Chapter 16- The dividend decision:
Introduction:
1. Is it important to actively manage dividends?
2. Is there more than one dividend policy?
Yes, management can determine the dividend policy. There is not one set
(IFRS) method.
3. Does the dividend policy have an effect on company value?
If the dividend affects the value, it is clearly relevant and must be actively
managed
If the dividend policy has no real affect on value, then it is irrelevant and is
simply the balancing figure after the financing and investment decisions have
been taken.
Investment, Financing and Dividend decisions:
o Consider all 3 when making decisions
o A decision on any one of these may affect the others and will affect the
sustainable growth rate of the firm.
o The financing decision depends on the capital structure of the firm.
Dividend - Active variable or passive residual?
o Dividend growth model:
o Share price = D1 / ke-g
“Bird in hand” vs. uncertain future growth
o The supporters of the dividend model argue that a dividend paid is more
valuable than uncertain future growth.
o Shareholders would rather invest in a company where they are sure of
dividends rather than investing in a company which depends on growth to pay
dividends
Dividend decision:
Modigliani and Miller:
o They believed that the dividend policy has no effect on the value of the
company
o There argument is based on the fact that if the company made a dividend
payment (+), then they would have to issue new shares to pay out new
dividends [% shareholding dilutes (-)]
Why?
o If the dividend is paid, the shareholder will receive the cash. In order to raise
the finance, the company will have to issue new shares amounting to the value
of that dividend. The shareholder is therefore in the same position.
Assumptions:
o No taxes
o No transaction costs
o No market imperfections
Relaxing these assumptions could alter the position. For example, if dividends and
capital gains are taxed at different rates, then the desirability will be affected.
, In summary: 2 Schools of thought
Active policy Passive (Residual) policy
Dividends have an effect on value of Dividends are irrelevant.
company
Policy should be actively managed. Only paid in case there is no other use for
funds.
Passive (Residual) policy:
Dividends are what are left after investment and financing decision have been made.
This means that dividends should be paid only if no other investment opportunities
are available in which they could place those funds and earn the required rate of
return.
There are no trends, the dividends will fluctuate constantly.
Identify:
1. Company’s investment opportunities
2. Company’s required rate of return (WACC)
3. Company’s target debt ratio (NB! Below difference)
Debt /Total assets
Debt to equity ratio = Total debt / Total equity
Example (NB!!!):
Before a company can decide on dividends, it must first identify all the investment
opportunities available as show below. All those that have a IRR of above WACC are
accepted. If the acceptable earnings do not utilise all the available funding, surplus earnings
are distributed by way of dividend.
G
Project A B C D E F H
IRR 18% 17% 15% 14% 12% 11% 9% 7%
Cost (Rm) 10 13.5 22 8.5 16 12 20 9
Cumulative 10 23.5 45.5 54 70 82 102 111
Cost of capital = 10%
Earnings = R80 000 000
Target Debt: Equity ratio =1:1
Acceptable projects = R82 000 000
Financed by:
50% Debt (41 000 000)
50% Equity (41 000 000)
Amount available to declare as dividend:
80 000 000 – 41 000 000 (equity) = 39 000 000
According to the residual approach, R39m would be paid out as a dividend, since these
cannot be invested profitably in another company.
Example:
Introduction:
1. Is it important to actively manage dividends?
2. Is there more than one dividend policy?
Yes, management can determine the dividend policy. There is not one set
(IFRS) method.
3. Does the dividend policy have an effect on company value?
If the dividend affects the value, it is clearly relevant and must be actively
managed
If the dividend policy has no real affect on value, then it is irrelevant and is
simply the balancing figure after the financing and investment decisions have
been taken.
Investment, Financing and Dividend decisions:
o Consider all 3 when making decisions
o A decision on any one of these may affect the others and will affect the
sustainable growth rate of the firm.
o The financing decision depends on the capital structure of the firm.
Dividend - Active variable or passive residual?
o Dividend growth model:
o Share price = D1 / ke-g
“Bird in hand” vs. uncertain future growth
o The supporters of the dividend model argue that a dividend paid is more
valuable than uncertain future growth.
o Shareholders would rather invest in a company where they are sure of
dividends rather than investing in a company which depends on growth to pay
dividends
Dividend decision:
Modigliani and Miller:
o They believed that the dividend policy has no effect on the value of the
company
o There argument is based on the fact that if the company made a dividend
payment (+), then they would have to issue new shares to pay out new
dividends [% shareholding dilutes (-)]
Why?
o If the dividend is paid, the shareholder will receive the cash. In order to raise
the finance, the company will have to issue new shares amounting to the value
of that dividend. The shareholder is therefore in the same position.
Assumptions:
o No taxes
o No transaction costs
o No market imperfections
Relaxing these assumptions could alter the position. For example, if dividends and
capital gains are taxed at different rates, then the desirability will be affected.
, In summary: 2 Schools of thought
Active policy Passive (Residual) policy
Dividends have an effect on value of Dividends are irrelevant.
company
Policy should be actively managed. Only paid in case there is no other use for
funds.
Passive (Residual) policy:
Dividends are what are left after investment and financing decision have been made.
This means that dividends should be paid only if no other investment opportunities
are available in which they could place those funds and earn the required rate of
return.
There are no trends, the dividends will fluctuate constantly.
Identify:
1. Company’s investment opportunities
2. Company’s required rate of return (WACC)
3. Company’s target debt ratio (NB! Below difference)
Debt /Total assets
Debt to equity ratio = Total debt / Total equity
Example (NB!!!):
Before a company can decide on dividends, it must first identify all the investment
opportunities available as show below. All those that have a IRR of above WACC are
accepted. If the acceptable earnings do not utilise all the available funding, surplus earnings
are distributed by way of dividend.
G
Project A B C D E F H
IRR 18% 17% 15% 14% 12% 11% 9% 7%
Cost (Rm) 10 13.5 22 8.5 16 12 20 9
Cumulative 10 23.5 45.5 54 70 82 102 111
Cost of capital = 10%
Earnings = R80 000 000
Target Debt: Equity ratio =1:1
Acceptable projects = R82 000 000
Financed by:
50% Debt (41 000 000)
50% Equity (41 000 000)
Amount available to declare as dividend:
80 000 000 – 41 000 000 (equity) = 39 000 000
According to the residual approach, R39m would be paid out as a dividend, since these
cannot be invested profitably in another company.
Example:
