Dividend Decisions Study Unit

APPLIED MANAGEMENT ACCOUNTING AND FINANCE MAF 402 – MODULE 2 2021
CHARTERED ACCOUNTANTS ACADEMY
MANAGEMENT ACCOUNTING & FINANCE DEPARTMENT
CERTIFICATE OF THEORY IN ACCOUNTING
STUDY UNIT 4: DIVIDEND DECISIONS

TABLE OF CONTENTS PAGE
Contents
1. Introduction ................................................................................................................... 1
2. Learning objectives under Dividend Decisions ................................................................ 1
3. Study material................................................................................................................ 1
4. Competence Framework expectation............................................................................. 1
5. Examination possibilities ................................................................................................ 2
6. Assumed Knowledge ...................................................................................................... 2
7. Integration ..................................................................................................................... 2
8. Dividend theories ........................................................................................................ 2
8.1. Dividend Relevance..................................................................................................... 2
8.2 Dividend Irrelevance View .......................................................................................... 3
9. Factors affecting the dividend decision ....................................................................... 2
10. Disadvantages of switching investments in companies ............................................... 4
11. Dividend Payment Policies .......................................................................................... 5
12. Bonus Issues and Share splits ..................................................................................... 7
13. Dividend reinvestment plans (DRP) and Scrip dividends ............................................. 7
14. Share buy-backs ......................................................................................................... 8
15. In conclusion, do dividends matter? ......................................................................... 10
1. Introduction
Three distinct, yet connected decisions affect the sustainable growth
rate of the firm. These are the Financing decision, Investment
decision and the Dividend decision. In making the dividend decision
some of the common questions include:
Does the dividend decision, along with the investment and financing
decisions affect the value of the company? / Is the dividend merely
a consequence of the other two decisions? / If a firm chooses to
finance a new investment by a cut in the dividend what is the impact
on existing shareholders and share price of the company?
2. Learning objectives under Dividend Decisions

After studying this unit, one should be able to:
• Contrast the active variable and passive residual approaches to managing dividends;
• Explain the effect of payments on the dividend growth model;
• Calculate the dividend by applying the residual approach;
• Identify factors that affect the dividend decision;
• Identify alternative dividend payout policies;
• List important dates in the declaration and payment of dividends;
• Explain alternative methods of making distributions to shareholders;
• Describe why share buybacks occur as an alternative to dividends; and
• Explain how dividend re-investment plans (DRPS) work
3. Study material
• Carlos Correia, Enrico Uliana & Michael Wormald (2011). "Financial Management".
7"Edition,
• CAA Applied Management Accounting and Finance MAF 402 Module 2
4. Competence Framework expectation

Competence area: Financial Management
V-3.4 Evaluates decisions related to distribution of profits
Level I
− Evaluates the manner in which an entity distributes profits to shareholders
− Incorporates tax considerations
− Recommends the most appropriate method to distribute profits
The dividend decision Knowledge level
▪ Factors affecting the dividend decision 2
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▪ Relevance and irrelevance theories 2

▪ Setting appropriate dividend policies 2
▪ Scrip dividends 2
▪ Share buy-backs 2
5. Examination possibilities
Dividend decisions are highly examined at CTA level and not regularly in the ITC.
6. Assumed Knowledge
All financial management topics are assumed knowledge so that a dividend decision
is made. These include topics covering the financing decision and the investment
decision. Income tax principles are also assumed knowledge.
7. Integration
This topic can be integrated with any topic, including corporate governance and risk
in relation to whether the distribution of dividends to shareholders follows relevant
legislation.
8. Dividend theories
(Is the dividend an active variable OR a passive residual?)
There are two schools of thought:
– A dividend affects the value of a company - it is relevant and has to be actively managed
– Alternatively, a dividend has no effect on value - it is irrelevant and remains a balancing
figure dependant on financing decisions
Differential tax rates could be the deciding factor for an investment preference between
capital growth or a cash dividend.
8.1. Dividend Relevance

Illustration

8.1.1. Dividends and capital structure

The capital structure of a company = debt and equity. Equity includes original invested capital
and retained earnings. The payment of a dividend reduces a company’s retained earnings.
This may deprive the firm of equity capital to be used for profitable investments. A reduction
in retained earnings may reduce the firm’s borrowing capacity
8.1.2. Valuation of ordinary shares using the dividend discount model

Value = D1/(k-g).
This is the dividend discount model of valuation.

