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

Tarang Ltd has paid a steady dividend for years. It announces a sharp, unexpected increase in the dividend and its share price rises by 6%. Which theory best explains the price rise without any change in the firm's investment plans?

Signalling theory best explains it. Management has better information than outside investors, and a surprise dividend increase is a costly commitment that conveys confidence in future earnings, so the share price rises even though investment plans are unchanged.

  1. AResidual dividend theory, because the firm had no good projects left to fund
  2. BDividend irrelevance, because the price rise shows investors value dividends and capital gains equally
  3. CSignalling theory, because management is conveying favourable private information about future earningsCorrect
  4. DClientele effect, because the firm changed the mix of its debt and equity
  5. Agency cost theory, because the dividend reduced shareholders' control over managers

Explanation

With investment plans unchanged, a price rise on an unexpected dividend increase suggests that investors read it as a credible signal of higher expected future cash flows, as management has more information than the market. Irrelevance would predict no price reaction. Residual theory concerns how the payout is set, not a price reaction to news.

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