Chapter 5 - Dividend Policy

Question 1

Dividend policy & senior management:

Answer 1

• Senior management may have to decide on a suitable pay-out policy that reflects the expectations and preferences of shareholders.
• Focus should be on the primary objectives of the organisation = if shareholders expect dividend to be paid, senior management must balance dividend payment, retention policies and ensuring sufficient funds are available to finance profitable investment opportunities.

Question 2

Influences on dividend policy:

Answer 2

• Investment and financing issues

* Cash needs of entity

Question 3

Investment and financing issues (RELATE):

Answer 3

1. Restrictive covenants (financing)
2. Expectations of shareholders (financing)
3. Liquidity (investment)
4. Attitude to debt (financing)
5. Tax (investment)
6. Evaluation by the market (financing)

Question 4

Restrictive covenants:

Answer 4

• Dividend payments may be restricted by covenants

* Ordinary dividends cannot be paid until any arrears on outstanding preference dividends are settled

Question 5

Expectations of shareholders:

Answer 5

• Clientele effect = particular companies attract a particular type of shareholder based on their dividend policy – a change in policy may cause these shareholders to sell their shares and the share price to fall
• Shareholders in private ltd companies may prefer a cash dividend because of the difficulty in selling their shares

Question 6

Liquidity:

Answer 6

• High levels of investment may cause liquidity problems

Question 7

Attitude to debt:

Answer 7

If company is not willing to use debt finance, then internal funds are more likely to be used

Question 8

Tax:

Answer 8

• If capital gains tax is lower than tax on dividends, entity may reinvest to increase the share price

Question 9

Evaluation by the market:

Answer 9

• If the market interprets an increase in the dividend as a positive signal then this can lead to a rise in the share price (signalling effect)
• Signalling effect = the dividend policy is used to indicate the future prospects of a company

Question 10

Cash needs of entity:

Answer 10

• Small company = may struggle to raise external finance therefore dividends may be restricted
• Growing company = require cash for investment opportunities, dividend policy may depend on its ability to raise external finance
• Mature company = can afford to pay out a dividend without compromising its internal cash requirements

Question 11

Practical dividend policies:

Answer 11

1. Constant pay-out ratio
   * Constant % of earnings is paid out each year
   * Logical, but could cause volatile dividend movements
2. Stable growth
   * Dividend payment that increases at a constant rate each year (constant growth)
   * Rate is set at a level that signals the growth prospects of the company
3. Residual policy
   * Dividend payments come out of the residual or leftover equity after investment opportunities has been exhausted
4. Zero dividend policy
   * No dividends are paid
   * Profits are re-invested in the business
   * Common in high growth technology companies

Question 12

Life Cycle Issues:

Answer 12

1. Young companies follow a residual policy
   * Investments offer high returns
   * Often prefer to avoid debt finance (unstable cash flows)
2. Mature companies follow a stable growth or constant pay-out policy
   * Investments offer lower returns
   * More likely to use debt finance (stable cash flows)

Question 13

Dividend irrelevance theory (Modigliani & Miller):

Answer 13

• In a tax-free world, shareholders are indifferent between dividends and capital gains
• Value of the company is solely determined by the earning power of its assets and investments

Question 14

M & M Theory - Company pays a dividend

Answer 14

• If company decides to cut the dividend it does not matter to shareholders because if shareholders do require cash, they can manufacture dividends by selling shares
• Shares will rise in value because of the investments & increase in value of the shares compensates for the loss of dividend

Question 15

M & M Theory - Company does not pay a dividend

Answer 15

• If the company decides to pay a dividend, the shortfall in funds will be made up by obtaining additional funds from outside sources
• There will be a loss in the value of the firm to the original shareholders due to external funds being raised – the loss in value will be equal to the amount of dividend paid so the shareholders will not have lost overall.

Question 16

Assumptions of M&M dividend irrelevance theory

Answer 16

• No taxes exist (corporate or personal)
• Capital markets are perfectly efficient = funds will always be made available to finance attractive investments
• No transaction costs = issuing new shares, taking out a bank loan or selling shares
• All info is fully & freely available to shareholders

Question 17

Criticisms of M&M dividend irrelevance theory

Answer 17

1. Impact of taxation = differing rates can create a preference for high dividends or high earnings retention which is one of the key reasons for the clientele effect.
2. Capital markets are not perfectly efficient = funds may not always be available to fund financially attractive investments
   * Where capital rationing is a issue, dividend retention may be preferred
3. Impact of transaction costs = investors who want some cash would prefer to receive a dividend rather than sell their shares for the cash required
4. Imperfect information = if markets do not price shares accurately, based on all info available, the investors may find it difficult to sell their shares easily at a fair price
   * Therefore, shareholders might require high dividends to fund other investments
   * Shareholders are also not always fully aware of the future investment plans and expected profits for their company
   * Even if management were to provide them with profit forecasts, it would not always be accurate unless backed up with a signal of confidence in the form of a rising dividend
   * Shareholders may therefore prefer a current dividend rather than future capital gain because the future is so uncertain (bird in hand theory)

Question 18

Alternatives to cash dividends:

Answer 18

• Scrip dividends

* Share repurchase

Question 19

Scrip dividends

Answer 19

• Scrip dividend = dividend paid by the issue of additional shares at no cost rather than by cash.
• Allows shareholders the choice of building their equity stake or taking cash.
• Has the effect of capitalising reserves, = reserves reduce and share capital increases (DR retained earnings, CR Share Capital with nominal value of shares)
• Enhanced scrip dividend = giving the shareholder the choice between taking cash or shares but offering a generous number of shares so that it is likely that the shareholders will take the share issue instead of cash

Question 20

Advantages of scrip dividends:

Answer 20

• Preserving the cash position

* Decreasing the gearing which enhances its borrowing capacity

Question 21

Disadvantages of scrip dividends:

Answer 21

• Higher future dividend payments if dividend per share is maintained
• Indication that the company may have cash flow issues
• Disadvantage to shareholders = EPS & share price is likely to fall due to greater number of shares in issue, although overall value of each shareholders shares should theoretically remain unchanged.

Question 22

Share repurchase:

Answer 22

• Used to return surplus cash to shareholders when the company has no positive NPV projects to invest the cash in – returns cash to shareholders so they can make better use of it

Question 23

Advantages of share repurchase:

Answer 23

• Finds a use for surplus cash, which may be a dead asset

* Increases EPS through reduction in the number of shares

Question 24

Disadvantages of share repurchase:

Answer 24

• Difficulty in arriving at a price that will be fair both to the vendors and to any shareholders who are not selling their shares
• Indication that company cannot make better use of the funds than shareholders