Tutorial 10 (Answers)

Corporate Finance BA303

1. Discuss the arguments in favour of a stable dividend policy (i.e. dividend smoothing
policy).
Answer:
A stable dividend policy gives reliability and security. Investors can plan their
future income and expenditures more easily. Sharp cuts in dividends, as well as
causing alarm, may force investors to sell shares on a weak market. Similarly, a
sharp increase in dividends may force investors to reconfigure their portfolios, as
well as triggering a Capital Gains Tax (CGT) liability.

2. Mondrian plc is a newly formed company which aims to maximise the wealth of its
shareholders. The board of directors of the company is currently trying to decide upon
the most appropriate dividend policy to adopt for the company’s shareholders.
However, there is strong disagreement between 3 of the directors concerning the
benefits of declaring cash dividends:

i. Director A argues that cash dividends would be welcomed by investors, and that as high
a dividend payout ratio as possible would reflect positively on the market value of the
company’s shares.
ii. Director B argues that whether a cash dividend is paid or not is irrelevant in the context
of shareholder wealth maximisation.
iii. Director C takes an opposite view to Director A and argues that dividend payments
should be avoided as they would lead to a decrease in shareholder wealth.

Required:

a) Discuss the arguments for and against the position taken by each of the 3
directors.
b) Assuming the board of directors decides to pay a dividend to shareholders, what
factors should be taken into account when determining the level of dividend
payments ?
Answers:
(a) The position taken by Director A reflects the traditional view of dividend policy, which
assumes that investors would prefer dividends today rather than either dividends or
capital gains at some future date. This is because investors prefer a certain sum of cash
today to an uncertain return in the future. The implications of this view for dividend
policy are that companies should attempt to pay out as much in the form of current
dividends as is consistent with the long-term objectives of the company. It is argued that,
because investors dislike uncertainty, they will apply a rising discount rate to future
returns. Thus, if current dividends are lowered in order to ensure high investment for the
future, the value of the company will fall as future dividends will be discounted at an
increasing rate over time. However, many believe that such views are based on a
misconception of the nature of risk. It can be argued that there is no reason why risk
needs to necessarily increase over time. Risk arises from the nature of the activities

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undertaken by the company and investors will normally demand a higher return from
companies that engage in high-risk ventures than companies that engage in low-risk
ventures. The level of risk associated with the activities of a company will already be
reflected in the discount rates applied to investment projects when assessing future
returns.

The view of Director B is supported by the work of Miller and Modigliani (MM). MM
demonstrated that, given certain restrictive assumptions, dividend policy is irrelevant.
They show that dividends do not change shareholder wealth but only its location. MM
argue that the value of a company will be determined by the level of future earnings, and
the degree of risk associated with the company. The way in which earnings are divided as
between dividends and retentions is not important. The level of dividend will not influence
share values provided the amounts retained are invested in similarly profitable projects.
Any reduction in dividends will be compensated by an increase in capital gains. In the
event that a shareholder requires cash, ‘home-made dividends’ may be created through
selling a portion of the shares held. Thus, any differences in the consumption patterns of
shareholders will be irrelevant. The arguments of MM concerning dividend irrelevance
rest on a number of important assumptions, which include the absence of taxes and share
transaction costs, and shareholders and managers having identical information
concerning future investment opportunities. These assumptions do not hold in the real
world and, as a result, the arguments put forward by MM are weakened. Differences in
tax treatment between dividends and capital gains have led many investors to prefer
capital gains as we discuss in some detail below. In addition, share transaction costs can
be relatively high when small amounts are being dealt with.

The view of Director C can be supported because of the different treatment, for taxation
purposes, afforded to dividends and capital gains. In the United Kingdom, dividends are
taxed at the taxpayer’s marginal rate of income tax, whereas, in the past, capital gains
are taxed at a variable rate – 18% or 28%, depending on the investor’s income level. This
difference in tax treatment leads many investors to prefer capital gains to dividends. Tax
on capital gains only arises when the gain is realised which means that investors can defer
payment of the tax, or perhaps even offset the capital gains in a year when a capital loss
arises. In addition, a certain amount of capital gain arising in a particular year is exempt
from taxation. However, there are practical problems associated with the view that
dividends should not be paid. The creation of ‘home-made dividends’ as a substitute for
a company dividend policy, as suggested above, may be difficult due to problems which
include the share transaction costs referred to earlier, the indivisibility of shares leading
to investors being unable to sell precisely the amount of shares required, and the lack of
marketability of shares in unlisted companies.

(b) A number of factors will influence the level of dividends that may be paid by a
company. These include:

(i) Availability of profits

Dividends are payable only out of profits which the law defines as being available for
distribution, that is, current profits plus retained earnings.

(ii) Shareholder requirements

The requirements of shareholders concerning the balance between dividends and capital
gains should be considered.

