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Hello John
In this question, the company proposes an increase in its dividend payments by 20% to be more attractive to equity investors. The question then asked to evaluate that proposal and the answer mentioned>> “Increasing the dividend would not make the company more attractive to equity investors, but would attract equity investors who desired the new level of dividend being offered”. It then concludes that it should not be done as it brings no new funds to the company.
My question is why would it not make the company more attractive to equity investors? If the increase in dividends are paid out of retained earnings then that would negatively affect the financial risk (which is not good). On the other hand there would be an increase in equity. This equity could then be used for further investments which would in turn increase the profits and by extension the shareholder wealth.links to the question and answer are shown below:
https://www.accaglobal.com/content/dam/acca/global/PDF-students/2012/december2007ques.pdf
https://www.accaglobal.com/content/dam/acca/global/PDF-students/2012/december2007ans.pdf
Several things:
Firstly the gearing is not really relevant because it is the gearing based on market values that really matters – not based on book values in the Statement of financial position.
Secondly, why should there be an increase in equity just because they paid a dividend?
Thirdly (and most importantly) in order for the business to grow they need cash in order to invest and expand. Paying out a higher dividend means they have less cash left in order to invest.
So although a higher dividend will be attractive to some investors, it will mean lower growth in the future, and it is the expected future dividends (and expected future growth) that determines the market value (as with the dividend growth formula).
In theory (according to M&M) it should not make any difference whether shareholders get low dividends but high growth, or high dividends and low growth and so the market value should be unaffected. However in practice investors tend to invest in those companies that follow a dividend policy that they individually want.
I do cover all of this in the free lectures (and explain how it is retention (i.e. lower dividends) that give rise to future dividend growth.
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