Equity sources and dividend policy

Question 1

What is the traditional school of thought regarding dividend policy? (5)

Answer 1

• Shareholders would prefer dividends today than dividends or capital gains in the future.
• This is because cash now is more certain than in the future.
• A consistent dividend stream is important.
• However, this implies that future payments would be discounted at a higher rate to take account of the uncertainty.
• Risk is related to the activities and operations of the business and so the discount rates applied to dividends should reflect this.

Question 2

What is Modigliani and Miller’s theory regarding dividend policy? (4)

Answer 2

• Share value is determined by future earnings and the level of risk.
• The amount of dividends paid will not impact shareholder wealth, providing retained earnings are invested in profitable investment opportunities and any loss in dividend income will be offset by gains in share price.
• Shareholders can create homemade dividends and do not have to rely on the company’s dividend policy; if cash is needed, they can sell shares instead.
• Taxes, share transaction costs and share issue costs will have an effect.

Question 3

What is the signalling view on dividend policy?

Answer 3

Dividends mean that management is confident about the future.

Question 4

What is the clientele effect on dividend policy?

Answer 4

Investors have a preferred habit; they seek a company with a dividend policy suited to them. If shares are unpopular because of inconsistent policy, then the share price will suffer.

Question 5

What is the impact of agency on dividend policy? (3)

Answer 5

• Separation of ownership from management of a firm can lead to suboptimal decisions being made. Agency costs are borne by shareholders.
• Managers may often make investments that do not increase shareholder wealth and dividends worsen as a result.
• Dividend commitments can reduce agency costs. A high dividend payout and low retentions leads to greater scrutiny of the firm’s investment decisions by outsiders due to the need for external funds.

Question 6

What is the impact of tax on dividend policy?

Answer 6

Some shareholders may prefer income to capital gains.