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SECTION E

CORPORATE DIVIDEND POLICY- ANSWERS

ANSWER 96
(a)

(i)

Pavlons dividend policy prior to listing is to maintain a fixed payout ratio of


approximately 43% of earnings after tax. This payout ratio is constant for each of the
five years.
Years prior to
listing
5
4
3
2
1
Current

Number of
shares
21,333,333
21,333,333
26,666,667
26,666,667
26,666,667
40,000,000

Total dividend Rs
768,000
1,024,000
1,642,667
1,749,333
1,898,667

Profit after tax


Rs
1,800,000
2,400,000
3,850,000
4,100,000
4,450,000

Payout ratio
42.7%
42.7%
42.7%
42.7%
42.7%

A dividend policy that maintains a constant payout ratio will lead to both rises and falls
in dividends per share if the company concerned experiences fluctuations in earnings
per share. If dividend policy is believed to affect the valuation of the company any fall
in dividend per share might have an adverse effect on share price (or, less likely, a
favourable effect depending on shareholder preferences for income or capital gains).
In practice companies appear to be reluctant to reduce the level of dividend per share
even if profitability and/or liquidity are poor.
Pavlons shareholders have not experienced a reduction in dividend per share during
the last five years as the company has experienced a continued growth in profits, but
falls in future profitability might occur, and a constant payout ratio is not normally
considered to be a suitable dividend policy for a quoted company. A stable policy that
at least maintains the existing dividend per share is more usual.
The proposed final dividend of 2.34 paisas will result in a total annual dividend of Rs
1,778,667 (W), which gives a payout ratio of 32.3% on estimated after tax profits of Rs
5,500,000, a significant fall in the payout ratio.
It has been suggested by some authors including Modigliani and Miller, that dividend
policy is irrelevant to the valuation of the firm. If this view is accepted then the
proposed final dividend of 2.34 paisas will be just as good as any other final dividend.
If dividend policy is believed to be relevant to the valuation of the firm, then the
proposed final dividend may upset the firms shareholders.
The clientele effect describes the process whereby shareholders choose companies
which adopt the dividend policy they prefer.
For example, capital gains can be taxed at zero % up to Rs 5,500, so private investors
may prefer capital gains to dividends. If income is required then dividends may be
created by selling a proportion of the shareholding (this may not always be an
acceptable alternative as it involves transactions costs and a possible reduction in
control of the company).
On the other hand, institutional investors such as insurance companies and pension
funds will not suffer any tax liability on dividend income from a Pakistan resident

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SECTION E

CORPORATE DIVIDEND POLICY- ANSWERS

company. Companies (but not pension funds) will suffer corporation tax on gains
realized on the sale of shares. Thus the institutions are likely to prefer dividends to
retained earnings.
In summary, the proposed dividend may be appropriate if the shareholders are mainly
private individuals, but is likely to be inappropriate if they are institutional investors.
WORKING
Number of shares on which interim dividend paid = 40m x

Hence total annual dividend is calculated as:


Rs
Interim 40m x

3 x 3.16 paisas

842,667

Final 40m x 2.34 paisas

Payout ratio =
(b)

936,000
1,778,667

1,779
= 32.3%
5,500

The current share price of Pavlon is Rs 78m/40m = Rs 1.95 per share. This is assumed to
include the value of the proposed final dividend of 2.34 paisas. Thus, the ex-div price is 1952.34 = 192.66 paisas.
Calculating the present value of future expected dividends.
Time
1
2
3
4 onwards

Dividend
per
share (paisas)
5.5 x 1.5 = 6.33
7.27
8.36
9.03 growing
@8% per annum.

Discount
12%
0.89
0.80
0.71
17.75 (W)

Theoretical market price per share.

factor

Present
(paisas)
5.63
5.82
5.94
160.28

value

177.67 paisas

WORKING
Discount factor for each flows starting @ time 4 and continuing into perpetuity with growth at
8% and cost of equity of 12%
DF =

1
x 0.71 = 17.75
0.12 0.08

Thus it appears that the share is currently overvalued.

