19 Dividends and Dividend Valuation Models

Question 1

How do dividends relate to the distribution of wealth

Answer 1

• Links to focus on increasing shareholder wealth
• Dividend policy will affect company value
• How it is split between RE and dividends
• As RE are reinvested and creates a growth of earnings

Question 2

What is the formula for the Gordon Growth Model

Answer 2

• A more realistic case is where a constant proportion of each year’s earnings are retained. This is Dynamic Growth
• A model which can be used to value the equity of a company in a dynamic situation is known as the Gordon’s dividend growth model
  V = D / (ke - g)
  Or
  ke = D / (V + g)
• Where g is the growth rate

Question 3

What is the modified Gordon Growth Model assuming dividends are continually discounted

Answer 3

V0 = D0 / (ke - g)

Question 4

What is the modified Gordon Growth Model assuming dividends are discretely discounted

Answer 4

V0 = D1 / (ke - g)

• The rate of growth, g, in dividends is defined as:
  g = b×r where:

b = proportion of Earnings (E) retained so

1 – b = proportion of E distributed and
E ( 1 – b ) = dividends
r = the rate of return on reinvestment

Question 5

What determines the growth rate of dividends

Answer 5

• The amount of earnings retained for investment
• The rate of return earned on those retained earnings
• The rate of return earned on existing assets

Question 6

How does rate of return relate to Ke

Answer 6

• The rate of return on reinvestments should be greater or equal to Ke .
• If this was not the case we would be earning less than the required rate of return and it would not be in the best interest of shareholders to reinvest earnings.
• Objective is to maximise shareholder wealth this would not be achieved if earnings were being reinvested at rates below Ke

Question 7

What is expansion and how does it link returns to Ke

Answer 7

• If r = KE , we would have what is called expansion rather than growth
• Expansion is where the company reinvests at the cost of capital, i.e. it has more and more assets, but continues to earn the same rate of return.
• New assets producing same rate of return

Question 8

What is growth and how does it relate to Ke and returns

Answer 8

• Growth is where a company has opportunities to invest at returns greater than the cost of capital
• New assets which accelerate growth

Question 9

What does the Gordon Growth Model collapse to under expansion

Answer 9

V0 = E1 / ke
* Makes a perpetuity
* Assuming constant growth rate
* Need to be able to derive this formula

Question 10

How do you find D1

Answer 10

• If you have D0 you can multiple by the growth rate to find D1
• Or if you know retention and earnings can you
  D1 = E (1 - b)
  Where:
  E1 = E0 (1 + g)
  Also might need to employ CAPM or SML

Question 11

How do you find Ke

Answer 11

• We may need to find Ke as it is one of the variables in the model
• Could use SML:
  Ke = Ei = Rf + (Em - Rf)βi

Question 12

What conditions are necessary for the Expansion Growth model to hold

Answer 12

1. g < Ke otherwise you would get some very peculiar figures.
2. b should be constant over time.
3. Also … it is important to note - the model is based on all equity financing, but, as an approximation and as a minimum, the debt / equity ratio should remain constant over time (otherwise ke would be changing because of the changes in the gearing ratio).

• While 1 and 2 will probably never be absolutely constant, they may well tend to be and use of this model may be valid under these circumstances.
• With reference to the debt equity ratio, simply by retaining earnings we are increasing the proportion of equity in the capital structure and so, to maintain the debt equity ratio constant we would need to raise some additional debt each year

Question 13

What must you watch out for when using the Expansion Growth Model

Answer 13

• Model will always give you the value at the time point before the first cash flow
• If you want to find the value at the of fist year you need to apply the growth rate to the cash flow and find the CF and the end of the second year which you can put into the Gordon Growth Model

Question 14

How do dividends relate to capital structure and theorists

Answer 14

• Dividends are part of capital structure
• As paying it reduces equity as being paid to shareholders
• Therefore links to Modigliani and Miller and the traditionalist views

