riskier than dividends, hence that a dollar of dividends contributes more to stock price than a dollar of retained earnings. According to this theory, the cost of capital would decrease, and the stock price would increase, as dividend payout is increased. Still others argue that tax factors cause investors to prefer capital gains to dividends, hence to prefer a low dividend payout. Capital gains are not taxed until the gain is realized. Due to the time value of money, taxes paid in the future will have a lower effective cost than those paid today. Finally, if a stock is held until death, no capital
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FM12_Ch_18_Tool_Kit - 1/2/2007 Chapter 18. Tool Kit for...

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