Question 10.S-TQ9: Explain the following terms: (a) the residual theory of divi...

(a) Residual theory of dividends: if the capital investment needs of the company are fully met and there are funds left over, these could be paid out as dividends. While corporate profits are cyclical, capital investment plans involve long-term commitment, so it follows that dividends may be used to take up the slack.

Financial managers cannot follow both a policy of stable dividends and a policy of long-term commitment to capital investment, unless they are willing to raise new finance in times of need to achieve both. Given the objective of shareholder wealth maximisation, if a company can invest in profitable projects and earn a higher return than is available to shareholders, then shareholders should be willing to subscribe new equity finance.

(b) Clientele effect: this term refers to the fact that companies can attract particular types of shareholder due to their dividend decisions. Companies can establish a track record for paying a certain level of dividend and shareholders recognise this. Because of their shareholders’ preferences, companies find it difficult to change their dividend policies suddenly.

(c) Signalling properties of dividends: with asymmetry of information, dividends can be seen as signals from the company’s managers to shareholders and the financial markets. With some exceptions, empirical studies show that dividends convey some new information to the market.

(d) The ‘bird in the hand’ argument: this arises from the existence of uncertainty. If the future were certain and there were no transaction costs, potential dividends retained by a company for the purpose of investment would lead to share price increases reflecting increases in wealth. With uncertainty, however, risk-averse investors are not indifferent to the division of earnings into dividends and capital gains in the share price.