Page 24 - CIMA SCS Workbook August 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

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.
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.
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). A stable dividend policy
enables investors to predict with reasonable certainty what their income will be each year.

The concerns of Fiona Finch and John Small

Introduction
Both Fiona and John have sent emails entitled “Dividend concerns”. However, they are concerned
about very different issues! I have first looked at the dividend policy of FNG over the last few
years, and then I have addressed each of their concerns in turn.

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