Luton Brickworks plc is newly formed company which aims to maximise the wealth of its shareholders. The board of directors of the company is currently trying to decide on the most appropriate dividend policy to adopt for the company’s shareholders.
However, there is a strong disagreement between three of the directors concerning the benefits of declaring cash dividends.
Director A argues that cash dividends would be welcome by investors and that a high dividend payout ratio as possible would reflect positively on the market value of the shares.
Director B argues that whether a cash dividend is paid or not is irrelevant in the context of shareholder maximisation.
Director C takes an opposite view and argues that dividend payments should be avoided, as they would lead to a decrease in shareholder wealth.
Present the theory of organisational dividend policies and integrate the assignment into your discussion.
a) Discuss the arguments for and against the position taken by each of the three 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 payment.
What is Dividend?
The term dividend refers to the part of divisible profits among its shareholders. In other words, dividend is that portion of company’s profit which is distributed among its shareholders as a percentage of par values of share at a fixed rate per share according to the decision of its board of directors.
The main purpose of any business is to create profits for its owners. When any company earns profit from its business, they can reinvest that money in their business, but some companies pay profits to its share holders. However when a company decides to pay dividend to shareholders, the cash available for business will reduce. Dividend inukare paid on a semi annual basis, net of deduction of tax at the standard personal income tax rate, these are called interim dividends. These interim dividends tend to be smaller than final dividends due to cash flow, taxation & financial planning considerations (Sangray, 2010).
Types of Dividends:
3)Stock Splits Dividend
Cash dividend plays a dominant role in sharing company’s profit; shareholders are being paid in part of company’s profit. However in US they double the taxation of cash dividend at a maximum rate of 15% and dividends are distributed to shareholders only after company pays income tax.
Stock dividend is paid to shareholders only if the companies not having healthy cash position, by combining the profits of both current & previous year. Such shares are also called as ‘bonus shares’ instead of paying dividend as cash. There is no great change in equity of shareholders, as stock dividend is paid until actual stock sold in order to avoid paying taxes. In general share holders have more scope to receive additional shares from the company, where it depends on the amount already owned by shareholders.
STOCK SPLITS DIVIDEND:
Stock split dividend is performed in a company, if there is increase in share price, obviously investors shares become too expensive to buy. Whereas liabilities, assets, equity remains same. InUKstock split is referred as “scrip issue”, “bonus issue”, “capitalization” or “free issue”. This stock split dividend resembles stock dividend.
SHAREHOLDERS WEALTH MAXIMIZATION:
Shareholders profit maximization consolidates the volume of risk & time. The goal of SWM states that the present value of the expected future cash flow of the firm should be maximized to shareholders.
He argues that cash dividends would be welcome by investors & that a high dividend payout ratio as possible would reflect positively on the market value of the shares.
This argument deals with RELEVANCE THEORY, where the supporting model for this argument is
James E. Walter (1999): dividends are relevant. The investment policy of a company & dividend policy both are inter-related as they cannot be separated by their own. The value of an enterprise will be affected by dividend policy.
Formula for Walter’s model:
Where P= PRICE OF EQUITY SHARES
D= INITIAL DIVIDEND
Ke= COST OF EQUITY CAPITAL
G= GROWTH RATE EXPECTED
ANOTHER MODEL WHICH SUPPORTS THIS ARGUMENT IS GORDON & LINTNER MODEL
Dividend relevance, as argued by “Linter and Gordon”, suggested that investors preferred dividends to capital gains due to their certainty
w The Gordon model can be used to find the theoretical value of a share by summing the share’s discounted future dividend payments to infinity:
P0= Do (1+g)/(y-g)
P0 = current ex-dividend market price of the share
r=shareholders’ required rate of return
g= expected future growth rate of dividends
D0 = declared dividend at time t0
Dividend relevance was further supported by the argument that dividends were seen by investors as signals of a company’s future profitability.
Arguments in favour of statement:
1)The company should pay dividend to shareholders if they have sufficient liquidity to satisfy their requirements.
2)The dividend acts as a signal to investors about the profits of the company is higher or not.
3)The company’s market value & confidence in society increase only if the dividends are paid to investors.
4)If company pays regular cash payments to customers & the firm will be recognised in the market to get financial support from other institutions with reasonable interest rates.
Arguments against the statement:
1)If the company pays dividend to investors in initial stage, it may lead to failure in important opportunities.
2)The share value of the company decreases if the company pays more dividends to shareholders. This leads to negative impact in the market.
3)According to nature of the business the company may suffer loss, as dividend may adversely affect the company.
4) The regular payout of dividends will also be taxed on regular intervals, as they are corporation profits. If this profits are transferred to reserves,(capital gains) in long run, the total impact of tax would be less than the tax paid on regular dividend payments.
Argues that whether a cash dividend is paid or not is irrelevant in the context of shareholders maximisation.
This argument deals with IRRELEVANCE THEORY, the supporting models for this theory could be MILLER & MODIGLIANI MODEL
According to “Miller and Modigliani” (2010 Sudesh Sangray) the dividend payments were irrelevant & should only be offered as a residual the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets. The dividend policy may have no influence on the market price of the shares.
Assumptions of M&M model
Surveillance of perfect capital markets and investors in it are rational. Securities are infinitely divisible, as there is no transactions cost, & investor cannot influence the market price of securities and there are no floatation costs.
