Financial Management problem

Dividends Signal Fundamentals
Before corporations were required by law to disclose financial information in the 1930s, a company's ability to pay dividends was one of the few signs of its financial health. Despite the Securities and Exchange Act of 1934 and the increased transparency it brought to the industry, dividends still remain a worthwhile yardstick of a company's prospects.

Typically, mature, profitable companies pay dividends. However, companies that do not pay dividends are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, the company should keep the profits and reinvest them into the business. For these reasons, few "growth" companies pay dividends. But even mature companies, while much of their profits may be distributed as dividends, still need to retain enough cash to fund business activity and handle contingencies.

The Dividend Yield
Many investors like to watch the dividend yield, which is calculated as the annual dividend income per share divided by the current share price. The dividend yield measures the amount of income received in proportion to the share price. If a company has a low dividend yield compared to other companies in its sector, it can mean two things: (1) the share price is high because the market reckons the company has impressive prospects and isn't overly worried about the company's dividend payments, or (2) the company is in trouble and cannot afford to pay reasonable dividends. At the same time, however, a high dividend yield can signal a sick company with a depressed share price.

Dividend Coverage Ratio
When you evaluate a company's dividend-paying practices, ask yourself if the company can afford to pay the dividend. The ratio between a company's earnings and net dividend paid to shareholders--known as dividend coverage--remains a well-used tool for measuring whether earnings are sufficient to cover dividend obligations. The ratio is calculated as earnings per share divided by the dividend per share. When coverage is getting thin, odds are good that there will be a dividend cut, which can have a dire impact on valuation. Investors can feel safe with a coverage ratio of 2 or 3. In practice, however, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, at which point prospects start to look risky. If the ratio is under 1, the company is using its retained earnings from last year to pay this year's dividend.

The Dreaded Dividend Cut
If a company with a history of consistently rising dividend payments suddenly cuts its payments, investors should treat this as a signal that trouble is looming.

Great Disciplinarian
Dividends bring more discipline to management's investment decision-making. Holding onto profits might lead to excessive executive compensation, sloppy management, and unproductive use of assets.

Finally, dividends are public promises. Breaking them is both embarrassing to management and damaging to share prices. To tarry over raising dividends, never mind suspending them, is seen as a confession of failure.

A Way to Calculate Value
Dividends can give investors a sense of what a company is really worth. The dividend discount model is a classic formula that explains the underlying value of a share, and it is a staple of the capital asset pricing model which, in turn, is the basis of corporate finance theory. According to the model, a share is worth the sum of all its prospective dividend payments, 'discounted back' to their net present value. As dividends are a form of cash flow to the investor, they are an important reflection of a company's value.

It is important to note also that stocks with dividends are less likely to reach unsustainable values. Investors have long known that dividends put a ceiling on market declines.

After a stock distributes its dividends, its share prices drop immediately.