Tutorial 7

Company A

Profit after tax

2014
RM000
1,168

Dividend per share 23.36

(sen)
Ordinary shares
2500
Dividends
Dividends payout
(%)

2013
RM000
1,260

2012
RM000
1,064

2011
RM000
856

25.20

26.6

21.4

2500

2000

2000

532
(532/1064)100
=50%

428
(428/856)100
=50%

584
630
(584/1168)100 (630/1260)100
=50%
=50%

Company B

Profit after tax

Dividend per
share (sen)
Ordinary shares
Dividends

2014
RM000
1435
25.2

2013
RM000
1260
25.2

2012
RM000
1064
25.1

2011
RM000
1956
25

3500

3500

3500

3500

882

882

878.5

875

(882/1260)100
=70%

(878.5/1064)100
=82.57%

(875/1956)100
=44.73%

Dividends payout (882/1435)100

(%)
=61.46%

The above calculations show that company A has adopted a policy of paying
dividends at a constant rate of 50% of profit after tax. This dividend payout policy is
not normally recommend as it might cause a fluctuating dividend per share if earnings
are volatile. A wide fluctuation in dividend per share may not convince investors who
seek minimum cashflow from dividend payments. But for investors who prefer their
income in the form of capital gains, the 50% payout ratio will be welcomed by them
because of the tax advantage on capital gains.
Company B maintains a constant dividend per share which will increase along with
inflation. The companys payout ratio is much higher than company A perhaps to
satisfy its own investor group. Both companies assume that dividend policy is
important to their investors and potentially their share price. However, this is in
contrast with to the MM theories which advocate that dividend policy is not relevant.
These companies decide on dividend payments on profit after tax but the management
should check on the companies cashflows.

2.
Investment, dividend and financing decisions are known as the decision triangle of
financial management. These decisions are closely related. When a company decides
to increase dividends, the action might reduce retained earnings for future
investments. Hence, the company need to source for external finance in order to meet
the requirements of proposed capital investment projects. Similarly, when the
managers allocate more earnings for capital investments, the payment of dividends
will be reduced.
Miller and Modigliani explored the relationship between the three decision areas.
Their conclusion was that, in a perfect capital market, the market value of a company
and its weighted average cost of capital (WACC) were independent of its capital
structure. Their remark is that the market value of a company relates directly to
business risk of the company and not on its financial risk. They noted that operating
income of a company that arise from investment decision is important in determining
its market value, while the financing decision, given their assumptions, was shown to
be not relevant in this context. However, in practice, it is argued that capital structure
may alter companys WACC and the market value will be adjusted accordingly.
Miller and Modigliani also analysed the relationship between dividend policy and the
share price of a company, i.e. the market value of a company. In their opinion, in a
perfect capital market, the share price of a company did not depend on its dividend
policy, i.e. the dividend decision was irrelevant to value of the share. The market
value of the company and therefore the wealth of shareholders were shown to be
maximised when the company implemented its optimum investment policy, which
was to invest in all projects with a positive NPV. The investment decision was
therefore shown to be theoretically important with respect to the market value of the
company, while the dividend decision was not relevant.
In practice, capital markets are not perfect and a number of other factors become
important in discussing the relationship between the three decision areas. Pecking
order theory, for example, suggests that managers do not in practice make financing
decisions with the objective of obtaining an optimal capital structure, but on the basis
of the convenience and relative cost of different sources of finance. Retained earnings
are the preferred source of finance from this perspective, with a resulting pressure for
annual dividends to be low rather than higher.

3.
DPS= $3.00, Target equity ratio=60%, Target debt ratio=40%
Shares outstanding=1.0 million, Net income= $8.0 million
Total capital budget =$10.0 million

a) if the company follows the residual dividend model, how much retained earnings
will it need to fund its capital budget?

Required retained earnings= total capital budget x target equity ratio

= $10.0m x 60%= $6.0m

b) If the company follows the residual dividend model, what will be companys
dividend per share and dividend payout ratio for the coming year?
Dividend per share = (net income-required RE) / shares outstanding
= ($8.0m-$6.0m)/ 1.0m
= $2.00 (so, the following residual policy would requires a dividend cut)
Dividend payout ratio
= dividend paid/net income
=$2.0m/$8.0m
=25%

c) If the company maintains its current $3.00 DPS for next year, how much retained
earnings will be available to support the companys capital budget?
Desired DPS=$3.00
Retained earnings for cap.budget = net income-(DPS x no. of shares)
= $8.0m- ($3.00 x 1.0m)
= $5.0m

d) Can the company maintain its current capital structure, maintain the $3.00 DPS,
and maintain a $10 million capital budget without having to raise new common stock?
Provide reason.
No. The required retained earnings to maintain the capital structure is $6 million [as in
(a)], while the retained earnings left for the capital budget if the $3 dividend is
maintained is only $5 million [as in (c)]. This means the firm would have to issue new
common stock (e). If the company wants to maintain the $3.00 DPS and in addition,
the company wants to maintain its target capital structure (60 percent equity, 40
percent debt) and maintain $10 million capital budget, what is the minimum dollar
amount of new common stock that the company would have to issue in order to meet
each of its objectives?
From (a), we see the required retained earnings is $6 million, but we see in part (c)
that there would only be $5 million available in retained earnings. Therefore, the
company must issue $1 million new common stocks.

4a) Expected cost of investment

Inflation
condition

Probability (P)

Cost of
Investment
RM million
(R)

RM million
PxR

P (R-)2

High Inflation

0.4

30

0.4*30=12

0.4(3028.4)2=1.024

Moderate
inflation
Low inflation

0.5

28

0.5*28=14

0.1

24

0.1*24=2.4

0.5(2828.4)2=0.08
0.1(2428.4)2=1.936
P(R)2=3.04

PxR

28.4
Expected cost of investment () = P x R= RM28.4 milliom
Standard deviation ( )=

P(R- )2= 3.04 =RM1.74 million

28
b) (i) dividend growth, g= 4 20 1
= 1.08775-1
= 0.08775*100
= 8.78%

ii) Dividend for 2015= 28sen (1+0.8775) =30.46sen

Shares outstanding=30,000,000
Net income=31000000
Forecast investment cost= 28,400,000
MV of equity
MV of debt

=30,000,000 shares*RM6.2
=RM
15000000*(RM102.50/RM100
)

Total capital

=RM 186,000,000
=RM 15,375,000

=RM201,375,000

Required retained earnings = RM28,400,000 *(RM 186,000,000/ RM 201,375,000)

= RM 26,231,657
External finance= RM (28,400,000-RM26,231,657)

= RM 2,168,343

5.
Advantages of companies paying dividends
A company attempts to signal the capital market about the potential growth and
positive net present value prospects of its attempt to penetrate the larger market share
within their products. Paying good dividends can underscore good results and provide
support to share price. Payments of good dividends may attract institutional investors
who prefer some return in the form of dividends. A mix of institutional and individual
investors may allow a company to raise capital at lower cost because of the ability of
the company to reach a wider market. When a company pay good dividends, investors
will have more confidence towards the company and due to high demand for the
shares, the share price will increase. Dividends absorb excess cash flow and may
reduce agency costs that arise from conflicts between management and shareholders.
Disadvantages of companies paying dividends
Dividends can reduce internal sources of financing. Dividends may force a company
to forgo positive NPV projects. A dividend paying company ought to rely on costly
external financing. With an established dividend policy, it is difficult for a company to
cut the dividend because a change in adverse dividend policy may adversely affect
share price.