7. Dividend Policy Flashcards
What are the 3 options to use surplus funds generated from projects?
- Retain within the business (to fund future)
- Return to shareholders as dividends
- Return to shareholders as share buybacks
What may the consequences be of failing to adopt a dividend policy that is consistent with what shareholders want?
- Shareholders may sell their holdings
- New investors may come along
- Share price becomes turbulent
What can happen to the share price if the market perceives a dividend announcement to be a positive sign?
It will grows
What might a company need to do to to pay a dividend if there is not enough cash?
Borrow
What are the tax implications of payment of dividends?
Shareholders will incur income tax on dividends, and capital gains tax on share buy backs.
What are the tax implications of retaining cash in the business?
Expected increase in future share prices and hence future capital gains tax
What is the ‘bird in the hand’ argument?
Investors may prefer the certainty of having a dividend now over the promise of a bigger dividend in the future
What are the 2 types of stable dividend policy?
- Constant
- Steadily growing
What are the 3 rates linked to stable dividend growth?
- Inflation
- Industry growth
- Profit growth
What is the constant dividend payout % policy?
Dividends are always a fixed % of profits
What is the problem with constant dividend payout % policy?
Dividends become erratic, which is not popular
What dividend policy do family run businesses often adopt?
Constant dividend payout %
What is the zero dividend policy?
No dividends are paid, all surplus are invested back into the business to generate growth - okay with shareholders as long as they believe growth will occur
What is residual dividend theory?
Dividends are paid out only after all value enhancing projects have been financed, with the rest paid as dividends - aims to maximise shareholder wealth
What is the problem with residual dividend theory?
Dividends become erratic, which is not popular
What is M&M’s dividend irrelevancy theory? (tax free)
The pattern of dividends over time is irrelevant as:
- A company will always invest in positive NPV projects
- If a company can’t invest in a +ve NPV project due to paying dividends, it will need to borrow
- Returns received will be reduced by the borrowing, but offset by dividend paid
What do M&M state that shareholders will do if the dividend is lower than desired?
Sell some shares to create some extra income
What do M&M state that shareholders will do if the dividend is higher than desired?
Use excess dividend to buy more shares
What is share buy back?
The company buys the shares back from investors and then cancels them
What are the 3 main arguments for share buyback?
- Doesn’t lead to future dividend expectations
- Favourable from a tax perspective (capital gain rather than income)
- Increased EPS and share price due to fewer shares
What are the 2 main arguments against share buyback?
- Increased dividends are seen as a stronger expression of confidence
- Often only benefitting large institutional investors
What is the Clientele effect?
Shareholders sell their holdings when the dividend policy is not what they want, and new investors come along
What is a scrip dividend?
Shareholders are offered additional shares free of charge, which reduces retained profits and increases share capital but requires no cash.
Share price and EPS may fall.