Question: Is it possible to increase the value by increasing the current dividend?
Answer: Increasing D1 will increase the value ONLY if this does not reduce the growth rate, g.
The growth rate depends on the reinvestment of retained earnings and we may reduce the
value of the company by increasing the dividend.
8.2 Dividend Irrelevance View

Proponents of the irrelevance view believe that:
− The payment of the dividend REDUCES the growth potential of a company and
consequently lowers future dividends
− A dividend should only be paid if a company has no other profitable use for the funds.
− Payment of a dividend is indicative of failure by management to find suitable
investments
− A dividend can only be assessed once investment decisions and financing policies have
been established
This view manifests itself in the Residual Approach to dividends

8.2.1. Bird in the hand theory (Dividends positively affect value)

An increased expected dividend = an increase in the value of the company. Why? A dividend
paid is more valuable than uncertain future growth. However, a counter argument is that re-
invested dividends are again subject to uncertain future growth.
8.2.2. The Millar-Modigliani Argument

The M-M argument assumes that, given certain assumptions, dividend policy has no effect on
the value of a company. Why?
− If a company with a viable financial policy pays a dividend in cash to shareholders, it
will have to raise the finance by issuing new shares amounting to the value of the
dividend.
− More shares will be in issue for the same assets.
− The shareholder is in the same position.
8.2.3. The Residual Approach

The Residual approach suggests that dividends are a passive variable. Dividends represent
“what is left over after financing and investment decisions have been made.” To adopt the
residual approach a company should identify:
− Its set of investment opportunities
− It’s required rate of return
− And its target debt ratio
− A company should accept all projects exceeding its required rate of return (cost of
capital)
− Any funds remaining should be paid as a dividend
9. Factors affecting the dividend decision
9.1. Legal and other requirements

Dividends may not be paid out of contributed share capital. The book value of the company’s
assets must exceed its liabilities. Dividends may be distributed out of profits without first
providing for past losses or depreciation of fixed assets. Working capital, depreciation and
losses should be considered and losses in previous years may be disregarded. Realized profits
on sale of fixed assets are available for distribution and unrealized profits on fixed and current
assets are available for distribution in certain circumstances. In relation to inflation there is
no requirement to maintain “real” capital

9.2. Information content of dividends

Investors find the annual financial statements a valuable but limited source of information.
Dividends signal the well-being of the company. Management’s confidence about future
earnings is reflected by increasing or decreasing dividends. An increase in dividends is a signal
that current earnings and dividends are seen by management to be sustainable, for example,
if a company records an increase in earnings AND increases its dividend, then management is
signaling that the increase in earnings is sustainable.
As dividends and earnings per share (EPS) are regarded as prime indicators by analysts,
companies ensure that their dividend figure is acceptable to investors. However, sound
financial practice for companies in the growth phase is to fund growth from retained earnings
and not pay out dividends. Companies will NOT reduce dividends unless this is absolutely
necessary. This is because management wishes to signal that any reduction in earnings is
temporary.
CSL recorded a significant fall in earnings per share in 2003. Yet the company maintained its
dividend per share.
Illustration
CSL’s management is trying to convey to the market that any reduction in EPS is temporary.
Is the conventional wisdom still true? FBL, a USA utility cut its dividend – “the dividend cut
heard around the world”. What happened to its share price? First it fell and then recovered
and the company outperformed other utilities when analysts understood that this was a
strategic decision and not a decision made under stress.
9.3. Taxation – dividends versus capital gains?

Dividends mean that a company will have to pay Dividend Withholding Tax (DWT). Capital
gains are now also taxed. What is better – to pay dividends or reinvest so that investor pays
Capital Gains Tax? Otherwise, should the company retain earnings and pay a dividend later?
Share dealer – subject to normal tax (Not CGT)

9.4. The Nature of the Shareholders

Shareholders are attracted to companies that satisfy their needs regarding the balance
between cash income and capital growth. This is known as the “clientele effect.”
Shareholders who require income will invest in companies with a higher dividend yield, for
example, utilities have traditionally paid a high level of dividends. Shareholders who require
growth and prefer capital gains will invest in low dividend yield but high growth companies.
Management is responsible for maximizing shareholders’ wealth and may choose to reinvest
rather than distribute dividends. However, management may decide to increase its dividend
payout policy if there are limited investment opportunities. In either case, the company may
see a change in the profile of its shareholders.
Why is the clientele effect important when shareholders can sell shares to obtain income?
Why should management consider the clientele effect when shareholders can switch
investments by selling and buying shares?
If a high dividend company decides to change its payout policy then shareholders can sell their
shares and buy into another company with a more appropriate dividend payout policy. Yet,
there are disadvantages of switching investments and buying and selling shares. What are
the disadvantages?
10. Disadvantages of switching investments in companies

