Question

Define “Clientele Effect” and “Signaling Content” and explain how it affects dividend policy? Explain the logic of residual dividend model and the steps a firm would take to implement it. What are the pros and cons of dividends and repurchases? Explain.

Answer 1

Clientele Effect is a tendency of a firm to attract a group of investors who like its dividend policy because different clients prefer different types of dividend payouts based on their income stage. Therefore firm should try to keep its dividend policy as fixed as possible to retain its regular clients.

Signaling Content assumes that investors regard dividend changes as signals of management’s earnings forecasts of the firm. Investors assumes that dividend policies have information or signaling content about future earnings of the firm and increase or decrease in dividend payout ratio is based on that.

Residual dividend model is a model in which the dividends are paid based of the residual or remaining amounts after deducting the amount of retained earnings necessary to finance the firm’s optimum capital budget. Therefore only the remaining amount after the necessary finances of the company is eligible for distribution as dividends.

Dividend payout is generally regular practice and stock repurchase is not a regular practice of the firm therefore it can made on an ad hoc basis without sending any negative signals to investors while any change in dividend payout policy, it gives the signals to investors about company’s expected future earnings. Repurchases are also use to make significant adjustment to firm’s debt-equity ratio. Repurchases of stock decreased the equity portion of the company therefore it is used to make significant adjustment to firm’s debt-equity ratio.