Question 15

How does Modigliani and Miller approach dividend policy

Answer 15

MM has lots of assumptions and need to ask if they are realistic
* Focuses on earnings and not how they are distributed
* If we agree then dividend policy is irrelevant to value of a company
o All about earnings generated from the investments and not how they are distributed
* If this argument is valid then the value of the equity and thus the wealth of the shareholders is not affected by the company’s dividend policy.
* The basis of MM’s hypothesis is that, once the investment opportunities open to a company are known, the expected future earnings are discounted to the present and this gives us the value of the equity
* Any time a new investment opportunity arises, its future earnings are immediately discounted and the value of the shares changes to take this into account.
* i.e. the equity value changes at the time the investment opportunity arises, and not as the actual earnings arise
* Given their view that dividend policy is irrelevant to the value of a company, MM’s conclusion is that two companies in the same risk class will have the same value, subject to a scale factor, regardless of dividend policy.
o Similar argument as with capital structure

Question 16

How does Modigliani and Miller suggest shareholders can undo dividends

Answer 16

• MM also argue that the dividend policy of a company is irrelevant in a perfect capital market because the shareholder can effectively undo the company’s dividend strategy.
• If a shareholder receives a dividend greater than desired he or she can reinvest the excess.
• If the shareholder receives a dividend smaller than desired he or she can sell off extra shares of stock. (Homemade dividend).
  o But this assumes no transactional costs

Question 17

What are the assumptions under Modigliani and Miller

Answer 17

1. Perfect capital markets including:
   a. Rational investors
   b. No transaction costs
   c. No taxes
   d. Equal cost and access to information for all
   e. One rate of interest for all
2. A given investment policy
3. All investors have homogeneous expectations
4. Perpetuities

Question 18

What is the traditionalist view on dividend policy

Answer 18

• The traditionalists disagree with MM.
• The theory of dividend irrelevance is controversial.
• It is attacked mainly on the assumptions upon which it is based
• One of MM assumptions is that capital markets are perfect.
  o Capital markets tend to be imperfect in that information is neither costless or universally available to all.
• The relevance to dividend theory is that where a company has adopted a policy of dividend stability, investors are likely to interpret a change in dividend rate as a change in the management’s view to the future profit prospects of the company
• This interpretation of information may be well beyond what it actually is. The dividend change provides the occasion for a price change which is not a true reflection of the change in future earnings.
  o Thus dividends have influenced share price

Question 19

What is financial fiction

Answer 19

• Another form of market imperfection which effects the irrelevancy proposition is what is called financial friction in the market.
• The existence of transaction costs gives importance to the decision relating to distribution.
• One element of friction is commission on the purchase and sale of securities, this exerts a strong bias in favour of dividends

Question 20

How do taxes affect Modigliani and Miller

Answer 20

• Another of MM assumptions is that of no taxes.
• In the real world taxes do exist.
  o There is a difference in the way dividends and capital gains are taxed.
  o The tax on capital gains is only paid when the shares are sold.
  o Also capital gains tax allowance

Question 21

What is signalling theory

Answer 21

• Dividends are important “signalling” devices.
• Dividend changes are methods by which management can convey information on future prospects to the shareholders.
• Accepting this then dividend announcements can result in movements in the share price.
• Companies are very reluctant to cut dividends even when earnings fall.
• Stability in dividends is important even when volatility exists in earnings.
• Accepting that dividend policy is important it is essential that the dividend policy set is one that can be maintained
• If strong form efficient then this wouldn’t be the case as markets would know true meaning behind everything
• Asymmetrical information between managers and shareholders means any change in the dividend policy is take as a signal to the market
  o As markets are informationally inefficient
• Assuming there is a signal when this is not the case or misreading the change if there is one
  o This can lead to temporary pricing inaccuracy

Question 22

What is the “bird in the hand” and how does it relate to dividends and capital gains

Answer 22

• Investors expect a return from their investment
• Can be in the form of capital gain and/or dividend
  o Capital gain is uncertain
  o Investors will prefer a certain dividend now to an uncertain capital gain in the future

Question 23

What is clientele theory

Answer 23

• In answer to criticism that certain shareholders would show a preference to either dividends or capital gains, MM evolved the “clientele theory”.
• If a company pursues a consistent dividend policy, each company will tend to attract a clientele consisting of those preferring a particular pay-out ratio.
• One clientele would be entirely as good as another with respect to the valuation it would imply to the company
  o Two companies which differ only in dividend policy will have the same market value.
  o The two companies will attract different investors, future earnings will be discounted at the same rate

