CH5 - The Dividend Decision Flashcards
Influences on Dividend Policy:
GLOCCPLT
- Growth – rapidly growing companies often pay very lower dividends, favouring expansion.
- Legal Position – Governments impose legal restrictions on number of dividends that can be paid.
- Other sources of finance – if no other sources of finance e.g. debt/equity. Retained earnings become important and therefore dividends will be low. Common for unquoted companies
- Control – internally generated funds = no dilution of control. Common among family run firms
- Cost – retained earnings are the cheapest
- Liquidity – need sufficient funds to do so after paying debtors.
- Inflation – higher inflation, dividends will need to be calculated on current cost accounting to ensure dividend pay-out isn’t too high.
- Profitability – Volatile profit = often low dividends
- Tax – Investors may prefer dividend or capital growth which can influence dividend decision.
Dividend Irrelevancy Theory
In an efficient market, if all retained earnings are invested in positive NPVs, shareholders are indifferent to the pattern of dividend pay-outs. Cash lost for a cut in dividend is compensated by an increase in share value, and invested funds can increase the value and outweigh the risk.
Why Reducing Dividends is seen as bad:
- Dividend Signalling - reductions in dividend can signal bad news to shareholders/the external market. The pattern of dividend payout is a key consideration for shareholders.
- Changes/reductions in dividends can conflict with investor liquidity requirements.
- Investor tax planning – companies attract investment and clientele due to their balance between income and growth. Dividends are taxed differently and therefore many investors prefer dividends as opposed to capital gain.
- Preference for current income – investors, retail and institutional have cashflow requirements that are dependent upon dividend pay-outs. Therefore regular cash dividend companies are valued more highly.
- Dividends are seen as more secure than capital gain.
Dividend Policies
Stable/constantly Growing
* Predictable flow.
* Reduces management opportunities to divert funds to non-profitable/risky activities – agency issue.
* Mature firms with stable cashflows.
Constant pay-out ratio
* Link between earnings, reinvestment, and dividend flow.
* Unpredictable for the investor.
* No indication of management intention.
Zero Dividend
* Common during growth phase.
* Should be reflected in increased share price.
* Only works whilst they are no further positive NPV projects are available.
Residual dividend policy
* Similar to above except dividends paid out after all positive NPV projects invested into.
* Good for companies without easy access to external funds = unquoted companies.
* Cashflow is unpredictable and constantly changing signals regarding expectations.
Ratchet Patterns – Stable but rising but can be maintained
* Variant on stable dividend policy. Stable but rising dividend per share.
* Dividends lag behind earnings but can be maintained when earnings fall below dividend level.
* Avoids bad news signals.
* Doesn’t disturb tax position of investors.
Scrip dividend (Share dividend)
* Dividend taken as new shares rather than cash.
* Saves on brokers fees and stamp duty for the investor.
* Company doesn’t have to pay dividend.
* Doesn’t dilute share price unless significant.
* More shares = lower gearing and increased borrowing capacity.
Share Buyback Schemes - Reducing Shares in Issue
- Has to be allowed by AoA
- Occurs when no more positive NPV projects
- Cosmetically increase share price
- Reduce cost of capital by increasing gearing?
- Positive signal to market – directors have more information than investors, buying back is a signal that shares are good value for none
Advantages
* Good when excess cashflows are temporary – distribution of cash in form of share buyback instead of higher cash dividends that can’t be maintained
* Reduced number of shares = higher EPS
* If growth and outlook is poor – allows to adjust equity base to more appropriate level
* Buy out dissent shareholders
* Creation of a market for an unquoted company
* Reduces cost of capital
* Reduces likelihood of takeover
Saves transaction costs and taxes of cash dividend. Gives S’Holders a choice
Disadvantages
* Requires approval by GM
* Company may pay too high or low of a price
* Might be seen as a failure of management to make use of surplus funds through reinvestment
* Shareholders may not enjoy the reduction of capital gains and dividends
Multinational Dividend Policy
Often Ratchet, Constant pay-out seldom used as many firms work towards long-run approach and want to smooth
Residual also good because:
- Positive NPV projects adopted, or funds returned
- Stops unnecessary transaction costs of paying a dividend and then asking for funds via rights issue
- Can lead to fluctuations in dividends
Must consider remittance blocking via exchange controls:
- Increasing transfer pricing from subsidiary to parent
- Lending equivalent of dividend to parent
- Payments in form of royalties, management fees, patents
- Charging the subsidiary additional head office overheads
- Parallel loans – subsidiary loans to another parent company
Free Cashflow to Equity for MNC
Gross Cashflow to Equity PART 1
Operating cash flow (Op Profit minus + depn)
+ dividends from subs (Net of profit)
– net interest paid on Operating Profit (DebtInterest rate(1-tax rate))
– tax on operating profit
- tax on sub profit - (Parent % - Sub %*Sub profit)
= Gross Cashflow to Equity
Dividend Capacity/Net free cashflow
gross cashflow to equity
– capital expenditure
+/- disposals or acquisitions
+ new capital issued
Capital structure – impact on free cashflow
Share repurchase – initially reduces free cashflow but potentially increases if fewer shares to pay dividends, or increases DPR
Debt issue for reinvestment – reduces free cash flow from interest cost and debt repayments
Debt issue for paying dividend or share repurchase – reduces free cash flow now and in future
New equity issue for reinvestment – increases number of shares. Depends on dividend policy as to whether this decreases free cashflow.
Transfer pricing – process for deciding on appropriate prices for intra-group transactions - Benfits
- Pay lower taxes, duties and tariffs e.g. minimize import duties by setting low transfer price. MNC’s are keen to transfer profits from high tax to low tax countries.
- Avoidance of exchange controls by setting low transfer price as an alternative to a dividend payment.
- Improving financial performance of subsidiary to satisfy earnings criteria set by lenders.
- Repatriate funds from foreign subsidiary to head office.
- Less exposure to FX risk.
- Build and maintain a better international competitive position.
- Enable foreign subsidiaries to match and beat local competitor prices.
- Good relations with international governments.
Transfer Pricing - Types - Good
Market Based - Encouraged by tax and customs in both parties
Profit split between group companies fairly for corp tax and duties payable
Why?
- Prices for the same goods can vary in different countries significantly
- Exchange rate changes
- Local taxes have a significant impact
- Subsidiary will want to set prices in accordance with local supply and demand
Full Cost - Corporate tax and duties set by correct cost of goods
Also acceptablel
Transfer Pricing - Types - Not good
Variable cost - All profits allocated to receiving company and no corporate tax paid by the parent
Ways Governments tackle transfer pricing:
- Exchange controls on amount of currency imported/exported. E.g. blocking funds and thus may have to be invested to Govt bonds and can’t be sent to parent until maturity
- Import tariffs to combat low transfer pricing
- Anti-dumping legislation – forcing market price based transfer pricing
Dividend Policy Question Focus
Growth in PAT
Growth in Dividends
Dividend Payout ratios
Growth in share price
Residual profit
