Module 8

Question 1

Dividend

Answer 1

Distribution of profits to the holders of equity investments in proportion to their holdings of a particular class of capital

Question 2

Constraints on dividend policy (2)

Answer 2

• Retained earnings

- Covenants

Question 3

If company choses to retain earnings instead of paying dividend (3)

Answer 3

• Dividend paid in short term will be lower
• Investors compensated for short term sacrifice by higher dividends in the future
• Capital value of shares should increase in line with retentions > producing capital gains

Question 4

Dividend decision interrelated with

Answer 4

Company’s investment and financing decisions

Question 5

Dividend policies adopted by companies (5)

Answer 5

• Constant percentage of annual earnings
• Stable growth
• Residual
• Zero
• Special or extra dividend

Question 6

Type of dividend policy depends on

Answer 6

Stage of lifecycle eg
Young companies > residual policy
Mature > stable growth/ constant

Question 7

If dividend policies are out of line with the market’s expectations

Answer 7

Appears to produce significant share price reactions

Question 8

Growth rate of dividends formula

Answer 8

g = rb

g = annual growth rate of dividends
r = rate of return on new investments
b = proportion of profits that are retained

Question 9

If next year’s dividend is provided, use

Answer 9

D1
___
(r-g)

Question 10

If current year dividend provided, use

Answer 10

D0 ( 1 + g)
_________
(r - g)

Question 11

Dividend declared can be interpreted as

Answer 11

Signal from directors to shareholders about the strength of the underlying project cash flows

Question 12

Clientele effect

Answer 12

Whereby investors chose to purchase shares based on their individual needs/ requirements (eg if want regular cash payments, chose company who traditionally pays regular dividends instead of potential for high capital gains)

Question 13

Clientele effect can

Answer 13

Place pressure on management to produce stable and consistent dividend policy

Question 14

Factors influencing the dividend policy

RELATE

Answer 14

R > Restrictive Covenants
E > Expectations of shareholders
L > Liquidity
A > Attitude to debt
T > Tax
E > Evaluation by the market

Question 15

Agency theory

Answer 15

Managers may not always act in the best interest of the shareholders

Question 16

One way for shareholders to keep control

Answer 16

Insist on relatively high payout ratios > forces the directors to have investment projects scrutinised by external providers

Question 17

Alternatives to paying a cash dividend > liquidity enhancing alternatives (2)

Answer 17

• Scrip dividend

- Concessions

Question 18

Scrip dividend

Answer 18

Shareholders are offered bonus shares free of charge as an alternative to cash dividend.
Distributable reserves reduce
Share capital increases

Question 19

Advantages of scrip dividend (2)

Answer 19

• Preserves cash position
• Creditors of company are provided with additional security because distributable reserves are converted into permanent capital

Question 20

Disadvantages of scrip dividend (2)

Answer 20

• Earnings per share will decrease as number of shares increases
• Can lead to tax implications for individual investor as capital gains are taxed at different rate from dividend income

Question 21

Concessions

Answer 21

Can provide concessions to shareholders instead of paying out all or some of dividend eg discount/ free products

Question 22

Alternatives to paying a cash dividend > liquidity reducing alternative

Answer 22

Share repurchase

Question 23

Share repurchase advantages (2)

Answer 23

• Fewer shares in issue so earnings per share will increase

- Can prevent unwelcomed takeover bid

Question 24

Share repurchase disadvantages (2)

Answer 24

• Implies that the company cannot use the funds as effectively as shareholders
• Difficult to find price which is fair to both seller and those shareholders not selling