− Transaction costs of selling and buying shares
− Gains may be classified as trading income and investors may be charged a higher tax
rate than the capital gains tax rate.
− Shareholders may be precluded by internal rules from disposing of the investment in
the company
− Loss of control. Dilution of the voting control of current shareholders will occur if the
company issues new shares in the future.
− Flotation costs are incurred when new shares are issued. It is cheaper for a company
to retain earnings rather than pay dividends and issue new shares

Business Stages
11. Dividend Payment Policies

The conflict for managers who have to maximize value for the business and keep shareholders
satisfied is reduced by setting a dividend policy.
− A stable dividend amount regardless of annual earnings.

− A stable payout ratio (stable dividend cover) which means that the company pays out
a fixed proportion of earnings as dividends.
− A stable dividend plus bonus for companies subject to volatile trading conditions.

Dividend Policies (Graph)
11.1. Payment of Dividends
The Dates associated with the payment of dividends are the:

i. Declaration date – the date on which the directors in meeting decide to pay a
dividend.
ii. Ex-dividend date – shareholders who purchase on or after the ex-dividend date will
not receive the dividend. A company’s share price will normally fall by close to the
dividend amount when it goes ex-dividend.
iii. Last day for registration (LDR) – shareholders registered on this day will receive the
dividend.
iv. Payment date - the date set by the directors to pay the shareholders registered by the
LDR.

12. Bonus Issues and Share splits
A Bonus Issue or Capitalization Award is the allotment of additional shares to all existing
shareholders at no cost to the shareholders. A Share Split is the division of existing shares into
a proportionately greater number of shares. Bonus shares and share splits do not affect the
value of the firm as there is no change in the firm’s cash flows, no cash paid, or change in risk
profile. However, the value per share changes. Companies will often undertake a share split
when the share price reaches a certain level and the company wishes to bring the share price
within a normal trading range to encourage affordability and liquidity.
Share splits example

Assume Econet’s share price rises from $10 to $30 per share. Econet then decides to do a
share split of 2 for 1, by issuing 2 additional shares for every 1 share owned. If you owned
1000 shares at $30 per share, you will now own 3000 shares priced at $10 per share. Your
wealth will not have changed.
Do companies that do well always undertake share splits? There is one notable exception.
Warren Buffet’s company, Berkshire Hathaway has never had a share split and the share price
in April 2014 was about US$190 000 per share.
Reasons companies undertake these distributions

If the shares have a high market value, then;
− Bonus shares and share splits reduce the price of each share, thus making them more
marketable
− Managers of organisations, precluded from using capital for operating expenses,
dispose of the additional shares to generate income
− Bonus shares and share splits signal management’s confidence in continuing good
performance.
13. Dividend reinvestment plans (DRP) and Scrip dividends

A company can offer shareholders the option of receiving the dividend in cash or as additional
shares. The shareholders who elect to receive a scrip dividend will own a greater proportion
of the company after the issue (unless all shareholders elect to take the shares). A scrip
dividend will not attract with-holding tax whilst the company is able to retain the capital for
investment purposes. Investors will usually receive shares at a discount of the current share
price. Investors also avoid brokerage and stamp duty costs. DRPs enable companies to
increase the payout ratio and retain capital for investment purposes. DRPs are affected by
the company’s debt-equity ratio and availability of profitable investment opportunities.

14. Share buy-backs
Companies buy their own shares as an alternative to declaring a cash dividend. Shareholders’
equity is reduced by the par value of shares acquired. Any premium over par may be paid out
of reserves.
Restrictions (from Companies Act):
– Special resolution required
– Repurchase is not permitted if the company cannot settle debts or if liabilities exceed assets
– Offer made to all shareholders
What is the effect of a share buy-back on a company’s balance sheet?

