- c) Describe two types of dividends which a corporate entity could pay its shareholders.
- c) Types of dividends which a corporate entity could play its shareholders:
- Payment of cash dividends.
This is where shareholders are given dividends in cash form.
- Bonus issue
This involves giving shares to the existing shareholders instead of cash dividends. The shares will be given in proportion to the shareholders ownership.
- Stock split
This is the process by which a company undertakes to reduce the par value of its shares and to increase the number of ordinary shares by the same proportion.
- Reverse stock split
This involves the consolidation of the shares into bigger units or stocks. In this case, the number of ordinary shares is reduced while the par value of the share is increased by the same proportion that has been used to reduce the number of the ordinary shares.
- Stock or share repurchase
This is where the company buys back some of the shares it had previously issued using the cash that would have been paid out as dividend.
- Discuss three factors that a company should consider when formulating its dividend policy.QUESTION 2(b) Factors to consider in formulating the dividend policy Profitability
A company needs to be profitable enough to consistently pay dividends and maintain a level of retained earnings to finance growth.
There must be sufficient cash to pay proposed dividend without compromising day to day cash financing needs.
Legal and other constraints
Dividend must only be paid in accordance with statutory requirements. Such dividends must be paid out of accumulated net profits. Other restrictions may result from restrictive covenants in loan issue documents.
Need for finance
Investment plans and financing needs of the company should be considered. It may be necessary to limit the need for external finance by keeping dividend increase in check.
Level of financial risk
Maintaining a low level of dividend payment can result to high level of retained earnings which will reduce gearing by increasing the level of reserves.
In a semi-strong form of efficient market, information available to directors is more substantial than that available to shareholders. If dividend decisions convey new information to the market, they have a signalling effect concerning the current position of the company and its future prospects.
- Baraka Ltd. has a cost of equity of 10%. Currently, the company has 250,000 shares which are quoted at the securities exchange at Sh.120 per share. The company’s earnings per share is Sh.10 and it intends to maintain a dividend pay-out ratio of 50% at the end of the current financial year.
The expected net income for the current year is Sh.3 million and the available investment proposals are estimated to cost Sh.6 million.
Using the Modigliani and Miller (MM) model, show that the payment of dividends does not affect the value of the firm.
- a) The following data was obtained from the financial statements of Nemax Ltd. for the year ended 30 September 2013:
Earnings per share (EPS) for 2013 Sh.3
Dividend per share (DPS) for 2012 Sh.l.20
Target payout ratio 0.6
Adjustment rate 70%
Using the Lintner’s model, determine the dividend per share (DPS) of Nemax Ltd. for the year ended 30 September 2013.
- Highlight four assumptions necessary for the dividend irrelevance theory to hold.
- Assumptions for dividend irrelevance theory to hold
- No transaction costs.
- Firms that pay too much dividends can issue stock again at no floatation cost.
- Investment decisions are unaffected by its dividend decisions.
- The firm’s operating cash flows are the same, no matter the dividend policy applied.
- Managers with large free cash flows do not waste them to invest in bad projects.
- Outline four advantages of paying scrip dividends
Advantages of paying scrip dividends
- Preservation of cash for re-investment.
- Unless-significant, a scrip issue will not dilute share price
- More shares reduce the company’s gearing and hence increase its borrowing capacity.
- Shareholders get more shares without incurring transaction costs.
- Shareholders may get a tax advantage, if dividends are in the form of shares rather than cash.
- Davirex Ltd’s share has a nominal value of sh. 80. The company pays 10% of the nominal value of the share as dividend for the year. The current market price of the share is sh. 160 with 15% earnings yield.
- Earnings per share. ii. Dividend cover.
iii. Price – earnings ratio.
- Nazitum Ltd. has current earnings per share of sh. 4.00. The company’s dividend for the previous year was sh. 1.50 per share and it has a target payout ratio of 0.60. The management of the company adjusts its dividend over two years.
The dividend per share for the current year.
(a) Discuss the effect of the following concepts on the firm’s dividend policy: (i) Clientele effect (ii) “Homemade” dividend.
- c) (i) Clientele effect
- Assumes that there is a tendency for him to attract investors who like the firm’s dividend policy. Therefore investors who desire current investment income would purchase shares in high dividend payout forms.
- Change in prices after dividend announcement is thus due to demand and supply forces occasioned by the investors keen on benefiting out of dividend announcement
- The implication of the dividend-clientele effect on dividend policy is that firms establish dividend policies that they deem would contribute to wealth maximization.
- The shareholders who do not like this policy sell their shares to those keen on driving dividend benefit.
- On the other hand, because of high switching costs (exit and entry) management is forced to establish dividend policies that meet investors.
- Investors who want current investment income should own shares in high dividend payout firms, while investors with no need for current investment income should own shares in low dividend payout firms.
