Dividend policy

Question 1

There are three main theories concerning what impact a cut in the dividend will
have on a company and its shareholders.

Answer 1

Dividend irrelevancy theory

Residual theory

Dividend relevance

Question 2

Dividend irrelevancy theory

Answer 2

The dividend irrelevancy theory put forward by Modigliani & Miller (M&M)
argues that in a perfect capital market (no taxation, no transaction costs, no
market imperfections), existing shareholders will only be concerned about
increasing their wealth, but will be indifferent as to whether that increase comes
in the form of a dividend or through capital growth.
As a result, a company can pay any level of dividend, with any funds shortfall
being met through a new equity issue, provided it is investing in all available
positive NPV projects

M&M’s theory states that provided a company is investing in positive
NPV projects, it will make no difference to the shareholder (and share
price) whether the projects are funded via a cut in dividends or by
obtaining additional funds from outside sources.
As a result of obtaining outside finance instead of using retained
earnings, there would be a reduction in the value of each share.
However, M&M argued that this reduction would equal the amount of
the dividend paid, thereby meaning shareholder wealth was unaffected
by the financing decision

Question 3

Residual theory

Answer 3

This theory is closely related to M&Ms but recognises the costs involved in
raising new finance.
It argues that dividends themselves are important but the pattern of them is not.
We’ll see in the cost of capital chapter that the market value of a share will
equal the present value of the future cash flows. The residual theory argues that
provided the present value of the dividend stream remains the same, the timing
of the dividend payments is irrelevant.
It follows that only after a firm has invested in all positive NPV projects (thereby
increasing the potential for higher dividends in the future) should a dividend be
paid if there are any funds remaining. Retentions should be used for project
finance with dividends as a residual. In this way, the cost of raising new finance
is kept to a minimum.
However, this theory still takes some assumptions that may not be deemed
realistic. This includes no taxation and no market imperfections

Question 4

Dividend relevance

Answer 4

Practical influences, including market imperfections, mean that changes in
dividend policy, particularly reductions in dividends paid, can have an adverse
effect on shareholder wealth:
 reductions in dividend can convey ‘bad news’ to shareholders (dividend
signalling)
 changes in dividend policy, particularly reductions, may conflict with
investor liquidity requirements
 changes in dividend policy may upset investor tax planning (clientele
effect).
As a result, companies tend to adopt a stable dividend policy and keep
shareholders informed of any changes.

Question 5

Taxation

Answer 5

In many situations, income in the form of dividends is taxed in a
different way from income in the form of capital gains. This distortion in
the personal tax system can have an impact on investors’ preferences.
From the corporate point of view, this further complicates the dividend
decision as different groups of shareholders are likely to prefer different
pay-out patterns.

Question 6

One suggestion is that companies are likely to attract a clientele of
investors who favour their dividend policy (for tax and other reasons)
e.g.

Answer 6

higher rate tax payers may prefer capital gains to dividend income
as they can choose the timing of the gain to minimise the tax burden. In
this case, companies should be very cautious in making significant
changes to dividend policy as it could upset their investors.

Question 7

Legal restrictions on dividend payments

Answer 7

 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.
Such limitations protect creditors by restricting a firm’s ability to transfer wealth
from bondholders to shareholders by paying excessive dividends

Question 8

Liquidity

Answer 8

Consider availability of cash, not just to fund the dividend but also cash needed
for the continuing working capital requirements of the company

Question 9

Alternatives to cash dividends

Answer 9

Share repurchase

Scrip dividends

A bonus (scrip) issue

Question 10

Share repurchase

Answer 10

 consider using cash to buy back shares as an alternative to a dividend,
particularly if surplus cash available would distort normal dividend policy.
 alternative is to pay one-off surplus as a ‘special dividend

Question 11

What is a scrip dividend

Answer 11

A scrip dividend is where a company allows its shareholders to take their
dividends in the form of new shares rather than cash

Question 12

Scrip dividends

Answer 12

 The advantage to the shareholder of a scrip dividend is that they can
painlessly 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 in certain circumstances, it can save tax

Question 13

A bonus scrip issue

Answer 13

A bonus issue is not an alternative to a cash dividend. Although these shares
are ‘distributed’ from a company to its shareholders, they do not represent an
economic event as no wealth changes hands. The current shareholders simply
receive new shares, for free, and in proportion to their previous share in the
company.
The rate of a bonus issue is normally expressed in terms of the number of new
shares issued for each existing share held, e.g. one for two (one new share for
each two shares currently held)

Question 14

What is a bonus scrip issue

Answer 14

a method of altering the share capital without
raising cash. It is done by changing the company’s reserves into share
capital