Palomino Enterprises has $100,000 in cash. They wish to invest the money in Treasury bonds at 6% and use the returns to pay dividends to shareholders after a year. Alternately they can pay a dividend and allow shareholders to make the investment. In perfect capital markets, which option will shareholders prefer?

Question

Quizplus · Accepted Answer

Shareholders should be indifferent between receiving a dividend after one year and directly investing in Treasury bonds with a 6% return themselves. In perfect capital markets, they can achieve the same return either way, hence they will be indifferent. The option of half from each source is not realistic and not a feasible choice. An immediate cash dividend will result in lost income from potential returns on the investment.

Palomino Enterprises Has $100,000 in Cash