Topic: Dividend Policy

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  • 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 – March 2023 – L2 – Q1b – Discounted cash flow | Dividend Policy

Calculate the value of a share for Oliso Ghana Ltd using projected dividend growth rates and the total value for an investor holding 1,500 shares.

Oliso Ghana Ltd paid a dividend of GH¢120 per share two years ago. In the previous and current year, dividend grew by 10% per annum. Starting from next year, dividend is projected to grow by 15% for the next three years and then 10% for another three years and finally settling at 12% forever. The investors expect 20% returns.

Required:
i) Calculate the value of a share in cedis for Oliso Ghana Ltd. (8 marks)
ii) If an investor holds 1,500 shares of the company, what will be the total value in cedis? (2 marks)

i) Calculation of value of a share:

  • Dividend two years ago: GH¢120
  • Growth rate over the last 2 years: 10%
  • Current dividend level:

Dividend projections for the next 6 years:

Year Dividend Growth Rate DF @ 20% Present Value
1 167 15% 0.833 139.11
2 192 15% 0.694 133.25
3 221 15% 0.579 127.96
4 243 10% 0.482 117.12
5 267 10% 0.402 107.33
6 294 10% 0.335 98.49
Total PV of Dividends 723.26

Calculation of price at period :

Present value of price at period 6:
PV6​=4,116×0.335=GH¢1,379

Total value today:
Total Value = 723.26 + 1,379 = GH¢2,102.26

ii) Value of 1,500 shares today:

 

 

  • 6 Marks

FM – MAY 2019 – L2 – Q5b – Business valuations | Dividend Policy

Identify and explain the weaknesses of the dividend growth model as a method for valuing companies.

Question:
The dividend growth model also has its fair share of criticism. While some have hailed it as being indisputable and not subjective, recent academicians and practitioners have come up with arguments that make you believe the exact opposite. Recent studies have unearthed some glaring flaws in what was considered to be a perfect valuation model.

Required:
Identify and explain THREE (3) weaknesses of the dividend growth model as a way of valuing a company with shares. (6 marks)

b) The dividend growth model (DGM) is used widely in valuing ordinary shares and
hence in valuing companies, but there are a number of weaknesses associated with
its use.

  • The future dividend growth rate
    The DGM is based on the assumption that the future dividend growth rate is
    constant, but experience shows that a constant dividend growth rate is, in reality,
    very rare. This may be seen as less of a problem if the future dividend growth rate
    is regarded as an average growth rate. Estimating the future dividend growth rate
    is very difficult in practice and the DGM is very sensitive to small changes in this
    key variable. It is common practice to estimate the future dividend growth rate by
    calculating the historical dividend growth, but the assumption that the future will
    reflect the past is an easy one to challenge.
  •  The cost of equity
    The DGM assumes that the future cost of equity is constant, when in reality it
    changes quite frequently. The cost of equity can be calculated using the capital
    asset pricing model, but this model usually employs historical information, which
    may not reflect accurately expectations about the future.
  •  Zero dividends
    It is sometimes claimed that the DGM cannot be used when no dividends are paid,
    but this depends on whether dividends are expected in the future. If dividends are
    forecast to be paid from a future date, the dividend growth model can be applied
    at that point to calculate a share price, which can then be discounted to give the
    current ex dividend share price. Only in the case where no dividends are paid and
    no dividends are expected to be paid will the DGM have no application.

(3 points well explained @ 2 marks each = 6 marks)

  • 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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