Acfa - Question2 (I) Signalling Essay

Submitted By DimitarSlatinski
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Pages: 4

The signalling implications of each policy
In perfect capital markets, the firm’s choice of dividend policy is irrelevant and does not influence the share price according to the Modigliani and Miller (Modigliani, Miller, 1961). However, financial markets are far from perfect in the real world and asymmetric information problems may arise. When managers have more information than investors especially in terms of the future earning prospects of the company, dividend payout policies may create positive or negative signals to the markets. Based on dividend signalling hypothesis, a change in dividend reflects the manager’s views on the firm’s future earning prospects (Berk, DeMarzo 2011). For example, during 1967-1993, companies that increased dividend at least 10% saw a 1.34% increase in stock prices after dividend announcement while the companies that reduced their dividend at least 10% saw a decrease in stock prices by 3.71% (Grullon et al. 2002). As a result, a change in dividend payout seems to be an important factor for the company’s share price movements.
Residual dividend payout
Under residual dividend payout method, Mulberry will only pay dividend from residual earnings, which is the dividend after using the fund for all positive NPV projects. This implies that the company will focus primarily on value maximization by investing in positive NPV investments. However, residual dividend policy in this case can also create a positive affect to the share price. If investors believe that managers are able to use the fund efficiently by investing in all positive NPV projects, rather than paying out high level of dividend, it will create a positive signal towards stock prices (Berk, DeMarzo 2011). Based on Royal & SunAlliance, a U.K.-based insurance group, cutting dividend to reinvest capital in the business leads to a positive stock price reaction (Wood 2001).
In this situation, Mulberry’s major shareholders, Ong and Rowland families, own approximately 81% stake in the company’s shares and Melissa Ong is also a member of the board. Despite the fact that the payout policy has not yet been communicated to the major shareholders, other investors may not be convinced that way. Given information asymmetry between outside investors and the Ong family, who has Melissa as a non-executive board director, outside investors may believe that the family can influence the company to do what is best for the shareholders, including themselves, in the long run e.g. investing in a positive NPV projects to maximize shareholder value. This will create a positive signal towards the company’s share price since outside investors may be convinced that the Ong family, who has some control over the company, foresees prospective future investments and decides to encourage the company to use the fund for positive NPV investments first, before paying out dividend.
Maintain current dividend but use excess cash to finance buybacks
The main difference between dividends and share repurchases is that the cost of share repurchase depends on the market value of the shares (Berk, DeMarzo 2011). Based on Brav et al (2005), most CFOs believe that they should concern primarily on the interest of the long-term shareholders. Berk and DeMarzo (2011) also add that share repurchase sends a signal that the shares are underpriced, since managers tend to invest in favour of the long-term shareholders by investing in a profitable investment. Thus, investors in general tend to act in favour with share