Question

1. United plc has been trading for 5 years but has never paid a dividend. Its share price has increased every year. A long-established competitor, City plc, has a history of paying dividends for many years.

a)Discuss briefly why United’s share price may have increased every year.

b) Discuss why an investor in City who wants to maximise income may buy the company’s ordinary shares rather than its preference shares.

Answer 1

1. a) Generally companies which were comparatively new and also growing at a rapid pace, do not pay the dividends. This is mostly due to reinvestment in new programs or expanding existing business. This helps the company to maintain a good health and opportunity to grow. So there is an assumption in the market that United plc has a better future up its sleeves- this results in high demand of it's share that results in increased price.

1. b) The advantage with preferred stock is that it gets paid out first in case of a bankruptcy. But preferred stock are sold at a premium and also pays a fixed amount, where as ordinary shares are relatively cheap and their dividend payment is linked with company's performance As City plc is a long established and stable company with many years of dividend paying history, so investors can rely on it's financial health and can invest in ordinary shares instead of preference shares- which will reduce the investment amount and on the other hand will allow to have more opportunity to earn.