Module 3 - Dividend Policy Flashcards
What is a dividend?
A dividend is a distribution of profits to the holders of equity investments in proportion to their holdings of a particular class of capital.
What are the 2 common constraints on dividend policy?
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.
What are the two ways a company can fund its investment decisions?
Companies can fund investment opportunities through internal funds in the form of retained earnings, or through external funds provided by lenders.
What effect does internal funding of investment opportunities have on the dividend policy of a company?
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.
What effect does external funding of investment opportunities have on a companies dividend policy?
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.
What are the main types of dividend policy?
Constant percentage of annual earnings
Stable growth
Residual
Zero
Special or extra dividend
Describe a constant percentage of annual earnings dividend
A constant percentage of earnings is paid out
each year. It seems logical but can create volatile
dividend movements if profits fluctuate.
Describe a stable growth dividend policy
Dividends increase at a constant rate each year.
The growth rate is set at a level that signals the
growth prospects of the company.
Describe a residual growth policy
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.
Describe a zero dividend policy
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.
Describe a special or extra dividend policy
A one-off dividend is paid outside of normal dividend distributions, usually arising from exceptional earnings
What effect does the stage in the company life cycle have on the choice of dividend policy?
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.
What is the dividend growth model?
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)
How do we calculate the share price using the constant dividend growth model?
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.
What is the signalling effect?
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.