Going public and the dividend policy of the company

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Теги реферата: конспект по математике, 7 ответов
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The company cost of capital is 16% its optimal debt to net assets ratio is 30% and the current year’s profit available to equity shareholders is ?350.000.

Required:
. State which projects would be accepted, and what is the total finance requires for those projects.
. Assuming that the company wishes to maintain its gearing ratio, how much of the required finance will be borrowed?
. How much of this year’s profit can be distributed?

The answers:
. A, B and C, with yield greater than or equal to the company’s cost of capital; total finance required ?300.000.
. Amount to be borrowed: 30% of ?300.000=?90.000.
. This year’s profit: ?350.000 less amount to be reinvested ?300.000-?90.000:
210.000

Profit for distribution: 140.000

Company’s shareholders obtain the best of both words. They can invest the
?140.000 received as dividends to earn a higher rate of return than the company could earn for them; and the ?210.000 retained by the company is reinvested to shareholders’ advantage. Shareholders’ wealth is optimized, and the dividend paid is simply the residual profit after investment policy has been approved.

If companies look upon dividend policy as what remains after investments are decided then the search for an optimum dividend policy is pointless. Shareholders wanting dividends can always make them for themselves by selling some of their shares.

Further support for the ‘residual’ theory of dividends, and the argument that the change in dividend policy does not affect share values, was advanced by Modigliani and Miller in 1961. They contended that in a perfect market the increase in total value of a company after it has accepted an investment projects is the same, whether internal or external finance is used.

One deficiency in the Modigliani and Miller hypothesis, however, is that they ignore costs associated with an issue of shares, which can be quite considerable.

1. Costs Associated with Dividend Policy

Capital floatation costs are a deterrent substituting external finance for retained earnings but there are other costs affected by the dividend decision.

If shareholders are left to make their own dividends by selling some shares, this involves brokerage and other selling costs that, on a small number of shares, can be extremely an economic. In addition, if they have to be sold during a period of low share price, capital losses may be suffered.

Another important factor is taxation. First, when the company distributes dividend it has to pay an advance installment of corporation tax (ACT), currently one quarter of the amount paid. But the offset against mainstream liability to pay corporation tax will be delayed by at least one year. Indeed, if the company does not currently pay this type of tax, the delay in setting off ACT will be even longer, and this will tend to restrain extravagant dividend distributions.

Second, from the investors’ viewpoint profitability invested retained earnings should increase share values, enabling shareholders to create their own dividends. Selling shares creates a liability to capital gains tax, currently 20%, 23% or 40%, but subject to a fairly generous exemption limit. By comparison, dividends in the hands of shareholders attract higher rate of income tax (up to 40%). Thus higher-rate taxpayers may prefer comparatively low dividend payouts to minimize their tax burden.

Third, financial institutions confuse the taxation picture even more, through their major holdings in the shares of quoted companies. They are able to set off dividends received against dividends paid for tax purpose but some may be liable to capital gains tax if they sell shares to make dividends.

The effect of taxation on dividend decision is difficult to analyse.
It may be argued that companies attract investors who can match their personal taxation regimes to company’s dividend policy, and that those who don’t join a particular ‘taxation club’ will invest elsewhere. If this were true, however, a change in company’s dividend policy would probably not find favour with its shareholders clientele. And would consequently affect share values, which seem to support the argument that dividend policy matters.

2. Other Arguments Supporting the Relevance of Dividend Policy.

Activity:
As a potential investor, how would you react to the following questions? a. Would you prefer cash dividends now, against the promise of future, perhaps uncertain, dividends? b. Would you prefer a stable, growing dividend to one that fluctuates in sympathy with company’s investment needs? c. If a company, in whose shares you invest, increases or decreases its dividend, would it change your personal investment policy?

In answer in question (a) you probably opted for cash now rather than cash you may never see. The future is uncertain and most people take much convincing that it is in their interests to postpone income. Although the equity shareholder by definition is the risk-bearer, he is also entitled to a reasonable resolution of dividend prospects to compensate for the additional risk he carries. An investor will almost certainty pay higher price for earlier rather than later dividends.

In question (b), in definition, a fluctuating dividend is more risky than a stable dividend. Investors will pay more for stability, especially if it is linked with steady growth. Research has shown that, in general, dividends follow a pattern of stability with growth. Maintenance

of the previous year’s dividend is the first consideration, with growth added when directors feel that a higher plateau of profitability has been consolidated.

As regards question (c), you would no doubt be very happy about an increase, and might even be prompted to buy more shares – thus helping to put the market price up. Conversely a decreased dividend would cause to review your investment, perhaps even to sell your shares to take advantage of better investment opportunities elsewhere. Investors tend to believe that dividend changes provide information regarding a company’s futures prospects, and they react accordingly.

3. Practical Factors Affecting Dividend Policy

Whatever dividend policy is thought to be best for a company in theory, certain practical factors influence the decision.

Availability of profit The Companies Act 1985 provides that dividends can only be paid out of accumulated realized profit less realized losses, whether these are capital of revenue. Previous or current years’ losses must be made good before a distribution can be made. If an asset is sold, any realized profit or loss arising can be distributed; but any profit or loss arising from revaluation of an asset cannot be distributed – unless and until the asset is sold.

Availability of cash Profit may be earned during a year and yet it may hot be possible to pay a dividend because of lack of cash. This can arise for different reasons. It may already have been expected or be needed to replace fixed and working assets, perhaps at inflated prices. Large customers may not yet have paid their accounts or cash may be needed to repay a loan.

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