Equity Sources and Dividend Policy

Question 1

What is the traditional viewpoint?

Answer 1

A constant dividend stream is important. Cutting a dividend may reduce shareholder wealth.

Question 2

What causes the traditional viewpoint? (dividends)

Answer 2

Shareholders may prefer the certainty of a cash dividend now to the promise of higher dividends in the future (the “bird in hand view”).

Question 3

Explain Modigliani and Miller’s dividend irrelevance hypothesis.

Answer 3

The pattern of dividends does not affect shareholder wealth because as long as directors invest in projects with NPV>0 an increased dividend in the future will compensate for today’s cut. If you need income you can always “manufacture” it by selling shares.

Question 4

How can a shareholder “Manufacture” income?

Answer 4

By selling shares.

Question 5

What are 3 assumptions of the M&M model?

Answer 5

1. Perfect information.
2. Investors are indifferent between income and capital growth.
3. In order to pay a dividend a company must have enough cash and have enough distributable profits on its balance sheet.

Question 6

What are two conclusions that can be drawn from the different models?

Answer 6

1. The directors must see whether the assumptions/arguments apply to their own particular circumstances in deciding their dividend policy.
2. If dividends have to be cut, try to ensure that shareholders are given full information so they understand why.