Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

a) Distinguish between the residual dividend theory‟ and clientele preference theory as they
relate to dividend policy formulation.
b) Discuss the Modigliani and Miller‟s (MM) dividend irrelevancy proposition (
c) Huge Ltd. is contemplating a complete share acquisition of Tiny Ltd. Huge Ltd is offering three of its shares for every two shares of Tiny Ltd. The data is relating to the two companies are shown below:

Required:

i) Determine the maximum offer price that will not dilute the EPS of Huge Ltd.
ii) Compute the premium payable to the shareholders of Tiny Ltd
iii) Given that the growth rate of Huge Ltd. is 8% while that of Tiny Ltd is 12%, compute the combined growth rate of the two companies

ANSWER

a) Dividends as residual

– In a small world with no external finance, dividend policy should be residual. This means that the only source of finance for additional investment is earnings and consequently dividends should only be paid when the firm has financed all its positive NPV projects
– In a world with transaction costs, associated with dividends and obtaining investment finance through the sale of new shares, dividend policy will be influenced by, but not exclusively determined the dividend as a residual approach policy.

Clientele preferences

– The clientele preferences or effect is the concept that shareholders are attracted to firms that follow dividend policy (ies) consistent with their objectives. In other words some shareholders prefer a dividend pattern which matches their desired consumption patterns.
– For example, retired people, listing off their private investments, may prefer a stable and steady income and so they would tend to be attracted to firms with a high and stable dividend yield. Likewise, pension funds need regular cash receipts to meet payments to pensioners.

b) M & Ms Dividend irrelevancy proposition

According to an important 1961 paper Modigliani and Miller (MM) (1961), if a few assumptions can be made, dividend policy is irrelevant to share value. Those assumptions include:

1. There are no taxes
2. There are no transaction costs
3. All investors can borrow and lend at the same interest rate
4. All investors have free access to all relevant information

MM concluded that the determinant of value is the availability of prospects with positive NPVs and the pattern of dividends makes no difference to the acceptance of these. The share price would not move if the firm declared either a zero dividend policy or a policy of high near-term dividends.

If a company chose not to pay any dividends at all and shareholders required a regular income then this could be achieved while leaving the firm‟s value intact. „Home-made dividends‟ can be created shareholders selling a portion of their shares to other investors – again as there are no transaction costs and no taxation the result is identical to the receipt of cash in the form of an ordinary dividend from the firm.

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