Chp 5: Dividend Policy Flashcards
What does RELATE stand for in terms of interrelationship betweent he three decisions?
Dividend Decision
- Restrictive Covenants - dividend payments may be restricted by covenants. Ordinary dividends can’t be paid until preference dividend arrears have been settled
- Expectations of shareholders - consistent dividend policy will attract investors who may wish to sell up if that changes. Private company shareholders may prefer cash dividends due to the difficulty with selling their shares
- Liquidity - may not have the liquiduty for dividends
- Attitude to debt - if a compnay doesn’t want to use debt finance, internal cash will be used
- Tax - If capital gains tax is lower than tax on dividends, then a company may reinvest to increase the share price
- Evaluation by the market - the market may interpret an increase in dividend as positive which could lead to an increase in share price
What is the signalling effect?
Using dividend policy to indicate the future prospects of the company
What is the clientele effect?
Particular companies attract particular types of clientele based on their dividend policy
What is a ‘Constant pay-out ratio’ dividend policy?
A constant percentage of earnings is paid otu each year.
Logical but can create volatile dividend movements
What is a ‘stable growth’ dividend policy?
Dividend grows at a constant rate, usually in line wiht expected company growth
What is a ‘residual policy’ dividend policy?
Dividends come out of the residual or leftover equity only after investment opportunitites have been exhausted.
What is a ‘Zero dividend’ dividend policy?
No dividends are paid, profits are re-invested in the business
Dividend irrelevancy theory
Authors and general principle
Modigliani and Miller
Proposed that in a tax free world, shareholders are indifferent between dividends or capital gains. Therefore, the value of a company is based solely on the earning power of its investments and assets
ie. whether a compnany pays a dividend or not, the share price will react to offset the potential gain
What are four assumptions of Dividend Irrelevancy Theory?
- No taxes exist
- Capital markets are perfectly efficient - fudns will always be available
- There are no transaction costs - ie. for selling shares, obtaining a loan or issuing new shares
- All information is fully and freely available to shareholders
What are four arguments against Dividend Irrelevancy Theory?
- Taxes do have an impact on shareholder preference
- Capital markets are not perfectly efficient and funds may not be available
- Transaction costs do exist and investors would prefer to avoid those by receiving a dividend
- Imperfect information - share price may not react perfectly to dividend issues
What is the ‘bird in the hand’ theory?
Shareholders may not be fully aware of future plans or investment opportunities and would prefer a certain dividend over a future capital gain due to the uncertainty of the future.
What is a scrip dividend?
A dividend paid by the issues of additional company shares instead of cash.
Advantage - companies cash flow benefits. Accounting entry is to Dr Retained Earnings; Cr Share Capital. May also reduce gearing, based on market values.
Disadvantage - share price and EPS are likely to fall due to the increase in the number of shares. Although, the relative value of the shareholder should remain the same. May also lead to high future dividend payments and could be an indication that the company has cash flow issues.
Share repurchase including advantages and disadvantages
When a company buys back it’s own shares
Advantages - Finds a use for surplus cash and increases EPS through a reduction in the number of shares
Disadvantages - indicates that a company cannot make better use of funds. Also difficult to determine a price when not every shareholder is involved
