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(a) A political advisory committee recently recommended wage and price controls to prevent the spiraling inflation that was experienced in the 1970s
(a) A political advisory committee recently recommended wage and price controls to prevent the spiraling inflation that was experienced in the 1970s. Members of the investment community and several labor unions have sent the committee reports that discuss whether or not dividends should be under the controls.
The reports from the investment community demonstrated that the value of a share of stock is equal to the discounted value of its expected dividend stream. Thus, they argued that any legislation that caps dividends will also hold down share prices.
The union reports conceded that dividends are important to shareholders, but only because the dividend is the shareholders’ wage. In order to be fair, the unions argued, if the government controls labor’s wage, it should also control dividends.
b) Comment briefly on each of the following statements:
(i) “Unlike new capital, which needs a stream of new dividends to service it, retained earnings are essentially free capital.”
(ii) “If a company repurchases stock instead of paying a dividend, the number of shares falls and earnings per share rise. Thus stock repurchase must always be preferred to paying dividends.”
Expert Solution
1.Comment on
"Unlike new capital, which needs a stream of new dividends to service it, retained earnings are essentially free capital"
The above statement is not completely correct.
Its right that the retained earning dont directly require dividends to be paid but these are also shareholders fund and when the company retains part of its earnings the shareholders expects that the company will invest those earnings wisely and as a consequence of which their share price will go up.
So retained earning are free in form that there is no flotation cost involved as compared to new issue of shares that require a good amount of outflow .
2. Comment On
“If a company repurchases stock instead of paying a dividend, the number of shares falls and earnings per share rise. Thus stock repurchase must always be preferred to paying dividends.”
The Earnings per share is calculated by deviding earnings of the company by number of shares outstanding (i.e. Earnings / Number of shares)
So it is correct that as the number of shares fall the earnings per share will increase .
But Price per share is calculated by deviding the future expected dividends by the Suitable discount rate (i.e. D 1 / Ke - g)
So if company didnt pay a decent dividend then price per share will fall in the market.
Final Conclusion - Company should make a blend of dividend payment and retention policy in order to make the shareholders happy as few shareholders require regular dividend paying stocks while other invest for value appreciation.
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