Dividend Policy (Chapter 7)
- Traditional dividend policy says that a consistent policy is important and SHs prefer having a
dividend now than the uncertainty of having to wait.
- When deciding whether to reduce the dividend payment or not, it is important to consider
shareholder expectations. Shareholders may have invested in this because they expected a
consistent dividend payment, changing this, could result in them being unhappy and selling
shares.
- M&M say that a consistent dividend stream is not important, as long as the SH wealth
increases, they are indifferent between a dividend payment or an increase in share price.
If SHs need a dividend, they can manufacture it themselves by selling some of their shares.
- In reality, shareholders prefer the certain dividend now than the uncertain share price
increase in the future.
- A reduction in dividends could signal that the company is struggling and may result in
shareholders selling their shares. As a result, share price may decrease
Briefly apply this to the question/scenario.
i.e; ‘the company was previously having a constant dividend (growing at a stable rate), so the
change could cause shareholders to fear the stability/future of the company and sell the shares’.
If the company is set in cutting the dividend, this should be communicated to the shareholders to
minimise the risk of the signalling effect and selling their shares.
Gearing Policy ‘impact of increasing gearing’
Recall there are three theories, traditional, M&M (with and without tax).
- All three theories agree that:
Debt is cheaper than equity, so the increased proportion of debt causes the WACC to decrease
However, as the debt increases, the greater the risk for equity shareholders (since they are
paid after debt interest) and so the cost of equity increases and the WACC increases, causing
the market value to decrease.
- Traditional: says that there is an optimal level of gearing (low WACC means a higher MV).
This is hard to find in reality, up to a certain point, the cheaper debt dominates and then the
increased risk/increased cost of equity dominates.
- M&M (without tax): The two effects perfectly offset each other and hence the WACC stays
unchanged as the gearing increases. The capital structure is irrelevant to the WACC.
- M&M (with tax): the more a company gears up, the WACC continuously decreases and the
share price increases. This recommends gearing up to the max (99% gearing).
However, this increases bankruptcy risk and shareholders are risk averse.
Briefly apply this to the question/scenario
- Current gearing level
- New gearing level when you increase the debt
- Compare the gearing level to other company’s in the industry
, Assumptions of the WACC:
- Assumes that the gearing won’t change (i.e, the proportion of debt to equity). Any changes to
this, will cause a change in the cost of debt and cost of equity, and hence the WACC will
change.
- Assumes that the risk of the project is the same as the risk of current projects.
- Also assumes that dividends are paid once a year and that the dividend policy is consistent
and the increase in dividend payments increases consistently. Therefore, assumes that the
past is a good indicator of future activity.
- Assumes that finances are not project specific
Weaknesses of the WACC:
- Assumes stable prices (Po)
- Assumes dividends grow at a constant rate
- Assumes a constant tax rate
- Ignores overdrafts and other sources of short term finance which can sometimes be used as
long term finance
- Assumes perfect prices/markets
Limitations of Gordon’s Growth Model
- Distorted by inflation
- Assumes that r and b remains constant
- Relies on historic information which is not always a good indicator of the future.
- Assumes that gearing remains constant
- Relies on accounting profits
Logic of using the CAPM to calculate the WACC:
- Considers both systematic and unsystematic risk
- Provides an alternative cost of equity calculation/value
- Considers market risk, beta is a measure of systematic risk against market risk.
- Assumes investors are diversified and considers the portfolio effect.
Compare and contrast dividend valuation model with the CAPM as a means of
calculating the WACC.
DVM: Shareholders receive the benefit of receiving a dividend from the share and the capital gain on
the value of the share. The PV of the benefits creates the current price of the share. This share price is
determined by expected future dividend dividends discounted at the investors rate of return (ke).
CAPM: Specific/unsystematic risk can be diversified away if they have a diverse portfolio (portfolio
theory). Systematic risk are risks which affect the whole economy and hence cannot be diversified
away. A company’s beta is calculated from the performance of its share price against the market
average. The higher the expected risk, the higher the beta figure, and therefore, the higher the returns.
