CFM Assignment Dividends in the Real World PDF

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Question 1 Why dividend is relevant in the real world? Answer: Dividends is one large component of the total returns that stocks have provided over time. Dividend is important and relevant in the real world because it is one of the signs that show the financial health and prospects of a company when they pay dividends to shareholders. Usually, mature and profitable companies will tend to pay dividends to its shareholders even though they would normally retain adequate cash to fund business activities and for other contingencies uses. However, it does not also mean that a company that does not pay dividends are not those who make profits. Companies, who think that there is huge growth potential in the company, should keep the profits and reinvest to grow and expand the company services and products. The two most common ways to reward shareholders are through cash dividends and share repurchases. Usually, a cash dividend payment will reduce a company’s assets and the market value of its equity. Stocks dividends are usually a more popular pay-out option in the form of new shares rather than cash. This method is usually more favourable for company that is growing. It is relevant especially for the shareholders because it is to make more informed decision so as to better develop and manage their own portfolio, making more sound reinvestments.

Question 2 Discuss the rationale of using non-dividend pay-out policy such as share repurchases. Answer: Share repurchases is a transaction whereby a company buy backs its own shares from the marketplace because the management thinks that their shares are below value. There are 3 types of method to repurchase shares and they are: 1. Buy in the open market 2. Buy a fixed number of shares at a fixed price 3. Repurchase by direct negotiation

Share repurchase largely reduce the number of shares that is on the open market and reducing the number of shares means earnings per share (EPS), revenue and cash flow grow more quickly. However, if a company uses large funds to buy its own shares, it will reduce interest income and earnings and if using borrowed funds, it may incur interest cost which may reduce earnings by the after-tax cost of the borrowed funds. Share repurchases fills the gap between excess capital and dividends so that the business returns more to shareholders without locking into a pattern (Staff, 2017). Companies likely to repurchase when good investments are hard to find and when their stock’s float is adequate and when they wish to offset option dilution. Although there is no concrete evidence to show that this type of pay-out policy tend to attract a particular type of investors, it does shows that shares repurchases are used to reduce excess cash holdings.

Question 3

Do you prefer dividend paying or non-dividend paying stocks? Justify your answer. Answer: The preference will depend on the investor’s portfolio requirement. In the ideal world, there should be a few considerations that look into the factors such as looking at the spectrum of criteria of stocks and not just the dividend stocks. However, if there would be a choice, I would prefer dividend paying as usually companies which have a long history of constantly increasing dividend pay-out are profitable companies. Dividend paying stocks usually have higher quality earnings. Dividend yields can also support a stock during a market crash, they usually hold up much better than non-dividend paying stocks. Shareholders would usually prefer dividend paying in such times during the crisis. Shareholders can also use the dividend pay-out to buy or fund other cheaper stocks, increasing the overall ownership of business in their portfolio. However, there is a cons in dividends paying as a shareholder will be taxed according to the dividend tax rate when a firms pays dividends. If the dividend is usually taxed at a higher rate than capital gain, then usually shareholders will probably prefer non-dividend paying stocks.

Question 4 Given two companies with the same amounts of assets and debts, should the dividend paying company have a higher valuation? Answer: No. Given the same assets and liability, it does not mean the companies can perform the same. The two companies could be similar in size but they could mean the management could be managing the company differently. The company with the highest expectation will usually be valued higher. Companies do these such as announcing the company corporate plans in the marketplace, providing confidence to the shareholders. The market will decide in consensus if the company would have a high valuation. Some risk adverse investors believe that income from future capital gains will discount the future earning from a higher discount rate.

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Biblography Berk, J. and DeMarzo, P. (2017). Corporate finance. 4th ed. Harlow, England: Pearson. Brav, A., Graham, J., Harvey, C. and Michaely, R. (2005). Payout policy in the 21st century. Journal of Financial Economics, 77(3), pp.483-527. Staff, I. (2017). Share Repurchase. [online] Investopedia. Available at: http://www.investopedia.com/terms/s/sharerepurchase.asp [Accessed 17 Apr. 2017].

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