(ii) Homemade dividend
- Refers to ability of stock holders to liquidate part of their holding hence realize cash inflow in lieu of dividend income.
- Implication of homemade dividend is that dividend policy is irrelevant and the argument is that paying or not paying dividend has a capital gain effect: paying dividends lead to an appreciation in stock values when dividends are not paid, stock prices fall.
- It is possible for investors to create homemade dividends thus the firm may opt to pay dividend and let investors to choose their own dividend policy. The firm can retain the profits and plough them through re-investment or can buy back shares.
- It ignores the signaling effect that a declared dividend will name.
- b) Enumerate four ways in which the dividend decision affects the wealth maximization goal of a company quoted in the securities exchange of your country.
- c) Four ways in which dividend decisions affects the weather maximization of a company quoted in the securities exchange
- High retention enhances future growth and value of the company ii. High dividend increases the value of the shares and the company as a whole iii. High retention reduces the firms gearing leading to decrease in cost of capital and an increase in the value of the company.
- Retained earnings is a cheap source of funds which end up increase the NPV of the projects undertaken and the value of the firm as a whole
- b) Explain three ways in which a company could pay dividends to its shareholders.
Three ways in which a company could pay dividends to its shareholders
- Constant payout ratio policy
The company can pay fixed proportion of earnings attributable to shareholders as dividends. Since the earnings fluctuate over time, the dividends will also fluctuate with the levels of earnings.
- Constant or fixed dividend per share policy
The company may pay a constant amount of dividends per share irrespective of earnings. Shareholders earns constant dividends same as preference shareholders.
- Fixed/ constant dividends per share plus surplus
Under this policy dividends is fixed and paid each year. However, extra dividends will be paid during years of high earnings.
- Residual dividend policy-
This is where dividends are paid out after investment opportunities have been financed.
- b) MCC Enterprises Ltd. expects its earnings before interest and taxes (EBIT) to fluctuate with the economic environment as shown below. You are advised that the earnings distribution is expected to continue in perpetuity. The company has one million shares outstanding and no debt in the capital structure. The company pays all its earnings in dividends and shareholders require a
|Bad||Fair Good||Very good|
EBIT (Sh. Million) 2.20 Earnings per share (Sh) 2.20
Return if share price is Sh. 35 6.29%
12% return. The company pays no taxes.
- Expected earnings per share and the standard deviation of earnings per share ii. The market value of MCC Enterprises Ltd
- b) Explain the arguments in favour of a stable dividend policy.
- Arguments in favour of stable dividend policy
- Desire for Current Income: Some investors like old persons, widow’s etc. desire to get stable current income to meet their living expenses. They invest their savings in shares with a view to get regular income for their living. If they get low dividend, they would be compelled to sell some of their shares to meet their living expenses. So they would prefer to invest in shares of those companies which pay regular and stable dividend and would be prepared to pay a little high price for shares of such companies.
- Removes Investors’ Uncertainty: The stable dividend policy removes uncertainty in investors’ mind about dividend payment. Even if the earnings of the company decline and the company continues to pay the constant amount of dividend, it would indicate that the management views the bright future prospects for the company. Thus, the changes or no changes in dividends work as a source of information about firm’s profitability.
- Additional Finance: The credit standing and prestige of the company paying stable dividend increases in the eyes of the investors. When the company wants to raise additional finance, investors would be willing to buy its shares or debentures. Particularly, small investors requiring regular income would like to invest their savings in shares of companies paying stable dividends. Even the preference shares and debentures of such companies would be easily subscribed, as the investors feel that such company would pay regular interest or dividend.
- Ploughing back of Profits: A company paying a reasonable proportion of stable dividend is able to retain good amount of profit with it, which it can plough back in the business. It is not compelled to resort to external financing for expansion purposes. The well-known large companies follow this stable dividend policy with great care and caution. Hence, they can use their retained earnings for future expansion.
- Stable Share Prices: A company paying regular and stable dividend has a high credit standing in the financial market and its share values remain at a high level. Besides share prices remain stable over a period of time and do not fluctuate violently as in case of other speculative shares.
- Leads to Management Efficiency: As stable dividend policy implies regular payment of dividend, the company has to earn profits every year which makes management more conscious towards their duties. This would lead to more efficient management
- c) PDS Ltd is a medium sized company quoted on the stock exchange. The company’s year-end is 31
December. The following data relate to the company’s earnings per share (EPS) and dividend per share (DPS) for the last five years.
