Question

Please respond to the following: The catering theory of dividends suggests that managers pay dividends because of investor demand. Using knowledge gained from this chapter, conduct a search for an article on this theory. Indicate the article you found and briefly provide an opinion on this theory. Propose alternative ways, covered in the reading material this week, in which investors can receive cash returns from their investment in the equity of a company.

Answer 1

Introduction

Dividends are of strategic importance to organisations because they form the nexus of organisations’ capital structures and have an important bearing on firm value. Investors tend to invest in shares with high profitability and dividend rates as their relative long-term investments to investors. The dividend level is positively related to the company's profitability. This is because companies with high profitability can pay more dividends because of the large available profits.

The theory suggests that management of companies pay dividend only when investors demand the same. When the demand for dividends is high, the investors put a stock premium on the payers in the market. Management responds to this demand by paying dividend. However, when investors are indifferent, they skip the dividend payments. The article presents and empirical way of deciding whether dividends should be paid or not. The analysis first disregarded the theory that the result is driven by Common time trend. The second theory that is established by the analysis is that dividends reflect other firm characteristics. Lastly, the analysis ruled out Time Varying Contracting problems and thus established the relationship between premium on dividend and close end funds discount. An equity shareholder receives cash returns from their investment primarily by two ways, the cash dividends and capital appreciation on the stock. Thus they can earn profits by gaining from the hike in the price of the shares they hold. The other method by which a shareholder can earn cash returns is by participating in capital restructuring. Under this scenario, they can sell back a portion of their stock to the company and buy debt if the company is offering any. This will get them the market price of the stock repurchased by the company and also regular interest on the debt that is purchased by the investors.