Question 24

What are the factors to consider when setting dividend policy

Answer 24

• There are various factors a company must consider when deciding on its dividend policy.
• Should it adopt a high dividend pay-out, low dividend pay-out, or even not pay dividends at all.
• Do not just regurgitate these factors in same order with same numbers need to be able to add examples to bring to life
  o Lecture has good examples – MUST RE WATCH
  1. Profitability
  2. Corporate Growth and Investment Requirements
  3. Access to Capital Markets and Other Forms of External Finance
  4. Control
  5. Repayment of debt
  6. Restrictive Covenants on Debt
  7. Taxation
  8. Levels of inflation
  9. Past Levels of Dividend Payments
  10. Competitors
  11. Liquidity
  12. Shareholders desire for current income

Question 25

How does profitability affect dividend policy

Answer 25

• Return on assets or capital employed and future earnings prospects.
  o If companies can only reinvest income to generate a relatively low return, investors may prefer a large dividend which may be reinvested elsewhere at a higher return
• Stability of profits.
  o A company with stable profits is more likely to be able to pay out a higher percentage of earnings than a company with fluctuating profits

Question 26

How does corporate growth and investment requirements affect dividend policy

Answer 26

• The greater the rate of corporate growth the greater the amount of funds companies are likely to need to finance expansion.
• Rapidly growing companies generally pay low dividends to finance expansion

Question 27

How does access to capital markets and other forms of external policy affect dividend policy

Answer 27

• Large established companies have easy access to external finance.
• Small companies have less access and thus may have to retain a higher proportion of their earnings to finance investment needs

Question 28

How does control affect dividend policy

Answer 28

• If higher levels of dividends are paid, a company may be forced to issue new share capital to raise finance.
• This could have the effect of reducing control of the company by existing shareholders.
• If control is a significant factor, dividend payments are likely to be low

Question 29

How does repayments of debt affect dividend policy

Answer 29

If any debt is due for repayment this will require funds and might cause a reduction in the level of dividend payment

Question 30

How does restrictive covenants on debt affect dividend policy

Answer 30

Debentures and other forms of debt might have restrictive covenants limiting the amount of growth of dividend payment

Question 31

How does taxation affect dividend policy

Answer 31

• The tax position of shareholders is likely to be a major influence.
• Shareholders in a high tax bracket are likely to prefer low or no dividends.
• Dividend tax is paid at source, capital gains tax is paid when the shares are sold

Question 32

How does levels of inflation affect dividend policy

Answer 32

Investors are sometimes thought to require dividends to increase at least in line with inflation

Question 33

How does past levels of dividend payments affect dividend policy

Answer 33

• Many companies act as if they are reluctant to reduce dividend payments, even when profits fall.
• Past dividend payments are likely to influence present dividend payments.
  o Signalling devices

Question 34

How do competitors affect dividend policy

Answer 34

Dividend policy of competitors might influence corporate dividend policy

Question 35

How does liquidity affect dividend policy

Answer 35

• In order to pay dividends a company will require access to cash resources.
• Even very profitable companies may have difficulties paying cash dividends if resources are tied up in other forms of assets, especially if bank overdraft facilities are not available

Question 36

How does shareholders desire for current income affect dividend policy

Answer 36

• It has been argued that individuals desire current income.
• Dividends are a form of current income

Question 37

How do companies set the level of dividend pay out

Answer 37

• On the one hand there are arguments in favour of corporations paying high dividends while on the other there are many good reasons to pay low dividends.
• All discussions on dividends are plagued by what is called the ‘two handed argument’.
• All factors suggest towards both sides of raising and lowering so giving a balanced view of these will get very high marks

Question 38

How is dividend policy set in practice

Answer 38

• In practice many companies appear to follow what amounts to a compromise dividend policy. Such a policy is based on five main goals:
  1. Avoid cutting back on positive NPV projects to pay a dividend.
  2. Avoid dividend cuts
  a. Signalling and behavioural finance
  b. Investors react stronger to a 5% loss than 5% gain
  3. Avoid the need to issue equity.
  a. As equity is very costly
  4. Maintain a target debt equity ratio.
  5. Maintain a target dividend pay-out ratio
  a. To prevent shocks and signalling unintended messages

Question 39

What are the effects of poor dividend decisions

Answer 39

• Poorly advised dividend decisions can inflict damage.
• In view of the market’s own savage reaction to dividend cuts, companies should operate a safe dividend cover, allowing sufficient pay-out flexibility should earnings decline