Question Tag: Dividend Policy

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  • 14 Marks

AFM – Nov 2016 – L3 – Q2a – Dividend policy in multinationals and transfer pricing

Advise on factors affecting dividend policy and calculate GGML’s dividend capacity and payout ratio for the next three years.

You are the newly employed Finance Director of Gala Gold Mining Ltd (GGML), a fast
growing Ghanaian mining company. The ordinary shares of GGML are listed on the Ghana
Stock Exchange. The company issued two million fresh shares in an Initial Public Offer (IPO)
to meet the minimum public shareholding requirement of the Exchange. In the prospectus
accompanying the IPO, the company proposed a stable earnings pay-out ratio of 20%.
It has been one year since the listing of GGML’s ordinary shares. At the first post-listing annual
general meeting, which was held last week, the directors recommended that the company
retains the entire profit earned in its first year as a public company to help finance profitable
mining opportunities in the Western part of Ghana. This 100% earnings retention proposal was
rejected by the shareholders, and the directors have promised to reconsider the issue and
recommend some dividends.
The directors would be meeting in the coming month to discuss the matter with the hope of
developing a sustainable dividend policy for the next three years. You are expected to make a
presentation on the company’s dividend capacity at the meeting.
You have gathered relevant extracts from the financial results of the past financial year (i.e.
financial year ending June 2015) and expected annual changes in the values over the next three
years (i.e. financial years ending June 2016, 2017 and 2018) presented in the Table below :

The company’s tax rate is expected to remain at 35%.
Required:
i) Advise the directors on THREE factors they should consider in developing an appropriate
dividend policy for GGML. (6 marks)
ii) Calculate the maximum dividends GGML can pay for the past financial year, and estimate
its dividend capacity for the next three years. Recommend an appropriate dividend payout ratio for the coming three financial years.

i) Three factors to consider when developing dividend policy:

  • Legal requirements: Dividends must be paid from distributable earnings as stipulated in the Companies Code. GGML must ensure it complies with all legal requirements.
  • Investment opportunities: GGML is a fast-growing company with high capital needs. Retaining earnings to finance profitable projects is crucial for future growth.
  • Alternative sources of finance: The availability of external financing affects how much GGML can afford to distribute as dividends. Limited access to external finance means more earnings need to be retained.

ii) Calculation of maximum dividends and dividend capacity for GGML:

  • Maximum dividend for 2015: GH¢30.1m, representing 10.2% of net income.
  • Recommendations for the next three years: Based on the FCFE projections, GGML can afford to pay dividends of GH¢55.42m in 2016, GH¢86.76m in 2017, and GH¢125.72m in 2018.
  • Recommended payout ratio: To maintain consistency, a minimum payout ratio of 15% or an average of 20% can be recommended over the three years.

 

 

  • 12 Marks

AFM – May 2019 – L3 – Q4b – Dividend policy in multinationals and capital structure decisions

Evaluate the financing options for Asana Ltd’s expansion, calculate the value of a right, dividend capacity, and debt-to-equity ratio under different methods.

Asana Ltd (Asana) is a manufacturing company based in Ghana. It is listed on Ghana’s stock exchange with a total market capitalization of GH¢400 million and 50 million shares outstanding. Its debt stock is made up of 10,000 18% bonds with a face value of GH¢100 each. Per the bond indenture, Asana is required to maintain a maximum debt-to-equity ratio of 80% and is prohibited from paying a dividend in any year unless its dividend capacity for that year is at least 45% of net income for that year. For the past three years, the company has not been able to pay dividends to its shareholders because it has not been able to meet the minimum dividend capacity requirement.

Presently, the company is planning an expansion project that could enhance its dividend capacity for the coming years. The expansion project is expected to increase profit before interest and tax by 15% above the recent figure of GH¢35 million. The directors are considering whether to use equity or debt finance to raise the GH¢50 million required by the expansion project. The amount required for the business expansion will be invested in additional property and equipment. Details of the two financing methods under consideration follow:

Method 1: Equity Finance
If equity finance is used, Asana will offer 1 new share for every 4 existing shares in a rights offer at a discount of 10% off the current market price.

