Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

The following data relates to a large company operating in the electronics industry:

A major institutional shareholder has criticized the level of dividend payment of the company suggesting that it should be substantially increased.

Required:
(a) Briefly discuss the factors that are likely to influence the company‟s dividend policy, and
(b) Discuss whether or not the institutional shareholder‟s criticism is likely to be valid.
ANSWER
(a) There is considerable debate as to whether dividend policy can influence corporate value. Much of the debate concerns the question of whether it is the dividend that affects share value, or the information implied the payment of the dividend. Dividends may provide, in the cheapest and most efficient manner, unambiguous signals about a company‟s future prospects and management performance. Managers have an incentive to send truthful signals via dividends, as any changes in dividends that are not likely to be accompanied changes in cash flows will not fool a market that is at least semi-strong form efficient. Dividends therefore may be a valuable communication medium.

There are a number of possible practical influences on dividend policy including:

(i) Dividends are to be discouraged as they may lead to issue costs associated with raising additional external finance.
(ii) Corporate growth. The faster a company is growing the lower the dividend payment is likely to be.

(iii) Liquidity. Cash is needed to pay dividends. The level of corporate liquidity might influence dividend payouts.

(iv) The volatility of corporate cash flows. Companies may be reluctant to increase dividends unless they believe that future cash flows will be large enough to sustain the increased dividend payment.

(v) Legal restrictions, for example, government constraints, limitations on payments from reserves, and covenants on debt that restrict dividends.

(vi) The rate of inflation. Many shareholders like dividends to increase at least as much as inflation.

(vii) The desires and tax position of the shareholder clientele. However, most companies have a broad spread of shareholders with different needs and tax positions.

(b) The company‟s dividend per share has increased, in real terms, between 6.6% and 12.53% per year during the last five years. Although no comparative industry data is available this appears to be a good performance. The payout ratio has reduced from 38% in 1994 to 30.5% in 1998, which may be why the institutional shareholder has made the criticism. However, there is little point the company paying out large dividends if it has positive NPV investments which can be financed partially dividend retention. Although there is no means a perfect correlation between NPV and earnings per share, the fact that earning per share have consistently increased over the period suggests that the company‟s investments are financially viable. The company has consistently had high net capital expenditure relative to earnings, and in such circumstances it is not unusual for dividend payments to be relatively low.

The company‟s share price has not increased as much as earnings per share, but without information on stock market trends and the relative risk of the company it is not clear whether or not the company‟s share price is under performing. Unless the institutional shareholder could invest any dividends received to earn a higher yield (adjusted for any differences in risk) there is little evidence to support the validity of the criticism.

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