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Passive Residual Theory of Dividends Questions

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1. Explain the following terms: a- passive residual theory of dividends The company would invest in all positive npv projects, and payout any earnings that were left as dividends – dividends would be unpredictable. b- Clientele effect The company will attract particular types of shareholders due to their dividend preferences. Companies establish a track record for paying divs, shareholders recognize this. Companies should not try to change div policy to attract new clientele . c- Signaling effects There is a problem with asymmetric information; managers can use the div to give indication about future performance of company d- ‘bird-in-the-hand’ view 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. 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. T ...
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