Question 3 (a) part i
Information content of dividend payment
3 marks
- Time to write
- About 6 minutes
From an older CBCS paper
Question
Question 3 (a) part i · 3 marksExplain:
- Information contents of Dividend payment
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
Read from the question
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- 1 Meaning: dividends convey information about profitability 1 mark 2 min
- 2 How the signal works: increases and cuts 1 mark 2 min
- 3 Significance for dividend policy 1 mark 2 min
Easy marks
- Step 1 opens with the meaning: a one-line definition, the quickest mark in it.
Try it first. About 6 minutes for 3 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.
Meaning. The information content of dividends is the idea that a dividend tells investors something about the firm that they cannot easily observe: management's view of its profitability and future earnings. The relevance school (Myron Gordon, James Walter and others) holds that dividends communicate information to investors about the firm's profitability, and that this is why the dividend decision affects the value of the firm.
How the signal works. Managers are more concerned with changes in dividends than with their absolute amount, and set dividends on a long-term view of sustainable earnings, raising them only when earnings have risen to a lasting higher level. So:
- an increase in the dividend is read as a sign that management expects higher earnings to last, and the share price tends to rise;
- a cut is read as a sign of falling earnings, and the share price tends to fall.
Significance. Because the market reacts to the signal, a firm avoids frequent changes in its dividend and prefers a stable policy. The price change on a dividend announcement may reflect the information conveyed rather than the dividend itself, which is how supporters of the irrelevance view explain the market's reaction.
Where the 3 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning: dividends convey information about profitability | 1 |
| 2 | How the signal works: increases and cuts | 1 |
| 3 | Significance for dividend policy | 1 |
| Total | 3 |
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