Page 23 - CIMA SCS Workbook February 2019 - Day 2 Suggested Solutions

CIMA FEBRUARY 2019 – STRATEGIC CASE STUDY

EXERCISE 3

Email

To: Paul Pau, CFO
From: Senior finance manager
Subject: Dividend policy

Introduction
I have explained below the main considerations when setting a company’s dividend policy, and
the terms “scrip dividend” and “share repurchase” that Chris Heloise mentioned in her email.
SETTING A DIVIDEND POLICY

Three inter-related decisions
The dividend decision can be seen as something of a balancing act. Given a certain amount of
available profit, the question is how much of it should be paid to the shareholders and how much
should be retained to finance the future growth of the company? On the face of it, more
dividends now means less available for future investment: therefore lower levels of future
growth; therefore less profit available in the future; and thus lower dividends in the future. Chris
recognises in her email that Vita needed to focus on investment rather than dividends when it
was a young and fast-growing company.

Whilst this tends to be seen as a decision of how to divide up the available profit (as above) the
company also needs to consider its cash position. The company may well have generated a
reasonable amount of profit but this may not be reflected in the cash balance.

However, the situation is further complicated by the availability of other sources of funds. If, for
example, debt funds could be used to finance the future growth then less of the profit is needed
so more can be paid as dividend. This is then linked to the decision about gearing levels.
Thus, the dividend decision, the investment decision, and the financing decision all affect one
another. No one decision should be taken without considering the impact on the other two.
Theoretical factors – Modigliani and Miller

There is no real theoretical answer to this problem. The available theory (Modigliani & Miller’s
dividend irrelevance theory) claims that it is not a problem; if the company has available
investment opportunities with positive NPVs, then these should take precedence over dividends.

In theory this will increase shareholder wealth whereas paying dividends does not.
However, the theory depends on a number of assumptions (the key ones being no differential
taxes and no transaction costs) which are simply not valid in practice.
Thus the theory is of little practical use.
Practical factors

In reality, apart from the interrelationships explained above, there are two main considerations in
deciding on the dividend to be paid:
The clientele effect

This is the idea that, over time, a company with a given dividend policy (whatever that may be)
will attract as its shareholders those investors who want that particular policy. Thus whatever
policy the company chooses it should stick to it.

82 KAPLAN PUBLISHING