ACCA Financial Management (F9) Certification Practice Exam

Which theory focuses on the effect of dividends on share price?

1. Irrelevancy Theory

2. Modern Portfolio Theory

3. Traditional View of dividends

4. Dividend Discount Model

The correct answer is: Traditional View of dividends

The Traditional View of dividends posits that dividend policies can significantly impact a company’s share price. This theory suggests that investors prefer dividends because they are perceived as a more certain source of returns compared to potential future capital gains. According to the Traditional View, higher dividends may lead to a higher share price as they signal a company’s financial health and stability, attracting investors looking for reliable income. Investors are often psychologically inclined to value dividends, often considering them as a sign of quality and strength in a company's financial management. This perspective aligns with the notion that dividends are not merely a distribution of profits, but a signal that can influence market perception and investor behavior. Essentially, if a company maintains or increases its dividend payouts, it is often believed to be performing well, resulting in an increased demand for its shares and thereby raising the share price. In contrast, other theories such as the Irrelevancy Theory argue that dividends should not affect the value of the firm because investors can create their own 'dividend' by selling shares. Modern Portfolio Theory focuses on how investors can optimize their portfolios and does not directly address the relationship between dividends and share prices. The Dividend Discount Model, while related to dividends, is primarily a valuation model rather than a theory about the