Reading 31: Dividends and Share Repurchases: Analysis-LOS b 习 associates, equity, center, research, 2011

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Session 8: Corporate Finance
Reading 31: Dividends and Share Repurchases: Analysis

LOS b: Discuss the types of information (signals) that dividend initiations, increases, decreases, and omissions may convey.

 

 

David Johnson, Karim Baghwani, and Marlon Fitzpatrick are equity research associates at Carp National Investments. Over lunch in the cafeteria, they began discussing the information content of dividends. Baghwani made the following statements to his colleagues:

Statement 1: There is no doubt that shareholders perceive changes in dividend policy as conveying important information about the firm. However, it is viewed differently in the U.S. and in Japan. In the U.S., investors infer that even a small change in a dividend sends a major signal about a company’s prospects.

Statement 2: In Japan, however, investors are less likely to assume that even a large change in dividend policy signals anything about a company’s prospects. Thus, Japanese companies are more free to increase and decrease their dividends than their U.S. counterparts without concerns over investor reactions.

With respect to Baghwani's statements:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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Both statements are correct. In the U.S., investors infer that even small changes in a dividend send a major signal about a company’s future prospects. However, in Asian countries such as Japan, investors are less likely to assume that even a large change in dividend policy signals anything about a company’s future prospect.

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In a recent lecture at a seminar titled “Dividends – Do They Really Matter?”, Matthew Janowski, CFA, made the following two statements regarding the information content in dividend policy changes across countries:

Statement 1: In the U.S., investors infer that small changes in dividends do not send a major signal about a company’s future prospects to existing and potential shareholders.

Statement 2: In Asian countries such as Japan, investors are unlikely to assume that even a large change in dividend policy signals anything about a company’s future prospect.

With respect to Janowski's statements:

A) both are correct.

B) both are incorrect.

C) only one is correct.

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The information content in dividend policy changes is viewed differently across countries. In the U.S., investors infer that even small changes in a dividend send a major signal about a company’s future prospects. Thus, Statement 1 is incorrect. However, in Asian countries such as Japan, investors are less likely to assume that even a large change in dividend policy signals anything about a company’s future prospect. As a result, Asian companies are freer to raise and lower their dividends as circumstances change without concerns over how investor reactions may affect the stock price. Therefore, Statement 2 is correct.

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At a recent conference, “Dividends ? Are They Increasing?”, several lecturers were discussing the signaling effect and their opinions on how changes in a company’s dividend policy are often viewed by investors. Linda Travis, an equity analyst at Girthmore Capital Management and one of the guest lecturers at the conference, made the following observations:

Observation 1: A dividend initiation is always viewed as a positive signal by investors. It is an indication that the company has so much cash at its disposal that it can afford to pay it out to shareholders.

Observation 2: A dividend decrease is typically a positive signal by a company’s management to its shareholders. It indicates that management has a variety of positive NPV projects in its capital budget and would like to finance as many of them as possible with retained earnings.

With respect to Travis' observations:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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A dividend initiation is often viewed differently by different investors. On one hand, a dividend initiation could mean that a company is sharing its wealth with shareholders – a positive signal. On the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities – a negative signal. Dividend decreases or omissions are typically negative signals that current and future earnings prospects are not good and that management does not think the current dividend payment can be maintained.

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