Example
Zimnat’s share price is $3.00 and Zimnat wishes to undertake a buy-back for $90m. What is
the effect on Zimnat’s Statement of Financial Position?
Before After buy-

Statement of Financial Position buy-back back
$m $m
Cash 120 30
Other non-current assets 60 60
Non-current assets 120 120
300 210
Contributed equity (100m shares
@$0.50: 75m @ $0.50) 50 35
Retained profits 250 175
300 210
A share buy-back will usually result in an increase in EPS due to the reduction in the number
of shares in issue.
14.1. Why do companies undertake share buybacks?

a. Signaling
Dividends signal a commitment to future levels of cash payments. If the company is uncertain
about sustaining the dividend it can rather buy back shares.
b. Flexibility
The declaration of a special dividend that does not imply ongoing commitment is a firm
commitment with specified date of payment. A repurchase plan allows for more time or
partial purchase if need be.

c. Taxation
If capital gains and dividends are taxed at different rates shareholders can manage tax more
efficiently and decide not to sell shares back to the company and avoid CGT.
d. Control
A share repurchase reduces the shares in issue. Shareholders not selling back to the company
hold a greater portion and form a block of influence over the firm.
e. Share price
If the share price is perceived to be undervalued, buying back shares concentrates true value
in shareholders’ hands, signals confidence and helps stem share price reductions.
f. Capital structure management

Company’s shares can be managed inexpensively through repurchase and sale of shares.
14.2. Share Buy-back or Declaration of a dividend?

Share repurchases are preferable if:
✓ there is uncertainty about sustainability of future cash flows
✓ future investment needs are uncertain
✓ share price is under-rated by market
✓ shareholders’ preferences relating to capital gains and ZIMRA rulings relating to the
dividends and capital gains.
✓ timing of cash flows are required to be spread out over a longer period of time.
14.3. Is a share buy-back a Financing or Investment decision?

Although a share buy-back is often seen as a financing decision - a company is buying an asset,
its own shares. It is also an Investment decision
A share buy-back is an alternative way of paying cash back to the shareholders. Yet, although
we have included it under dividends, there are subtle and powerful differences. What is
driving the decision of the company to purchase its own shares? It appears to be a financing
decision, but it is really an investment decision.
Whilst setting a dividend may reflect the company’s dividend policy, the company is really
setting its reinvestment policy. What the company pays out, it does not retain. Why use a
share buy-back to pay money back to shareholders? Firstly, the company can exercise greater
flexibility in relation to share repurchases as compared to dividends. Secondly, there may be
tax advantages to a share buy-back. A share buy-back will enable the company to dramatically
alter its capital structure and increase its debt-equity ratio. Otherwise, the company may have
accumulated reserves and cash resulting in a debt-equity ratio that is far away from its target
capital structure. A share buy-back will enable the company to reduce its equity and move

towards a debt-equity ratio that is more aligned to its target capital structure. The significant
fall in interest rates also enabled firms to issue corporate bonds at lower cost as compared to
equity.
14.4. When does a share buy-back reflect an investment decision?

If a company’s shares have fallen from grace and are trading at levels below its intrinsic value,
then a share buy-back is an investment decision and it is also a signal that management
believes that a company’s share price is undervalued.
14.5. Taxation consequences

− Withholding tax arises on cancellation of shares on distributable earnings portion
(includes earnings previously capitalised)
− Share buyback in hands of investor subject to CGT (Share dealer – normal tax)
− If held in subsidiary – marketable securities tax on gains
15. In conclusion, do dividends matter?

• Purely analytical point of view
➢ Don’t matter – homemade
➢ Dividend growth model rebalances
➢ M & M – but assumptions
➢ Residual approach
➢ Failure by management
➢ Taxation issues, DWT vs CGT
➢ Divisible profit – legal requirements
• Non-financial considerations
➢ Bird in the hand theory
➢ Cash information – strong information
➢ Can be managed, increases sustainable, declines long lasting
➢ Limitations of annual financial statements
➢ Complexity
➢ Manipulation
➢ Historic cost
➢ Clientele effect
➢ Transaction costs if no dividends (flotation, trading costs)
➢ Share dealer tax consequences
➢ Institutional rules
➢ Issues of control
➢ Volatility, therefore smoothed
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• Alternatives
➢ Scrip dividends
➢ Bonus dividend
➢ Capitalisation award / share split
➢ Share repurchases

