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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

A listed Indian company that has never changed its dividend suddenly announces a 30% increase in the dividend per share, and its share price rises. Which theory most directly explains the price rise?

The signalling theory explains it: a surprise dividend increase tells the market that management expects stronger, sustainable future cash flows, so investors revalue the shares upward even though the cash paid out is not itself creating value.

  1. ASignalling: the increase conveys management's confidence in future cash flowsCorrect
  2. BResidual dividend policy: surplus cash after investment is paid out
  3. CClientele effect: tax-exempt investors have left the register
  4. DModigliani-Miller irrelevance: the price move is caused by the payout ratio itself
  5. Pecking order theory: retained profits are the cheapest finance

Explanation

Because managers know more than outsiders, a dividend rise is read as favourable private information about sustainable earnings, lifting the price. MM irrelevance would predict no effect from payout alone, and the residual and pecking order ideas concern financing, not information.

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