514 CHAPTER 14 Distributions to Shareholders: Dividends and Repurchases
tax is due at all—the beneficiaries who receive the stock can use the stock’s value on
the death day as their cost basis and thus completely escape the capital gains tax.
Because of these tax advantages, investors may prefer to have companies retain
most of their earnings. If so, investors would be willing to pay more for low-payout
companies than for otherwise similar high-payout companies.
Using Empirical Evidence to Decide Which Theory Is Best
As Figure 14–1 shows, these three theories offer contradictory advice to corporate
managers, so which, if any, should we believe? The most logical way to proceed is to
test the theories empirically. Many such tests have been conducted, but their results
have been unclear. There are two reasons for this: (1) For a valid statistical test, things
other than dividend policy must be held constant; that is, the sample companies must
differ only in their dividend policies, and (2) we must be able to measure with a high
degree of accuracy each firm’s cost of equity. Neither of these two conditions holds:
Stock Price($)
0 50% 100%
Payout
Bird-in-the-Hand
MM: Irrelevance
Tax Preference
Cost of Equity
(%)
0 50% 100%
Payout
Bird-in-the-Hand
MM: Irrelevance
Tax Preference
rs
P 0
FIGURE 14-1 Dividend Irrelevance, Bird-in-the-Hand, and Tax Preference
Dividend Theories
510 Distributions to Shareholders: Dividends and Repurchases
