Question

A utility company has been in existence for over 50 years. Its business is highly regulated. E.g. the company must apply for rate increases through a utility commission, which leads to low business risk and a steady stream of income. Investors in the utility are often retired people who use the dividends to pay their living expenses. Which of the three main dividend theories would apply to this utility company?

A. Dividend Preference Theory

B. Signaling Theory

C. Dividend Irrelevance Theory

D. Tax Preference Theory

Answer 1

Dividend preference theory applies to this company. This theory says that investors prefer the certainty of regular dividends to the uncertainty of potential future capital gains. Retired people depend on investment income for their living expenses. Hence they prefer low risk investments such as utility companies. There is much lower potential for future capital gains, but more certainty of regular dividends

Signaling theory applies when investors view increased dividend payouts as a signal of bright future prospects for the company

Dividend irrelevance theory says that investor are indifferent to dividends, and a stock's value does not depend on its dividend payouts

Tax preference theory applies when taxes on dividends are lower than taxes on capital gains