Chapter 7

Question 1

What is the dividend irrelevance theory (M&M)

Answer 1

• pattern of dividends over time is irrelevant in determining shareholder wealth based on:
• company will always invest in positive NPV projects
• if company can’t invest in certain projects out of retained earnings (due to dividends being paid out) then it will need to raise funds from other sources
• will potentially lead to existing shareholders receiving proportionally less of the returns from the new projects but this loss will be offset by the dividend they are receiving now
• hence the ultimate pattern of dividends is irrelevant.

Question 2

What did M&M state if the firms dividend policy was not to the taste of shareholders? (2 actions)

Answer 2

Shareholders could take action:

• if dividend is lower than desired, simply sell a few shares to create extra income to replicate increased dividend
• if dividend is higher than desired, use excess dividend to buy some additional shares

In reality due to tax this logic is flawed

Question 3

What are the six arguments for the dividend policy theory relevance?

Answer 3

Clientele effect: shareholders invest in company because of the dividend policy, if it changes they may divest

Uncertainty: cash now is more certain for shareholders than possible future returns hence they would prefer a dividend now

Signalling: markets eee dividend reductions as bad news and this may lead to a share price fall

Agency problem: shareholders may be nervous that directors act in their own interests and hence would prefer a cash pay out now to limit the impact of this

Taxation: dividend and capital gains on shares are taxed differently, hence depending on the shareholders position they may favour one over the other

Cash availability: dividends can only be paid if a company has sufficient cash

Question 4

What is the pecking order when it comes to raising equity finance?

Answer 4

Because of issuance costs, firms often follow the following pecking order:

Retained earnings
Rights issues and placing a
New issues to the public

Question 5

What is a share repurchase?

Answer 5

An alternative to dividend payments

Might use cash to repurchase issued shares (reducing equity and increasing gearing) returning cash to the shareholders without disrupting pattern of dividends

Special dividend makes it clear the payment was a one off

Question 6

What is stock or scrip dividends?

Answer 6

Companies may offer scrip dividends in lieu of cash dividends

Scrips can help companies avoid liquidity problems and allows shareholders to swap cash now for capital gain