Pesca Artesanal

problem

(a) (i) Cum dividend price after declaration of £150 000 dividend = 140p. The total value of Pulini plc will be £1.4 million.

(ii) The current price reflects the expected dividend of £150 000. The share price should increase by the NPV of the contract.

KE = + = Dividend = = Ex div value NPV £80 000 £80 15 125 12% 000 0.12 – £ . 22400 012 = +560 000 Share price should increase by £560 000 ÷ 1mn = 56p;

Revised cum dividend price = 196p; Revised total value = £1.96mn.

(iii) By using the £80 000 revenue from the project Pulini can increase its current dividend from 15p to 23p per share. The way in which the market responds to this will depend upon whether it is efficient in the semi-strong or strong form.

(1) Semi-strong. The revised price will depend upon whether the market sup-

poses that the increased dividend is a one-off payment for this year only, or, based on Pulini’s past record of constant dividends, anticipates the increased dividend to continue indefinitely:

One-off: Cum-div price = 140p + 8p = 148p Total value £1.48mn.

Continuing: 23p+23p =215p 0.12

Total value £2.15mn.

(2) Strong form. If the market is efficient in the strong form it will learn of the

project and the share price will adjust to 196p as calculated in part (ii) above. (b) In theory, dividends are a passive residual in the context of financial decision making. As the positive net present value of investment projects accrues to shareholders it must necessarily be the company’s aim to undertake all projects giving a positive net present value even if this entails reductions in dividends below previously existing levels. Funds not required for investment will be paid out as dividends. For these ideas to be valid there must be perfect information about company activities available to shareholders, who must understand and believe the information. They will then accept any reduction in dividend as being in their own interest and the share price will in fact rise to reflect this improvement in the value of the company.

In the short term at least, the reduction of dividends to finance beneficial investment would in theory substitute a capital gain for dividends. Shareholders must be prepared to accept this distribution. They will do so only if they can borrow at the same rate as the company (and repay later out of a future enhanced dividend) or if they can realize the capital gain to obtain cash in substitution for the dividend. These will only be adequate substitutes if there are no transaction costs or distorting taxes.

If the conditions necessary to uphold the ‘dividend irrelevancy theory’ were met in practice then dividends would truly be a residual and not a determining factor in the

Chapter 22 The dividend decision

valuation of a company. However, in reality, they do not hold well and it is necessary to examine those aspects of dividend policy which may in practice affect a company’s market value.

It is information which determines share price and one of the principal pieces of objec- tive information available to investors to assist them in pricing shares is the level of divi- dend. Whilst published accounts and reported earnings are extremely useful, they are both historical, indicating what the company has done rather than what it is doing or will do. Dividends are, by contrast, an indicator of the current state of the company and its future prospects. The amount of, and trends in, dividends are thus strongly reacted to by the market. This is strikingly illustrated by the different reactions to reduced dividends in theory and practice. In theory this could well herald further beneficial investment and increased company value whereas in practice it is likely to be seen as evidence of severe difficulties and the share price is likely to drop. Even if the management set out clearly their intentions for the use of funds, it is possible that the message will not be fully under- stood, or may be treated with scepticism. In view of these practical realities, company management are likely to pursue a policy of dividend stability and, where possible, steady growth at a prudent rate. Above all shareholders require a consistent policy. Where this is possible, uncertainty, and hence risk, is reduced. The rate of return required by investors may therefore be adjusted downwards leading to higher market capitalization.

In summary, investors are not indifferent between current dividends and the retention of earnings with the prospect of future dividends, capital gains, or both. They prefer the resolution of uncertainty and are willing to pay a higher price or a share that pays a greater current dividend, all other things being equal.

(c) The factors that will influence company management’s dividend policy relate essen- tially to prudence, company funding requirements and regard for individual sharehold- ers’ requirements.

With regard to prudence, it might well be that whilst a company makes good profits, a significant proportion of these may not be realized in cash terms and it is therefore not possible to pay substantial dividends without placing strains on the company’s liquidity. Dividends must be budgeted for as an integral part of the cash flow forecast and where necessary further funds obtained for the purpose of dividend payments. The alternative to this is a more restrained payout policy.

