7. Dividend Policy

Question 1

What are the 3 options to use surplus funds generated from projects?

Answer 1

1. Retain within the business (to fund future)
2. Return to shareholders as dividends
3. Return to shareholders as share buybacks

Question 2

What may the consequences be of failing to adopt a dividend policy that is consistent with what shareholders want?

Answer 2

• Shareholders may sell their holdings
• New investors may come along
• Share price becomes turbulent

Question 3

What can happen to the share price if the market perceives a dividend announcement to be a positive sign?

Answer 3

It will grows

Question 4

What might a company need to do to to pay a dividend if there is not enough cash?

Answer 4

Borrow

Question 5

What are the tax implications of payment of dividends?

Answer 5

Shareholders will incur income tax on dividends, and capital gains tax on share buy backs.

Question 6

What are the tax implications of retaining cash in the business?

Answer 6

Expected increase in future share prices and hence future capital gains tax

Question 7

What is the ‘bird in the hand’ argument?

Answer 7

Investors may prefer the certainty of having a dividend now over the promise of a bigger dividend in the future

Question 8

What are the 2 types of stable dividend policy?

Answer 8

1. Constant
2. Steadily growing

Question 9

What are the 3 rates linked to stable dividend growth?

Answer 9

1. Inflation
2. Industry growth
3. Profit growth

Question 10

What is the constant dividend payout % policy?

Answer 10

Dividends are always a fixed % of profits

Question 11

What is the problem with constant dividend payout % policy?

Answer 11

Dividends become erratic, which is not popular

Question 12

What dividend policy do family run businesses often adopt?

Answer 12

Constant dividend payout %

Question 13

What is the zero dividend policy?

Answer 13

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

Question 14

What is residual dividend theory?

Answer 14

Dividends are paid out only after all value enhancing projects have been financed, with the rest paid as dividends - aims to maximise shareholder wealth

Question 15

What is the problem with residual dividend theory?

Answer 15

Dividends become erratic, which is not popular

Question 16

What is M&M’s dividend irrelevancy theory? (tax free)

Answer 16

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

Question 17

What do M&M state that shareholders will do if the dividend is lower than desired?

Answer 17

Sell some shares to create some extra income

Question 18

What do M&M state that shareholders will do if the dividend is higher than desired?

Answer 18

Use excess dividend to buy more shares

Question 19

What is share buy back?

Answer 19

The company buys the shares back from investors and then cancels them

Question 20

What are the 3 main arguments for share buyback?

Answer 20

1. Doesn’t lead to future dividend expectations
2. Favourable from a tax perspective (capital gain rather than income)
3. Increased EPS and share price due to fewer shares

Question 21

What are the 2 main arguments against share buyback?

Answer 21

1. Increased dividends are seen as a stronger expression of confidence
2. Often only benefitting large institutional investors

Question 22

What is the Clientele effect?

Answer 22

Shareholders sell their holdings when the dividend policy is not what they want, and new investors come along

Question 23

What is a scrip dividend?

Answer 23

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.