Question

Explain why the decision to distribute cash to shareholders matters to the firm, and discuss the factors that the firm needs to consider when making this decision (e.g clientele effect, signalling )

Answer 1

Why the decision to distribute cash to shareholders matters to the firm

The dividend decisions bring impact on the value of the company in the following ways:

1. Signalling effect: Dividend decision of the company signals information to existing and prospective shareholders. If the information is interpreted positively, the share price will increase, and vice versa
2. Clientele effect: The company creates a client base by making dividend decisions. Such decisions will make a specific group of clients happy while others are unhappy. Thus the behaviour of clients affect the value of the company
3. Free cash flow theory: According to this, the company should distribute dividend only if it has free cash flow. Free cash flow is the cash in excess of investment opportunities in the projects which add value to the company.

Thus dividend decision is important for a company.

Factors that the firm needs to consider when making Dividend decision

• Liquidity position of the company
• Stability of Earnings
• Debt obligations of the company
• Tax position of the shareholders
• Investment opportunities of the company
• Dilution of ownership of the company
• Profit rate of the company