Question

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First you should explain the relationship between dividends and stock prices with reference to the dividend discount model. As dividends are of two types i.e. cash dividends and stock dividends, what are the reasons for giving either type of dividends and does giving of such dividends affect the stock price? In your answer also bring in the discussion about dividend yield and dividend payout ratio. Link in your answer a discussion of profits and retained earnings with dividends. Should you buy shares of firms that pay dividends or should you buy growth stocks; are firms that pay high dividends good or those that pay low dividends – why?

Answer 1

Dividend discount model

The dividend discount model is a method used for the predicting about the stocks price of a company based on the theory that is present day price is worth the sum of all its future dividend payment.

The relationship between the stocks price and dividend:-

After the declaration of dividend the stocks price often increase. However, because a stock dividend increases the number of shares outstanding while the value of the company remains stable, it dilutes the book value per common share, and the stock price is reduced accordingly.

formula

1. stocks value = dividend per share / (required rate of return - dividend growth rate )

2. rate of return = (dividend payment / stocks price )+ dividend growth

As dividend are two type one is the cash dividend and second is the stocks dividend the following reason that giving either cash or stocks dividend

A corporation might declare a stock dividend instead of a cash dividend in order to

1. increase the number of shares of stock outstanding

2. move some of its retained earnings to paid-in capital

3.  minimize distributing the corporation's cash to its stockholders

Dividend payout Ratio

The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company.

The payout ratio is important because it tells investors how much of the company's profits are being given back to shareholders. Put another way, a payout ratio of 20% means for every dollar the company earns in net income, 20% is being returned to shareholders as a dividend.