The Dividend Theory (Term Paper Sample)
The paper required me to answer the following finance questions Question 1: When a company director announces new information, the share price of company will change accordingly. Discuss this view Question 2: Discussion of dividend policy is a waste of time because it has no effect on the shareholders wealth. Discuss this statementsource..
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TABLE OF CONTENT
Question 1: When a company director announces new information, the share price of company will change accordingly. Discuss this view
1 The Efficient Market Hypothesis
2 Influence of Demand And Supply On Stock Prices
3 Criticism of The Efficient Market Hypothesis
Question 2: Discussion of dividend policy is a waste of time because it has no effect on the shareholders wealth. Discuss this statement
5 Definition of Dividends and The Importance of A Dividend Decision Policy
6 Modigliani and Millers dividend irrelevancy theory
7 The agency theory
8 Bird in hand theory
9 Clientele theory
10 Tax differential theory
Informational signal theory
Discussion of the view that when directors release information, whether good or bad, the share price will reflect the information accordingly
When a company director releases new information, the share price of the company will change accordingly to reflect the impact of the information. This statement is supported by the efficiency market hypothesis and the random walk theory of stoke valuation. The random walk theory of valuation holds that the prices of securities rely on those factors affecting expected risk an expected return. Information on these factors is usually released to the markets at different intervals and that the investors or users of the financial information react differently to the information. According to this theory, securities follow a random walk hence stoke prices cannot be predicted accurately. A critical evaluation of the efficient market hypothesis will help us have a clear understanding of why release of new information will lead to a change in share price.
1.1 The efficiency market hypothesis
Samuelson, Mandelbrot and Fama developed the hypothesis in the 1960's. It holds that information whether good or bad, when it is released to the market; it will quickly be absorbed and reflected in the security price. This implies that the share prices react instantly, rationally and fairly to any news. If for instance a company releases bad news like projecting a decline in dividends at the end of the year, these information will be reflected in the stoke price since the demand for the shares at the stoke exchange markets will decline. On the other hand, in case a company releases good news to the market like a projection of revenue increase that would increase returns to the shareholders, it is expected that the stoke price will increase since there will be increased demand for the securities in the securities exchange market.
The hypothesis has three underlying assumptions namely: that investors are rational, informed, independent and anticipate for the highest profits. The second assumption is that information is random and freely available and that it is not possible for any investor to predict information and use it to his advantage. Lastly, there are no transaction fees and taxes in the market. Under the assumptions, share prices reflect all the information available currently and the prices are subjected to changes with release of new information. This implies that future security prices can not be predicted accurately since they follow a random trend. The efficiency of the security exchange is often measured by the speed at which the released information is reflected in the share price. Studies by various scholars indicate that there are three types of market efficiencies. These include the strong, semi strong and the weak levels of efficiency.
Weak form of market efficiency
Here the securities prices only reflect historical data. Under this form of efficiency, it is not useful analyzing past trends in prices because share prices do not exhibit any patterns to the assets prices. This hence implies that technical analysis is not useful. When a director releases information to market, this information will not be reflected in the share prices if a weak form of market efficiency holds.
The semi strong form of market efficiency
In this level, the securities reflect current information that has been released to the public as well the historical information. The publicly available information may be in form of published accounting statements and the directors' decision on behalf of the shareholders. Under this level of efficiency, confidential information is not available.
The strong form of market efficiency
This occurs when a security price reflects historical or past information, present information that has been released to the public as well as future information that is confidential to the management of the company. The confidential information may include information such as the directors having a plan to issue a right issue that announced to the public.
1.2 Influence of demand and supply on stock prices
Stoke prices are influenced by supply and demand factors initiated by many willing buyers and willing sellers. Through the buying and selling of the stoke, a price equilibrium will be established as demonstrated below.
Whenever good news is released, more investors are willing to buy the stoke causing the demand to increase. Since the supply of the stoke is fixed, the increased demand will lead to an increase of the shares price. Whenever bad news is released in an efficient market, the holders of the stoke are willing to offload there shares. Increased supply of the floated shares causes a decline in prices since the demand is lower than the supply.
1.4 Criticism of the efficient market hypothesis
Researchers and investors have criticized the hypothesis since its assumptions are not practical in the current business environment. For instance, transactions costs and taxes are inevitable since various governments have implemented withholding taxes in security investments. Another weakness of the hypothesis is that it holds that all investors should have all the information and no investor should have access to information that other investors have. The critics hold that confidential information may found its way out to some investors through insider trading.
From the analysis of the views of the researchers above, it is evident that most researchers support the efficient market hypothesis that holds that release of new information has an impact on the share price. The critic's however are important since they raise questions that the current researchers should lay emphasis on. From the studies by the different researchers on the efficient market hypothesis, it is easy for a finance analyst to support the hypothesis since its arguments are consistent with the happening in the business world. The writer of this paper hence agrees with the fact newly released information by directors will be reflected on the share price of the company.
Evaluation of the statement that the dividend policy is a waste of time since the dividend policy has no effect on shareholders wealth
Discussion of the dividend policy is a waste of time since the dividend policy has no effect on shareholders wealth. Some researchers such as Modigliani and Miller support this statement while others argue that a company's dividend policy has an impact on the value of the firm. In order to evaluate this statement these paper seeks to highlight and critically evaluate the various theories regarding the impact of a dividend policy on the value of a firm or shareholders wealth.
2.1 Definition of dividends and the importance of a dividend decision policy
Dividends are the earnings by the company that are distributed to ordinary shareholders as a return for their investment in a company. The dividend decision is important to any company because of two main reasons. First, it provides a solution to the dividend puzzle of whether payment of dividends increases or reduces the value of the firm. Additionally, a dividend decision is important because its part of a company's finance strategy in that payment of high dividend means low retained earnings and hence the need for more debt capital in the company's capital structure.
In making a dividend policy decision, we include four critical issues. These are when should a firm pay dividend, how much a company should pay, how should the dividends be paid and why should the dividends be paid. Our research is centered on the last question on why a company should pay dividends. Researchers have advanced various theories to explain whether a company's dividend policy has an effect on the value of the company. The theories are explained as follows:
2.2 Modigliani and miller's (MM) dividend irrelevancy theory (1961)
In a theoretical article by MM on dividend policy, the researchers argued that dividends policy has no effect on the price of the firm's stoke or its cost of capital. They stated that the dividends policy is hence irrelevant; they also argued that it is the basic earnings power or cash flows and the risks class that determine the firm's value.
Dividend policy has therefore no effect of either the manner of earnings are split between dividends and additions to retained earnings. They based their theory on the following assumptions:
* The security markets are efficient
* The information known to managers is also known to shareholders
* The company's investment policy is independent of its dividend policy
* There are no taxes on corporate on personal income
* There are no transaction costs associated with floatation of the shares
Using the assumptions, Modigliani and miller proved that payment of dividend is irrelevant as follows.
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