Dividend Policy

Question 1

What are dividends?

Answer 1

1. Discretionary and decided by the board of directors and are declared with the company’s financial results (interim and final).

Question 2

Who does a company pay a dividend to?

Answer 2

SHAREHOLDERS in cash on a per share basis; or
in new shares if the shareholder elects (scrip dividend)

Only payable if there are sufficient retained earnings but can be paid if uncovered by annual earnings.

Question 3

What are the 2 names for the dividend ratios?

Answer 3

1. Dividend cover and dividend yield.

Question 4

What is the calculation for the dividend cover?

Answer 4

Dividend cover = earnings per share ÷ dividend per share (i.e. 2x)

Question 5

What is the dividend yeild calculation?

Answer 5

Dividend yield = dividend per share ÷ clean share price (i.e. 3%).

Question 6

What is the dividend decision?

Answer 6

To see if a company’s dividend policy affect shareholder wealth?

Question 7

What are the two types of dividend policies?

Answer 7

1. Regular - long-term pattern and level of payments.

2. Complementary - one-off or short-term payments.

Question 8

What are the considerations by the directors when deciding the dividend policy?

Answer 8

1. If it’s a xero or non-zero policy?
2. If it’s a stable or fluctuating dividend?
3. What the Pay-out ratio is (level of regular dividend relative to annual earnings)?
4. The use of complementary policies?

Question 9

What are the 5 regular dividend policies?

Answer 9

1. Zero dividend policy
2. Constant dividend policy (Same dividend each year).
3. Progressive dividend policy as the dividend increases year on year at a similar rate
4. Constant pay-out ratio:
   Dividends paid are a constant proportion of annual earnings per share
5. Residual approach as dividends are only paid if cash remaining after investment.

Question 10

Why is dividend policy irrelevant to shareholder wealth (according to M&M’s irrelevancy theory)?

(slide 6).

Answer 10

1. The value of the company is the sum of the future cash flows of its investment projects discounted by investors’ required rate of return.
2. As long as the company is financing projects which increase shareholder wealth it does not matter how the finance is raised – either externally or internally via a dividend cut
3. Investors that require income can generate “home-made” dividends by selling some of their shares.

Question 11

What happens in a perfect market according to M&M’s irrelevance theory? (Slide 7).

Triple check this.

Answer 11

In a perfect market paying no dividends and raising external finance whilst paying a dividend will increase shareholder wealth by the npv of the project. BUT paying a dividend and not investing in the project will lead to no change in shareholder wealth.

Question 12

What are the 3 perfect market asusmptions?

Answer 12

1. No transaction costs occuring but creating “home-made” dividends incurs direct costs for shareholders and raising finance incurs indirect costs for shareholders.
2. No (differential) investor taxation but shareholders are subject to different taxes levied at different rates and thus not indifferent to income or capital gains
3. No information asymmetry but directors are always privy to inside information. Shareholders only receive company information periodically also.

Question 13

What is the main conclusion of the irrelevance theory?

Answer 13

Companies ought to adopt the residual approach (fluctuating dividends).

Question 14

What is the 3 dividend relevant theories as shareholders prefer more predictable dividend policies due to a realistic imperfect market?

Answer 14

1. The signalling effect
2. The clientele effect
3. The bird in hand theory.

Question 15

What is the signalling effect?

slide 10

Answer 15

When the market assumes that directors use the dividend to convey signals.

E.g. An increased dividend is a signal that directors have confidence in the future performance of the company.

E.g. v2 A decreased dividend (cut) is a signal that directors are concerned about the future performance of the company

Question 16

What are the results of the signalling effect which is expected by the market?

Answer 16

1. Higher increase or lower decrease – share price rises
2. Lower increase or higher decrease – share price falls
3. Unexpected cut – share price falls sharply

Question 17

What is the Clientele Effect?

Answer 17

When particular types of investors (clienteles) are attracted to the historic dividend policy of companies due to high pay out ratios ( a regular income) or low pay out ratios as they prefer to pay capital gains tax (lower rates) rather than income tax (higher rates).

Question 18

What would a significant change in the dividend policy do for clientele?

Answer 18

1. Alienate the existing clientele
2. Attract a new clientele
3. Cause turbulence in the share price

Question 19

What does the bird in hand theory suggest?

Answer 19

That shareholders prefer the certainty of higher dividends now; compared to lower dividends now in return for the promise of higher dividends in the future.

However share prices already discount future dividends to allow for this uncertainty.

Question 20

What are the 2 other types of complementary dividend policies?

Answer 20

Special dividend which is a ‘One-off’ very large dividend to return surplus funds in cash.

Share buy-back (repurchase and cancellation) scheme whcih is a short term scheme but may be renewed annually. This usually leads to an increase in the signalling effect and increased earnings per share for shareholders. However shareholder wealth is only increased if company buys shares below “intrinsic” value.

Question 21

Is there an optimal dividend policy?

Answer 21

NOOOO but shareholder wealth can be destroyed by unpredictable policies.

Question 22

Why would most listed companies establish a progressive regular dividend policy at a conservative dividend growth rate and affordable pay out ratio? (Slide 14).

Answer 22

1. They can maintain this policy in “normal” years and pay special dividends if windfall gains made.
2. They can Increase the growth rate and/or buy-back shares in “good” years.
3. They can reduce the growth rate in “bad” years even though dividend may be uncovered.