Page 24 - CIMA SCS Workbook February 2019 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

The signalling effect

The shareholders think that the dividend declared each year reflects the directors’ confidence in
the future performance of the company. Thus dividends should not be varied year on year just
because of short term fluctuations in company performance.
Possible choices

Bearing in mind all the points addressed above, there are a number of different policies that
companies can follow. The main choice is between:

Residual dividend
Here any available profits are first used to invest in positive NPV projects. A dividend is only paid if
there are profits left after all available positive NPV projects have been undertaken. This is
following the theory mentioned above.
Constant pay-out ratio
Each year the dividend paid is a fixed proportion of that year’s available profit.

Stable dividends
The company pays a constant dividend each year, or a dividend growing at a constant rate.

Zero dividend policy
No dividend is paid out, but instead all the cash generated is kept in the business to invest in new
investment opportunities.
The first two of these end up with varying and largely unpredictable dividends and, if there is one
thing that shareholders dislike above all else, it’s uncertainty (or risk). However, the stable
dividend policy and the zero dividend policy don’t make a link between investment needs or
profitability and dividend levels.

THE SUGGESTIONS OF CHRIS HELOISE
Introduction

Chris Heloise suggests that Vita could undertake a scrip dividend or share repurchase. I have
explained these two terms below, and outlined the advantages and disadvantages to Vita of using
these strategies.

Scrip dividend
Definition

A scrip dividend does not involve the payment of any cash to shareholders. Instead, the
shareholders are given bonus shares in proportion to their existing holdings (so for example a 1
for 5 scrip dividend involves issuing 1 new share for every 5 held at the moment).
Advantages and disadvantages of paying a scrip dividend

The main advantage to Vita of offering a scrip dividend is that the company is giving something to
shareholders but keeping cash within the business at the same time. The shareholders might see
the scrip dividend as a positive signal and be pleased to have a higher number of shares. However
this last point could be a problem to Vita in the future.
After a scrip dividend there are more shares in issue, so the shareholders might have expectations
of higher dividends in the future when the zero dividend policy ends. Therefore in the long term,
offering a scrip dividend now might contribute to a greater annual cash flow commitment for Vita.

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