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Chapter 11 Developing a Dividend Policy Answers to Review Questions 11.1 • • • • • A business may decide to repurchase shares in order to: Return surplus cash to shareholders Get rid of unwelcome shareholders Adjust its capital structure Increase future EPS by decreasing the number of shares outstanding. Support its share price or help in leasing it. 11.2 The residual theory of dividends states that dividends can be regarded as a residual amount arising when the business does not have enough profitable opportunities in which to invest. The argument assumes that shareholders will prefer the business to reinvest earnings rather than pay dividends, as long as the returns earned by the business exceed the returns that could be achieved by shareholders investing in similar projects. However, when all the profitable projects that meet this criterion have been exhausted, any surplus remaining should be distributed to shareholders. Thus, dividends will be, in effect, a by-product of the investment decision. 11.3 The type of distribution policy adopted may not be critical because of the clientele effect. The particular distribution policy will attract a certain type of investor depending on his or her cash needs and tax position. Thus, investors who rely on dividend income to meet living expenses may prefer a high payout policy, whereas investors with high marginal tax rates may prefer a low (or zero) payout policy. 11.4 Agency theory is based on the idea that the business is a coalition of interest groups, with each group seeking to maximize its own welfare. This behaviour is often at the expense of the other groups, and so agency costs arise. In order to minimize these agency costs, the particular group bearing the costs may seek to restrain the actions of others through contractual or other arrangements. Thus, in order to prevent managers from awarding themselves various perks, the shareholders may insist that all surplus cash be returned to them in the form of a dividend. Similarly, in order to prevent shareholders from withdrawing their investment in the business and allowing lenders to bear all—or the majority of—the risks of the business, the lenders may seek to limit the amount that can be declared in the form of a dividend. Copyright © 2009 Pearson Education Canada 1 11.5 The dividend growth model has validity because at some point investors expect to receive a cash return on their investment. However, as we have seen in Chapters 6 and 7 on capital budgeting, young, fast growing companies often have many more high return investment opportunities than they have cash available. So, often these types of companies do not pay dividends but instead plough money back into their firm in order to generate even more profits. Investors hope to be rewarded with capital gains instead of dividends as the share price appreciates. Cash is cash, whether it comes in the form of a dividend or from selling some shares at a higher price for a capital gain. Copyright © 2009 Pearson Education Canada 2