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(iii) Market expectations
The market may have expectations concerning the level of dividends payable that the
company may wish to meet in order to retain the confidence of investors.

(iv) Liquidity
The cash available for dividend payments must be determined. Other commitments of
the business (e.g., purchase of fixed assets) will influence the amount considered prudent
to distribute to shareholders.

(v) Market signals

Dividends can be used by companies to signal to the market the directors’ views
concerning the future. For example, a higher than expected dividend may be used to
signal confidence in future earnings levels.

(vi) Financing policy

Some companies may decide to re-invest a high proportion of earnings, thereby leaving a
relatively small amount available for dividends. This policy may be adopted for various
reasons including the avoidance of dilution of control and share issue costs.

(vii) Loan restrictions

A company may be prevented from announcing a high dividend because of loan
covenants. To protect lenders, a loan agreement may contain a clause restricting the level
of dividend that can be paid to shareholders.

(viii) Earnings pattern

A company that has a volatile earnings pattern may decide to smooth the flow of
dividends over time. This will involve retaining a proportion of profits during years when
profits are high in order to be able to distribute dividends when profits are low or losses
are being made. Thus, the future pattern of earnings volatility may influence current
dividend policy.

3. Brighton plc has recently obtained a listing on the Stock Exchange. 90% of the
company’s shares were previously owned by members of one family, but, since the
listing, approximately 60% of the issued shares have been owned by other investors.
Brighton’s earnings and dividends for the 5 years prior to the listing are detailed below:

Years prior to listing Profit after tax (£) Dividend per share (£)
5 1,800,000 0.036
4 2,400,000 0.048
3 3,850,000 0.0616
2 4,100,000 0.0656
1 4,450,000 0.0712
Current year 5,500,000 (estimate)

The number of issued ordinary shares was increased by 25% 3 years prior to the listing and by
50% at the time of the listing. The company’s authorised capital is currently £25,000,000 in
£0.25 ordinary shares, of which 40,000,000 shares have been issued. The market value of the
company’s equity is £78,000,000. The board of directors is discussing future dividend policy.
An interim dividend of £0.0316 per share was paid immediately prior to the listing and the
finance director has suggested a final dividend of £0.0234 per share. The company’s declared

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objective is to maximise shareholder wealth. The company’s profit after tax is generally
expected to increase by 15% per annum for 3 years, and 8% per year after that. Brighton’s cost
of equity capital is estimated to be 12% per year. Dividends may be assumed to grow at the
same rate as profits.

Comment upon the nature of the company’s dividend policy prior to the listing and discuss
whether such a policy is likely to be suitable for a company listed on the Stock Exchange.

Answers :

Years prior to No. of shares Total dividend Payout ratio

listing (million) (£) (%)
5 21.33 768,000 42.7

4 21.33 1,024,000 42.7

3 26.67 1,642,667 42.7

2 26.67 1,749,333 42.7

1 26.67 1,898,667 42.7

Current 40.00

The number of shares is found by working backwards from the present figure of 40
million and adjusting by the two specified new issues (50% at listing and 25% three years
previously). The total dividend paid is found by multiplying the dividend per share by the
number of shares and the payout ratio then follows.

The company’s declared objective is to maximise shareholder wealth. In principle, a

variety of dividend policies is consistent with this aim depending on factors such as the
tax position of the clientele and whether dividend policy has been used to convey
information to the market. Brighton plc has followed a remarkably consistent dividend
policy, adhering to a constant payout ratio. At the time of listing, it would presumably
have stated its dividend policy in its prospectus and unless specified otherwise,
shareholders would have been justified in expecting continuation of this policy. A switch
in dividend policy so soon after listing is certain to offend at least some portion of its
clientele.

However, whether the pursuit of a constant payout ratio is rational is debatable. As long
as earnings are increasing, the company is able to continue to increase dividends, but
should earnings fall, adherence to a constant payout implies lower dividend per share and
possibly lower share price. It is more usual to follow a dividend policy incorporating a
stable dividend per share, with ample dividend cover, to allow earnings fluctuations to be
smoothed out.

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4. Newcastle plc is a public-listed firm. Its earnings and dividends for 6 years after its Initial
Public Offering (IPO) are shown below:

Years after IPO Profit after tax (£) Dividend per share (£)
6 4,400,000 0.051
5 5,600,000 0.072
4 6,800,000 0.096
3 7,700,000 0.1232
2 8,200,000 0.1312
1 8,900,000 0.1424
0 11,000,000

Further Information
• The quantity of ordinary equity had increased by 10% after the 3rd year.
• The quantity of ordinary equity had increased by 20% after the IPO until the 3rd year.
• The no. of shares the firm issued is 50,000,000 shares.
• The market capitalisation of the firm is £156,000,000.
• The cost of equity is 15% per annum.
• The company’s goal is to maximise shareholders’ wealth.
• After year 6, dividends will grow at a constant rate of 10% forever.

