7. FM - Equity sources and dividend policy Flashcards
What are the 3 main methods to raise equity finance?
- Retained profits (in which case dividends may be cut)
- Rights issues
- New issues
How does the historic source of funds affect Ke?
And what is Ke?
Ke - cost of servicing the equity
It is the same regardless of the historic source of the funds
Why is Ke the same regardless of the historic source of the funds?
The return required on each £ of equity held by the company depends on the risk suffered by the equity SH.
it is irrelevant where the funds originated from
What is the theory that argues that equity finance is irrelevant?
M&M
What are the 3 theories relating to the irrelevancy of dividend policy?
Traditional theory
M&M
M&M with tax
What is the traditional position for irrelevancy of dividend policy ?
- Suggests that a consistent dividend stream was important
- Traditionally, it was believed that it was better to have the certainty of a known dividend now than the uncertainty of having to wait (known as the bird in the hand view)
What is the bird in the hand view?
Traditionally, it was believed that it was better to have the certainty of a known dividend now than the uncertainty of having to wait
What is the argument in MM theory?
Consistency of the dividend stream is irrelevant
As long as divs are cut to fund a +ve NPV project, then the increased dividends in the future would be more than enough to compensate for the lower dividends today
How do M&M suggest that investors can create DIY dividends?
They suggested that where investors required a certain level of income, then if dividends were cut, they could simply sell a few shares, therefore manufacture their own dividends
Give some examples of issues that suggest that M&M theory doesn’t;t hold out in the real world?
- Dividend signalling
- Clientele effect
- Pecking order theory
What is dividend signalling and why does it go against M&M theory?
M&M assumed that investors had perfect info about a company
But in practice, although this is true for small owner managed businesses, with listed companies, a reduction in div can covey ‘bad news’ to SH
What is the clientele effect and why does it go against M&M theory?
M&M assumed that inv were indifferent between divs and capital growth, and that if an investor required cash then he could manufacture dividends by selling his shares
But in practice, tax differences and transition costs mean this is to the case
What is pecking order theory and why does it go against M&M theory?
A firm would generally choose to get income in the following order if possible:
- Retained profit (immediate w no cost issues)
- Rights issue (some cost issues but no control or value given away)
- As a last resort, a new issue (expensive, difficult to price)
But in practice, most firms adopt a stable dividend policy, paying out a stable but rising dividend per share
It is prudent to make sure div lag behind earnings, so they can then be maintained even when earnings temporarily fall
What are the alternatives to dividends if a company wants to distribute to their SH?
- Share buybacks
- Scrip (stock) dividends
What is a scrip dividend?
Where a company allows its SH a choice of taking their dividend in the form of new shares rather than cash
