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Valuing Stocks, paying dividends good for shareholders?

Increasing growth may require investment from the firm and money spent on investment cannot be used to pay dividends. On the one hand, cutting the firm's dividend to increase investment will raise the stock price if and only if the new investment has a positive NPV. Discuss why.

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There are quantitative and qualitative reasons why investment in a firm increases the stock price. Likewise, there are actions that also will decrease the stock price, cutting the dividend being one of them. In the short run, the stock will be likely to bounce around. Long term, the impact of accepting positive NPV projects will increase the operating leverage (or should) of the firm resulting in greater earnings and/or greater margins or growth in top line revenue. All of these generally will increase the equity value of the firm. If the project fails to generate additional earnings, the equity doesn't grow and therefore the stock price would all else held constant remain the same.

Theoretically, from a pure dollars and cents perspective no project should be taken on if the NPV is negative due to the fact that the project does not add any value to the equity firm in the form of equity growth. Investments in operating capital grow the asset side of the balance sheet and therefore also grow equity. More assets generally will create more opportunity to grow revenue. The effect is the same as retaining earnings, with the difference being ...

Solution Summary

Solution provides insight into stock pricing mechanisms in relationship to dividends from a qualitative perspective when tested against NPV measures. While in general theory will hold true there are counter-arguments to generally accepted arguments for positive NPV projects impact on stock price.