Question

1. Discuss fully Modigliani and Miller’s irrelevance theory of dividends (1961) and compare and contrast it with the following:

1. clientele effects
2. residual dividends
3. signalling theory

Pear plc has reported the following over the last eight-year period;

	Earnings	Dividends
	Cents per share	Cents per share
2012	57.7	33.8
2013	65.4	35.5
2014	77.5	38.7
2015	86.5	42.0
2016	84.2	45.0
2017	70.1	48.0
2018	66.7	51.0
2019	70.3	52.0

Required:

2. Analyse whether the points discussed in part a) are consistent with the observation of a slow steady growth in dividends? Use the dividends of Pear plc to illustrate your analysis.

Answer 1

1. Modigliani and Miller (MM) suggested that in a world with no taxes or bankruptcy cost, the dividend policy is irrelevant. They proposed that the dividend policy of a company has no effect on the stock price of a company. MM say that if an investor gets a dividend that’s more than he expected then he can re-invest in the company’s stock with the surplus cash flow. If the expected dividend is too small, then he can sell a part of his shares and replicate the same cash flow he would get if the dividend was what he expected. In both cases, investors are irrelevant to what the company’s dividend policy is because they can create their own cash flows.

A. Clientele effect suggests that stock price of a company is dependent upon what their investors wanted in returns, capital growth, dividends etc. If a company changes its dividend policies then investors would adjust their holdings based on their goals. Therfore dividend policies matters in in making a company's share attractive to investors.

B. Residual dividends policy are adopted by companies to prioritize capital expenditures over immediate shareholder dividend payments. This policy somehow resembles close to idea by MM where they suggested dividend irrelevance. As company may adopt this policy if it considers that dividends are not that relevant rather than capital growth by reinvesting.

C. Signalling theory suggests that company announcements of dividend increases are an indication of positive future results. Therefore it makes dividends relevant in companies and invetsors decision making which is opposite of MM theory.

2.

Year	EPS	Dividends	Dividends %
2012	57.7	33.8	58.6%
2013	65.4	35.5	54.3%
2014	77.5	38.7	49.9%
2015	86.5	42.0	48.6%
2016	84.2	45.0	53.4%
2017	70.1	48.0	68.5%
2018	66.7	51.0	76.5%
2019	70.3	52.0	74.0%

As this can be seen above, company has consistently increased dividends in absolute amount and on % basis as well (except in 2 years). Company has even maintained its dividend growth in the time of declining EPS which suggests that it comsiders dividend as important part of its signalling and a relevant one.

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