ACCA Advanced Financial Management (AFM) Practice Exam

Higher dividend payments generally lead to what market effect?

1. Increase in stock price

2. Decrease in stock volatility

3. Decrease in investor confidence

4. Increase in operational efficiency

The correct answer is: Increase in stock price

Higher dividend payments typically lead to an increase in stock price due to several key factors related to investor perception and the signaling theory of dividends. When a company pays higher dividends, it is often interpreted by investors as a positive signal regarding the company's current financial health and future earning potentials. This perception stems from the idea that a stable or increasing dividend indicates management's confidence in generating consistent cash flows and overall profitability. Investors often prefer companies that provide regular and significant dividend payouts because they represent a return on investment and can be seen as a form of income even in volatile markets. As a result, increased dividends can attract more investors, leading to heightened demand for the stock, and consequently, driving up the stock price. Furthermore, higher dividends can reduce uncertainty in the stock. A reliable dividend policy can stabilize a company's stock price as it assures investors about the firm’s financial health, diminishing speculation about potential downgrades in payments and thereby enhancing the stock's market performance. Overall, the positive market effect of higher dividend payments reflects a combination of increased investor confidence, assurance of the company’s financial stability, and a demand-driven rise in stock price.