Method 2: Debt Finance
If debt finance is used, Asana will raise the required GH¢50 million through a syndicated loan arrangement. The interest rate on this syndicated loan is expected to be 20%. It is assumed that the entire principal will be drawn immediately and paid back in a lump sum in 5 years’ time.

Additional information:

  1. Presently, the book value of equity is GH¢200 million, while the debt level is GH¢100 million.
  2. The recent profit before interest and tax is reported after charging depreciation of GH¢10 million and profit on disposal of non-current assets of GH¢2 million. The aggregate cost of the non-current assets sold is GH¢10 million, and their aggregate accumulated depreciation is GH¢8 million.
  3. In addition to the business expansion expenditure, GH¢2 million will be invested to maintain existing productive capacity in the coming year. This will be financed from retained earnings.
  4. Additional investment in net working capital will be 20% of the current net working capital balance of GH¢100 million.
  5. Asana pays corporate income tax at 22%.

Required:

i) Supposing equity finance is used, compute the value of a right.
(2 marks)

ii) Forecast the dividend capacity of Asana under both financing methods after the business expansion. Conclude whether Asana would be able to pay dividends to its shareholders in the coming year.
(5 marks)

iii) Compute the revised debt-to-equity ratio of Asana under both financing methods after the business expansion.
(3 marks)

iv) Use the results of the calculations above to evaluate whether equity or debt finance should be used for the planned business expansion.
(2 marks)

i) Value of a Right

ii) Dividend Capacity Forecast

Conclusion:
Asana would be able to meet its dividend capacity requirement if equity finance is used, as the dividend capacity (GH¢7.81 million) exceeds the minimum required. However, under debt financing, the dividend capacity (GH¢4.30 million) would not meet the required threshold, and the company would not be able to pay dividends.

iii) Debt-to-Equity Ratio

iv) Evaluation of Financing Methods

  • If equity finance is used, the company will have a lower debt-to-equity ratio (40%) and be able to pay dividends to shareholders, meeting both debt and dividend requirements.
  • If debt finance is used, the company will have a higher debt-to-equity ratio (75%) close to the maximum limit of 80%, leaving little room for future borrowing. Additionally, the company will not meet the minimum dividend capacity requirement.

Conclusion: Equity finance is the better option for the planned business expansion.

  • 6 Marks

AFM – Nov 2016 – L3 – Q1a – The role and responsibility of senior financial executive/advisor | Financial strategy formulation

Discuss the interrelation between investment, financing, and dividend policies and their effect on firm value.

When determining the financial objectives of a company, it is necessary to take three types of policy decisions into account: investment policy, financing policy, and dividend policy.

Required:
Discuss the nature of these three types of decisions, commenting on how they are interrelated and how they might affect the value of the firm (i.e., the present value of projected cash flows).

The investment decision considers the benefits of investing cash either in projects, working capital, or high-yield deposit accounts. It is crucial for shareholders, as it affects cash flow generation, dividends, and share price. Shareholders compare the risk versus return, knowing that higher-risk investments require higher returns.

The financing decision involves selecting the sources of finance, typically a mix of equity and long-term debt. Debt is cheaper but increases risk for shareholders due to interest obligations, potentially affecting company stability.

The dividend decision determines how much profit is distributed to shareholders versus retained for future investment. Predictable dividends tend to reduce perceived risk and increase firm value.

These three decisions are interrelated as funding investments may come from internal retained earnings or external financing. The cost of capital from the financing decision affects investment viability, which impacts dividends. Ultimately, these decisions together influence the present value of future cash flows, thus affecting the firm’s value.

