2.

Although companies frequently announce their dividend policy in practice, there are several advantages and disadvantages to this decision. Advantages: o Announcing dividends is generally viewed as good news by the market. o Announcing dividends signals to investors that a firm can generate not only accounting income, but also generate high enough levels of cash flow to support dividend payments. o Once dividends have been announced, managers have an incentive to perform well enough to maintain the dividend. Thus, managers will set dividends at levels that are permanently sustainable. This tells us that dividends are managers estimates of for sure profitability. o Announcing dividends also reduces investor uncertainty. This is generally associated with lower capital costs and higher stock prices, all other things being equal. o Firms that announce dividends can distinguish themselves from less profitable firms. Disadvantages: o If a firm that has announced a dividend performs poorly and is forced to cut the dividend, it is generally bad news. This will most likely result in a drop of the stock price due to the lack of confidence by the investors in the firms management team and the profits they can produce. o If a firm (like Bessemer Steel) performs poorly and needs to borrow money to pay out the announced dividends, then it further worsens the companys current and debt ratios. o Announcing dividends generally decreases corporate flexibility. If a firm comes upon a positive NPV project that they didnt budget for (after announcing the dividend), then they might be forced to pass on it because the existing cash flows will be used to pay the announced dividend. 3.
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In the equation for calculating the sustainable growth rate shown above, d represents the dividend payout policy. As it is evident, (1-d) refers to the retention ratio (b), or the earnings credited to retained earnings. As the amount of dividends (d) paid out increases, the retention ratio (1-d) decreases. This causes the sustainable growth rate to decrease because the numerator decreases, while the denominator simultaneously increases in the equation above. This effect is also observed vice-versa. In theory, the growth rate is dependent on two things- the amount of investment using retained earnings and the associated returns on those investments. Usually, the greater the amount of investment the greater the returns and the greater the growth rate. However if the amount you invest is dependent on the retention ratio and the retention ratio is decreasing due to an increase in dividend payouts, then your returns on investments and the growth ratio will both decrease. Again, this effect is observed vice-versa if the amount of dividends paid out decreases.