Chapter 16 - Dividend Policy

Question 1

Residual theory

Answer 1

1. Argues that provided the present value of the dividend stream remains the same, the timing of the dividend payments is irrelevant.
2. It follows only after a firm has invested in all positive NPV projects should a dividend be paid if there are any funds remaining. Retentions should be used for project finance with dividends as a residual.

Question 2

Dividend relevance

Answer 2

Changes in dividend policy particularly reductions in dividends paid can have adverse effect on shareholder wealth.

1. Reductions in dividend can convey ‘bad news’ to shareholders
2. Changes in dividend policy, particularly reductions may conflict with investor liquidity requirements.
3. Changes in dividend policy may upset investor tax planning.

Question 3

Alternatives to cash dividends

1. Share repurchase

Answer 3

1. Consider using cash to buy back shares as an alternative to a dividend, particularly if surplus cash available would distort normal dividend policy.
2. Alternative is to pay one-off surplus as a special dividend.

Question 4

2. Scrip dividends

Answer 4

A scrip dividend is where a company allows its shareholders to take their dividends in the form of new shares rather than cash.

1. The advantage to the shareholder is they can increase his shareholding in the company without having to pay broker’s commissions or stamp duty on a share purchase.
2. The advantage to the company is that it does not have to find the cash to pay a dividend and in certain circumstances it can save tax.

Question 5

A bonus (scrip) issue

Answer 5

A method of altering the share capital without raising cash. It is done by changing the company’s reserves into share capital.

Question 6

Dividend irrelevancy theory

Answer 6

1. In a perfect capital market (no taxation, no transaction costs, no market imperfections), existing shareholders will only be concerned about increasing shareholder wealth but will be indifferent as to whether that increase comes in the form of a dividend or through capital growth.
2. A company can pay any level of dividend with any funds shortfall being met through a new equity issue, provided it is investing in all positive NPV projects.
3. Any investor requiring a dividend could manufacture their own by selling part of their shareholding.
   Any shareholder wanting retentions when a dividend is paid can buy more shares with the dividend received.