How Does the Dividend Policy Affect Expected Equity Returns

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Examlex · Accepted Answer

The Answer is Share repurchases provide a better method of distributing cash than dividends because most investors prefer capital gains income to an equivalent dividend taxed at a higher rate.Equities with higher dividend yields,to compensate investors for their tax disadvantage,should thus offer higher expected returns than similar equities with lower dividend yields.Firms with higher dividend yields,but equivalent cash flows,should then have lower values,reflecting the higher discount rates that apply to their cash flows.Because the marginal investor in an equity with a high dividend yield is likely to have a low marginal tax rate,the after-tax value of the dividend should be relatively close to the amount of the payout.However,the marginal buyer of an equity with a low dividend yield is likely to have a high marginal tax rate and thus will place a much lower value on the dividends.Equities with high dividend yields are fundamentally different from equities with low dividend yields in terms of their characteristics and their risk profiles.Therefore,it is nearly impossible to assess whether the relation between dividend yield and expected returns is due to taxes,risk or other factors such as investor sentiment.

How Does the Dividend Policy Affect Expected Equity Returns

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