Going public and the dividend policy of the company

Dividends as a Residual Profit Decision

It would seem sensible for a company to continue to reinvest profit as long as projects can be found that yield returns higher than its cost of capital. In this way, the company can earn a higher return for shareholders than they can earn for themselves by reinvesting dividends. Such a policy can be optimal, however, only if the company maintains its target-gearing ratio by adding an appropriate proportion of borrowed funds to the retained earnings. If not, the company’s coast of capital would increase because of its disproportionate volume of higher-cost equity capital; this would be reflected share price.

Activity:

The LTD Company has the chance to invest in the five projects listed below:

Projects

Capital outlay, ₤

Yield rate, %

A

70.000

18

B

100.000

17

C

130.000

16

D

50.000

15

E

100.000

14

The company cost of capital is 16% its optimal debt to net assets ratio is 30% and the current year’s profit available to equity shareholders is ₤350.000.

Required:

State which projects would be accepted, and what is the total finance requires for those projects.

Assuming that the company wishes to maintain its gearing ratio, how much of the required finance will be borrowed?

How much of this year’s profit can be distributed?

The answers:

A, B and C, with yield greater than or equal to the company’s cost of capital; total finance required ₤300.000.

Amount to be borrowed: 30% of ₤300.000=₤90.000.

This year’s profit:₤350.000

less amount to be reinvested ₤300.000-₤90.000: 210.000

Profit for distribution: 140.000

Company’s shareholders obtain the best of both words. They can invest the ₤140.000 received as dividends to earn a higher rate of return than the company could earn for them; and the ₤210.000 retained by the company is reinvested to shareholders’ advantage. Shareholders’ wealth is optimized, and the dividend paid is simply the residual profit after investment policy has been approved.

If companies look upon dividend policy as what remains after investments are decided then the search for an optimum dividend policy is pointless. Shareholders wanting dividends can always make them for themselves by selling some of their shares.

Further support for the ‘residual’ theory of dividends, and the argument that the change in dividend policy does not affect share values, was advanced by Modigliani and Miller in 1961. They contended that in a perfect market the increase in total value of a company after it has accepted an investment projects is the same, whether internal or external finance is used.

One deficiency in the Modigliani and Miller hypothesis, however, is that they ignore costs associated with an issue of shares, which can be quite considerable.

Costs Associated with Dividend Policy

Capital floatation costs are a deterrent substituting external finance for retained earnings but there are other costs affected by the dividend decision.

If shareholders are left to make their own dividends by selling some shares, this involves brokerage and other selling costs that, on a small number of shares, can be extremely an economic. In addition, if they have to be sold during a period of low share price, capital losses may be suffered.

Another important factor is taxation. First, when the company distributes dividend it has to pay an advance installment of corporation tax (ACT), currently one quarter of the amount paid. But the offset against mainstream liability to pay corporation tax will be delayed by at least one year. Indeed, if the company does not currently pay this type of tax, the delay in setting off ACT will be even longer, and this will tend to restrain extravagant dividend distributions.

Second, from the investors’ viewpoint profitability invested retained earnings should increase share values, enabling shareholders to create their own dividends. Selling shares creates a liability to capital gains tax, currently 20%, 23% or 40%, but subject to a fairly generous exemption limit. By comparison, dividends in the hands of shareholders attract