Module 3 - Dividend Policy

Question 1

What is a dividend?

Answer 1

A dividend is a distribution of profits to the holders of equity investments in proportion to their holdings of a particular class of capital.

Question 2

What are the 2 common constraints on dividend policy?

Answer 2

Retained earnings - a company can pay out more than its annual profit to shareholders only if it has retained earnings from previous years and the cash to do so.

Covenants - covenants in loan documentation, bond agreements and preference share terms and conditions may restrict the dicvidend policy of the company.

Question 3

What are the two ways a company can fund its investment decisions?

Answer 3

Companies can fund investment opportunities through internal funds in the form of retained earnings, or through external funds provided by lenders.

Question 4

What effect does internal funding of investment opportunities have on the dividend policy of a company?

Answer 4

Internal funding using retained earnings will lower the dividend expectations of investors.

Investors can expect to be compensated for this short-term sacrifice by higher dividends in the future when the investment pays off.

The gains might not necessarily be lower in the short term as the investment with internal funds may lead to increased capital value and a corresponding capital gain for the shareholder.

As banks demand higher fees for future refinancing, dividends have been cut by some companies in recent years to preserve liquidity.

Question 5

What effect does external funding of investment opportunities have on a companies dividend policy?

Answer 5

Shareholders cannot look forward to higher dividends in the future in the same way as for internal funding.

Higher dividends in the short-term come at the expense of more claims on the future earnings of the company from the providers of the external finance. If more debt or equity is issued, future dividends per share will be reduced to meet these additional obligations.

Question 6

What are the main types of dividend policy?

Answer 6

Constant percentage of annual earnings

Stable growth

Residual

Zero

Special or extra dividend

Question 7

Describe a constant percentage of annual earnings dividend

Answer 7

A constant percentage of earnings is paid out
each year. It seems logical but can create volatile
dividend movements if profits fluctuate.

Question 8

Describe a stable growth dividend policy

Answer 8

Dividends increase at a constant rate each year.
The growth rate is set at a level that signals the
growth prospects of the company.

Question 9

Describe a residual growth policy

Answer 9

The conpany seeks to maximise shareholder wealth by investing in projects with a positive NPV with internal funds. Only after all these options have been exhausted will the residual be distributed to shareholders.

Question 10

Describe a zero dividend policy

Answer 10

No dividends are paid. Profits are reinvested in the business. this is common in high growth companies as the capital gain compensates for the lack of dividend.

Question 11

Describe a special or extra dividend policy

Answer 11

A one-off dividend is paid outside of normal dividend distributions, usually arising from exceptional earnings

Question 12

What effect does the stage in the company life cycle have on the choice of dividend policy?

Answer 12

Young companies often follow a residual dividend policy. At this stage, investments by the company offer high returns and are numerous. preference to avoid debt financing and use retained earnings.

mature companies prefer to follow a stable growth or constant payout policy. There are less positive NPV investments available to the firm. These firms are more likely to se debt financing.

Question 13

What is the dividend growth model?

Answer 13

The growth rate of dividends may be expressed as:

g = rb

Where:
g = annual growth rate of dividends
r = rate of return on new investments
b = the proportion of profits that are retained (retention)

Question 14

How do we calculate the share price using the constant dividend growth model?

Answer 14

Constant dividend growth model
P = D0(1 + g)/(r - g)
= D1/(r - g)

Where:
D1 is the value of the next dividend and is equal to the value of the current dividend D0 increased by the dividend growth rate, g.

The traditional theory of dividends states there is an optimal dividend payout that will maximise the share price.

Question 15

What is the signalling effect?

Answer 15

The dividend declared by the company directors is based on the internal cash flow information that is not available to the wider market. As such, dividend policy can be interpreted as a signal on the strength of the underlying cash flows. A cut in the dividend may be seen as a signal of cash flow issues.

A consistent dividend policy with stable dividends or stable dividend growth is desired by most investors.Large fluctuations in the dividend can impact the share price of the company.

Question 16

What is the clientele effect?

Answer 16

The clientele effect is where investors purchase share in a company because they like its dividend policy.

The clientele effeect can put pressure on management to adopt a stable and consistent dividend policy.

Question 17

Describe the characterisitics associated with a preference for dividend income

Answer 17

Typical retired individuals and pension funds are attracted have a preference for dividend income.

They tend to invest in mature companies as a result of their dividend policy which tends to payout high and stable dividends.

Question 18

Describe the characterisitcs associated with a preference for capital gains

Answer 18

High salaried individuals that do not rely on dividend income tend to have a preference for capital gains over dividend income.

Tend to invest in high growth companies with residual or zero dividend policies.

Question 19

What factors influence the dividend policy of a firm?

Answer 19

Restrictive covenants

Expectations of shareholders

Liquidity

Attitude to debt

Tax

Evaluation by the market

Question 20

What effect can restrictive covenants have on the dividend policy?

Answer 20

Dividend payments may be restricted explicitly by the covenant.

Ordinary dividends cannot be paid until the outstanding preference share obligations have been settled

Question 21

How does the expectation of shareholders effect dividend policy?

Answer 21

Consistent dividend policy will attract shareholders who like the policy. A change in policy may cause these shareholders to sell shares causing a fall in the share price (the clientele effect).

Shareholders in private limited companies may prefer a cash dividend because of the difficulty in selling their shares.

Question 22

How does liquidity effect dividend policy?

Answer 22

The availability of positive net present value (NPV) projects may mean that instead of paying a dividend, the money could be reinvested in the company to make a greater return for the shareholders in the future.

High levels of investment can cause liquidity problems.

Question 23

How does the company’s attitude to debt effect the dividend policy?

Answer 23

If a company pays out a dividend and consequently has to seek external debt funding for its investments, then the level of gearing within the company will increase.

Question 24

How does tax effect the dividend policy?

Answer 24

If capital gains tax is lower than tax on dividends, an entity may reinvest to increase the share price.

Question 25

How does evaluation by the market effect dividend policy?

Answer 25

If the market interprets an increase in the dividend as a positive signal then this can lead to a rise in the share price (signalling effect).

Question 26

What is agency theory?

Answer 26

Managers are supposed to act in the best interests of the company’s shareholders. They do not always do this and may instead pursue their own interests. This is known as a principal-agent problem in agency theory.

Question 27

How can the dividend policy limit the principal-agent problem?

Answer 27

By insisting on high dividend payouts, managers will be forced to secure funding for projects externally. This puts the projects themselves under external scrutiny.

This should make it more difficult for managers to act in a way that does not serve the interests of the shareholders.

Question 28

What is a scrip dividend?

Answer 28

A liquidity enhancing alternative to cash dividends.

Shareholders are offered bonus shares free of charge. This capitalises the reserves.

Provides the creditors of the company with extra security as reserves are converted into permanent capital restricting future payouts.

EPS will decrease as the number of shares increases.

Can lead to tax complications. Capital gains are taxed at a different rate to dividend income.

Question 29

What are concessions?

Answer 29

A liquidity enhancing alternative to cash dividends.

Concessions are provided to shareholders rather than dividends.

An example would be a hotel chain granting shareholders a 15% discount on rooms.

Question 30

What are share repurchases?

Answer 30

A liquidity reducing alternative to cash dividends. This is used by companies which are cash rich.

Offers cash to investors without increasing dividend payments which would effect investor expectations.

Tends to be used by companies when there are no NPV positive investment opportunities available to the company.

Fewer share in issue will cause a decrease in earnings.

Can prevent unwanted takever bids.

Implies the company cannot use the funds as effectively as shareholders can.

Difficult to find a price which will be fair to the seller and the shareholders who are not selling their shares.