ANSWER 97
(a)

Calculation of changes in dividends

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SECTION E

CORPORATE DIVIDEND POLICY- ANSWERS

Let 31 December 19X8 = time 0.


Description
Purchase/sale of machinery
Net revenue (W1)
Capital allowances (W2)
Tax on revenue

0
Rs
(100,000)
-

1
Rs
90,000
8,750
-

2
Rs
30,000
160,000
6,563
(31,500)

3
Rs
9,187
(56,000)

Change in cash flow

(100,000)

98,750

165,063

(46,813)

WORKINGS
1

Calculation of net revenue


19X9
Sales 200,000 x Rs 3
Variable costs (80% x 600,000)
Fixed costs

Rs
600,000
(480,000)
(30,000)
90,000

19Y0
Sales 250,000 x Rs 4
Variable costs (80% x 1,000,000)
Fixed costs (30,000 x 1 1/3)
2

1,000,000
(800,000)
(40,000)
160,000

Capital Allowances Computation


Accounting
Period ended
31 December
19X8
Cost
WDA @ 25%
19X9
WDA @ 25%
19Y0
Proceeds
Balancing
allowance

Written Down
Value

Tax Cash Flow


@35%

Time

Rs

Rs

100,000
(25,000)
75,000

8,750

6,563

9,187

(18,750)
56,250
30,000
(26,250)

ANSWER 98

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SECTION E

CORPORATE DIVIDEND POLICY- ANSWERS

(a) The cost of equity capital can be calculated using the dividend valuation model:

i=

d(1+g)
V

where V
d
g
i

+g

= market value per share at present, ex dividend


= dividend per share just paid
= predicted constant growth rate in dividends
= shareholders' required rate of return (cost of equity)

Substituting in the formula, gives


i=

0.30(1+0.5)
3.15

+0.5

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SECTION E

CORPORATE DIVIDEND POLICY- ANSWERS

=0.10+0.05
=0.15 or 15%
(b) The argument advanced by F. Franc seems to contain a great deal of truth. For many years Franc
Brothers has distributed
75% of its equity earnings, and to reduce this level of dividend now would
be seen by many shareholders as an admission of failure. Reasons for the market interpreting the
situation in this way are as follows:
(i) Shareholders believe that the current level of dividends is determined by the current size of the
company's earnings. In fact companies are often seen to be aiming to maintain a certain payout
ratio: for example, up to now Franc Brothers dividends have remained stable at 75% of equity
earnings. As a result the market is almost sure to interpret a reduction in the level of distribution as
an indication that a fall in the company's profits is to be expected in the near future.
(ii) If the directors make appropriate statements in their annual report it is likely that the market will
find these difficult to believe. This will be so even if it is clearly explained that funds are to be
retained in the business to take advantage of available investment opportunities and that as a
result future profits will be expected to show a significant increase. Dividends which come in the
form of cash flows are more real to a shareholder than promises which appear in an annual report.
Thus, a firm's dividend policy will provide information about the business to shareholders and
potential investors. A cut in dividend will be interpreted as an indication that earnings are likely to fall,
and as a consequence the company's share price will be forced down.
B. Franc's argument appears also to be fairly sound. Distortions in the capital market caused by
taxation, transaction costs, etc., will mean that a company's dividend policy will influence its
shareholders' wealth and the type of investor which the company attracts. The present system of tax
in the country also has a bearing on the shareholders preferences between capital gains and
dividends. Tax is withheld on dividends and is treated as the final tax liability on dividend income of
shareholders whereas capital gain on shares of public companies is exempt from taxation.
As Franc Brothers have maintained a high level of distribution it will have attracted the class of
investors who prefer current dividends to future capital gains. If it now proposes to introduce a policy
of capital growth, the present shareholders will probably suffer a serious reduction in their income
and will be forced to switch their investments away from the company. However, such a switch will
involve considerable transaction costs, and will almost certainly lead to a reduction in the company's
share price. The company will then have failed in its duty to maximize the wealth of its existing
shareholders.
(c) It is plain that both F. and B. Franc have put forward realistic arguments and that the proposed
change in the dividend policy will probably lead to a fall in the company's share price. The directors
should, therefore, abandon D. Mark's suggestion to cut dividends and continue to pursue the present
distribution policy. It remains true that the required rate of return of 20% on new investments is
artificially high. However, the return required by shareholders will be inflated by a risk premium factor
and, therefore, the use of the return on equity for appraising new investment projects may not be
appropriate.
ANSWER 99

