Skip to content

CMA Intermediate · Financial Management and Business Data Analytics · Dividend Decisions and Dividend Theories

Under the tax preference theory, which investor behaviour is predicted when long-term capital gains are taxed at a lower effective rate than dividend income in the hands of a high-income investor?

Tax preference theory predicts that investors facing a lower tax rate on capital gains than on dividends favour companies that retain earnings. Retained profits convert into taxed-later, lower-rate gains, so high-payout shares must offer higher pre-tax returns. Preference for certain dividends belongs to the bird-in-hand argument.

  1. AThe investor prefers firms that retain earnings, accepting lower payout in return for capital gainsCorrect
  2. BThe investor prefers firms with the highest payout because dividends are certain
  3. CThe investor is indifferent between dividends and capital gains
  4. DThe investor demands a lower required return on high-payout shares

Explanation

Tax preference theory says that if gains are taxed more lightly than dividends (and gains tax is deferred until sale), high-tax investors prefer retention. High-payout shares would therefore need to offer a higher pre-tax return, not a lower one. Preference for certain dividends is the bird-in-hand argument, which is a different theory.

Did you get it right without looking?

One question tells you little. A timed set on Dividend Decisions and Dividend Theories shows your real accuracy, how long you take and where you lose marks.

Practise Dividend Decisions and Dividend TheoriesFree diagnostic mock

More Dividend Decisions and Dividend Theories questions