Dividend theory Flashcards
What is dividend policy?
Dividend policy is the determination of the proportion of profits paid out to shareholders. It also looks at whether shareholder wealth can be enhanced by altering the patterns of dividends not the size overall.
What are the assumptions?
- The underlying investment opportunities and returns on business investment are constant.
- The extra value that may be created by changing capital structure is constant.
Who decides what dividends are paid?
Board of directors are empowered to recommend the final dividend level, but shareholders vote at the AGM to decided whether or not it should be paid.
Where can dividends be paid from?
Only paid out of accumulated profits, not out of capital
What is Miller and Modigliani’s dividend irrelevancy proposition theory?
Dividend policy is irrelevant to share value.
Any money paid out can quickly be replaced by having a new issue of shares. Homemade dividends can be created by shareholders selling a portion of shares to investors.
What are the assumptions for the dividend irrelevancy proposition theory?
There are no taxes
No transaction costs
All investors borrow and lend at the same rate
All investors have free access to relevant info
Investors are indifferent between dividends and capital gains
What is a residual dividend policy?
Company pays dividends that remain after paying for capital expenditures and working capital.
e.g. when they have financed all +ve NPV projects.
How does dividend policy become important determinants of shareholder wealth when using residual dividend policy?
If cash flow is retained and invested within the firm at less than the cost of equity shareholder wealth is destroyed, therefore it is better to raise the dividend payout rate.
If retained earnings are insufficient to fund all +ve NPV projects shareholder value is lost, it would be beneficial to lower the dividend.
What are influences on dividend policy?
Clientele effects
Dividends as conveyors of information
Resolution of uncertainty
Agency theory
Explain clientele effects as an influence on dividend policy.
- Total return on shares is made up of dividends and capital growth, some shareholders prefer income, others prefer capital growth.
- Retired people live off their private investments and so prefer income, they want firms with a high and stable dividend yield.
- Some clientele aren’t interested in receiving high dividends, instead they want good growth potential. e.g. wealthy middle aged people who have enough income already to paid for their consumption needs.
How does clientele effects affect management?
Creates pressure on the management to produce a stable and consistent dividend policy. Most firms have a dividend policy based on long term views of earnings and investment capital needs, shortfalls are adjusted through other sources of finance.
How does taxation affect clientele effects?
Taxing dividends and capital gains of shares influences the preferences of shareholders for receiving cash either in the form of a regular payment from the company (dividend) or by selling shares.
Explain dividends as conveyors of info as an influence of dividend policy.
Dividends are conveyors of info about companies, it signals how the directors view the prospects of the firm. Large increases indicate optimistic views about future profitability, declining dividends signal that directors view the future with pessimism.
What is the resolution of uncertainty for dividend theory?
It explains that investors prefer dividends from stock investing over capital gains because of the uncertainty associated with capital gains, dividend payments are more certain that future higher capital gains and so are more preferred. Therefore, more distant future cash flows have a higher discount rate due to the perceived risk.
Explain agency theory in dividend theory.
The reason for paying high dividends then issuing new shares to raise cash for investment can either be due to the signalling value this brings (high dividends give company good rep) - sometimes costs are too high to re-issue shares so this can be explained by agency theory. Owners insist on high pay out ratios as they have different interests in mind for the business. Managers then must ask for funds for investment due to lack of them.