- Traditional dividend policy says that a consistent policy is important and SHs prefer having a
dividend now than the uncertainty of having to wait.
- When deciding whether to reduce the dividend payment or not, it is important to consider
shareholder expectations. Shareholders may have invested in this because they expected a
consistent dividend payment, changing this, could result in them being unhappy and selling
shares.
- M&M say that a consistent dividend stream is not important, as long as the SH wealth
increases, they are indifferent between a dividend payment or an increase in share price.
If SHs need a dividend, they can manufacture it themselves by selling some of their shares.
- In reality, shareholders prefer the certain dividend now than the uncertain share price
increase in the future.
- A reduction in dividends could signal that the company is struggling and may result in
shareholders selling their shares. As a result, share price may decrease
Briefly apply this to the question/scenario.
i.e; ‘the company was previously having a constant dividend (growing at a stable rate), so the
change could cause shareholders to fear the stability/future of the company and sell the shares’.
If the company is set in cutting the dividend, this should be communicated to the shareholders to
minimise the risk of the signalling effect and selling their shares.
Gearing Policy ‘impact of increasing gearing’
Recall there are three theories, traditional, M&M (with and without tax).
- All three theories agree that:
Debt is cheaper than equity, so the increased proportion of debt causes the WACC to decrease
However, as the debt increases, the greater the risk for equity shareholders (since they are
paid after debt interest) and so the cost of equity increases and the WACC increases, causing
the market value to decrease.
- Traditional: says that there is an optimal level of gearing (low WACC means a higher MV).
This is hard to find in reality, up to a certain point, the cheaper debt dominates and then the
increased risk/increased cost of equity dominates.
- M&M (without tax): The two effects perfectly offset each other and hence the WACC stays
unchanged as the gearing increases. The capital structure is irrelevant to the WACC.
- M&M (with tax): the more a company gears up, the WACC continuously decreases and the
share price increases. This recommends gearing up to the max (99% gearing).
However, this increases bankruptcy risk and shareholders are risk averse.
Briefly apply this to the question/scenario
- Current gearing level
- New gearing level when you increase the debt
- Compare the gearing level to other company’s in the industry
, Assumptions of the WACC:
- Assumes that the gearing won’t change (i.e, the proportion of debt to equity). Any changes to
this, will cause a change in the cost of debt and cost of equity, and hence the WACC will
change.
- Assumes that the risk of the project is the same as the risk of current projects.
- Also assumes that dividends are paid once a year and that the dividend policy is consistent
and the increase in dividend payments increases consistently. Therefore, assumes that the
past is a good indicator of future activity.
- Assumes that finances are not project specific
Weaknesses of the WACC:
- Assumes stable prices (Po)
- Assumes dividends grow at a constant rate
- Assumes a constant tax rate
- Ignores overdrafts and other sources of short term finance which can sometimes be used as
long term finance
- Assumes perfect prices/markets
Limitations of Gordon’s Growth Model
- Distorted by inflation
- Assumes that r and b remains constant
- Relies on historic information which is not always a good indicator of the future.
- Assumes that gearing remains constant
- Relies on accounting profits
Logic of using the CAPM to calculate the WACC:
- Considers both systematic and unsystematic risk
- Provides an alternative cost of equity calculation/value
- Considers market risk, beta is a measure of systematic risk against market risk.
- Assumes investors are diversified and considers the portfolio effect.
Compare and contrast dividend valuation model with the CAPM as a means of
calculating the WACC.
DVM: Shareholders receive the benefit of receiving a dividend from the share and the capital gain on
the value of the share. The PV of the benefits creates the current price of the share. This share price is
determined by expected future dividend dividends discounted at the investors rate of return (ke).
CAPM: Specific/unsystematic risk can be diversified away if they have a diverse portfolio (portfolio
theory). Systematic risk are risks which affect the whole economy and hence cannot be diversified
away. A company’s beta is calculated from the performance of its share price against the market
average. The higher the expected risk, the higher the beta figure, and therefore, the higher the returns.
