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Discuss the factors that should be considered by the senior managers

of a listed company in making a decision on the size of the annual
dividend to pay its shareholders.

The decision regarding the paying of dividends to the shareholders is an
important aspect of any particular company. It is important to note that the
main objective of the company should be to maximize the shareholder value.
For this, shareholders receive dividends. This would reduce a portion of cash
available to the company for investment purposes and it would have to fall
into the trap of debt for increasing companys capital (Stern, 2011). The
factors are as under:

i. The dividend payout ratio reveals the portion of earnings distributed
to the stockholders of company. As mentioned above, the dividends
reduce the total cash available to the company (Finance, 2012). This
ratio should be considered for the decision regarding the paying of
dividends by keeping a balance between two main objectives that are
to maximize shareholders value and to keep sufficient funds for
investment purposes (Ratios, 2011). For this purpose, the managers
refer an industry average.

i. The newly established firm would require much of its earnings for its
expansion and growth (Fontinelle, 2012). Therefore, when the firm has
just started its business then it would have to follow a rigid dividend

ii. The liquidity of any particular company should be concerned first
before paying dividends to the shareholders. If the liquidity position is
strong, then the managers should not worry of distributing the cash
dividends to them (Star, 2012). Otherwise, stock dividends are

iii. The working capital is definitely the most important factor. This is
because it decides if the firm is in a dire need for an additional capital.
If that is so, the firm should continue paying dividends at low rates and
shareholders can cooperate on the fact that the company is trying to
expand itself further.

iv. Government policies also shape the dividend policies. Such policies
restrict dividend rates beyond a particular percentage in any particular
industry (FreeMBA, 2011).

v. The taxation policy also affects the decision if the taxation is
determined to be high for the complete business activity and even if the
government levies tax of distribution of dividend beyond a certain limit.

vi. Established Companies have an easy access to the capital market.
Therefore, they can borrow funds when needed and their dividend
policy is not disturbed. However, smaller and developing companies
have to vary the dividend rates, as they cannot easily access the
capital market for borrowing purposes.

vii. The company is bound to vary the dividend rates if it restricted to do so
due to the repayment of loans (Rafique, 2012). If the amount of loan
is high then the company is bound to keep a good portion of retained
earnings for such purpose. Hence, this lowers the dividend rates
distributed to the shareholders.

viii. If the expected rate of return is high for any particular investment then
the company should retain the earnings for further growth purposes.
The dividends rates should be set low then (Moradi, et al., 2010).

ix. The desire for control factor is important when there is a need for
further financing. Therefore, the firms management would not decide
to issue common stock further as there could be a chance of dilution in
control on management. Hence, that firm is obliged to retain the
earnings to satisfy their financing need.

2. GLC plc. has just announced an ordinary dividend of 20p per share. The
past four years dividends per share have been 15p, 17p, 19p and 20p,
with the most recent dividend last. Shareholders require a return of 15
per cent.
GLC decides to increase its debt level, thereby increasing the financial
risk associated with its equity shares. Because of this, the companys
shareholders require an increased rate of return to 16.5 per cent.

A. Identify what is a fair price for GLCs shares prior to the
increased debt level?

The most appropriate method in this particular scenario is the absolute
valuation. This method has the ability to compute the absolute fair value of
GLC shares. The Gordon growth model suits the scenario well. This method
is based on the future payment of dividends at a rate that is constant. The
method helps in computing the present value of infinite series of future
dividends. The formula is as under:

Stock Value (P) = D / (k G) (Analyst, 2013)

Where D is the expected dividend per share one year from now.
K is the return required by an investor
In addition, G is growth rate of dividends.
We assume that dividend per share to be paid next year is 22p per share.
Therefore, the growth G is 10%. The fair value is:

Stock Value (P) = D / (k G)
Stock Value (P) = 22/ (15 10)
Stock Value (P) = 22 / 5 = 4.4p per share

B. Calculate what is a fair price for GLCs shares after the increase in

Using the same formula,

Stock Value (P) = D / (k G)
Stock Value (P) = 22 / (16.5 10)
Stock Value (P) = 3.14p per share

It can be said that the fair price of GLC shares declined to some extent
because the company opted for further debt, which increased the
shareholders rate of return. The rate of return required increases because of
the fact that the company faces an increased risk due to its decision of issuing
debt and the second reason could be that the shareholders expect further
dividend payments. The share prices declined because of the increased rate
of return.