Year ended 31 December
2009 2008 2007 2006 2005
EPS (Sh.) 14.0 13.6 13.1 12.7 12.2
DPS (Sh.) 8.2 8.1 7.9 7.8 7.7
If the current dividend policy is maintained, the directors of PDS Ltd. expect that annual growth in earnings and dividend will be the same as the average growth in earnings over the past four years. PDS Ltd., which is wholly equity financed, is reluctant to obtain debt to finance its growth opportunities. The company is therefore considering a change in its dividend policy where 50% of its earnings will be retained to finance identified projects which are estimated to have an average post-tax return of 15%.
The company’s cost of capital is 12%.
The share price of the company which might be expected by the market (i) If the company does not announce the change of dividend policy.
(ii) If the company announces the change of dividend policy.
- a) Outline the reasons that may constrain a company from paying dividends to its shareholders at the end of a financial year.QUESTION 12
- a) The reasons that may constrain company from paying dividends to its shareholders at the end of the financial year
- Ability to raise funds from other sources. If a firm has no ability to raise funds from other sources it will pay lower dividends.
- Expectations from the investors.
- Legal requirements i.e. insolvent firms are not to pay dividends.
- In case there is need to finance acceptable or viable projects. This will obviously lead to payment of low dividends
- If the firm profitability is unstable the amount of dividends paid will be lower.
- a) Explain the factors that influence the dividend policy
- a) Explain the factors that influence the dividend policy
- Legal requirements-they can be classified as follows;-
- The net profit rule which states that dividends can only be paid from the companies available profits.
- Insolvency rule which states that the company cannot pay dividends when its insolvent i.e. when total assets are less than liabilities. iii. Capital requirement rule which prohibits payment of dividends from capital through sale of assets to raise money to pay dividends.
- Shareholders expectations-if the company shareholders are wealthy, in a high income bracket, they may prefer capital gains over dividends and therefore company may retain more funds.
- Bond covenants-these are terms and conditions of the loan agreement, the restrictions may restrict the company from paying dividends, unless earnings exceed a certain amount.
- Industrial norms – a company will adopt a dividend policy which is similar to its competitors in the industry that it operates.
- Profitability and liquidity position- companies’ ability to pay dividends will be determined by the ability to generate stable profits.
- b) Jambo Kenya Ltd. Has followed a policy of paying out a gradually increasing dividend per share over the past five years as shown below:
Year Earnings per share Dividend per share
2001 118.00 5.00 2002 125.00 5.50
2003 146.00 6.00 2004 135.00 6.50
2005 160.00 7.30
- The company has paid the year dividend. The shares are therefore quoted ex-dividend.
- Management is considered a change in the financing policy whereby greater financing will be provided from internally generated funds. This change is expected to reduce the dividend per share to Sh.5.00 in the year 2006.
- The growth rate in earnings per share and dividend per share is expected to increase to 14% per annum from year 2006.
- The company’s shareholders require a minimum return on investment of 16%.
- Using the dividend growth model, calculate the market price per share as at 31 December 2005 prior to the change in the financial policy.
- Calculate the market price per share as at 31 December 2005 under the new financing policy. iii) Determine the break-even growth rate in dividend per share using the market price calculated in i) above
The following is the summarized Balance sheet of Kaka Kuona Ltd. as at 30 November 2003:
Land and buildings
Furniture and fittings
Cash in hand
Ordinary share of Sh.10 each
Long term debt
- In the past Kaka Kuona ltd.’s earnings per share (EPS) averaged Sh.6 and the dividend payout rate was 50% or Sh.3 per share. For the year ended 30 November 2003, the EPS declined to Sh.2.50. Because it was felt that this decline was temporary, the annual dividend of Sh.3 per share was maintained for the financial year ended 30 November 2003. As well as for the first six months of the financial year ending 30 November 2004
- Recent projections however have caused management to revise downwards the expected EPS. For the financial ending 30 November 2004, the forecast of EPS has been reduced to Sh.2 per share and for the financial year ending 30 November 2004, the forecast of EPS has been reduced to Sh.2 per share and for the financial year ending 30 November 2005, adjusted to Sh2.20
- Kaka Kuona Ltd. ‘s ordinary shares are currently selling in the market at Ss. 15 per share
The management of Kaka Kuona Ltd. is considering whether or not to retain the cash dividend of Sh.3 per share for the next two financial years
- Calculations to help determine whether it will be feasible to maintain dividends at Sh.3 Per share for the next two financial years
- Determine whether the company should replace the cash dividend with a bonus issue of one share for every four ordinary shares
- Explain the course of action that the management of Kaka Kuona Ltd should take in the light of the declining projections in dividend payouts.
- c) The course of action that the management of Kaka Kama Ltd should take in the light of the declining projections in dividend payments.
- The management should look for new market areas in order to increase sales volume that may lead to increase in the profits of the firm.
- Diversification of the operations of the firm that will minimize business risk because the company will be holding a portfolio.
- The management should change the company’s dividend policy from the ratio of 50% to a lower dividend payout ratio.
