Financial Management Essay Example | Topics and Well Written Essays - 2000 words - 1

Financial Management - Essay Example Dividend relevance The relevance of dividends in the price movement of the shares will be very high in case there is a shift in the fundamental factors governing dividend policy. ‘Agency theory posits that dividend mechanism provides an incentive for managers to reduce the costs associated with the principal/agent relationship. Distributing resources in the form of cash dividends forces managers to seek outside capital, thus causing them to reduce agency costs as they subject themselves to the scrutiny of the capital marketplace’ (Moh’d et al., 2005, p.367) The fundamental factors in this regard are profitability of the companies, the investment opportunities available to the companies for plough back of profits for the growth and management policy. Therefore, any change in the continued practice or policy is reviewed critically by the investors. In could affect the value of the shares in the following ways. 1. The existing investors sell the stocks if the change in policy impacts future dividends and is inconsistent with their investment objectives. 2. The change in policy could attract new investors if it is consistent with their investment objectives. 3. The demand and supply of stocks due to change in dividend policy will influence the market prices. ... The process of price discovery in the market is greatly vitiated in general by the interplay of these factors. Though these factors do cause price movements, the impact is very unpredictable. This leads to speculation with regard to the motives of the management of a company relating to dividend decisions. The investor community would generally be affected by these dividend decisions due to lack of access to market information or inability to interpret the information and its impact on the stock prices. There would be violent fluctuations of the stock prices in the short run which are caused not due to information content in respect of dividends, but other considerations or perceptions. The fundamental factors influencing dividend policy Profitability of company, its growth over years, the opportunities available to company for investment within company and management policy are the important factors governing dividend policies of the companies. Earnings growth The consistency and gr owth in payment of dividends by a company over years are discounted in the stock prices under efficient market conditions. The companies with good track record in this respect command high price/earnings multiple in valuation of their companies’ stocks. Dividend policy is, therefore, relevant to the premium in price/earnings multiple attached to the stocks. But, the recurring dividend announcements in line with the expectation of the market are not the determinants of the value of the stocks. However, when the earnings beat the expectation of the market and company increases dividends substantially or the payout ratio is increased significantly, the investors expect that the increase in dividends will be maintained in the