BLOCK ONE REVISION -ADVANCED FINANCIAL MANAGEMENT

Questions and Answers 

Question 1

  • Explain the factors that finance managers should analyze before making a dividend decision.
  • Assume all things are held constant other than the item in question, for each of the

companies below:

  • A company with a large proportion of insider ownership all of whom are high-income
    individuals. A growth company with an abundance of good investment opportunities.
    A company experiencing ordinary growth that has high liquidity and much unused borrowing
    capacity. A dividend paying company that experiences an unexpected drop in earnings from a trend.
    A company with volatile earnings and high business risk.
    Required:
    Explain whether or not you would expect each company to have a medium/high or a low dividend payment
    ratio and the reasons for such categorization

Answers

A company may pay a different dividend from another even if their issued capital is the same because of differences associated with:

  • Liquidity of each firm – The more liquid the firm, the higher the dividends other things constant.
  • Tax position of shareholders e.g shareholders with low income from other sources will prefer high dividends to supplement their income.
  • Profitability of the firm – Other factors constant, the higher the profits, the higher the dividends.
  • Bond/debt covenants e.g restrictions of payment of dividends from retained earnings.
  • Availability of investment opportunities – The more the projects yielding a positive NPV the higher the retained earnings and the lower the dividends.
  • Access the capital markets e.g firms which can easily and cheaply secure debt capital can afford to pay high dividends and vice versa.
  • Capital structure decisions – If the firm wants to reduce gearing through increase in equity, retained earnings will be increased thus lower dividends paid.
  • Level of business risk – Firms with high volatility of earnings will generally pay low dividends (other factors constant) due to uncertainty of profits and reduced ability to borrow.
  • Shareholders expectations – If shareholders have been receiving increasing DPS, the firm would persist on this trend since any reverse trend may affect the market value of shares

 

  • A firm with a large proportion of high income individuals will pay low or no dividends. Such shareholders prefer high capital to reduce their tax burden since capital gains in Kenya are tax exempt.
  • A growth company with abundance of good investment opportunities. Such a firm would pay low and retain more profits to finance its good investment opportunities.
  • A company with ordinary growth and high liquidity. Such a firm could pay high dividends and retain less. With high liquidity and much unused debt capacity, the firm can easily borrow debt capital to achieve optimal debt capital. It has access to capital markets.
  • A dividend paying company that experiences an unexpected drop in earnings from trend. Such a firm would pay medium dividends but if the drop in earnings persist in future it should adopt payment of low dividends.
  • A company with volatile earnings an high business risk.This firm should pay low dividends and retain more profits to finance its investments. With high business risk, the firm does not have access to capital markets and it is difficult to raise secure debt capital which would nevertheless increase the financial risk of the firm

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