Dividend Policy Flashcards
What is the dividend theory?
Should an organisation pay out a regular dividend or use the cash to fund further investment?
What are the dividend irrelevancy theory (Modigliani & Miller) assumptions?
There exists a perfect capital market
There are no transaction costs
There are no taxes on dividends and capital gains are taxed in the same way.
What do Modigliani and miller (M&M) suggested that entities should focus on?
investment policy rather than dividend policy and that if investors required income, they could sell shares to ‘manufacture’ dividends.
What is residual theory?
This theory is closely related to M&Ms but recognises the costs involved for the company in raising new finance.
It argues that dividends themselves are important but the pattern of them is not.
Only after a firm has invested in all positive NPV projects should a dividend be paid if there are any funds remaining.
What is resolution of uncertainty?
Myron Gordon (1963) argued that investors perceive that a company, by retaining and reinvesting a part of its current cash flow, is replacing a certain dividend flow to shareholders now with an uncertain more distant flow in the future The market places a greater value on shares offering higher near-term dividends because of the “perceived” risk regarding longer term receipt of dividends-”bird in the hand” notion
What is dividend signalling?
Dividend signalling (reductions in dividends can convey ‘bad news’ to shareholders who aren’t fully informed about why the dividend has been cut (a market imperfection))
Information available to directors is more substantial than that available to shareholders, so that information asymmetry exists. This is one of the causes of the agency problem.
If dividend decisions convey new information to the market, they can have a signalling effect concerning the current position of the company and its future prospects.
The signalling effect also depends on the dividend expectations in the market. A company should therefore consider the likely effect on share prices of the announcement of a proposed dividend.
How does the need for finance and dividend policy link?
There is a close relationship between investment, financing and dividend decisions, and the dividend decision must consider the investment plans and financing needs of the company.
A large investment programme, for example, will require a large amount of finance, and the need for external finance can be reduced if dividend increases are kept in check.
Similarly, the decision to increase dividends may reduce retained earnings to the extent where external finance is needed in order to meet investment needs.
How does profitability affect dividends?
Companies need to remain profitable and dividends are a distribution of after-tax profit.
A company cannot consistently pay dividends higher than its profit after tax.
A healthy level of retained earnings is needed to finance the continuing business needs of the company.
How does the level of financial risk affect dividends?
If financial risk is high, for example due to a high level of gearing arising from a substantial level of debt finance, maintaining a low level of dividend payments can result in a high level of retained earnings, which will reduce gearing by increasing the level of reserves.
The cash flow from a higher level of retained earnings can also be used to decrease the amount of debt being carried by a company.
What are the legal restrictions on dividends?
rules as to distributable profits that prevent excess cash distributions
bond and loan agreements may contain covenants that restrict the amount of dividends a firm can pay.
How does liquidity affect dividends?
Although a dividend is a distribution of profit, it is a cash payment by the company to its shareholders. A company must therefore ensure it has sufficient cash to pay a proposed dividend and that paying a dividend will not compromise day-to-day cash financing needs.
What is share repurchase?
buy back of shares, particularly if the amount of surplus cash available would distort normal dividend policy.
The alternative is to pay one-off surplus as a ‘special dividend’
What is scrip dividends?
allowing shareholders to take their dividends in the form of new shares rather than cash
