Question 4 OR (a)

Stability of dividends and why firms follow it

6 marks

Time to write
About 12 minutes
Topic
Dividend theories and dividend policy

Question

Question 4 OR (a) · 6 marks

What is meant by stability of dividend? Why do firms follow a stable dividend policy?

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

12 minfor 6 marks

Read from the question

  • What is meant…?Why…?2 asks, each with its own marks below. Answer both. Where it asks why, give reasons, not a description.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Meaning and forms of stability of dividends 3 marks 5 min
  3. 2 Reasons for a stable dividend policy 3 marks 5 min
  4. Check: every ask answered, key terms underlined 1 min

Easy marks

  • Step 1 opens with the meaning: a one-line definition, the quickest mark in it.

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

Try it first. About 12 minutes for 6 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. Stability of dividends means a regular, steady payment of dividends that does not swing with every change in the year's earnings. It can take three forms:

  1. Constant dividend per share: a fixed amount every year, whatever the earnings, often supported by a dividend equalisation reserve; it is raised only when the higher earnings look lasting.
  2. Constant payout ratio: a fixed percentage of each year's earnings, so the dividend moves with earnings.
  3. Stable dividend based on long-term earnings: the dividend is set on a long-term forecast of sustainable earnings and increased only when earnings have risen to a substantially higher level; managers are more concerned with changes in the dividend than with its absolute amount.

Why firms follow a stable dividend policy

  1. Investors who depend on dividend income (individuals and institutions meeting living and operating expenses) prefer a regular dividend.
  2. Higher market value of shares: many companies believe a stable dividend policy maximises the market value of their shares.
  3. Better image and investor confidence: the company's standing in the market improves and investors favour such companies.
  4. Easier future financing: a firm with a steady dividend record can approach the market successfully for additional funds for expansion when needed.
  5. Information content: since managers are reluctant to change dividends, a steady dividend signals confidence in sustainable earnings, and a cut is read as bad news.

Where the 6 marks sit

#ComponentMarks
1Meaning and forms of stability of dividends3
2Reasons for a stable dividend policy3
Total6
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