  • 10 Marks

AFM – May 2018 – L3 – Q5a – Dividend policy in multinationals and transfer pricing

Discussing why share prices plunge when multinational companies suspend paying dividends and outlining theories of dividend policy.

Recently, some multinational companies have suspended paying dividends. If, as some say, dividends are irrelevant, why have share prices plunged in most of these companies?

Required:
In your answer, outline both dividend policy theory and relevant examples.

Dividend Policy Theories:

  1. Residual Theory of Dividend:
    • The residual theory suggests that dividends should only be paid after all positive Net Present Value (NPV) investment opportunities have been funded. The focus of management should be on investment decisions, not on dividends. Under this theory, if there are no investment opportunities, the firm may distribute excess cash as dividends.
    • Since dividends are seen as a residual, their impact on share price is minimal in this view, making dividends “irrelevant” to shareholders.
  2. Dividend Irrelevance Theory (Modigliani & Miller):
    • According to Modigliani and Miller’s (MM) theory, dividend policy does not affect the value of the firm or shareholders’ wealth, as long as the firm’s investment policy is unchanged. Shareholders can create their own “homemade” dividends by selling a portion of their shares if they need cash.
    • MM argue that share price is determined by future earnings and profitability, not by dividend payouts, assuming perfect capital markets, no taxes, and no transaction costs.
  3. Dividend Relevance (Bird in Hand Theory):
    • Gordon and Lintner argue that dividends are preferred to capital gains because they are more certain (the “bird in the hand” argument). Investors prefer to receive dividends now rather than rely on uncertain future capital gains, leading to a higher valuation for firms that pay dividends regularly.
    • According to this theory, when dividends are suspended or reduced, investors might perceive the company as less stable, leading to a drop in share price.
  4. Signaling Theory:
    • Dividends can serve as a signal to investors about a firm’s future prospects. A stable or increasing dividend is often interpreted as a sign of strong future earnings. Conversely, when a company suspends or cuts dividends, it may signal to investors that the firm is facing financial difficulties or expects lower future profitability, resulting in a decline in share price.
    • This signaling effect helps explain why share prices tend to plunge when dividends are suspended.
  5. Clientele Effect:
    • Different groups of investors, or clienteles, have preferences for dividend-paying stocks versus non-dividend-paying stocks. For example, retirees and institutional investors often prefer regular dividend payments to provide stable income. When a company suspends its dividends, it may alienate this group of investors, causing them to sell their shares and driving down the share price.

Why Share Prices Plunge When Dividends are Suspended:

  • Investor Expectations: Investors often expect stable dividends from multinational companies. The suspension of dividends creates uncertainty about the company’s financial health, which leads to negative market reactions.
  • Signaling Financial Stress: When dividends are cut or suspended, investors may interpret this as a sign of financial distress, which can lead to a sell-off in shares and a significant drop in share price.
  • Preference for Dividends: Many investors, particularly income-seeking investors, rely on dividends. When dividends are suspended, they lose confidence in the company, leading to a decline in demand for the stock, which causes the price to drop.

Example:

  • A well-known case is when companies like General Electric (GE) reduced dividends during financial crises. The cut in dividends sent negative signals to the market about the company’s performance and financial stability, which resulted in a sharp decline in its share price.

(10 marks)

  • 5 Marks

FM – Nov 2020 – L2 – Q4c – Dividend Policy

Distinguish between dividend irrelevance theory and traditional dividend relevance theory, and explain dividend relevance theories.

There are two major opposing views of dividend policy: the Modigliani and Miller’s dividend irrelevance theory and the traditional view of dividend policy.

