Modig theory says percentage earnings that a firm pays in dividends has no effect on its cost of capital, but it does affect its stock price. Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout, announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument. Other things held constant, the higher a firm's target dividend payout ratio, the higher its expected growth rate should be. The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, an increase in the tax rate on dividends relative to that on capital gains would logically lead to a decrease in dividend payout ratios. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a high dividend payout ratio.

Modig theory says percentage earnings that a firm pays in dividends has no effect on its cost of capital, but it does affect its stock price. Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout, announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument. Other things held constant, the higher a firm's target dividend payout ratio, the higher its expected growth rate should be. The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, an increase in the tax rate on dividends relative to that on capital gains would logically lead to a decrease in dividend payout ratios. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a high dividend payout ratio.

Intermediate Financial Management (MindTap Course List)

13th Edition

ISBN:9781337395083

Author:Eugene F. Brigham, Phillip R. Daves

Publisher:Eugene F. Brigham, Phillip R. Daves

Chapter11: Determining The Cost Of Capital

Section: Chapter Questions

Problem 5MC

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