The tax-preference theory of dividends would suggest that investors (assume capital gains tax rate is lower than dividend income tax rate)

A. prefer that firms pay dividends.
B. prefer that firms retain and reinvest earnings.
C. are indifferent between dividend payment and earnings retention.

Correct Answer: B

According to the tax-preference theory of dividends, investors would prefer that earnings be reinvested in the firm so that they can avoid paying taxes until the future. If investors need the cash, they can sell shares and pay taxes on capital gains at the lower capital gains tax rate.