Is It much ado about nothing?

By Gregory Rivera,2014-07-26 00:06
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Dividend policy

Question 21

    1.Joe Smolinski’s suggestion of not paying any dividend in order to retain all earnings to reinvest

    in the business. Dividends have a cost which is higher than the after tax cots of debt. Besides, the retain earning has helped them to withstand the difficult times as their stock price dropped drastically during the down period. He wants to prevent stock price drop after the payment of dividend.

    The advantages of not paying any dividends (Pros) are:

    a) It is a source of internal funds without having to pay floatation cost.

    b) Less of a negative price on stock as the share price will be boosted by the company's stronger cash position.

    c) The management is confident that the company's earnings will always be sufficient to pay that dividend, it would attract more investors.

    d) A stock that pays stable annual dividends is more attractive to investors, because they can trust that even if the stock price dips a bit, they will still make money from the dividends.

The disadvantages of not paying any dividends (Cons) are:

    a) It would give a negative impact on stock price.

    b) When the company pays dividends that means it has less money to invest in company growth. c) Dividends come out of net income so the dividend is subject to double taxation: taxed at the corporate level and at the investor level.

    d) Dividends are taxed as ordinary income and not the lower capital

    gains rate.

2. Jim Baker’s argument is correct; if a company doesn’t pay dividends to the shareholder, it

    could bring false information to the investors that the company doesn’t perform well and gain no

    profit. However, the stock price will suffer or not is depends on the desires of majority of shareholders. The firm can convince shareholders that their money is being wisely invested and will lead to further stock price appreciation; the stock price may not necessarily suffer.

    3. The homemade dividend is sale of a portion of shares held by a shareholder. This differs from dividends that shareholders receive from a company according to the number of shares the shareholder has. If shareholders don’t like the dividend, they can create homemade dividends.

    Selling off the shares similar to the value of the dividends that they were expecting to receive and diversify their investment via reinvest the cash from those sales into alternative investments. This could bring better income instead of waiting for dividends. The existence of homemade dividends is the reason some financial analysts believe that looking at a company’s dividend policy is not important. If investors desires an income stream they will either sell their shares when they want the income or they will invest in other income-generating assets.

    The value of sharehlder shares = the price of the share x the amount of shares = 0.25 x 1000

    = 250

    Shares that shareholder could sell off = The value of existing shares / the price per share

= 250 / 8


    The remaining shares = 1000 shares 32 shares = 968 shares

    4 The dividend policy is a policy that a company uses to decide how much it will pay out to shareholders in dividends. Taxes are significantly affecting the dividends payment. The tax disadvantages related with dividends is being taxed at a higher rate that capital gains. Therefore, the shareholders will have different tax rates, exemptions and options. The composition of shareholders group within a company would have different preferences as well. Therefore, the firm must understand the shareholders needs when making dividend policy so as to make sure the composition of shareholder groups within a corporation has to match the policy with the desire of majority shareholders group. Base on Table 1, the majority shareholding groups are individual shareholders. So NewWave should adopt residual dividend policy because it could bring satisfaction to their shareholders and keep their target capital structure. Besides, residual dividend policy could help to reduce to the issues of new stocks and flotation costs.

    5. Under a residual dividend policy, the firm pays dividend only after meeting its investment need while maintaining a desired debt to equity ratio.

    In the case in new wave

The investment need= 1,000,000

    Total current liabilities= 3,350,000

    Market value of equity=8,000,000

    Net income available= 960,000

Target capital structure: E/D+E & D/D+E

    Market value of Equity= 8,000,000/11,350,000= 70.5%

    Market value of Debt=3,350,000/11,350,000=29.5 %

    Equity portion of needed investment based on target capital structure= 0.705x1,000,000 =705,000

    Net income available for dividend at residual approach = 960,000-705,000= 255,000 Dividend per share=255,000 / 1,000,000 = 26 cent per share

    6. Dividend residual policy would influence the dividend payout ratio and it is fluctuated for each quarter leading to a very unstable dividend policy. The net income and investment will affect the dividend and if they cut down the dividend due to low net income or high retain earning for future investment, it would significantly affect the stock price. A firm will allow a compromise policy based on debt to equity ratio and allowing the proportion to vary in short run. Besides, to avoid drastic change in dividend payout ratio, a firm will create two types of dividend: regular and extra (Extra dividends are paid during a good business). Other firms use share repurchases as a way of returning capital to stockholders.

    7. Actually, residual policy and repurchasing stock are correlated. Residual policy is the decision to pay out earnings versus retaining and reinvesting them. Stock Repurchases is another way which is suggested by Ed to acquire its own stock. Ed suggested that repurchasing stock at $8 is a way to maximize the profit if they repurchase the stock in the low price and after the increasing

    of their project, stock can be sold again to get profit and it is more profitable to the company. Besides, the shareholder will gain profit from this suggestion. The main objective of a residual dividend policy is to set a target payout which is the earnings that need to be retained as back up for the capital budget and the earnings that are left can be paid out as dividends to the shareholders. It is another way to cash dividends, shares outstanding are reduced and EPS increases, the stock price increases. However, the firm must have an excess cash to perform stock repurchases and if the share price too low, the firm need more excess cash to repurchase the outstanding shares so as to drive the stock price up.

     Residual dividend policy is referring to how much they can afford to pay out based on their

    immediate investment needs and target capital structure. The dividend payments are made right after the equity where all the investment needs are met. The company should maintain a balanced debt/equity ratio to make sure a certain amount of money is retained so that it could distribute that money to its shareholders as dividends. Therefore, it has to set a target capital structure.

     Repurchases stock is helped to avoid a high setting dividend that cannot be maintained, repurchased stock can be resold to raise cash whenever is needed and stockholders may think that the stock is undervalued.

    8. Base on my opinion, they should not pay dividend. They can retain the money to reinvest as they have just get approval for the $1000, 000 projects but it is suggested that the rest of returning can be paid to shareholder. They should continue evaluate the amount to be used to invest in the business and the balance amount to be returned to shareholder based on residual policy theory and repurchase stock theory. The dividend policy that should be adopted is residual dividend policy because this policy can keep the shareholders happy and maintain the target capital structure. It could satisfy both sides; the firm and also the shareholders.

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