16. Practice Question
Background
Anglo Astounding Limited (AA) is one of the world`s largest mining groups. With its
subsidiaries, joint ventures and associates, it is a global leader in platinum group metals and
diamonds, with significant interests in coal, base and ferrous metals, as well as an industrial
minerals business. The Group is geographically diverse, with operations in Africa, Europe,
South and North America, Australia and Asia.
A friend of yours Professor Patrick Dickson, has approached you recently regarding his
minority investment in the company. Your friend is retired and uses his investment income
for his daily living expenses. Your friend has approached you for advice regarding the recent
dividend declaration for the 2018 final dividend for AA, where the company decided not to
pay any dividend. He is highly concerned and has asked whether you could explain to him the
dividend policy considerations which the company would have taken into account in reaching
this unexpected decision. Your friend has collected the following information to aid in your
explanation:
AA - Half Year Financial Report for the six months ended 30 June 2018
AA announces further progress on delivery of value financial results
- Group operating profit from core operations of $2.1 billion
- Underlying earnings of $1.1 billion and underlying earnings per share of $0.91
- Profit attributable to equity shareholders down 31% at $3.0 billion
- Net debt of $11.3 billion at 30 June 2018
- Committed undrawn bank facilities and cash of over $9 billion at 30 June 2018
Driving operational performance and delivering significant value

- Significant cost reductions achieved across the Group and global headcount
reduction ahead of target
- Delivery focused on high quality growth in most attractive commodities
- Development of three key strategic projects on track - Minas-Rio, Los Bronces
and Barro Alto
- Near term liquidity addressed - $6.5 billion raised through new financing and
proceeds from sale of residual shareholding in AngloGold Ashanti - Sale of Hulamin
shareholding for approximately $148 million

HIGHLIGHTS FOR 6 months ended 30 June 6 months ended 30 June Change

2018 2017
$million $million
Group revenue 11 132 17 915 37.9%
Operating profit 2 054 5 974 65.6%
Basic earnings per share 2.47 3.56 30.6%
Underlying earnings per 0.91 2.90 68.6%
share
Jun Dec Jun Dec

PER SHARE/UNIT STATISTICS (cents per share/unit)
2018 2017 2017 2016
Interim Final Interim Final
D ebt : Equity ratio 0.81 0.99 0.67 0.61
Quick Ratio 0.73 0.52 0.87 0.66
Current Ratio 1.10 0.73 1.13 0.87
P:E ratio 10.84 6.75 14.64 14.08
Comments from an interview with the Chief Executive Officer (CEO):

"We took early and decisive action in order to respond effectively to the global economic downturn; we have
focused on driving operational performance, preserved capital through halving our planned capital expenditure
for the year, scaled back higher cost production and growth plans in platinum and coal and suspended dividend
payments. As expected, the market environment has been challenging in the first half of 2018 and AA`s
performance was impacted by the sharp declines in commodity prices against the prior year and anticipated
reductions in volumes, partially offset by exchange rate benefits compared to the first half of 2017.
We also successfully addressed our near-term liquidity in the first half, raising $6.5 billion of funding, including
two over-subscribed bond issues and the sale of our residual shareholding in AngloGold Ashanti. In combination
with the tough but necessary decisions we took around capital expenditure, production scheduling and dividends,
this positions the Group well to carry us through the downturn and enables us to preserve the development of our
key strategic growth projects, a key value driver for shareholders’’.
Dividends
The resumption of the payment of a dividend to shareholders remains a key priority for the
board. This will be considered against the background of the overall market environment, the
Group`s capital requirements, as well as the future earnings and cash performance of the
business.

AA has leading positions in commodities where there is limited availability of new supply
sources, given the scarcity of attractive, large scale projects and capital constraints. Such
characteristics are typical of the platinum, diamond and iron ore industries, for example.
• AA benefits from being positioned in commodities that have attractive
industry cost structures, which drive both profitability and stability of production.
• AA has developed a portfolio of world-class operating assets and development
projects focused on those commodities with the most attractive risk-return profile.
The majority of AA`s capital is employed in platinum, iron ore and copper,
commodities that have generated the most attractive average returns on invested
capital for companies focused on those commodities.
• In addition to making targeted high-quality investments in nickel. The decision
to preserve the development of its three key near term strategic growth projects
during the economic downturn positions the Group to capitalise on the next phase of
global economic growth. The three projects are all well placed on their respective
industry cost curves, have long resource lives and are on track to enter production
from 2020 onwards, in what is expected to be a growing commodity demand
environment.
Outlook
• The global economic downturn had a profound effect on all commodity prices
in the second half of 2017 and early 2018. From their high points in the first half of
2017, the price of platinum had fallen by 59% by the end of the year; copper by 65%
and nickel by 69% - as the banking system came close to collapse, confidence and
credit drained from the system and global financial markets went into free fall. In the
second quarter of 2018, prices for a number of commodities strengthened. While such
price recovery offers grounds for increased optimism, the overall economic situation
remains fragile. Global GDP growth is forecast by the IMF to decline by 1.4% in 2018,
with major contractions in industrialised countries being partly offset by growth in the
emerging and developing economies, with China forecast to grow at above 7.5%.
• The long-term fundamentals for the mining industry remain very robust from
both the demand and supply sides. The industry has seen curtailment of many high
cost operations in nickel, iron ore and coking coal, while the difficult financing
conditions are expected to continue to impact the funding and timing of many
potential new mines and expansions, constraining supply as economic growth returns.
In terms of demand, whilst China is expected to support both near and long-term
demand growth for bulk commodities and base metals, the recovery of the OECD
countries, stimulated further by government spending programmes in many major
economies, will be an important factor, with upside for platinum group metals.

