Question

QUESTION FOUR

1. Dividend policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation.

Required:

Discuss the theories of dividend policy and their implication on managerial decision making.                                                                         (9 Marks)

2. Explain any three factors that shouldbe considered when deciding the dividend policy to be implemented.                                                                (3 Marks)
3. Consider company XYZ that wishes to spend K150, 000 on new projects and maintains 40% debt financing. if the forecasted net income is k120,000:
   1. How much should the company pay out as dividends under the residual dividend model?                                                                          (2 Marks)
   2. How would a drop in net income to K80, 000 affect the dividend?

(2 Marks)

4. Explain two advantages and two disadvantages of the residual dividend model?

(4 Marks)

[TOTAL: 20 MARKS]

Answer 1

a) There are three theories of Dividend policies, which are discussed in detail along with their implications on managerial decision making are as below -

Theory # 1. Modigliani-Miller (M-M) Hypothesis:

Modigliani-Miller hypothesis provides the irrelevance concept of dividend in a comprehensive manner. According to them, the dividend policy of a firm is irrelevant since, it does not have any effect on the price of shares of a firm, i.e., it does not affect the shareholders’ wealth.

They expressed that the value of the firm is deter­mined by the earnings power of the firms’ assets or its investment policy and not the dividend decisions by splitting the earnings of retentions and dividends.

M-M hypothesis is actually based on some assumptions.Under these assumptions, no doubt, the conclusion which is derived is logically sound and consistent although they are not well-based.For instance, the assumption of perfect capital market does not usually hold good in many countries. Since the assumptions are unrealistic in nature in real world situation, it lacks practical relevance which indicates that internal and external financing are not equivalent.

Theory # 2. Walter’s Model:

Professor, James, E. Walter’s model suggests that dividend policy and investment policy of a firm cannot be isolated rather they are interlinked as such, choice of the former affects the value of a firm. His proposition clearly states the relationship between the firms’ (i) internal rate of return (i.e., r) and its cost of capital or the required rate of return (i.e., k).

That is, in other words, an optimum dividend policy will have to be determined by the relationship of r and k. In short, a firm should retain its earnings it the return on investment exceeds the cost of capital and in the opposite case, it should distribute its earnings to the shareholders.

Theory # 3. Gordon’s Model:

Gordon’s theory on dividend policy is one of the theories believing in the ‘relevance of dividends’ concept. It is also called as ‘Bird-in-the-hand’ theory that states that the current dividends are important in determining the value of the firm. Gordon’s model is one of the most popular mathematical models to calculate the market value of the company using its dividend policy.The Gordon’s theory on dividend policy states that the company’s dividend payout policy and the relationship between its rate of return (r) and the cost of capital (k) influence the market price per share of the company.

Relationship between r and k	Increase in Dividend Payout
r>k	Price per share decreases
r<k	Price per share increases
r=k	No change in the price per share

b) Three factors which should be considered while deciding on the dividend policy to be implemented are as follows :

1. Few investors prefer receiving their dividend distributions right away instead of deferring the current dividend income for an unknown level of capital gain – or loss – in the future. While some investors refer to this approach as the “bird in the hand” theory, it is commonly known as the dividend discount model or the Gordon Model.

2. Some investors subscribe to the Modigliani-Miller Theorem.This theorem claims that a company’s dividend policy has no impact on the level of long-term capital gains in perfect market conditions. Proponents of this theory argue that dividend payouts might be a good management strategy only if investment opportunities with high potential returns are unavailable. However, believers in dividend distributions claim that back-tested results indicate that companies with a dividend policy of rising dividends outperform the market in the long run.

3. Also to consider varied dividend taxation levels in different markets. Some countries tax dividend income at ordinary income rates, which can be significantly higher than tax rates for capital gains. In those instances, investors favor stock dividends, share repurchase programs or reinvestment of the earnings into growth opportunities, all of which provide potential for additional capital gains over the extended time horizon.

c) I.

XYZ Co.	In K
Estimated spend on new projects (i)	1,50,000
Forecasted Net Income (ii)	1,20,000
Debt Financing Ratio (iii)	40%
Equity Financing ratio (1-Debt Financing ratio) (iv)	60%
Debt Financing (i*iii) = (v)	60,000
Equity Financing (i*iv) = (vi)	90,000
Residual Dividend (ii-vi)	30,000

II.

XYZ Co.	In K
Estimated spend on new projects (i)	1,50,000
Forecasted Net Income (ii)	80,000
Debt Financing Ratio (iii)	40%
Equity Financing ratio (1-Debt Financing ratio) (iv)	60%
Debt Financing (i*iii) = (v)	60,000
Equity Financing (i*iv) = (vi)	90,000
Residual Dividend (ii-vi)	-

All earnings will be retained resulting dividend and its pay-out to be 0.

d)

Advantages and Disadvantages of a Residual Dividend Policy

Advantages, a residual dividend policy requires -

(i) less new stock issues.

(ii) fewer flotation costs.

Disadvantages-

(i) a variable dividend policy sends conflicting signals to investors.

(ii) It also comes with an Increased risk for investors, making future stock offerings difficult.