A firms value depends on its expected free cash flow and its

A firm’s value depends on its expected free cash flow and its cost of capital. Distributions made in the form of dividends or stock repurchases impact the firm’s value and the investors in different ways.

Consider the scenario, and answer the questions that follow:

Mainway Oil Company is an oil drilling company and has some free cash flow that is not expected to be used for growth or investment projects. The company plans to distribute to its shareholders but is still deciding whether they should conduct a stock repurchase or distribute dividends.

Which of the following is a characteristic of a firm’s optimal dividend policy?

It maximizes the firm’s total assets.

It maximizes the firm’s earnings per share.

It maximizes the firm’s stock price.

It maximizes the firm’s return on equity.

Modigliani and Miller argued that each shareholder can construct his or her own dividend policy. This statement is:

False

True

Modigliani and Miller also pointed out that many institutional investors do not pay taxes and can buy and sell stocks with very low transaction costs. For these investors, dividend policy is (more, less) relevant than it is for an individual investor.

Some researchers and analysts have noticed a trend in which firms that increase their dividends see an increase in their stock price. The theory of (clientele effect, information content)   explains this phenomenon.

In some cases, analysts notice that groups of similar investors tend to flock to stocks that have dividend policies consistent with their needs. This circumstance is an illustration of:

The clientele effect

The information content effect

Solution

1. Option D. It maximizes the firm’s return on equity. The Optimal dividend policy should look towards maximization of income to the investor

2. false. Modigliani and Miller argued that each shareholder can construct his or her own dividend policy. An Individual shareholder cannot construct his own dividend policy as it depends on the market situations.

3. Modigliani and Miller also pointed out that many institutional investors do not pay taxes and can buy and sell stocks with very low transaction costs. For these investors, dividend policy is more relevant than it is for an individual investor.

4. Information Content effect. explains the phenomenon of change in stock price based on change in dividend price

5. Clientele effect.