You are on page 1of 4

SECTION E

CORPORATE DIVIDEND POLICY - QUESTIONS

QUESTION 96
Pavlon Ltd has recently obtained a listing on the Stock Exchange. 90% of the companys shares were
previously owned by members of one family but, since the listing, approximately 60% of the issued shares
have been owned by other investors.
Pavlons earnings and dividends for the five years prior to the listing are detailed below:
Years prior to listing
5
4
3
2
1
Current year

Profit after tax (Rs.)

Dividend per share (paisas)

1,800,000
2,400,000
3,850,000
4,100,000
4,450,000
5,500,000 (estimate)

3.6
4.8
6.16
6.56
7.12

The number of issued ordinary shares was increased by 25% three years prior to the listing and by 50%
at the time of the listing. The companys authorized capital is currently Rs 25,000,000 in 25 paisas
ordinary shares, of which 40,000,000 share have been issued. The market value of the companys equity
is Rs. 78,000,000.
The board of directors is discussing future dividend policy. An interim dividend of 3.16 paisas per share
was paid immediately prior to the listing and the finance director has suggested a final dividend of 2.34
paisas per share.
The companys declared objective is to maximize shareholder wealth.
Requirements.
(i)

Comment upon the nature of the companys dividend policy prior to the listing and
discuss whether such a policy is likely to be suitable for a company listed on the Stock Exchange.
(6 marks)

(ii)

Discuss whether the proposed final dividend of 2.34 paisas is likely to be an appropriate
dividend:
if the majority of shares are owned by private individuals;
if the majority of share are owned by institutional investors.
(6 marks)

(b) Assume that the final dividend of 2.34 paisas is paid and that dividends are generally expected to
increase by 15% per year for three years, and 8% per year after that. Pavlons cost of equity capital
is estimated to be 12% per year. Using the dividend valuation model give calculations to indicate
whether. Pavlons shares are currently undervalued or overvalued. (5 marks)
QUESTION 97

E-1

SECTION E

CORPORATE DIVIDEND POLICY - QUESTIONS

Idomeneo Ltd is considering whether to invest in a project with a life of two years. The project involves the
purchase of machinery for Rs. 100,000 on 31 December 19X8. This will attract capital allowances at 25%
on the reducing balance basis. The machinery will be sold at the end of two years for Rs. 30,000. The
machinery will be used to manufacture a product, the demand for which will be 200,000 units in 19X9
and 250,000 in 19Y0. The selling price per unit of the product will be Rs. 3 during 19X9 and Rs. 4 during
19Y0. Fixed costs will be Rs. 30,000 in 19X9 and are expected to increase by one-third in 19Y0. Variable
costs per unit will be 80% of selling price in both years.
Idomeneo has an effective after tax cost of capital of 10%. The companys effective corporation tax rate is
35% and you are to assume that this rate will continue in the future. Corporation tax is payable twelve
months following the end of each financial year. Idomeneos accounting reference date is 31 December.
All cash flows will arise on the last day of the financial year to which they relate.
If the project is accepted, Idomeneo will distribute all available net cash inflows, after making associated
taxation payments, immediately as dividends. The initial outlay of Rs. 100,000 will be provided by
reducing the dividend due on 31 December 19X8.
Requirements.
(a) Calculate the year-by-year changes in dividends payable by Idomeneo Ltd. for 19X8, 19X9, 19Y0
and 19Y1 if the project is undertaken.
(10 marks)
(b) On the basis of the dividend changes calculated in (a) evaluate whether acceptance of the project is
worthwhile for:
(i)
(ii)

a shareholder whose marginal tax rate is 25%;


shareholder whose marginal tax rate is 40%;

Comment upon your results.


(7 marks)
(c) Discuss how personal taxes might influence a companys decision on whether to retain earnings or
distribute them as dividends.
(8 marks)

E-2

SECTION E

CORPORATE DIVIDEND POLICY - QUESTIONS

QUESTION 98
Franc Brothers Ltd. is a small public company, with no major shareholders and very little debt in its capital
structure. It has for many years maintained a 75% distribution of its equity earnings. Dividends have been
growing steadily at about 5% per annum and a payment of 30p per share has just been made. The
current market value of the company's shares is Rs 3.15. Only retained earnings are used to finance
capital investment because of the prohibitive cost of raising external funds where relatively small amounts
of capital are to be invested.
The newly appointed finance director, D. Mark, suggests that the board consider a reduction in the
dividend distribution ratio to accelerate the company's growth. Mark argues that the board has been
forced to reject profitable investment opportunities due to lack of funds and that the required rate of return
of at least 20% on new investment is artificially high. The managing director, S. Franc, disagrees with
Mark's analysis and has called upon him to substantiate his claim that shareholders in the company
would accept a lower rate of return on new investment.
The chairman of the board, F. Franc, also opposes Mark's suggestion. He believes that a cut in dividends
is likely to be misinterpreted by the market and be taken as a failure on the part of the firm to maintain its
level of dividend. This, he argues, would be the case regardless of any statements to the contrary that the
directors may make in their annual report.
The company secretary, B. Franc, states that dividend has never been a contentious issue at the
company's annual general meeting. This being so, he reasons, shareholders are clearly satisfied with the
longstanding dividend policy and may well object to a move by the company away from a high distribution
policy.
Required:
a) Calculate the cost of equity capital. (5 marks)
b) Discuss briefly the arguments advanced by F. and B. Franc. (12 marks)
(c) Which policy do you consider the company should follow? (3 marks)
(Total 20 marks)

E-3

SECTION E

CORPORATE DIVIDEND POLICY - QUESTIONS

QUESTION 99
Feret Ltd. has ten million shares in issue and has been paying dividends of 10p per share for a number of
years and with its existing business is expected to be able to continue to earn sufficient profits to enable it
to pay such a dividend for the foreseeable future. The company has been offered a new contract which
would take two years to complete and would involve an investment outlay of Rs 500,000 in each of the
next two years. The board plan to finance the investment by a reduction of dividend.
If the project is undertaken when it is completed it will increasethe earnings of the company above their
expected level by Rs 350,000 per annum for the foreseeable future.
The current market price of an equity share of Feret Ltd. is Rs 0.90. The yield on company debentures is
10%. The management of Feret believes that the market value of shares in the company is based on
dividends. Taxation can be ignored.
Required:
(a)

Would an announcement of a decision to reduce dividends with an explanation of why this was
being done and with details of the proposed investment, lead to an increase or decrease in the
current share price? Show calculations to justify your conclusion. (8 marks)

(b)

Is it possible for an investor owning 100 shares in Feret Ltd. who is dependent on the annual
income from investments to increase spending power during the next two years while still being
able to maintain spending potential in subsequent years? Illustrate your answer with appropriate
figures. (6 marks)

(c)

What are the implications of your analysis for dividend decision making? On what assumptions
does your answer depend, and how might these deviate from what in fact happens in practice?
(6 marks)
(Total 20 marks)

E-4

You might also like