ACCA Advanced Financial Management (AFM) Practice Exam

In which scenario would a decrease in dividends most likely send a negative signal to investors?

1. If the firm is financially stable

2. If earnings are expected to grow

3. If the firm has previously increased dividends

4. If the firm has sufficient cash flow

The correct answer is: If the firm has previously increased dividends

A decrease in dividends is often perceived negatively by investors when a firm has previously established a pattern of increasing dividends. This pattern typically signals a stable or growing company that is confident in its ability to generate consistent profits. When a firm that has been consistently raising dividends suddenly reduces them, it can lead investors to believe that the company's financial health is deteriorating or that management lacks confidence in future earnings. This perception arises because regular increases in dividends are typically associated with positive business prospects and robust cash flows. Therefore, a reduction may indicate that the firm is facing challenges that have led to a reassessment of its profit outlook. Investors often interpret such changes as a potential warning sign, which can impact stock prices and investor sentiment. In contrast, if a firm is financially stable, expecting growth, or has sufficient cash flow, a dividend cut may not trigger the same level of concern among investors since these conditions suggest that the company could potentially be reallocating resources for better opportunities or managing temporary setbacks more effectively. However, when a prior commitment to increasing dividends is reversed, the negative signal is particularly pronounced.