- Disposal of non-profitable assets.
Cost cutting measures e.g. retrenchment of unproductive employees.
- State the circumstances under which it would be advantageous to lenders and to borrowers from the issue of:
- Debentures with a floating rate of interest.
- Zero-coupon bonds. (Ignore taxation)
- Debenture with floating interest rate
- A debenture whose interest rate is variable and pegged to charges in interest rate on Treasury bill e.g. a debenture/bond may have a 3% premium above interest rate on
Treasury bill such that:-
- If interest rate on treasury bill is 7%, interest rate on the bond is 7% + 3% = 10%
- If interest rate on Treasury bill rises to 8.5%, the interest rate on the bond rises to 8.5% + 3% = 11.5%.
- Such a bond is advantageous when market interest rates are volatile.
- If market interest rate falls the borrower pays lower interest charges and when it rises, the lender receives more interest income.
- Since the coupon rate is matched to market interest rate, the intrinsic value of the bond is usually stable and easy to determine.
- Zero coupon bonds
- The bonds do not pay periodic interest hence the words “zero coupon” bond.
They are issued at a discount and mature at par.
- Therefore, interest is accumulated and accounted for in the redemption value of the bond.
- The lender is not locked into low fixed interest rate while the borrower does not have fixed financial obligations of paying fixed interest charges.
- The liquidity of the borrower is not affected until the redemption date.
- Debenture with floating interest rate
- (i) Briefly discuss the disadvantages of the constant growth dividend model as a valuation model.
(ii) The dividend per share of Mavazi Limited as at 31 December 2000 was Sh.2.50. The company’s financial analyst has predicted that dividends would grow at 20% for five years after which growth would fall to a constant rate of 7%. The analyst has also projected a required rate of return of 10% for the equity market. Mavazi’s shares have a similar risk to the typical equity market.
The intrinsic value of shares of Mavazi Ltd. As at 31 December 2000.
The financial data given below shows the capital structure of Akabebi Company Limited.
|10% Sh.1,000 debenture
Ordinary share capital (Sh.20)
The structure is considered optimum and the management would wish to maintain this level.
Akabebi Company Limited intends to invest in a new project which is estimated to cost Sh.16,800,000 with an expected net cash flow of Sh.3,000,000 per annum for 10 years. The management has proposed to raise the required funds through the following means:
- Issue 100 10% debentures at the current market value of Sh.5,000 per debenture.
- Utilise 60% of the existing retained earnings.
- Issue 10% Sh.20 preference shares at the current market price of Sh.25 per share
- Issue ordinary shares at the current market price of Sh.45 per share. Floatation cost per share is estimated to be 12% of the share value.
The company’s current dividend yield is 5% which is expected to continue in the near future. Corporation tax rate is 30%.
iii) Determine the current dividend per share. iv) Determine the number of ordinary shares to be issued.
- Determine the marginal cost of capital for Akabebi Company Ltd based on the above information.
- Evaluate whether it is viable to invest in the proposed project (Round off your answer for cost of capital to the nearest 1)
- Explain clearly the sense in which depreciation is said to be a source of funds to business firms.
- Depreciation as a source of finance to the firm in 2 ways:
- It is tax allowable thus will yield a tax shield/saving to the firm since it reduces firms tax liability.
- Provision for depreciation is an appropriation from the company’s profits. This appropriation is transferred to a sinking fund which becomes a source of capital for replacing an existing asset. It is an internal source of finance.
- State the alternative dividend policies a firm may adopt.
- The alternative dividend policies are:
- Fixed or constant dividend per share policy:
- The firm pays a fixed dividend per share irrespective of how much profit is available. This creates certainty for shareholders but put pressure on the firm to pay the same dividends even when the profits are low. The earnings per share (EPS) will be fluctuating over time.
- The D.P.S could be increased to a new level if it looks reasonably sustainable.
- Fixed or constant dividend per share policy:
- Fixed payout ratio policy:
- A fixed proportion of equity earnings will be paid out as dividends meaning that the dividends shall fluctuate over time creating high uncertainty for shareholders. This could adversely affect the market price per share (MPS) as well as the required rate of return.
- The E.P.S and D.P.S will fluctuate over time.
- A low fixed D.P.S plus surplus:
- The firm will first provide for investment needs out of its equity earnings and the surplus/residual profits (if any) would be paid out as dividends.
- This policy maximizes shareholders wealth since projects with positive N.P.V are first financed from equity earnings.
- Identify 6 factors a firm must consider when designing dividend policies.
- Factors influencing design for dividend policies
- Legal rules – net profit, capital impairment and insolvency rules.
- Liquidity and profitability
- Tax position of shareholders
- Restrictions from band covenants
- Access to capital markets.
- Investment needs of the firm and the stage of growth.