Equity sources and dividend policy Flashcards
Is the cost of servicing the equity (i.e. Ke) the same regardless of the historic source of the funds?
Yes
This is because the return required on each £ of equity held by the company (i.e. Ke) depends on the risk suffered by the equity shareholder. It is irrelevant where the funds originated.
M&M used this logic to argue that the source of equity finance is irrelevant.
What is the traditional view on dividend policy?
A consistent dividend stream was important.
Traditionally it was believed that it was better to have the certainty of a known dividend now than the uncertainty of having to wait (known as the ‘bird in the hand view’).
What is the M&M view on dividend policy?
Consistency of the dividend stream is irrelevant
What is M&M’s main argument re. dividend policy?
As long as a dividend cut is being used to fund a positive NPV project, then the increased dividends in the future would be more than enough to compensate for the lower dividend today
What do M&M suggest investors could you if they require a level of income and don’t have dividends?
‘DIY dividends’
By selling some shares
Arguments against M&M’s dividend view
- Dividend signalling
- The clientele effect
Arguments against M&M’s dividend view: Dividend signalling
M&M assumed investors had perfect information about the company. In
practice, although this is true for small owner managed businesses, with listed companies, a reduction in dividend can convey ‘bad news’ to shareholders.
Arguments against M&M’s dividend view: The clientele effect
M&M assumed that investors were indifferent between dividends and capital growth, and that if investors require cash then they could manufacture dividends by selling shares. In practice, tax differences and transaction costs mean this is not the case
Dividend policy: What policy do most listed firms adopt in practice?
A stable dividend policy
Paying out a stable, but rising, dividend per share
How are dividends prudentially paid to minimize the risk of earnings temporarily falling?
Ensuring dividend payments lag behind earnings
Other methods for a company to make distributions to their shareholders
Share buybacks
Scrip (stock) dividends
What is a scrip dividend?
Where a company allows its shareholders the choice of taking their dividends in the form of new shares rather than cash.
Not a scrip issue
Scrip dividends: Advantage to sharehoders
Painless increase in shareholding because no brokerage fees or stamp duty
Scrip dividends: Advantages to company
Doesn’t need to pay a cash dividend
Can save tax
