Chapter 15, Problem 1Q

Define each of the following terms:

1. a. Optimal distribution policy
2. b. Dividend irrelevance theory; bird-in-the-hand theory; tax effect theory
3. c. Signaling hypothesis; clientele effect
4. d. Residual distribution model; extra dividend
5. e. Declaration date; holder-of-record date; ex-dividend date; payment date
6. f. Dividend reinvestment plan (DRIP)
7. g. Stock split; stock dividend; stock repurchase

Summary Introduction

To discuss: Meaning of optimal distribution policy.

Explanation of Solution

A corporate policy outlining how to communicate and distribute the messages throughout the various divisions and departments of the company, and it can also affect how documents are filed.

Summary Introduction

To discuss: Meaning of dividend irrelevance theory, tax effect theory and bird-in-the-hand theory.

Explanation of Solution

Dividend irrelevance theory: The dividend irrelevance theory holds that dividend policy has no effect on either the stock price of a company or its capital cost. Merton Miller and Franco Modigliani (MM) are the main proponents of this view.

In a theoretical sense, they prove their position, but only under strict assumptions, some of which in the real world are clearly not true.

Theory of “bird-in-the-hand”: The theory of “bird-in-the-hand” assumes that investors value a dividend dollar higher than a dollar of expected capital gains because the component of dividend yield, D₁/P₀ is less risky than the component of ‘g’ in the total expected return equation,

 ${\text{r}}_{\text{S}}=\frac{{\text{D}}_{\text{1}}}{{\text{P}}_{\text{0}}}+\text{g}$

Tax effect theory: The tax effect theory proposes that investors prefer capital gains over dividends as capital gains taxes can be postponed into the future, while dividend taxes must be collected as dividends as earned.

Summary Introduction

To discuss: Meaning of signaling hypothesis and clientele effect.

Explanation of Solution

Information or signaling content, hypothesis: Is an indicator by the company through a price changes in the dividend that can provide insight as to what the anticipated earnings may be for the company making the actual announcement of the dividend.

Clientele effect: The effect information about dividend announcements on stockholders earning dividends.

Summary Introduction

To discuss: Residual distribution model and extra dividend.

Explanation of Solution

Residual distribution model: The residual dividend model implies the irrelevance of the theory of dividends, which claims that investors are indifferent between dividend returns or capital gains.

Extra dividend: Extra dividend paid on good times in addition to the regular dividend. It is not always possible to pay or sustain this dividend in the future.

Summary Introduction

To discuss: Declaration date, holder-of-record date, payment date and ex-dividend date.

Explanation of Solution

Declaration date: It is the date the directors met to declare the regular dividends.

Holder-of-record date: The date on which all registered owners of a company’s stock will receive dividends based on the number of shares held.

Ex-dividend date: It is the date when the right to the dividend leaves the stock.

Payment date: It is the date when the company actually mails the check to the record holders.

Summary Introduction

To discuss: Dividend re-investment plan (DRIP).

Explanation of Solution

An automated way for shareholders to voluntarily purchase common stock shares instead of having dividends paid out in cash.

Summary Introduction

To discuss: Stock split, stock dividend and stock repurchase.

Explanation of Solution

Stock split: If shares of a company’s stock are split, thereby increasing the number of outstanding shares on the market, a strategy for holding a stock in an optimal price range.

Stock dividend: Increases the number of outstanding shares as with a split stock, but as a stock dividend, stockholders will receive a proportionate share of stock at no expense.

Stock repurchase: It is nothing but when a company buys back some its own outstanding stock.