The Group`s forecasts and projections, taking account of reasonably possible changes in
trading performance show that the Group will be able to operate within the level of its
current facilities.
We have continued to see that, although some emerging market economies are doing less
badly than others, the spread of globalisation over the last two decades, means that the
world is far more inter-connected than ever before. Thus, the recession is being felt even in
those countries that have pursued orthodox macro-economic policies and whose regulatory
systems have not failed. Against a background of great uncertainty about the length and
depth of the recession, your Board took the difficult decision to recommend that no dividend
should be paid. This was done with the greatest reluctance and with a full understanding of
the difficulties which our decision may cause for many individual and institutional investors.
We entered the recession with a strong balance sheet and with what had been thought of by
many, at the height of the boom, as a relatively conservative level of borrowing. However,
in the current context, $11 billion of borrowing represents a significant sum.
We believe it to be sustainable, against a background of halving our capital expenditure this

year and aggressive targets for savings from procurement and asset optimisation
programmes. Recently, we have further underpinned our position through the sale of the
last tranche of our stake in AngloGold Ashanti and a new bond issue. However, the Board
took the view that, in current conditions, cash preservation was paramount in order to
maintain the maximum degree of flexibility. We have a strong, long-term business and we
have taken difficult decisions intended to position the business for the upturn when it arrives.
During the year, the priorities for most of our businesses altered radically; moving from
wrestling with the need to expand production to the current focus on asset optimisation and
cash conservation. I recognise the very considerable strain that this has imposed upon our
people. It was, therefore, with considerable regret that, in February, we announced the need
to reduce our workforce - of employees and contractors - by some 19,000 people.
AA`s world-class strategic growth prospects

I have talked about the importance of continuing the development of our key strategic
growth projects, albeit on revised schedules. AA has one of the strongest and highest quality
project pipelines in world mining, focused on the most attractive commodity segments, with
projects approved or already under way totalling some $16 billion. These projects are a key
driver of future value creation for you, our shareholders. Our projects have the great benefits

of large scale and long life: an average life of more than 40 years, against an industry average
of well under half that.
Outlook
In summary, commodity markets have experienced a turbulent six months, though prices for
most commodities appear to have stabilised more recently. Indeed, there are even signs of
some improvement.
Looking forward, we are confident that the medium- to long-term fundamentals are firmly in
place for strong commodity demand growth. We see significant value to be created by the
Group`s long-life, low-cost growth projects, several of which are well timed to enter
production in 2020, and our continued success at driving down our operating costs will
further strengthen our competitive position through the cycle.
Furthermore, let us not forget the effect of the downturn on many of the mining industry`s
junior players and the resulting impact on exploration activity, in addition to the
abandonment or delays to many major greenfield projects across some of the more
established players.
When the cycle turns, supply of many commodities is likely to be severely constrained. By
preserving our key growth projects, uplifting the performance of our existing operations and
continuing to drive down costs, AA is well placed to reap the rewards of that upswing.
Dividend Distributions
180
160
140
120
Special
100
Final
80
60 Interim
40
20
0
2010 2011 2012 2013 2014 2015 2016 2017 2018
Special dividends in 2014 and 2015 were paid out of proceeds from the sale of non-core
assets of the company.

