dividend policy Flashcards
describe the dividend policy theory - dividends as residual
if raising external finance was so expensive it was impossible then dividends should only be paid when the firm has financed all its positive NPV projects
dividend policy becomes an important determinant of shareholder wealth
If retained earnings are insufficient to fund all positive NPV projects shareholder value is lost, and it would be beneficial to lower the dividend
If cash flow is retained and invested within the firm at less than kE, shareholder wealth is destroyed; therefore it is better to raise the dividend payout rate
describe the dividend policy theory - dividends as conveyors of information (signaling)
unexpected change in the dividend is regarded as a sign of the directors’ view on the firms future prospects
unusually large increase = optimistic
declining = pessimistic
dividend is an information transferring device because of market imperfection
describe the dividend policy theory - owner control
Many firms seem to have a policy of paying high dividends and then, shortly afterwards, issuing new shares to raise cash for investment
Possible answer is signaling
Second potential explanation lies with agency cost
Owners insist on relatively high payout ratios. Then if managers need funds for investment they have to ask
describe the dividend policy theory - clientele effects
Some shareholders prefer a pattern which matches their desired consumption pattern. There may be natural clienteles for shares which pay out a high proportion of earnings and another which have a low payout rate
Eg. Retired people require high steady income
Others prefer to invest in companies with high growth potential resulting in a rising share price and capital gains
Pressure on the management to produce a stable and consistent dividend policy
Most firms seem to have a consistent dividend policy based on a medium– or long-term view of earnings and investment capital needs. The shortfalls and surpluses in particular years are adjusted through other sources of finance
describe the dividend policy theory - catering theory
Managers give investors what they currently want
Catering implies that managers tend to initiate dividends when investors put a relatively high stock price on dividend payers, and tend to omit dividends when investors prefer nonpayers
describe the dividend policy theory - Modigliani and Miller view (with and without taxation)
Assumptions – no taxes, no transaction costs, all investors can borrow and lend at the same interest rate, all investors have free access to all relevant info, investors are indifferent between dividends and capital gains
If a firm has plenty of positive NPV projects and pays out 100% of profits as dividends each year wealth would be destroyed because in an ideal world the firm would simply replace money paid out by issuing new shares
If a firm paid 0% profits as dividends, shareholders would produce homemade dividends by selling a portion of their shares to other investors