C. Discuss any problems with using the dividend growth model as a way
of valuing shares and suggest alternative models, which could be used
to value companies and shares. In this discussion you should also
identify any merits and disadvantages of each method.

The dividend growth model states that the price of a stock should be equal to
the sum of current and future cash flows respectively after the consideration
of time value of money.
The above statement clearly explains us two different concepts.
1. Estimating Current and Future Cash flows
The shareholders invest the cash in the desired companies where they
expect some return as dividends. This is the only way to determine the
future cash one can expect to get. More importantly, if a company is not in
a state to pay dividend to its shareholders then the price of stock is
determined by assuming that the company will pay it later. Therefore, if
there were no way a company could pay dividends then investors would
never be interested in buying the stocks of such company.

2. The time value of money
It is important to note that investing is just like saving. When there is, an
additional money left after ones expenses are paid then that people set it
for future use. Through saving, one can achieve this purpose. Most
importantly, investing can help you to invest today and receive more
money in future.

The DDM is a basic valuation tool that is well suited for investing
purposes. This principle combines the time value of money factor and
future cash flows through the following formula:

Stock Price = the Sum of the Present Value of All Future Dividends
Stock Price = (D
/ (1 + r)
Where t is time or year, D
is the dividend during year t and r is the rate
required on the stock.


Buy and Hold
The following formula would allow us to determine if an investor can
purchase the stock. If the calculated value is higher than the state price
then the shareholder can wait for price to decline. The formula is as under:
Stock Price = Dividend / required rate of return

Dividend Growth
If the company ABC has the ability to grow its dividend through enhanced
earnings, then the formula for computing the stock price is an under:

Stock Price = D
/ (r - g)
= Dividend declared during year 1
g = dividend growth rate

Issues in this model
The model is best for those companies that pay dividends. However, two
third of the companies retain a portion of their earnings for further
investment purposes. Therefore, analysts would need to make assumption
on how much the company would pay later (Springer, 2011). Therefore, a
misassumption about company can result in either overvaluing or
undervaluing of stock.

The other drawback tells us that if the dividend of any particular company
grows faster, the denominator becomes a negative value. For example,
suppose ABC pays a $3 dividend and has a dividend growth rate of 15%.
The required rate of return is 10%. The value of ABCs stock become
($3 x 1.15) / (0.10-0.15) = -$69.

I would suggest the following models:
1. Earnings per share which is the net income divided by the number of
shares outstanding. The main advantage of this method is that it gives
an outlook of companys earning power. Therefore, it is a good
measure of profitability. The disadvantages of this method is that it
does not tell us about the future of company as when any asset like
building is sold, then it will result a sudden fluctuation in EPS.
2. Price to earnings ratio reflects the confidence of investors in the
company in the future. It is a straightforward method of valuing a stock
but it has an inability to consider the growth of company as P/E has a
limited meaning.
3. Return on assets tells us the profit earned on the resources or assets
altogether. This technique measures the use of effective use of assets
in the companys operation. It also entails the productivity of business
(Leskov, 2007). However, it gives no indication as to how to assets
were financed.
4. Market Capitalization measures the size of a business by multiplying
the share price by the number of shares outstanding. The most
important benefit of using this model is its simplicity and lets the
investors know if the fund invests in either large or small cap stocks.
Therefore, A high M cap helps improve a companys credit rating,
lowers borrowing costs and makes raising funds for expansion via a
rights issue easier (Abdolmohammadi, 2005).


Abdolmohammadi, M. J., 2005. Intellectual capital disclosure and market
capitalization. Journal of Intellectual Capital, 6(3), pp. 397-416.

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Fontinelle, A., 2012. Investopedia. [Online]
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FreeMBA, 2011. [Online]
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Leskov, ., 2007. 5th International Conference on Management, Enterprise and
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Moradi, M., Salehi, M. & Honarmand, S., 2010. POSLOVNA IZVRSNOST ZAGREB,
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Rafique, M., 2012. Factors Affecting Dividend Payout. Business Management
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Ratios, R., 2011. Ready Ratio. [Online]
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Springer, L., 2011. Investing Answers. [Online]
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Star, M., 2012. Morning Star. [Online]
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