Chapter 7 Equity sources and dividend policy Flashcards
1.1 The irrelevance of the source of equity finance
There are three main methods of raising the equity finance: retained profits, rights issues and new issues. The cost of servicing the equity (Ke) will be the same regardless of the historic source of funds. This is because the return required on each £ of equity held by the company (Ke) depends on the risk suffered by the equity shareholder, it is irrelevant where the funds originated.
2.1 Irrelevancy of dividend policy
A traditional position is a consistent dividend stream was important, it was also viewed that it was better to have the certainty of a known dividend now than the uncertainty of having to wait.
Modigliani and Miller position was that the consistency of the dividend stream was irrelevant. As long as a dividend cut is being used to fund a positive NPV project, then the increased dividends in the future will compensate for the current lower dividend today. They suggested where investors required a certain level of income, then if dividends were cut, they simply sell a few shares, thus manufacturing dividends.
3.1 Dividend policy in the real world
A number of arguments are put forward that dividend policy is relevant. M&M assumed investors had perfect information about the company, with listed companies a reduction in dividend can convey bad news to shareholders (dividend signalling). M&M assumed investors were indifferent between dividends and capital growth, and that if investors require cash then they could manufacture dividends by selling shares, tax differences and transaction costs mean this is not the case (clientele effect).
3.2 Pecking order theory
A firm would generally choose finance in the following order: retained profit, rights issue and as a last resort, a new issue.
In practice most listed firms adopt a stable dividend policy, paying out a stable, but rising dividend per share. It is prudent to make sure dividends lag behind earnings, so they can then be maintained even when earnings temporarily fall.
4.1 Dividend alternatives
Other methods of distribution include share buybacks and scrip dividends.
A scrip dividend is where a company allows its shareholders the choice of taking their dividends in the form of new shares rather than cash. The advantage to shareholders is they can increase their shareholding in the company without having to pay broker’s commissions or stamp duty on a share purchase. The advantage to the company, is that it does not have to find the cash to pay a dividend and, it can save tax in certain circumstances.
