Explain the role that dividends play in meeting investor goals

By | April 16, 2014

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1.        Question 1 (10 Marks)


1.1    Explain the role that dividends play in meeting investor goals and its impact on price volatility (6 Marks)


1.1.1            Impacts of dividends changes on price volatility


The Gordon growth model was developed by Gordon and Shapiro (1956) and Gordon (1962) assuming that dividends has a current value of D that grows indefinitely at a constant rate of g, the model also assumes that the required rate of return for the stock remains constant at k>g which is equal to the cost of equity for that company, the calculation of the value of price current P is:


D1 = D0 (1 + g),

Formula 1 Price of shares determination in Gordon growth model


Suppose D1 = 1 $, k = 10%, g = 5%

P0 = 1/(10% – 5%) = 1/0.05= 20


According to this model, if D1 increases significantly, the price of the stock will also grow dramatically:

Say the dividends increase by 50% to 1.5 $

P0 = 1.5/(10% – 5%) = 1.5/0.05= 30


So suppose other factors would not change obviously, the anticipated sustainable increased high dividends will drive up the price of the stock according to the Gordon growth model. What is more, several academic studies have related the price change related with the announcement of a special dividend and also find a positive stock price respond (Baker 2009, p. 314). One early study carried out by Brickley (1983) also demonstrates that the stock prices increase by about 2 percent when firms announce unanticipated SDDs. Vice versa, since dividends anticipate future earnings, it is no surprise to find that announcements of dividend cuts are usually taken by investors as bad news (stock price typically falls) and that dividend increases are good news (stock price rises). In addition, as the dividends given change unexpectedly, the stock price could bounce back and forth as the individual investors and institutional investors try to figure out the implications of the changes in dividends (Brealey & Myers 2003, p. 159). In conclusion sudden and unexpected dividends changes tend to increase the degree of the price volatility.


1.1.2            Role of dividends in meeting investor goals


Formula 2 Present value of a stock based on an infinite stream of dividends

Source: Brigham & Ehrhardt 2010, p.275


Like all financial assets, the value of a stock is estimated by finding the present value of a stream of expected future cash flows, to a stock such cash flows are the future dividends of the stock plus the expected sale price of the stock in term of present value. Looking back on the case stated in question in which the Australian share market is delivering in bucket loads for investors, if the individual investors apprehend the this unexpected growth in the dividends as sustainable and reliable, then a reliable stream of dividends would certainly add on to the intrinsic value of the stocks expected by the investors.


But according to a simple model of stock valuation, dividend is not the only thing that would be taken into account, the valuation process of the stocks suggests that value of a stock depends on the firm’s earning, dividend policy and the investor’s required rate of return which takes into account of the risks associated with the particular stock (Mayo 2007, p. 313).


In term of the dividend policy, there are various types of dividend policies which include stable dividend-per-share policy, constant dividend-payout-ratio, a compromise policy and residual dividend policy. The core initiative of using these various dividend policies is to determinate the amount of earning to be retained and given to the shareholders and the predictability and continuity of the amount given in multiple years. The selection of the dividend policy will be affected by various factors such as nature of the industry (earnings stability), company growth rate, restrictive covenants, profitability, maintenance of control, degree of financial leverage and uncertainty (Shim & Siegel 2007, p. 339). In the perspective of the shareholders, the adoption of the particular dividend by the concerned company actually transmit messages that the company tries to communicate to the investors, and it is not always good for the company to issue high dividends to the investors even in the view of the investors. For example, though a company is earning abundant profits but due to the fact that the company is actually experiencing one of the highest growing period in its business, to the long term share holders it is good for the company to restrict the dividends in the following several years to retain more profits for reinvestment purpose to increase the business scale which in return will benefit the shareholders by driving up the share prices. Vice versa, if there is too much profit given out in term of dividends, it could be a bad signal to the investors because the companies retain too less for the future development.


1.2    Discuss how market volatility can be beneficial (4 Marks)


Firstly, volatility does not necessarily measure historical fluctuations; rather, it is a forecast of the underlying asset’s future volatility as perceived by the market (Marketwatch.com 2011). Secondly, though volatility is often associated with failing stock prices, a rising market can also sometimes be characterized as having high volatility. Thirdly, to the smart volatility traders, no matter what market delivers, they are prepared to make use of the unique trading opportunities that various states of the market volatility foster. Fourthly, the periods of high volatility are often the result of an emotionally driven market (Fontanills & Gentile 2003, p. 8). Two major kinds of emotions are fear and greed. It takes time for the investors to gather the new information and thus make decisions based on the changed market situations. The period of volatility is actually a period of adjustment for the investors psychologically.