Question

Dividend Policy Question: a) Discuss the existing theories that attempt to explain dividend increases, and describe what might be the announcement effects predicted by these theories. [8 Marks] b) When analyzing announcement effects, what are the other relative financial issues that are associated with those effects?

Answer 1

a) There are two theories to consider a) dividend signalling and b) dividend irrelevance theory.

a) Dividend Signaling: Investors tend to prefer companies with a long dividend history. Companies paying the highest level of dividends are more profitable than otherwise identical companies. Increases in payout of dividends are taken favorably by the market as it indicates bright future. While cuts in dividend payout leads to a drop in stock price.   

b) Dividend Irrelevance Theory: Modigliani and Miller assert that the dividend policy of a company has no impact on the company’s stock price. Their argument is that investors are free to sell their stock holding when in need of cash. In real world this argument is not validated.

b) There are 3 things to consider when deciding whether to pay a dividend or not:

1. Keep cash balance as emergency fund
2. Reinvest in the business
3. Pay a dividend

Paying a dividend sometimes suggest that company’s investment opportunities are exhausted. Thus, it is better to return money to shareholders as the IRR of future projects is less than the IRR of current projects.

Hence, even though you might get dividend but stock price appreciation will be limited. This will lead to a lower total return(Dividend + Stock Price Appreciation).