Chartered Financial Analyst (CFA) Practice Exam Level 2

According to financial theory, what impact do dividend payments have on a company's stock price?

1. Dividends increase stock price

2. Dividends decrease stock price

3. Dividends have no impact on stock price

4. Dividends fluctuate based on market conditions

The correct answer is: Dividends have no impact on stock price

The impact of dividend payments on a company's stock price is grounded in financial theory, particularly the Dividend Discount Model (DDM) and the Modigliani-Miller theorem. According to these theories, dividend payments do not intrinsically affect a company's stock price; rather, they are viewed as a distribution of the company’s earnings to shareholders. The DDM suggests that the value of a stock is equal to the present value of its future dividends. If a company is expected to grow and retain earnings for reinvestment rather than paying them out as dividends, the stock price can still rise based on anticipated future cash flows. Thus, dividends, while providing immediate income to shareholders, do not change the underlying fundamentals of the company or its growth potential. Moreover, the Modigliani-Miller theorem postulates that, in a perfect market with no transaction costs or taxes, the value of a firm remains constant regardless of its dividend policy. This indicates that whether a company pays dividends or reinvests its earnings, the total value to shareholders will remain the same. Any change in stock price due to dividends is often offset by changes in investor expectations about future growth or risk. Therefore, while dividends certainly play a role in investor perception and can influence market behavior,