Required:

i) Distinguish between the TWO (2) opposing views of dividend policy. (2 marks)
ii) Explain TWO (2) of the dividend relevance theories. (3 marks)

i) Dividend irrelevance theory vs. Traditional dividend relevance theory:

  • Dividend irrelevance theory (Modigliani and Miller):
    This theory, proposed by Modigliani and Miller, argues that in a perfect market (no taxes, no transaction costs, etc.), the dividend policy of a company does not affect the value of the firm. According to this view, the value of the firm is determined solely by its earnings power and risk of its underlying assets, and not by how it distributes its earnings between dividends and retained earnings.
  • Traditional dividend relevance theory:
    The traditional view suggests that dividend policy does impact the value of the firm. This theory argues that investors value dividends more highly than future capital gains because of the certainty associated with dividends. Consequently, higher dividends increase the value of the firm, and therefore, dividend policy should be designed to maximize shareholder wealth.

(2 marks)

ii) Dividend relevance theories:

  1. The Bird-in-Hand Theory:
    This theory posits that investors prefer dividends over future capital gains because dividends are more certain. According to this theory, investors view dividends as “a bird in the hand,” which is more valuable than “two in the bush,” i.e., potential future capital gains. As a result, companies that pay higher dividends will have higher share prices.
  2. The Signaling Theory:
    This theory suggests that dividend announcements convey information to the market about the company’s future prospects. For example, an increase in dividends may signal that the company’s management is confident about future earnings, leading to a positive reaction in the stock price. Conversely, a decrease in dividends may signal financial trouble, leading to a decrease in stock price.

(2 theories @ 1.5 marks each = 3 marks)

  • 10 Marks

FM – May 2020 – L2 – Q1a – Introduction to Financial Management

Brief the board of directors on the objectives and factors affecting investment, financing, and dividend decisions.

K-Force Ltd, a newly established security company, has constituted its first board of directors. The directors are expected, among others, to take financial decisions in the areas of investment, financing, and dividend payment. A consultancy firm has been engaged to run an orientation program for the directors in the coming week.

You work with the consultancy firm that has been engaged to run the orientation program for the new directors. You have been asked by your boss to prepare briefing notes on the specific roles the directors are expected to play in the three fundamental decision areas and the constraints that government policies might impose on them.

Required:
Prepare a briefing note on the nature of the three fundamental decision areas. Specifically, the briefing notes should cover the objective of each class of decision; TWO (2) specific decisions the directors are expected to take in each class of financial decisions; and TWO (2) factors in the external environment they should consider when making financial decisions.

Investing decisions
Investing decisions relate to the acquisition and disposition of assets that would generate cash flows for the firm. The objective is to achieve optimal allocation of limited resources to investment opportunities. Directors are expected to make decisions such as:

  • Deciding on growth strategy, whether to employ internal or external growth strategies.
  • Deciding on the proportion of the components of assets needed to achieve the firm’s objectives.

Financing decisions
Financing decisions are related to the mix of the various types of finance the firm should use. The objective is to minimize the risk and cost of finance. Directors are expected to make decisions such as:

  • Deciding on the blend of equity and debt in the financing structure.
  • Deciding on the method of issuing new securities.

Dividend decisions
Dividend decisions are related to the payment of dividends and retention of earnings for reinvestment. The objective is to achieve a balance between meeting shareholders’ expectations of current dividends and reinvesting enough earnings to achieve targeted growth. Directors are expected to make decisions such as:

  • Deciding on whether to recommend payment of dividends or reinvestment of earnings.
  • Deciding on the amount of dividend to recommend.

Relevant factors in the external environment
Directors should consider the following external factors when making financial decisions:

  • Laws and regulations
  • Economic factors
  • 5 Marks

FM – NOV 2015 – L2 – Q2c – Dividend Policy

Calculate the average dividend growth rate for Sankofa Ltd based on given earnings and dividend cover.

c. Sankofa Ltd has a dividend cover of 4 times and recorded the following earnings after tax:

Year Earnings (GH₵)
2010 100,000
2011 120,000
2012 180,000
2013 220,000
2014 300,000

Required:
Calculate the average dividend growth rate for Sankofa Ltd. (5 marks)

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