Share buybacks
2017 AFS
The $4 billion share buyback programme announced in August 2016 was suspended, with
around $1.7 billion of shares having been repurchased.
2016 AFS
The $3 billion share buyback program announced in February was completed in October 2016
and the additional share buyback program of $4 billion, announced in August, is 33%
complete with around $1.3 billion of shares having been repurchased at 19 February 2017.
REQUIRED Marks
a. Write a report to Professor Patrick Dickson explaining the dividend
policy considerations which the company would have considered in
reaching their unexpected dividend decision. Your answer should
explain:
• the current dividend theories, and how these would have been
applicable; 32
• how the circumstances of the company and financial position may have
affected the dividend decision, including how you feel the financial
indicators have affected the decision;
• what further information you would require to fully inform the
Professor?
b. Should he sell his shares due to the dividend cut? 3

c. The cancellation of the share buyback in 2017 was not viewed by the
investors as seriously as the cutting of the dividend in 2018. Explain why
this would have been viewed as being less serious by investors. 5
TOTAL 40

Suggested Solution
Dividend Policy report
Professor Patrick Dickson
By: CTA Student
Date: DD/MM/YYYY
Dividend policy for 2019 dividend
Dear Patrick,
General
Dividends generally make no economic sense, retained earnings are cheapest form of
finance. (1)
Miller and Modigliani - when dividends are paid, there is need to raise new capital
thereby diluting value. But assumptions (1)
• No taxes - but AA will be subject to Capital Gains Tax (1)
• No transaction costs - but AA have listing costs, transaction costs, prospectus (1)
• No market imperfections - Markets are semi strong at best (1)
According to the dividend discount model, although you can increase the numerator
with a higher dividend the lower growth will cancel out any effect in value. For AA,
growth will increase value, not dividend. (1)
AA has not paid a dividend to fund growth opportunities, evidencing this relationship. (1)
Bird in hand theory, states dividends are better than uncertain future growth, but (1)
dividends are reinvested.
Asymmetry of information - management has more information (Agency theory) (1)
Profitability
Appears that AA is implementing a residual policy, where dividends are only paid if
there is surplus. (1)
Profits are down by 31%, therefore have reason in difficult environment to consider
cutting dividend. Revenue is down by 38%, profit down 66%, cash flows down 60%,
profitability position supports cut (1)
Profits are down due to environment, commodity prices low, volumes down, therefore
not in control of AA, and makes sense not to pay dividend. (1)
Debt and liquidity
AA does have cash on hand of $9 billion to pay dividends, so have cash, but $6.5 billion
was raised recently, to pay dividend out of new debt raised would not be appropriate. (1)
But with cash, are trying to grow, 3 new acquisitions which need available funding. (1)
Battling in recessionary environment. Makes sense to preserve and retain cash. (1)

Debt: Equity ratio has deteriorated signalling concern on financial position, justified to
keep cash. (1)
Current liquidity - quick and current ratios look reasonable, therefore could pay (1)
dividend.
Sale of bonds oversubscribed, suggesting a large discount, need cash urgently, reducing
dividend. (1)
Debt capacity and debt rating may be affected if a dividend is paid. (1)
PE ratio
PE ratio is down, signalling share price has been hit hard, as Earrings will also be down,
Price must be down even further. Price hit harder than Earnings. (1)
PE however up from December, indicating that shareholders may be pricing in growth. (1)
Other measures
AA has already halved their planned capital expenditure, so have to cut back on
dividend to retain growth. (1)
Continuing with growth plans is doing what is best for the business. (1)
AA is still well placed in the commodity industry, with good assets, appears to be a (1)
sustainable company.
AA in fact is a good position to capitalise on the liquidity crisis to buy smaller weaker (1)
competitors.
Commodity prices have strengthened, indicating div resumption imminent. (1)
Cash retention stated to be for retaining flexibility, justified reason for cutting (1)
dividends.
Also retrenching staff shows AA is in difficulty, and perhaps the dividend cut justifiable.
Unions may react negatively if cut jobs and then pay dividends. (1)
Legal and other requirements
AA did make a profit, therefore according to companies act, can pay a dividend. (1)
Clientele effect - investor base
Patrick is retired and lives off income, therefore prefers dividend. (1)
Company will consider that some investors prefer capital growth, and others dividend
income. (1)
Environment
Decision based on uncertainty, as to depth and length of recession. (1)

Dividend cut may be accepted by market due to state of global economy. (1)

