Chapter 16 - Dividend Policy

Question 1

What are the assumptions of the dividend irrelevancy theory (M&M)?

Answer 1

• there exists a perfect capital market
• there are no transaction costs
• there are no taxes or dividends and capital gains are taxed in the same way

Question 2

What is the theory behind M&M?

Answer 2

the pattern of dividends payouts should be irrelevant . As long as companies continue to invest in positive NPV projects, the wealth of the shareholders should increase whether or not the company makes a dividend payment in the year

Question 3

What do M&M suggest?

Answer 3

that entities should focus on investment policy rather than dividend policy and that if investors required income, they could sell shares to ‘manufacture’ dividends.

Question 4

What is the residual theory?

Answer 4

closely related to M&M’s but recognises the costs involved for the company in raising new finance

Question 5

What does the residual theory argue?

Answer 5

that dividends themselves are important but the pattern of them is not

Question 6

What does the residual theory state?

Answer 6

It follows that only after a firm has invested in all positive NPV projects should a dividend be
paid if there are any funds remaining.

Question 7

What are the practical influences on dividend policy?

Answer 7

• dividend signalling
• investor liquidity requirements
• clientele effect

Question 8

What is dividend signalling?

Answer 8

reductions in dividends can convey ‘bad news’ to shareholders who aren’t fully informed about why the dividend has been cut (a market imperfection)

Question 9

What are investor liquidity requirements?

Answer 9

a cut in a dividend or an unexpected dividend may conflict with investors liquidity requirements

Question 10

What is clientele effect?

Answer 10

investors may have invested for a specific reason such as tax planning. As income tax and capital gains tax are taxed differently, a dividend policy change can affect the taxes incurred by investors

Question 11

What are other practical constraints?

Answer 11

• legal restrictions on dividend payments
• liquidity

Question 12

What are some of the legal restrictions on dividend payments?

Answer 12

• rules as to distributable profits that prevent excess cash distributions
• bond and loan agreements may contain convenants that restrict the amount of dividends a firm can pay

Question 13

What are alternatives to cash dividends?

Answer 13

• share repurchase
• scrip dividends

Question 14

What are share repurchase?

Answer 14

buy back of shares, particularly if the amount of surplus cash available would distort normal dividend policy

Question 15

what are scrip dividends?

Answer 15

allowing shareholders to take their dividends in the form of new shares rather than cash