Module 12 Finance Theory

Question 1

Why is the level of dividend important?

Answer 1

• Dividends are regarded as communicating a message about management’s view of current and future profitability (‘signalling hypothesis’)
• A dividend is cash in hand and is, therefore, more certain than an expectation of future capital growth
• Investors place heavy emphasis upon past dividend levels when making investment decisions.

Question 2

No dividends policy

Answer 2

• All profits are reinvested by the company.
• Shareholders may be unhappy as they receive no income, and future profits and capital appreciation are uncertain.
• Possible taxation advantage as capital gains are taxed at a lower rate for individuals than dividend income.

Question 3

Constant dividend growth policy

Answer 3

• Dividends grow at x% per year.
• Predictable income stream will appeal to many investors.
• Possible concerns where the dividend growth rate does not match up with the rate of growth in profits.

Question 4

Constant payout ratio policy

Answer 4

• For example, 25% of profits are paid out as a dividend and the remainder retained.
• Investors may like the link to the company’s profits each year.
• Some investors may not react well to dividend levels falling in years with lower profits.

Question 5

100% payout policy

Answer 5

• Tax disadvantages for investors as dividend income taxed at higher rate than capital gains.
• Investors are unlikely to approve this policy as it implies the shareholders can invest their money more profitably than the company and its directors.

Question 6

Walters model

Answer 6

• If rate of return is greater than the cost of capital zero dividends paid
• Lower rate of return than the cost of capital 100% dividends paid generate a higher rate of return in other opportunities

Question 7

Walters model assumptions

Answer 7

• Retained earnings are the only source of finance
• The cost of capital and the rate of return on investments stay constant
• The life of the company is endless

Question 8

Residual theory

Answer 8

• company should retain profits it needs to fund its upcoming investments and projects
• distribute any remaining profits to the shareholders as dividends
• dividends can be quite volatile
• investors either receive value now as a dividend, or later in the form of capital appreciation
• dividend irrelevancy theory

Question 9

Modigliani-Miller Theory of Dividend Policy

Answer 9

• dividend irrelevancy theory
• dividends the investors do not want can be invested in more shares
• company retains profits share price should rise
• If investors would prefer dividends sell their shares to realise the value of this gain

Question 10

The Efficent Maerkets Hypothesis

Answer 10

• States that investors should not be able to ‘beat the market’
• No investment is either under or over-priced
• Investors looking to maximise their returns can only do this by minimising their expenses

Question 11

Expected return from a single investment

Answer 11

Question 12

Expected risk from a single investment

Answer 12

Question 13

Systematic risk

Answer 13

Systematic risk is the risk inherent in the political and economic renvironment common to all companies. Like intrest rate fluctations

Question 14

Specific risk

Answer 14

Risk specific to an individual company

Question 15

Beta

Answer 15

• Beta (‘β’) measures how the return from a particular security typically performs in relation to the average return that has been earned over the same period by all investments in the market
• less than 1 indicates that the security is less risky, while a beta of more than 1 indicates that the security in question is more volatile than the market
• stock market as a whole is deemed to have β = 1.
• negative β could arise if the company’s fortunes have been observed to move in the opposite direction to the market as a whole (defence company in times of war)

Question 16

CAPM formula

Answer 16