Question

12. Dividend policy

A firm’s value depends on its expected free cash flow and its cost of capital. Distributions made in the form of dividends or stock repurchases impact the firm’s value and the investors in different ways.

Some analysts have argued that a firm’s value should solely be determined by its basic earning power and the business risk of the firm. Which of these concepts would support these analysts’ argument?

The signaling hypothesis

The clientele effect

Dividend irrelevance theory

The residual dividend model

Consider the case of Blue Water Producers Inc., and answer the question that follows:

Blue Water Producers Inc. is an oil-drilling company. The company paid a dividend of $1.75 last year, and, in the past, its dividend has increased steadily by about 4% a year. Blue Water just announced that its dividend will increase to $2.50 this year, and its share price rose from $30 per share to $33 per share immediately after the announcement.

Which of the following best explains why Blue Water’s stock price increased as it did?

The signaling hypothesis

The clientele effect

Dividend irrelevance theory

Modigliani and Miller argued that each shareholder can construct his or her own dividend policy. This statement is:

False

True

Modigliani and Miller also pointed out that many institutional investors do not pay taxes and can buy and sell stocks with very low transaction costs. For these investors, dividend policy is   relevant than it is for an individual investor.

Another firm, called Cheatum Power & Water, an established public utility company, has been paying dividends for the past 20 years. This year Cheatum also announced that it will increase its dividends by 10%. Which class of investors is more likely to be pleased by Cheatum’s dividend announcement?

Investors with low tax rates who depend on current dividend income for living expenses

Investors with high tax rates who don’t depend on current dividend income for living expenses

A firm’s   dividend policy determines its current clientele of investors.

Answer 1

1) Some analysts have argued that a firm’s value should solely be determined by its basic earning power and the business risk of the firm. Which of these concepts would support these analysts’ argument?

The signaling hypothesis : this states that policies like dividends are used to send a positive signal to investors rather than serving an actual purpose. this it supports the fact that dividends have an effect on share prices thus taxes, dividends etc have an effect on share prices

The clientele effect : here the belief is that company share prices move in reaction to investors goals and demands

correct answer is : Dividend irrelevance theory : this theory states that dividends declaration and payments has no or little impact on the stock prices.

The residual dividend model : this model is used to calculate how much dividend should be paid to shareholders

2) Consider the case of Blue Water Producers Inc., and answer the question that follows:

Blue Water Producers Inc. is an oil-drilling company. The company paid a dividend of $1.75 last year, and, in the past, its dividend has increased steadily by about 4% a year. Blue Water just announced that its dividend will increase to $2.50 this year, and its share price rose from $30 per share to $33 per share immediately after the announcement.

Which of the following best explains why Blue Water’s stock price increased as it did?

correct answer is :The signaling hypothesis : the increase in dividends gave a positive signal to the investors and the stock price shot up

The clientele effect

Dividend irrelevance theory

3) Modigliani and Miller argued that each shareholder can construct his or her own dividend policy. This statement is:

False

correct answer is True : M&M states that there is no difference between a company financing itself using debt / equity. It says that value of a company depends only on the earning power and risk of underlying assets.

4) Another firm, called Cheatum Power & Water, an established public utility company, has been paying dividends for the past 20 years. This year Cheatum also announced that it will increase its dividends by 10%. Which class of investors is more likely to be pleased by Cheatum’s dividend announcement?

retail investors / individual investors who do not pay taxes on the dividends received would be happiest with this announcement.