a) Stock dividends and stock splits do not affect the wealth of shareholders in
ID: 2787872 • Letter: A
Question
a) Stock dividends and stock splits do not affect the wealth of shareholders in a perfect
world. We continue to see the share price responding favorably to such announcements.
Explain the reason for such behavior? (5 marks)
b) You have invested 200 shares in Maxwell’s Company Limited. For the next three years you
will receive dividends of $1.50 per share in year one, $1.75 per share in year two and a
liquidating dividend of $15.00 in year three. Assume Maxwell Ltd has a required rate of
return of 15 percent and dividend is an annuity.
(i) What is the price of Maxwell’s stock today? (3 marks)
(ii) You wish to maintain an equal dividend cash flow through the three year period,
how would you accomplish this using the concept of homemade dividend?
(7 marks)
Explanation / Answer
(a) Stock dividends and splits do not affect the wealth of shareholders in a perfect world. This is because there is no impact of splits and dividends on stockholder’s equity. The only impact is on the way the shares are allocated. In a perfect capital market there are no buyers or sellers who are large enough and information regarding the ruling price is available to one and all without any costs. As per Modigliani Miller (MM) proposition the sum of the present value per share after the payment of dividends equal the current value per share before the dividend payments.
Despite this share price respond favorably to announcements of dividends and splits. This is because sentiments of investors come into play. Investors anticipate benefits that may result from a lower per share stock price in case of stock split. Dividends are a signal from company’s management regarding favorable information. Both this creates a positive anticipation effect leading to positive market reaction.
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