Module 8: Dividend Policy Flashcards
The 5 different types of dividend policy
- Constant % of annual earning
- Stable growth
- Residual
- Zero
- Special or extra dividend
A start up company would choose which type of dividend policy?
Residual policy
Mature companies often follow which dividend policy?
stable growth or
constant % of annual earnings
Dividend growth formula
g=r x b
Dividend growth model
Is the price of a share
P = D1/(r-g)
Signalling effect
Dividend declared interpreted as a signal from directors to SHs about the strength of underlying project CFs
Investors expect a consistent dividend policy with stable divs each year or steady div growth. Large rise or fall can have a marked effect on share price
Stable dividends or steady growth usually needed for share price stability. Cut in dividends signal future prospects are weak. Div paid signals future prospects strong.
Clientele effect
SHs may choose to purchase shares because the dividend policy of that particular company suits them
Investors preference = capital gains or div income
Clientele effect places pressure on mgmt to produce stable and consistent dividend policy. Any inconsistency results in decrease in share price.
Capital gains investors
High salaried individuals who do not rely on dividends for their consumption
Invest in high-growth companies
Dividend policy adopted = residual or zero div policy
Dividend income
Retired individual or pension fund
invest in mature companies
Div policy = high and stable dividend policy
Interrelationship of the financing and investment decisions with the dividend decision. Factors to consider?
RELATE
Restrictive covenants - div payment restricted by debt covenant, OS div can’t be paid until pref share div arrears are settled
Expectation of shareholders - consistent div policy wanted => change in policy will result in SHs selling => share price will fall. Private limited comps prefer cash div as they will struggle to sell (clientele effect)
Liquidity - availability of +ve NPV projects => reinvest to make greater return in the future. High levels of investment may cause liquidity problems.
Attitude to debt - pay div then immediately seek external debt to fund investments => level of gearing increases
Tax - capital gains tax lower than tax on divs => comp reinvest to increase share price
Evaluation by the market - signalling - +ve signal => share price increase
Agency theory
Managers don’t always act in the best interest of the SHs (e.g. paying out dividend then issuing new shares to raise funds for investment straight after).
Shareholders, to keep control over the money they put in, can insist on relatively high payout ratios => harder for comp to embark on -ve NPV projects.
Alternatives of paying a cash dividend )liquidity enhancing)
Scrip dividend - SHs offered bonus shares free of charge (distributable reserves reduce, share capital increases).
Concessions - provide concessions to their SHs instead of paying out some or all dividend (e.g. 15% reduction in hotel room for SHs in Hilton)
Ads to scrip shares
- preserves cash position
- useful when liquidity is an issue
- useful when cash is needed for investment
- creditors supplied with additional security because distributable reserves are reduced => restricted scope of future dividends
Disads to scrip dvidends
- EPS decreases as number of shares increase
2. leads to tax complications for investor as capital gains are taxed at diff rate to div income
Alternative to cash dividends (liquidity reducing alternatives)
return surplus cash to SHs
Share repurchase
used when the company has no +ve NPV projects to invest in => buy back shares and returns the cash to SHs so they can make better use of it
