Download Chapter 11 Developing a Dividend Policy

Chapter 11
Developing a Dividend Policy
Answers to Review Questions
11.1
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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.
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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.
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