Question

Suppose management of Lilydale Sports Corporation decides to use cash to pay a dividend of $8,000,000, and then issues more shares to new shareholders to replace the cash. What will happen to the market value of the existing shares and shareholders’ wealth? Explain your answer clearly.            

Answer 1

Any company when has excess retained earnings usually look at 2 option: 1. Retain it and invest in either existing business lines or in new business ventures 2. Disperse the funds to shareholders either as cash dividends or go for buyback of shares. The choice of route to take for any company depend on their view of future prospects, market scenario, shareholders sentiments and other factors.

When a company pays a cash dividend to the shareholders, its shareholder equity value is decreased by the total dividend amount dispersed to the shareholders. But cash dividend is a means by which companies reward existing shareholders. The shareholder sentiments may be alleviated on short term and can attract more value investors. Buy when we are funding this cash dividends from more share issue, the company is giving a mixed message. The company is increasing its equity base without sacrificing a shareholder backlash.

Thus on short term the shareholder wealth is now decreased with the increased equity capital burden but shareholder sentiments is currently not very pessimistic due to the cash dividend provided to existing shareholders.