Finance - Revision Exercise 5 - Solutions Finance - Revision Exercise – Dividends, Capital Structure, Forex, Options Solutions 1. Explain the following terms (a) passive residual theory of dividends (b) clientele effect (c) signalling effects (d) ‘bird-in-the-hand’ view (a) The company would invest in all positive npv projects, and payout any earnings that were left as dividends – dividends would be unpredictable. (b) The company will attract particular types of shareholders due to their dividend preferences. Companies establish a track record for paying divs, shareholders recognise this. Companies should not try to change div policy to attract new clientele. (c ) There is a problem with asymmetric information, managers can use the div to give indication about future performance of company (d) Said that near dividends were less risky than distant payouts, a certain payment now is more valuable than an uncertain gain in the future. But discount rate values all div at the same risk adjusted rate. 2. The decision over how much to payout and how much of earnings to retain is a key decision for managers. Identify and discuss the important factors that management should consider when deciding on the size of dividend to be paid to investors. Main factors: profitability of company (and prospects for profits over business cycle), company’s need for additional finance (liquidity position), the ability of the company to raise additional finance on the markets, its shareholders dividend preferences. The dividend decision would also take into account the gearing level which might limit the company’s ability to pay divs. 3. Three old lags from business school meet up to spoil a good walk by playing a round of golf. During the game they discuss the profitable companies they now run. The conversation drifts towards dividend policy… Boss A says his dividend policy is to pay no dividends at all . Boss B says that he always pays a dividend of 50% of earnings after tax. Boss C s

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