Chartered Financial Analyst Level 2
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- For which of the following companies would a dividend increase most likely be viewed as a positive signal by its shareholders?
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A
A retailer facing financial pressure
B
An undervalued manufacturing company
C
A fast growing tech company planning to raise equity
Explanation:
Explanation
A dividend increase is most likely viewed as a positive signal by shareholders for an undervalued manufacturing company (Option B).
Analysis of Each Option:
Option A: A retailer facing financial pressure
- A dividend increase when a company is under financial pressure would be viewed negatively
- It signals poor capital allocation decisions and potential financial distress
- Shareholders would prefer the company conserve cash rather than pay dividends
Option B: An undervalued manufacturing company
- ✓ CORRECT ANSWER: A dividend increase signals management's confidence in future cash flows
- For undervalued companies, it demonstrates financial strength and commitment to shareholders
- It can signal that the company has stable earnings and strong cash generation capabilities
Option C: A fast growing tech company planning to raise equity
- A dividend increase would be contradictory for a fast-growing company needing capital
- Shareholders would prefer reinvestment in growth opportunities rather than dividend payments
- It would signal that the company lacks profitable investment opportunities
Key Concept:
Dividend signaling theory suggests that dividend increases convey positive information about management's confidence in future earnings and cash flows, particularly for mature, stable companies with undervalued stock.
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