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SECTION E

CORPORATE DIVIDEND POLICY- ANSWERS

The announcement of the change in dividend policy would lead to an increase in the share price from Rs
0.90 to Rs1.08. The new share price can be calculated using the dividend valuation model as follows:
First calculate Ferets cost of share capital, i Future dividend payments will represent a perpetuity of 10 p
each year and i can be calculated by equating the present value of this perpetuity with the current share
price of Rs 0.90, i.e.
PV of perpetuity = Rs 0.10/i
Rs 0.90 = Rs 0.10/i
i
= Rs 0.10/Rs 0.90
i
= 11%
Following acceptance of the new contract the dividend stream will alter as follows:
For each of the next two years:
Original dividend per share
Less: Reduction to finance new project:
Rs 500,000/ 10,000,000 shares
Revised dividend per share
For each year thereafter:
Original dividend per share
Add: Earnings from new project:
Rs 350,000 / 10,000,000 shares
Revised dividend per share

RS
0.10
0.05
0.05
0.10
0.035
0.135

Using the dividend valuation model the new share price, V, will then be given by:
V=

0.05
1.11

0.05
(1.11)2

0.135
(1.111)3

+..+

0.135
(1.11)n

As n tends to infinity, terms on the right-hand side of the equation except the first two will represent the
present value of a perpetuity of Rs 0.135 beginning at the end of Year 3.
V= (0.05 x 1.713)+

1
(1.11)2

0.135
(1.11)

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SECTION E

CORPORATE DIVIDEND POLICY- ANSWERS

= Rs 1.08
(b) The investors original spending power is
100 shares x 10 p = Rs 10 per annum
For each of the next two years his annual dividend will fall to Rs 0.05 per share giving a total income of
Rs 5 per annum. However, he will be able to more than make up for this shortfall in spending power by
selling five shares worth Rs 1.08 at the end of each of the next two years. His total annual income in year
1 will then rise to Rs (5 + 5 x 1.05) = Rs 10.40. In year 2 it will be (95 x Rs 0.05) + (5 x 1.08) = Rs 10.15.
Thereafter his shareholding have been reduced to 90 shares. However, with the increased dividend per
share of Rs 0.135, his annual income will rise to Rs 12.15, Thus, the investor will be able to increase his
spending power during the next two years and more than maintain his spending potential in subsequent
years.
(c) The implications of the above analysis for dividend policy include:
(1) If an investment is to be financed by a reduction of dividend, then investors will he able to take
appropriate action to maintain their annual income without prejudicing their future spending
power.
(2) The company should inform the market of the reasons why it has chosen a particular policy.
However, information likely to be harmful to the company's business should not be disclosed in
this way.
The above analysis is based upon the following assumptions:
(1) The dividend valuation model can be used for valuing shares. This implies that shareholders and
potential investors will consider the future dividend stream ream when deciding what price they are
prepared to prepared for a share
(2) The announcement of the decision to reduce dividends and of the proposed investment is
believed by the market.
(3) The company's cost of share capital will not alter as a result of the falling dividend or the new
project. If shareholders believed that these proposals increased the risk of their investment, then
they would require a higher return from the company.

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