Question 4 OR (a)

Informational content of dividends; determinants of dividend policy

4 marks

Time to write
About 8 minutes

From an older CBCS paper

Question

Question 4 OR (a) · 4 marks

What is the "informational contents" of dividend payment ? Enumerate the main determinants of a firm's dividend policy. 4

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

8 minfor 4 marks

Read from the question

  • What is the…?Enumerate…2 asks, each with its own marks below. Answer both.
  • EnumerateHeaded points, one or two lines of explanation each.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Informational content of dividends 1½ marks 3 min
  3. 2 Determinants of dividend policy 2½ marks 4 min

Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks.

Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

Informational content of dividends. A dividend conveys information to investors about the firm's profitability and prospects, which they cannot observe directly; this is one reason the relevance school holds that the dividend decision affects the value of the firm. Because managers change dividends only when they expect the change in earnings to last, a dividend increase is read as good news and a cut as bad news, and share prices react accordingly.

Picture itInformational content of dividends; determinants of dividend policy

1With the new plant half-built outside the window, the board votes to keep the coins in the bag.

Investment opportunitiesA company with profitable investments in hand prefers to retain more of its earnings to finance them.

2The retired couple at the AGM would rather have the envelope today.

Expectations of shareholdersShareholders who invest for regular income prefer current dividends to future growth.

Main determinants of a firm's dividend policy:

  1. Availability of funds and investment opportunities: a firm needing funds for profitable projects retains more, saving flotation costs and avoiding dilution of control.
  2. Cost of capital: if finance can come from cheaper debt, more can be distributed; if it must come from new equity, retained earnings are preferable.
  3. Capital structure: the target debt–equity ratio.
  4. Stock price: higher dividends generally raise the market value of shares.
  5. Trend of the industry and shareholders' expectations: investors relying on regular income expect dividends.
  6. Legal constraints: section 123 of the Companies Act, 2013 limits the sources from which a dividend may be declared; one of them is the profits of the year arrived at after providing for depreciation.
  7. Liquidity and access to the capital market: a dividend is a cash outflow, so a firm short of cash or unable to raise funds easily pays less.

Where the 4 marks sit

#ComponentMarks
1Informational content of dividends1.5
2Determinants of dividend policy2.5
Total4
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