Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

The board of directors of Rutherford plc is arguing about the company‟s dividend policy. Director A is in favour of financing all investment retained earnings and other internally generated funds. He argues that a high level of retention will save issue costs, and that declaring dividends always results in a fall in share price when the shares are traded ex div.

Director B believes that the dividend policy depends upon the type of shareholders that the company has, and that dividends should be paid according to shareholders‟ needs. She presents data relating to the company‟s current shareholders.

She argues that the company‟s shareholder „clientele‟ must be identified, and dividends fixed according to their marginal tax brackets.

Director C agrees that shareholders are important, but points out that many institutional shareholders and private individuals rely on dividends to satisfy their current income requirements, and prefer a known dividend now to an uncertain capital gain in the future.

Director D considers the discussion to be a waste of time. He believes that one dividend policy is as good as other, and that dividend policy has no effect on the share price.

You are required to discuss critically the arguments for each of the four directors using both the information provided and any other evidence on the effect of dividend policy on share price that you consider to be relevant.
Answer Plan
(1) Director A: effects of a residual policy; advantages of using internal funds for investment; impact on ex div share price.
(2) Director B: tax effects of dividend policy; clientele effect.
(3) Director C: consideration of income requirements; relative risk of dividends and capital gains.
(4) Director D: effect of market imperfections.
(5) Conclusion.

Director A is in favour of financing all investment retained earnings and other internally generated funds. This will probably entail the company following a residual dividend policy whereany funds remaining after all investments are undertaken are paid out as dividends. Such a policy is based on the assumption that shareholders will prefer the company to reinvest attributable earnings, provided the return so earned exceeds any possible alternative return which the investors could otherwise achieve. However, there are the following limitations associated with this policy:

(i) Since dividends represent the balance of earnings after all worthwhile investments have been undertaken, they will necessarily fluctuate from year to year, depending on the level of investment available. In some years dividends will be zero, whereas in other years they could be fairly substantial unless the company chooses to retain earnings for a future year. Such fluctuations in dividends may not suit certain investors.

(ii) In order for a policy of fluctuating dividends to be accepted, shareholders must fully understand the company‟s policy and have confidence in its investment criteria. This involves the free flow of information which only exist in a perfect market. Thus in the real world a policy of fluctuating dividends could reduce investor confidence and depress the share price.

(iii) Finally a residual payment policy could lead to the company deviating from its optional capital structure of debt to equity.

However, there are major cost savings and benefits which arise through the use of retained earnings for investment.

(i) The raising of new finance externally involves high issue costs which are eliminated with the use of internal funds.

(ii) The issue of new equity except in the case of a rights issue, dilutes the control of existing shareholders.

(iii) Advance corporation tax is payable on dividends which may be irrecoverable in certain circumstances or, if not, is disadvantageous inasmuch as it represents an adverse timing effect on tax payments. Therefore a low dividend payment policy is preferable.

(iv) Certain investors may prefer returns to be mainly in the form of capital gains due to the tax effects. Although capital gains and income are taxed at the same marginal rate, investors may still have a preference for capital gains due to the annual exemption and the fact that tax is not payable until the gain is realized. Return in the form of capital gain would be achieved through a low dividend payout policy.

The share price does usually fall once a dividend has been declared and the shares are traded ex- dividend. But that fall in value usually reflects the fact that the forthcoming dividend no longer accompanies that share and thus the fall in value equates with the declared dividend. There is thus no associated decrease in the underlying value of the share.

Director B believes that the dividend policy should be tailored to the needs of individual shareholders. Since capital gains and income are taxed at the same marginal rate, all tax paying shareholders will prefer returns way of dividends due to the associated tax credit. However, this will be complicated slightly the existence of an annual exemption on capital gains. Any non-tax paying shareholders will likewise show a preference for dividends, since they will be able to reclaim the ACT (or tax credit) paid the company. But, as was mentioned above, the tax advantage of capital gains may lie in the fact that tax is payable only when the gain is realized. The different shareholders may therefore have differing preferences concerning dividend policy.

The idea of the clientele effect, however, counters any argument of reviewing dividend policy. It suggests that through following a certain set dividend payout strategy the company has attracted a clientele of shareholders to whom this policy is suited. Therefore no benefit would be desired through attempting to alter the policy to meet individual preferences.

Director C suggests that many shareholders rely on dividends in order to satisfy current income requirements. An alternative exists, whereshares could be sold in order to realize the capital gain and thus provide income. However, this is not equivalent to a dividend payment since transactions costs would be involved, share holdings would be diluted and such an action could be tax disadvantageous as discussed above. Thus Director C is correct in his assessment and a constant stable dividend policy is what is required.

However, Director C‟s second point concerning risk is fallacious. A capital gain should be compared with total dividend payments not simply the current dividend and therefore both capital gains and dividends relate to future periods and are uncertain. In addition, both dividends and gains are determined the same factors. They are both generated the cash flows produced the company and these cash flows are determined the company‟s investment strategy.

Director D is a proponent of the dividend irrelevancy hypothesis which states that a company‟s value is dependent on the future earnings stream but independent of the particular dividend payment

policy. In theory this hypothesis is correct, but it is dependent on perfect capital market conditions, which clearly do no exist in practice. Several market imperfections have already been discussed above which suggest that dividend policy is important.

These include the following:

(i) the information content of dividends;
(ii) the existence of transactions costs;
(iii) the existence of issue costs on raising new finance;
(iv) the clientele effect;
(v) taxation considerations.

There are in reality many factors to take into consideration in determining an optimal dividend policy, and despite considerable research into the subject, no absolute conclusion has been reached on the effect of dividend policy on share valuation.

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