This week\'s readings introduce a method of valuing a company\'s stock called th

Question

This week's readings introduce a method of valuing a company's stock called the Dividend Growth model, which bases a company's valuation on several factors, starting with a company's expected dividend payout and growth rate. Based on this model, why might a company be hesitant to reduce its dividend growth rate?

Certain industries, such as utilities, are known for generally high dividend payout ratios, whereas other industries exhibit generally low or no dividend payout ratios. Why might that be? What does a company's dividend policy say about management's view of the company?

Explanation / Answer

As per dividend payout model

Price = recent dividend* ( 1 + growth rate )/( required rate of return - growth rate)

Price is directly proportional to dividend growth rate

Thus Firms are unlikely to reduce the dividend growth rate as it will reduce firm's stock price

Some firms might not pay out large dividends because they might be having a large amount of positive NPV projects

It is cheaper to retain internally generated funds and reinvest them in these projects that to raise it externally

Management's view

Dividends are sticky, that is if they are raised they need to be maintained at that level else it gives a bad signal to the market. Thus Management will increase dividends only if they are solidly confident of the firms financial position.

But a firm increasing dividends may also indicate that they are not having positive NPV projects and that they are repaying the investors idle funds.

If management reduces dividends, this indicates deteriorating financial position of the firm,however it also means that they are trying to retain internally generated funds to meet their positive NPV projects

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