Required :
(a) Critically examine the company’s dividend policy after its IPO and evaluate whether
such a policy is good for the firm.

(b) Evaluate whether Newcastle’s shares are undervalued or overvalued. Calculations need
to be provided wherever is applicable.

(c) Examine the weaknesses of the model that you used in (b).

(d) John told William that he just received a dividend worth £0.20/share from his equity
investment. He further told William that this dividend definitely worth more than those
dividend from the same equity which are going to be paid in the future. Do you agree
or disagree with John’s statement to William ? Justify your stance with proper
explanations.

(e) Robert told Peter that dividend is not relevant to investors as the latter can sell their
equity anytime to earn returns. Discuss critically why the “Dividend Irrelevance
Theorem” as suggested by Robert is not realistic in the real world.

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Answers:

(a)

No. of years after No. of shares Total dividend Payout ratio

IPO (million) (£) (%)

6 66 3,366,000 76.5

5 66 4,752,000 84.86

4 66 6,336,000 93.18

3 60 7,392,000 96

2 60 7,872,000 96

1 60 8,544,000 96

Current 50

From the figures in the table, we can conclude that the company’s dividend policy
emphasise a relatively high payout to its shareholders after its IPO consistent with its
shareholders’ wealth maximisation goal. There are pros and cons of a high payout policy.
High payout policy may signal to investors that the company is being governed well and
good financial performance can be expected in the future. This will instill confidence on
the firm’s shareholders as well as attract potential investors to buy the company’s shares.
On the other hand, if the company pay too much dividend, it has to continue this policy
in the future because if it changes its payout policy, this may signal to investors that the
firm is encountering financial problems or other problems which may not be a good sign
to the latter. A high payout policy can also reduce the firm’s liquidity in the long run as
it takes away the firm’s cash flow which are used to pay short-term expenses and short-
term investments needed by the firm. A high payout policy will also reduce the cash flow
needed by the firm to reinvest into its investment projects or to invest into new projects
or research and development (R&D). This may lead to the problem of underinvestment
by the firm in the long run.

(b) The Supernormal Growth Model is used:

P0 = (PV of dividends over Years 1–6) + (PV of subsequent dividends)

= [D1/(1.15)] + [D2/(1.15)2] + [D3/(1.15)3] + [D3/(1.15)3] + [D4/(1.15)4] + [D5/(1.15)5] +
[D6/(1.15)6] + [P6/(1.15)6]

where P6 = end of Year 6 share price and hence the PV of dividends from Year 7 and
thereafter.

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P0 = [14.24/(1.15)] + [13.12/(1.15)2] + [12.32/(1.15)3] + [9.6/(1.15)4] + [7.2/(1.15)5] +
[5.1/(1.15)6] + [P6/(1.15)6]
= 12.38 + 9.92 + 8.10 + 5.49 + 3.58 + 2.20 + [(5.1)(1.1)/(0.15-0.1)]/[(1.15)6]
= 90.18 pence or £0.9018

The market share price is:

Market value / Number of shares = £156mill / 50 mill = £3.12

As a conclusion, Newcastle stock is overvalued.

(c) The Gordon Growth Model inside the Supernormal Growth Model have several
weaknesses. It cannot incorporate zero dividend payments. It cannot tolerate the cost of
equity less than the growth rate of dividends. It assumes going concern of the firm. In
addition, dividend is not the only factor that influence firm value. Some firms experience
significant increases in asset value which have important effects on their share prices.
This signals that the assets concerned are more valuable compared to dividends.

(d) Disagree. The risk of dividends does not depend upon the timing of the dividend
payments but rather on the risk of the investment projects undertaken by the firm. This
misunderstanding is called “bird-in-the-hand fallacy”. Dividend risk should already have
been catered for by discounting cash flows at a suitably risk-adjusted discount rate. To
deflate future dividends for risk further would involve double-counting. There is no
reason why risk necessarily increases with time. Hence, dividends paid nearer in time are
not necessarily less risky compared to dividends paid in later time periods.

(e) The “Dividend Irrelevance Theorem” is not realistic in the real world due to the
following reasons :
(i) Certain type of investors are dependent on equity dividends for their stable
income. For example, retirees and institutional investors rely upon a stable income
to finance their lifestyle or to ensure stable returns in their investments. Hence,
dividend is relevant to certain investors and not totally irrelevant.

(ii) Transaction costs such as brokerage costs could also serve as barriers for investors
to sell their shares to earn significant returns, hence making dividends more
relevant than capital gains.

(iii) Selling equity may trigger the capital gains tax liability for investors in certain
countries. Hence, in these countries, dividends are more relevant compared to
capital gains.
(iv) In some countries, the capital gains tax may be higher compared to the dividend
tax. Hence, due to this discrepancy, investors in these countries may prefer
dividends rather than capital gains. This renders the “Dividend Irrelevance
Theorem” questionable.