Company management will also have regard to future funding requirements. Use of retained earnings is one of the simplest and cheapest ways of obtaining finance for expan- sion, and it is therefore quite attractive to management to pursue a relatively low payout policy in order to retain funds for expansion. The company’s access to capital markets will also play a large part in the decision on retention policy. A company with ready access to capital markets may in practice prefer a higher payout policy coupled with regular rights issues rather than keep dividends deliberately low to provide a large pool of retained earn- ings. Smaller companies cannot count on this advantage and therefore in practice will seek funding largely from retained earnings.

In financial management it is generally assumed that the objective of company man- agement is to follow a policy of maximizing the wealth of shareholders. To this end divi- dend policy is of vital importance. Clearly a high retentions policy is commensurate with high capital growth in share value whilst high payouts will benefit shareholders who require high income. Whilst in a perfect capital market with no taxes this differentiation of policy would be irrelevant, in actuality the tax position of shareholders will signifi- cantly influence their accumulation of wealth through shareholdings. Whilst in large companies researching shareholders’ preferences and setting policy accordingly might be impracticable, this will not necessarily be so in small companies where tax consider- ations may well play an extremely important part in setting dividend policy.

It should not be forgotten that dividends can only be paid regularly where the company is inherently profitable and hence management must examine profitability in setting dividend policy, and in particular the stability of earnings. Where earnings are very stable the company will be less at risk in following a high percentage payout policy than if earnings are extremely volatile. Dividend cuts are usually anathema to company management as the market is likely to consider that this presages bad news, with conse- quent disastrous effects on share price. Hence companies with volatile earnings are unlikely to risk dividend cuts by pursuing a high payout policy. Indeed good dividend policy is to pursue the ideals of stability and consistency. Variable dividends are uncer- tain dividends, giving rise to an increased risk perception in shareholders. This feeds through into a higher required return and hence lower market capitalization, defeating the company aim of shareholder wealth maximization.

While the conventional models assume the objective of maximization of shareholder wealth this may not be the objective being pursued by particular companies. It may be that corporate managers are pursuing alternative objectives such as sales maximization, market share maximization or the maximization of managerial discretion subject to the constraint of providing an acceptable return to investors. Alternatively managers may not be maximizing at all but may be ‘satisficing’, i.e. pursuing a battery of parallel objec- tives. In such circumstances they will need to modify their dividend policies to suit the objectives they are pursuing. In any event they will need to know what constitutes an acceptable return to their investors and this in turn requires a knowledge of what can be earned on similar risk investments elsewhere, i.e. the opportunity cost of capital.

Finally it cannot be forgotten that there are legal requirements governing dividend payments and company management must have regard to the legal definitions of distrib- utable profits.

problem

(a) Net present value to Charles Pooter (Contractors) Ltd: NPV = –3 000 + 800(1.04) + 1 000(1.04)–2+ 1 700(1.04)–3 NPV= –3 000 + 769 + 925 + 1 511 = +£205

(b) (i) Lupin is satisfied (as stated in the question). Charles can borrow one half of the present value of the cash inflows from the project (i.e. he can borrow the present value of the dividends he expects to receive):

Charles can borrow (1

2× £3 205) £1 602 at 4% (and go on the cruise)

Interest Year 1 at 4% 64 1 666 Repay end Year 1 (1

2× £800) 400

1 266 Interest Year 2 at 4% 51 1 317 Repay end Year 2 (1

2× £1 000) 500

817 Interest Year 3 at 4% 33 850 Repay end Year 3 (1

2× £1 700) 850

By borrowing, and using his dividends to repay the loan, Charles is £102 better off if the project is accepted than if it is rejected. So the company is acting in the best interests of both shareholders by accepting the project.

(ii) Lupin is still satisfied (as stated in the question). The present value of Charles’s dividends at a 10% discount rate is:

400(1.10)–1+ 500(1.10)–2+ 850(1.10)–3 = 400(0.9091) + 500(0.8264) + 850(0.7513) = £1 415

which is the maximum amount he could borrow and repay out of his share of the project dividends. He would be better off with an immediate dividend of £1500. So the company is not acting in the best interests of both shareholders.

(c) The above analysis suggests that the net present value rule results in correct invest- ment decisions provided that all shareholders have the same ‘cost of capital’ as the company, even if their consumption preferences vary. Any shareholder can adjust his dividend receipts to fit his desired consumption pattern by lending or borrowing. (b)(ii) suggests that the net present value rule needs to be applied cautiously where sharehold- ers’ costs of capital differ from the company’s (e.g. where capital markets are imperfect). In this case it may not be possible for shareholders to adjust their consumption patterns by lending or borrowing without incurring an interest cost different from the company’s.