Increase And Decrease When Personal Income Tax Rates

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14-2. a. Decrease. When personal income tax rate increases, stockholders would want the firm to retain its earnings, so it could reinvest them. This is so because an increase in personal taxes would apply to the taxes that stockholders have to pay on their income from dividends.
b. Increase. The more rapid that depreciation can occur, the larger the cash flows that stockholders can receive. This increased cash flow should lead to an increase in the payout ratios for the stockholders.
c. Decrease. An increase in interest rates would create a higher balance in retained earnings. Though this could lead to an increase in payout ratio, it is often likely that the ratio will decrease.
d. Decrease. If the rise in corporate profits is
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“Companies can use the residual model to set a target cash distribution level and then divide the distribution into a dividend component and a repurchase component” (Ehrhardt & Brigham, 2017, p. 591). This will lead to a decrease in the number of outstanding shares and will cause the dividend to continue to grow. “The company has more flexibility in adjusting the total distribution than it would if the entire distribution were in the form of cash dividends, because repurchases can be varied from year to year without giving adverse signals” (Ehrhardt & Brigham, 2017, p. 591). Thus, the growth of the dividends can be less impacted by the cash inflow of the company because in years with less cash inflow, the company can reduce the amount of stocks that it repurchases instead of having a large fluctuation in the dividends. These are two of the several reasons why firms are motivated to repurchase stock instead of using a cash dividend.
2. There is a tradeoff when deciding to pay dividends or retain the free cash flow. This is particularly important when there are floatation costs to consider. “If flotation costs are high, then the required return on new equity, re, will be well above the required return on internally generated equity, rs, making it better to set a low payout ratio and to finance through retention rather than through the
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