There are no differences in tax rates which are applicable to capital gains and dividends.
The investment policy of a firm does not change. It implies the financial status of the company which gives an opportunity to invest in new projects. As retain earnings will not change the business risk of the firm.
Arguments in favour of statement: (MR.B)
1)Investors will not get affected if dividend is paid but investment policy will have impact on shareholders wealth maximization.
2)The investors are less concern about dividend payment as they always want to maximise their wealth.
3)The home made dividend pays to shareholders who expect regular income selling particular shares instead of anticipating dividend.
4)If a company tries to get income from external source, by supplying sufficient funds, then retain earnings come completely irrelevant. Where shareholders wealth can be maximised by getting income from external source.
Arguments against the statement: (MR.B)
The perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs.
Paying present cash dividend is far better than capital gains, where whose appearance is definite & more accepted by the shareholders.
If a company paying dividend from external source of income is not a good idea, as it leads to increase in interest rate & gearing ratio, which will effect shareholders wealth.
This argument deals with which is similar to relevance theory, there is no specific model that supports this argument, but
Argument for and against that Dividend payment should be avoided since it reduces
Arguments in favour of the statement
Net income of the share holders decreases, as they pay taxes on dividend received. This result to decrease of wealth.
The profitable opportunities for firm reduce, when there is regular payment of dividend to shareholders.
So, the firm should try to avoid the dividend payment to its shareholders and try to concentrate on its investment opportunities.
Argument against the Statement
As mentioned by “Watson & Head” (2004) in the article “DIVIDEND POLICY” cash dividend plays an important role to provide reliable information to the investors. That financial condition of company is strong.
The uncertainty of shareholders income reduces when payment of cash dividend is high.
The management tries to reduce conflict & ensure their personal benefits are mention, as there is a scope of agency problems because of owner’s interest. There is decrease in interest rates when dividend payment is high which indicates the shareholders wellbeing is doing well by management are not.
FACTORS DETERMINE DIVIDEND PAYMENT:
The decision of dividend is difficult because of conflicting objectives & lack of decision making techniques, maximizing shareholders wealth is not easy in the long run.
FACTORS AFFECTING DIVIDEND POLICY:
NATURE OF BUSINESS:
Mostly dividend policy is adopted by companies which earn unstable profits; where it is different from company earn stable profits.
COMPOSITION OF SHAREHOLDING:
If the company have cumulative preference shares, they have to be paid the present year dividend in the next year along with next year dividend and if it has equity share they need not be paid even the company has profits. Example: Microsoft etc.
RESTRICTIONS BY CONCERNED BODIES:
In long-term some financial companies restrict the company on paying dividend to shareholders, they pronounced a clause that no payment to be made till the loan amount is repaid back to financial institutions.
During inflation it is not much important to pay dividend. As there is no chance of replacing the equipment as funds are generated from depreciation.
FIRM ORIENTED CONSIDERATION:
The dividend policy is not determined by ownership interest rates. As firm’s needs are considered as important, this includes the following.
Risk of losing control on organization
Post dividend policies and stockholders relationships.
Relative cost of external funds
Contractual & legal restrictions
Availability of external capital
As explained in Investopedia Dictionary. “The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity”. To increase the sales profits earned by company should reinvest in fixed assets & working capital. There are some companies which cannot generate sufficient cash even if they get profitable income.
The identification of owner’s interest becomes difficult if it is decentralized on wide spectrum. As every shareholder have their own objectives & different opinions. Investor companies are which combines the mix of both growth & desired dividends.
Concluding that, this report explains the financial status of the company and their decision regarding shareholders wealth maximization.
1)Dividend is paid to shareholders & dividend policy is taken to distribute dividend to shareholders.
2)There are 3 types of dividends cash, stock, stock splits dividend, which plays a key role in paying dividends.
3)Paying dividend to shareholders is an added advantage, which increase the company’s reputation in the market.
4)There is a possible adverse effect to the company depending on the nature of the business.
5)As investors always look forward to maximise their wealth.
6) It is not a good idea to pay dividend to shareholders now, as investors may think that the company is not having any future projects to enhance their business.
7)Recommending that the company should wait for some time to gain good reputation in market and investors as well to get more profits, which help to increase in market share, and overall profits of the company.
8)Concluding that as Luton Bricks Plc is new to company in market, there will have less scope for earning profits.
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American psychological association. Www.dictionary.com. dividend, Collins English dictionary, 10th edition. May 22, 2011.
Pike Richard. (1996). Decisions and Strategies. In: Richard Pike and Bill Neale Corporate finance and investment. 2nd Ed.New York: Prentice Hall,. 196-216.
Watson, Denzil. And Head Antony(2007). Corporate finance: principles and practices. 4th ed.Harlow: ft/prentice hall. pg.no:286.
Sangray, S. (2011) Week-10. Advanced Corporate Finance, Dividend Policy. (Online). Available at www.breo.beds.ac.uk.(accessed on December 10, 2010).
Gitman, L., J. (2009) the principles of managerial finance. 12th ed.London: Pearson Prentice Hall.
Agrawalsumeets. (2010). Theories-of-Dividend-Policy. Available: http://www.scribd.com/doc/28162428/Theories-of-Dividend-Policy. Last accessed 27 July 2011.
Dictionary. (2007). Dividend. Available: http://www.investopedia.com/terms/d/dividend.asp. Last accessed 02 august 2011.
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