But still should be questioned on how bad their circumstance is. (1)
This is countered by the information on strength of the company released by the CEO. (1)
AA in strong position to acquire or capitalise on their supply advantage when market
recovers. (1)
Banks will be slow to provide debt in a recessionary environment, perhaps reason for
bond issue? (1)
Previous years dividends
The company has a history of increasing interim and final dividends, will have created
an expectation for shareholders. (1)
Special dividends were paid in 2005 and 2006, for specific disposals, do not imply
sustainable. (1)
However, sale of Ashanti - would there not be expectation created for special dividend
on disposal? (1)
Continual increase, shows confidence in growth, good upward trend. (1)
Year 2018 shows a decline in dividends, in line with the recessionary economy, info
content bad. (1)
Although is in context of recessionary economy, and additional information to explain
decline. (1)
Information content of dividends
As you are a minority investor, will be reliant on dividend information content. (1)
Powerful cash backed form of information. Signal of wellbeing of company. (1)
Confidence about sustainability of earnings, therefore committed to dividend long term
if increase. (1)
If decrease, is a particularly bad signal, as dividends can be managed, signal of long-term
decline. (1)
Shortcomings of AFS. Historic, complexity, backward looking, timeliness. (1)
Other information you require
Overall profile of investor base for AA to assess clientele effect. (1)

Future projections of AA, particularly profitability and dividend. AA mentioned these
supports resuming dividend. (1)
Information on tax profile of investor base of AA. (1)
Conclusion
Circumstance seems to justify the cut in dividends, the additional information mitigates
the bad information content of the dividend. (1)

Structure of report (1)

Flow of argument (1)
Logical structure (1)
Max 32
Part 2.
Should he sell his shares?
If he needs the cash dividends to live off, he could move his investment to a more stable
div payer, (1)
If not, the info content is bad, but other info shows company is well positioned going
forward. (1)
Could in the interim create a homemade dividend by selling shares to generate revenue,
but costs. (1)
Tax consequence - CGT will arise immediately. (1)
AA made statement that committed to resuming dividend, know this will affect
shareholders. (1)
Total 5
Max 3
Part 3.
Cancellation share buyback

Share buyback is not a commitment as a dividend is. (1)
There is no expectation of sustainability by shareholders (1)
Each shareholder does not benefit individually from a share buyback as with a
dividend. (1)
The information content was therefore not as significant as the cut in the dividend. (1)
With the decline in the share price, from a capital structure perspective, it probably
made sense not to continue repurchasing shares. (1)
Total 6
Max 5

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE MAF 402 – MODULE 2 2021

CHARTERED ACCOUNTANTS ACADEMY

MANAGEMENT ACCOUNTING & FINANCE DEPARTMENT

CERTIFICATE OF THEORY IN ACCOUNTING

STUDY UNIT 4: DIVIDEND DECISIONS

TABLE OF CONTENTS PAGE

2. Learning objectives under Dividend Decisions

4. Competence Framework expectation

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▪ Relevance and irrelevance theories 2

There are two schools of thought:

8.1. Dividend Relevance

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8.1.1. Dividends and capital structure

8.1.2. Valuation of ordinary shares using the dividend discount model

This is the dividend discount model of valuation.

8.2 Dividend Irrelevance View

This view manifests itself in the Residual Approach to dividends

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8.2.1. Bird in the hand theory (Dividends positively affect value)

8.2.2. The Millar-Modigliani Argument

8.2.3. The Residual Approach

9. Factors affecting the dividend decision

9.1. Legal and other requirements

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9.2. Information content of dividends

9.3. Taxation – dividends versus capital gains?

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9.4. The Nature of the Shareholders

10. Disadvantages of switching investments in companies

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11. Dividend Payment Policies

− A stable dividend amount regardless of annual earnings.

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Dividend Policies (Graph)

11.1. Payment of Dividends

The Dates associated with the payment of dividends are the:

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12. Bonus Issues and Share splits

Share splits example

Reasons companies undertake these distributions

13. Dividend reinvestment plans (DRP) and Scrip dividends

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14. Share buy-backs

What is the effect of a share buy-back on a company’s balance sheet?

Before After buy-

14.1. Why do companies undertake share buybacks?

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f. Capital structure management

14.2. Share Buy-back or Declaration of a dividend?

14.3. Is a share buy-back a Financing or Investment decision?

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14.4. When does a share buy-back reflect an investment decision?

14.5. Taxation consequences

15. In conclusion, do dividends matter?

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16. Practice Question

Driving operational performance and delivering significant value

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HIGHLIGHTS FOR 6 months ended 30 June 6 months ended 30 June Change

Jun Dec Jun Dec

Comments from an interview with the Chief Executive Officer (CEO):

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