Dividend Policy

Question 1

Dividend Irrelevancy (M&M) theory

Answer 1

In a perfect capital market, shareholders don’t mind whether wealth growth comes from dividend or capital growth.
Company can pay any level of dividend, any need for more funds = more equity issues, must invest in positive NPV projects.
Investors wanting retention can buy more shares, and wanting more dividends can sell part of their shares

Question 2

Dividend Irrelevancy theory disadvantages

Answer 2

Assumes a perfect capital market of no market imperfections, transactions costs and taxation.
Using outside finance to keep investment stable would reduce share value (PE ratio).
M&M argues the reduction is offset by increased shares paid

Question 3

Residual theory

Answer 3

Similar to M&M but recognises costs of raising new finance
Dividends paid are important but pattern irrelevant
Must ingest all positive NPV projects
Retentions kept for project finance and then dividends paid
Assumes no taxation or market imperfection

Question 4

Residual theory visualisation

Answer 4

E.g. company cancels T1 dividend to invest, T2 dividend higher to offset this

Question 5

Dividend relevance

Answer 5

Changes in dividend policy have affects:
Dividend signalling - reduction in dividend conveys bad news
Changes in dividend policy can affect shareholder liquidity needs
Changes in dividend policy may affect tax planning (capital gains tax cheaper than tax on dividends)

Question 6

Dividend signalling

Answer 6

Dividend policy is relevant under signalling as increase in dividends argues confidence, increase in future retained earnings and increase in share price
Companies should adopt stable and rising payout

Question 7

Clientele effect:

Answer 7

High dividend companies attract low income tax bracket clients

Question 8

Legal restrictions on dividends

Answer 8

If a company is funded by debt, bond holders may put covenants on dividend policy to restrict dividend to stop excessive transfer of wealth

Question 9

Other practical constraints on dividends

Answer 9

Liquidity! Require a need to reinvest

Question 10

Alternatives to cash dividends

Answer 10

Share repurchase - buy back shares as an alternative if alternative cash distorts dividend policy
Scrip dividend - take dividend in from of shares instead of cash, no transaction cost
Bonus scrip issue - issuing new shares with no cash paid - changing reserves into share capital