Question

Other dividend policy issues

Several factors affect a firm's ability to pay a dividend. Three such factors are described in the table: profitability (an increase in net income),
investment opportunities, and capital structure (an increase in the debt ratio). Use the table to indicate how a firm's ability to pay a dividend is affected by the factors described.
(Hint: Consider each factor in isolation, with everything else held the same.)
Ability to Pay Dividends The ability to pay dividends The ability to pay dividends The ability to pay dividends Factors Affecting Dividend Payment Net income increases. More profitable investment opportunities are available. The firm increases its debt ratio. Dernham Burnham Inc. is a typical company that is very concerned with meeting investors’ expectations and keeping investors happy. Its earnings tend to fluctuate from year to year because of the nature of the business the company is in. Which of these statements most likely describes Dernham Burnham Inc.’s dividend policy?
A. Despite the fact that Dernham Burnham Inc.'s earnings tend to fluctuate from year to year, the company most likely pays a predictable, stable dividend each year.
B. Dernham Burnham Inc. most likely pays very large dividends in years with high earnings and small dividends in the years with low earnings. Grade It Now Save & Continue Continue without save in

Answer 1

1.

Net income increases. - Ability to pay Dividends increases.

Dividends are paid from Retained Earnings which are derived from Net Income. If Net income increases therefore, so does the ability to pay Dividends.

More profitable investment opportunities are available - Decreases Ability to pay Dividends.

If there are more profitable opportunities for investment available, the business will invest in those opportunities. By doing so they will reduce the amount of cash that they have which is cash that could have been paid as dividends.

The firm increases its debt ratio. - Ability to pay Dividends Increase

As a result of the company borrowing more money, there will be more money left to pay out dividends so more dividends will be paid.

2. A. Despite the fact that Dernham Burnham Inc.'s earnings tend to fluctuate from year to year, the company most likely pays a predictable, stable dividend each year.

Companies like Dernham that aim to please investors usually adopt a predictable, stable dividend policy every year so that the investors will have more faith in them and be sure of earnings every year. This will give them a higher rating with the investors.