Business Finance Decisions

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The dividend decision

Dividend irrelevancy theory

In an efficient market, dividend irrelevancy theory suggests that, provided all retained earnings are invested in

positive NPV projects, existing shareholders will be indifferent about the pattern of dividend payouts. But there

are certain points against dividend irrelevance:

Reductions in dividend can convey bad news to shareholders (dividend signalling).

Changes in dividend policy, particularly reductions, may conflict with investor liquidity requirements

Changes in dividend policy may upset investor tax planning

Companies attract a certain clientele of shareholders precisely because of their preference between income and growth (Clientele effect)

Example 1

X limited has in issue 5 million shares having market value of Rs 50 each. The dividend proposed for the

current year is Rs 5 per share. The company can invest cash surpluses at 10% pa at the same level of risk as

current operations. Compute the effect on shareholders wealth of the following options: (a) continuing with the current dividend

(b) retaining an extra Rs 10 millions and investing it at 10%

(c) paying out normal dividend and raising an additional Rs 10 million for investment at 10% by right issue

Practical influences on dividend policy

levels of profitability

inflation

growth

control

tax

liquidity/cash

other sources of finance.

Types of dividend policy

Stable dividend policy

Constant payout ratio

Zero dividend policy

Residual dividend policy

Winter 2011Q1 (a) Briefly discuss the Dividend Irrelevance Theory developed by Miller and Modigliani

(MM). State three arguments against the validity of this theory. (05 marks)

(b) Al-Ghazali Pakistan Limited (AGPL) is a listed company whose shares are currently traded at Rs. 80 per

share. AGPLs Board has approved a proposal to invest Rs. 600 million in a project which is expected to commence on 31 December 2012. There are no internal funds available for this investment and the company

would have to finance the project from the profit for the year ending 31 December 2012 and through right

issue. AGPL has a share capital consisting of 20 million shares of Rs. 10 each and its profit for the year ending

31 December 2012 is projected at Rs. 250 million. The annual return on 1-year treasury bills, the standard

deviation of returns on AGPLs shares and the estimated correlation of returns with market returns are 7.5%, 8% and 0.8 respectively. The current market return is 12.9% with a standard deviation of 5%.

Required:

Using MM Theory of Dividend Irrelevance, estimate the price of AGPLs shares as at 31 December 2012, if the company declares:

(i) 20% dividend

(ii) Nil dividend (05 marks)

(c) Justify the MM Theory of Dividend Irrelevance, based on your computation in (b) above.(05 marks)

Business Finance Decisions

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Right issues

Theoretical ex-right price

It is the price of the shares after the issue of right shares: MV of old shares + cash from new shares

Total no of shares in issue

Value of a right

Ex-right price minus issue price

Example 2

ABC has 1 million shares in issue having a market value of Rs 20 per share. A one for four right issues at Rs 15

per share has been made. Determine the ex-right price and the value of a right.

Winter 2009 Q5 Sajawal Sugar Mills Limited (SSML), a medium sized listed company, is planning to expand

its production capacity. The management has estimated that the expansion would require an outlay of Rs. 300

million. Following have been extracted from SSMLs financial statements for the year ended June 30, 2009.

To finance the expansion, SSML is considering a right issue. However, the management of SSML wants to

maintain its existing debt equity ratio, return on total assets ratio and dividend payout percentage. Moreover,

they wish to keep the ex-right price to be the same as current market price. SSML follows a policy of retaining

30% of its profits. The current market price of its shares is Rs. 20 whereas its share price beta is 1.23. Presently,

market return is 16% whereas yield on one year treasury bills is 12%. Market is assumed to be strong form

efficient.

Required: Under the circumstances referred to in the above situation, what should be:

(a) The right ratio (b) The right offer price

(c) Theoretical ex-right price (d) Value of each right (17)

Past papers

Qs. no in paper Attempt Topic Level of difficulty

5 W 09 Right issues Average

1 S 10 Dividend policy calculations Average

5 S 10 Right issues Difficult

1 W 11 Dividend irrelevance Average