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Unformatted text preview: Answers to End-of-Chapter Questions 15-1 The biggest advantage of having an announced dividend policy is that it would reduce investor uncertainty, and reductions in uncertainty are generally associated with lower capital costs and higher stock prices, other things being equal. The disadvantage is that such a policy might decrease corporate flexibility. However, the announced policy would possibly include elements of flexibility. On balance, it would appear desirable for directors to announce their policies. 15-2 While it is true that the cost of outside equity is higher than that of retained earnings, it is not necessarily irrational for a firm to pay dividends and sell stock in the same year. The reason is that if the firm has been paying a regular dividend, and then cuts it in order to obtain equity capital from retained earnings, there might be an unfavorable effect on the firm’s stock price. If investors lived in the world of certainty and rationality postulated by Miller and Modigliani, then the statement would be true, but it is not necessarily true in an uncertain world. 15-3 Logic suggests that stockholders like stable dividends—many of them depend on dividend income, and if dividends were cut, this might cause serious hardship. If a firm’s earnings are temporarily depressed or if it needs a substantial amount of funds for investment, then it might well maintain its regular dividend using borrowed funds to tide it over until things returned to normal. Of course, this could not be done on a sustained basis—it would be appropriate only on relatively rare occasions. 15-4 a. MM argue that dividend policy has no effect on r s , thus no effect on firm value and cost of capital. On the other hand, GL argue that investors view current dividends as being less risky than potential future capital gains. Thus, GL claim that r s is inversely related to dividend payout. b. MM could claim that tests which show that increased dividends lead to increased stock prices demonstrate that dividend increases are causing investors to revise earnings forecasts upward, rather than cause investors to lower r s . MM’s claim could be countered by invoking the efficient market hypothesis. That is, dividend increases are built into expectations and dividend announcements could lower stock price, as well as raise it, depending on how well the dividend increase matches expectations. Thus, a bias towards price increases with dividend increases supports GL....
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This note was uploaded on 02/11/2011 for the course FIN 3403 taught by Professor Tapley during the Spring '06 term at University of Florida.
- Spring '06