ACCA Advanced Financial Management (AFM) Practice Exam

When investors prefer low dividends, which of the following scenarios applies?

1. Tax rates on dividends are lower than on capital gains

2. Tax rates on dividends are higher than on capital gains

3. Taxation does not affect investment decisions

4. All investments are treated equally

The correct answer is: Tax rates on dividends are higher than on capital gains

Investors may prefer low dividends when tax rates on dividends are higher than those on capital gains. This preference stems from tax efficiency; if dividends are taxed at a higher rate, receiving less in dividends allows investors to defer taxes and potentially benefit from a lower tax rate when realizing capital gains upon selling the stock. When dividends are minimized, the retained earnings can be reinvested in the company, contributing to capital appreciation. This is attractive for investors looking to maximize their after-tax returns. In this context, the focus shifts towards long-term growth rather than immediate income distribution, aligning with the investors' interests in optimizing their tax liabilities. The other scenarios do not apply because if tax rates on dividends were lower than on capital gains, investors would typically prefer higher dividends to benefit from the lower tax burden. If taxation did not affect investment decisions, investor behavior regarding dividend preferences would not show a clear inclination for lower dividends. Lastly, stating that all investments are treated equally disregards the nuances of tax implications, which significantly influence how investors approach their returns.