Financial Markets

QUESTION

a) In perfect capital markets, the dividend policy is irrelevant. Let us imagine that the firm pays dividends without changing investing and financing policies. The company maintains the same amount of debt and it needs to issue new shares to finance the dividends. The new shareholders will pay only what the shares are worth, and the old shareholders receive the amount as dividends. From this the value of the firm remained the same, but money changed hands from new to old. Under M&M assumption, there is no reason to believe that dividend policy will change the discount rate. Since the firm is maintaining the same amount of debt and the value remained unchanged, the cost of capital does not change with payment of dividends. Therefore, the statement is false. b) A company retained earnings are those that are left with the company. You are keeping it. In a way, you are investing for them in your company. but shareholders expect some return on that money which you are keeping. They expect the same return as if they had gotten the retained earnings in the form of dividends, and bought more stock in your company with them. That is the cost of retained earnings.You have to ensure that if you are retaining earnings, then the shareholders will get atleast as good a return on the money if they had re-invested the money back into the company. Truly speaking there is really “no” cost involved in the cost of retained earnings becasue the money is not

hanging hands. But you are keeping the shareholders money which is not of “free” of cost.Therefore, i disagree with the statement. c) Dividend is distribution of value to shareholders and stock repurchase is just one form of divdend. When a company buys back its own shares, it has to offer higher price than the current prevailing market price. Otherwise, the shareholders have no incentive to sell their stock. But offering a higher price than the markets the company is distributing value to its existing shareholders. Dividend is value distribution as well as cash distribution to shareholders and it is the most common fom of dividend. Dividends are future cash flows that will be paid in a regular basis. But stock repurchase is “one-time dividend” or one-time deal which the shareholders dont expect it to contiue in any regular fashion in the future. When the company has excess amount of money, then it plans for a share-repurchase. Therefore, the statement is false.

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