Professional Documents
Culture Documents
a Dividend policies are the regulations and guidelines that companies develop 5 marks
and implement as the means of arranging to make dividend payments to
shareholders.
Establishing a specific dividend policy is to the advantage of both the
company and the shareholder
The companies have two options with them:
They can retain these profits within the company
They can pay these profits in the form of dividends to their
shareholders
b 1. The liquidity position of the firm – just because a firm has income 5 marks
doesn’t mean that it has any cash to pay dividends.
2. Need to repay debt – oftentimes there are negative covenants that
restrict the dividends that can be paid as long as the debt is outstanding.
3. The rate of asset expansion – the greater the rate of expansion of the
firm, the greater the need to retain earnings to finance the expansion.
4. Control of the firm – if dividends are paid out today, equity may have to
be sold in the future causing a dilution of ownership.
5. Legal Considerations:
Technically, it is illegal to pay a dividend except out of retained
earnings. This is to prevent firms from liquidating themselves
out from underneath the creditors.
From revenue authority – Improper Accumulation of funds. This
is to prevent individuals from not paying dividends in order to
avoid the personal income taxes on the dividend payments.
C (i) Net income = shs. 7,000,000, amount needed to finance project internally = 5 marks
60% of 10,000,000, hence is 6,000,000. Residual is 1,000,000, therefore shs.
1,000,000 will be used to pay dividend if residual policy is followed;
C (ii) If the company decides to maintain last year's dividend, how much will it 5 marks
pay out in dividends this year?
Distribution = last annual dividend per share * outstanding shares
Distribution = shs. 0.50 *5,000,000 = shs. 2,500,000
Question no. 2
a Given data: (10 marks)
No of ordinary shares oustanding =100,000
Price of share ex-dividend shs 6.12
Cost of new project shs. 100,000
Growth rate 6%
Net income (old) 175,000
Additional income 45,000
Total expected income shs. 175,000 + 45,000
Question no. 3
a 14
P/E ratio: because Chwaka ltd is an unquoted company its ratio will be below the
marks
industry of 12 due to the increased risk. However, it has a better profit record than
company with a ratio of 8. Therefore ratio could be in the rage of 8 to 10.
Earnings the average earnings over the last five years are shs. 57,200, over the last
four years (60+63+59+64)/4 = shs. 61,500. The growth pattern of the earnings is
uncertain however; therefore a low estimate of future earning could be shs. 61,500
and higher estimate shs. 64,000 a range could be as:
• With high P/E ratio and high earnings the company can be valued at 10
x shs. 64,000 = shs. 640,000
• With low P/E ratio and low earning company’s valuation is 8 x 61,500 =
shs. 492,000
b Dividend yield is a way to measure how much cash flow you are getting for each 2
(i) shilling invested in an equity position marks
A financial ratio that shows how much a company pays out in dividends each year
relative to its share price. In the absence of any capital gains, the dividend yield is
the return on investment for a stock
Formula is not useful in investment process but is used as yardstick on how better is
the company in question.
b 2
The EPS is to be multiplied by the P/E ratio to arrive at the market price of equity
(iii) share (MPS). marks
The P/E ratio may be derived given the MPS and EPS.
A high P/E multiple is suggested when the investors are confident about the
company's future performance/prospects and have high expectations of future
returns; high P/E ratios reflect optimism.
a low P/E multiple is suggested for shares of firms in which investors have low
confidence as well as expectations of low returns in future years; low P/E ratios
reflect pessimism
Question no 4