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Chapter Seven

Dividend Policy

1 Introduction

To maximise S/H wealth the Board should establish a dividend policy-

the payment pattern to the equity investors.

2 Theories

Several theories have been put forward to assist:

2.1 Residual – If spare cash exists at the end of the year pay dividend.

2.2 Pattern – Be consistent with dividend payments. Either

! Pay the same dividend per share (DPS) each year.

! Maintain the payout ratio (DPS/EPS)
! Maintain the same year-on-year growth rate in dividends.
The latter links into the Po via the dividend valuation model
(DVM)

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2.3 Irrelevancy (M&M)

In a perfect capital market providing the directors can invest in

projects with a positive NPV no dividends are required. The Ve will rise
and the S/H can sell shares to create the cash the need (Manufacture
Dividends).

3 Practical Considerations

There are many to consider:

! Availability of cash
! What dividends do S/H want (clientele effect)?
! Signalling effect –payment of dividends indicates a healthy
company
! Retaining cash is a key source of finance.
! Dividend growth should be greater than inflation
! Tax impact upon S/H
! Effect the dividend will have on dividend cover (EPS/DPS)
! Number of investment opportunities will restrict dividend
payments.
! Risk-paying now is safer than promising to pay next year
! Is the dividend within the company law regulations?

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4 Alternatives to Cash Dividends

4.1 Scrip Dividends

4.1.1 The S/H will receive extra shares instead of cash on a pro rata
basis.

4.1.2 This will allow the S/H to sell extra shares for cash and the gain will
be subject to CGT.

4.1.3 The effect will:

! Increase the issued equity capital

! Dilute EPS and Po values
! Create pressure for the board to pay more total dividends in the
future as more shares are in issue

4.2 Share Buy Back

4.2.1 If the board has “one off” period of excess cash, they could
consider a share buy back.

i.e. Buy back shares at Po and cancel them.

4.2.2 Considerations:

a) Allowable under company law.

b) Increase gearing as Ve may fall.
c) Tax implications for the S/H(CGT)
d) Reduced number of shares will cut supply for trading
purposes.
e) Less dividend pressure on the board in future.
f) Criticism-is this the best use of company cash.

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4 Maximum Dividend Payable and Free Cash Flows (FCF)

4.1 Free Cash Flows will be discussed in great detail in a later chapter.
It is worth noting that the MAXIMUM DIVIDEND PAYABLE in any year will
be equal to the FCF available to the equity holders. ie FCFe.

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Past ACCA P4 Question – Limni Co

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