Week 10- Dividend Policy and Market Efficiency

Question 1

What are some of the practical issues that support dividend policy relevance (4) ?

Answer 1

Legal Constraints:
- Dividends can only be paid from accumulated net profits
- Governments may impose restrictions on dividend payments
Liquidity:
- Dividends reduce the available cash to a firm which reduces liquidity and increases risk of default
- High levels of profit may not mean large dividends as profit is not the same as cash
Interest payment obligations:
- High gearing will mean high interest payments reducing availability of cash for dividend payments
Investment opportunities:
- Dividend payments will depend on the attitude of shareholders and markets to cut dividends, availability and cost of external finance

Question 2

What is the bird in hand argument?

Answer 2

Supports dividend policy relevance by arguing that firms that pay higher dividends will attract more investors than firms that pay lower dividends since investors see higher dividends as less risky investments.

Question 3

What is the clientele effect/theory?

Answer 3

supports dividend policy relevance by arguing that the best approach is to create a consistent dividend policy because it attracts investors that have similar consumption patterns with the dividend pattern

Question 4

What is the signalling theory?

Answer 4

Supports dividend policy relevance by arguing that raising dividend payments signals good news to the market about firm performance which will encourage share price to rise

Question 5

What is agency theory?

Answer 5

Supports dividend policy relevance by aruging that if the firm retained all earnings, it would raise questions on whether the management was utiling all the earnings for maximising SH wealth or whether they were using some self interestedly. By paying dividends you can remove these doubts and thereby reduce agency costs

Question 6

What is income tax?

Answer 6

tax charged on all types of personal income including dividend payments from companies

Question 7

What is Capital gains tax?

Answer 7

Tax charged on the profits amassed from the rise in value of an asset

Question 8

Why might an investor prefer to create their own dividend policy by selling or buying more of their share in a business?

Answer 8

Their capital gains tax rate margin may be lower than their income tax rate margin.

Question 9

Describe how the nature of the firm itself can influence dividend policy

Answer 9

i.e if the firm is a family firm it may give special circumstance to the owners

Question 10

Describe dividend policy in practice

Answer 10

Dividend should come second to the investment opportunities for firms and their availability of funds. DIvidends should be out of leftover earnings.

Question 11

What is an efficient market?

Answer 11

A market that fully and instantly reflects all relevant and available information quickly and rationally

Question 12

If a market was efficient how could you tell what the true value of a share was?

Answer 12

Through the current market value

Question 13

What is an ineffient market?

Answer 13

When it takes longer ie a few days for information to be reflected in the share price of a firm

Question 14

How can you create effiecient markets?

Answer 14

Competition

Question 15

What are the different types of market efficiency?

Answer 15

1) Informational (pricing) Efficiency: Market prices instantly and fully reflect all relevant available information
2) Operational efficiency: costs of carrying out transactions in markets in the most cost-effective way
3) Allocational efficiency:the extent to which capital is allocated to the most profitable enterprise

Question 16

Why is market efficiency important?

Answer 16

If the stock market was inefficient then CAPM would not be able to provide financial managers with an NPV discount rates for project appraisal purposes

Question 17

Who came up with the Efficent Market Hypothesis and in which years?

Answer 17

Eugene Fama (1965,1970)

Question 18

What is the distinguishing factor about the weak form of EMH?

Answer 18

The market information is based on past history

Question 19

What is the Random Walk Hypothesis?

Answer 19

RWH says that if the market only incorporates past firm information then future share price movements are unpredictable for investors. This means that no abnormal returns can be achieved by trying to draw patterns except by chance since share price movements are completely random

Question 20

What are the implications of the random walk hypothesis for investors?

Answer 20

1) Investors don’t need to try and time there investments as it is unlikely to have any impact on the returns
2) an investors ability to outperform the market will be more luck than skill

Question 21

How can you test Weak form EMH?

Answer 21

1) Autocorrelation: tests whether asset returns are related through time. Tends to confirm that share returns are independent of each other
2) Filter Rule: Classic market trading strategy. If the price increases by some pre-determined percentage (A%) BUY, Hold until the price falls by another pre-determined percentage (B%) below the intervening high, at which point sell and “go short”

Question 22

What is the distinguishing factor about the semi strong form of EMH?

Answer 22

Market prices are based on past and present publicly available information

Question 23

can you receive abnormal returns in an semi strong market?

Answer 23

No because the information is public and is rapidly incorporated into share prices

Question 24

What test can you use to validate semi-strong EMH?

Answer 24

1) Event studies: examines the impact of new information on the movement of share prices i.e mergers, dividend increases/decreases, annual earnings etc. Returns on the day are compared to those before and after the event

Question 25

Does empirical evidence support weak and semi-strong EMH forms?

Answer 25

Yes

Question 26

What is teh distinghishable factor about strong form of EMH?

Answer 26

It is based on past, public and private information

Question 27

Have there been any tests for Strong form EMH? Why?

Answer 27

No because strong form EMH implies insider trading which is illegal in most countries so it has not be tested directly

Question 28

Does emipiral reseacrch support the strong form?

Answer 28

No

Question 29

Can insiders (directors etc) make abnormal profits by trading on private information? What does this mean?

Answer 29

Yes, therefore we should reject the Strong form

Question 30

Why should we care about market efficiency (4)?

Answer 30

1) Investing decisions: If the market is efficient then the CoC will accurately reflect the prospects for each firm meaning firms with the most attractive opportunities will be able to get capital at a fair price that reflects their potential
2) Financing decisions: If the market ids efficient then the firms share price will never be over or under valued and this means that there is no need to time when you issue equity
3) marketing decision: Because an efficient market fully and instantly reflects new firm information there is no need for firms to tel people how well they are doing to boost their share price, it will be done instantly
4) Accounting decision: An efficient market converts all different forms of accounting procedure used by different companies into oe universal format so there is no effect on stock price if a firm uses a certain type of accountancy procedure

Question 31

What are some market anomalies that undermine the validity of EMH?

Answer 31

January effect: higher return in January as compared to other months.
o Monday effect: trend in increase/decrease in share price from previous
Friday’s trading.
o Turn of the month effect: temporary increase in stock prices in the last few
days and first few days of the month.
o Holiday effect: the tendency of the stock market to gain on the final day of
trading day before a long weekend.
o Small firm effect: the tendency over long periods of time for smaller-company
stocks to generate larger returns that those of large-company stocks.
o P/E ratio effect: stocks of companies with low P/E ratio earned a premium for
investors during period 1957-1971.
o Over/under reaction of stock prices to earnings announcements: evidence
suggests that information is not impounded in prices instantaneously as the
EMH would predict

Question 32

What is the influence of behavioural finance on the work of EMH?

Answer 32

Questions whether all investors are rational. Only takes a few irrational investors to affect market prices significantly over the long term