Each part requires 150-250 word explanation.
Part One: Dividends
Modigliani & Miller show that dividend policy can also be considered irrelevant. Yet, unexpected increases in dividends are often closely followed by price increases, why?
To clarify, when a firm pays a dividend the stock price should drop by the amount of the dividend on the ex-dividend date. Let’s say a firm has 5 stockholders, each holding 1 share. The firm owns $2,000 in cash and $3,000 in other assets. So, the firm is worth $5,000 (it owes no debt). Each stockholder’s claim is worth:
$5,000/5 = $1000.
Now the firm declares a dividend of $100/share. They must pay out a total of $100 x 5shares = $500. So, after the dividend is paid the firm now has $1, in cash and $3,000 in other assets, for a total of $4,500. Dividing this by 5 stockholders, we find that each stockholder’s claim is $900. The same as if we take $1,000 less $100 dividend to get $900. The stockholder hasn’t lost anything, he still has $1,000 in value, just $900 in the firm and $100 in cash now.
But what we often see in practice is:
Let’s say the firm was expected to pay a $100/share dividend, but instead pays a dividend of $110. Like the example above, we would expect to see the stockholder’s value fall to $890 ($1,000 – $110 = $890). Again, the stockholder still has $1,000; $890 in the firm and $110 in cash. In practice though, we see that instead of the stock dropping to $890, it falls to say, only $895. Thus, the stockholder’s value is now; $110 + $895 = $1,005.
Why did they gain $5 in value, just by issuing the dividend?
Part Two: Derivatives
What are the key practical differences between a Forward contract and a Future contract? Why are Futures much more common? When are Forwards more useful?
Part Three: Selling Milk
Read the article on “Merton H. Miller”. After also watching this week’s video, do you think that Merton’s “whole milk” illustration can apply to dividends also, especially the monthly vs. quarterly issue?
http://www.econlib.org/library/Enc/bios/Miller.html
Part Four: Prospect Capital’s New Dividend Policy: Trick? or Treat?
Watch the video posted showing a dividend announcement.
What do you think was the main reason for the company’s stock price reaction to the dividend announcement?
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