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What are the three theories concerning what impact a cut in dividend will have on company and it's shareholders?

Dividend irrelevancy theory
Residual dividend policy
Dividend relevance


what is dividend irrelevancy theory?

This is Modigliani and Miller’s theory. In a perfect market (no taxation or transaction costs and perfect information) shareholders will be indifferent between receiving a dividend or a capital gain from a change in the share price.

If a dividend is foregone the share price should rise by the value of the dividend foregone. Shareholder wealth is the same whether a dividend is paid out or, alternatively, funds are retained and reinvested.

A shareholder who needs cash could manufacture a dividend by selling some of their shares.


what is dividend residual dividend policy theory?

This theory is closely related to M&Ms but recognises the costs involved in raising new finance. It argues that dividends themselves are important but the pattern of them is not. The residual theory argues that provided the present value of the dividend stream remains the same, the timing of the dividend payments is irrelevant.

This theory suggests that if a company has positive NPV projects available then the company should always invest in these positive NPV projects using retained earnings to finance the investment rather than pay the earnings out as a dividend to shareholders. Thereby also increasing the potential for higher dividends in the future

A company should only distribute a dividend to shareholders after all of these positive NPV projects have been undertaken.

This theory also assumes that there is no taxation, there are no transaction costs and that information is perfect)








what is dividend relevance?

Practical influences, including market imperfections, mean that changes in dividend policy, particularly reductions in dividends paid, can have an adverse effect on shareholder wealth:

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 (clientele effect).

As a result, companies tend to adopt a stable dividend policy and keep shareholders informed of any changes.


what is dividend signaling

n reality, investors do not have perfect information concerning the future prospects of the company. Many authorities claim, therefore, that the pattern of dividend payments is a key consideration on the part of investors when estimating future performance.

This argument implies that dividend policy is relevant. Firms should attempt to adopt a stable (and rising) dividend pay-out to maintain investors’ confidence.


what is preference for cash income?

Many investors prefer cash today as opposed to potential rewards in the long term! They rely on high levels of cash income/dividends.

This does not only apply to individual investors needing cash to live on but also to institutional investors, e.g. pension funds and insurance companies, who require regular cash inflows to meet day-to-day outgoings such as pension payments and insurance claims.

implies that many shareholders will prefer companies who pay regular cash dividends and will therefore value the shares of such a company more highly.


what is the clientele effect?

Changes in dividend policy may upset shareholders e.g. for tax planning purposes. A company that, for example, has always retained a high proportion of its earnings will, for example, have shareholders who want the company to retain a high proportion of its earnings. Any change in policy will therefore upset those shareholders.

income in the form of dividends is taxed in a different way from income in the form of capital gains. This distortion in the personal tax system can have an impact on investors’ preferences.

Research in the US tends to confirm this ‘clientele effect’ with high dividend pay-out firms attracting low income tax bracket investors and low dividend pay-out firms attracting high income tax bracket investors.


what are some legal restrictions that can be placed on dividend payments?

Rules as to distributable profits that prevent excess cash distributions.

Bond and loan agreements may contain covenants that restrict the amount of dividends a firm can pay.

Such limitations protect creditors by restricting a firm’s ability to transfer wealth from bondholders to shareholders by paying excessive dividends.


what are some alternatives to cash dividends?

Share repurchase
scrip dividends/ bonus (scrip) issue


what is share repurchase and a side effect

Instead of a paying a dividend, shares are bought back by the company from the shareholders. This can be useful if the company has large cash surpluses that it wishes to return to the shareholders, but does not want to pay a large dividend as it would affect ratios such as dividend per share, and may set an expectation of large dividends again in the future.

Side effect- it can be beneficial for certain ratios e.g. EPS. EPS will rise after becaue now you've got less shares in issue so more earnings per share


what is scrip dividends / scrip issue (bonus shares)

what is the journal entry and why are these types issued

A scrip dividend is where a company allows its shareholders to take their dividends in the form of new shares rather than cash.

bonus (scrip) issue is a method of altering the share capital without raising cash. It is done by changing the company’s reserves into share capital.

A bonus issue is not an alternative to a cash dividend. Although these shares are 'distributed' from a company to its shareholders, they do not represent an economic event as no wealth changes hands.

givs the impression that it IS payng dividend consistently with previous years. e.g.
DR Dividend (SOCE)
CR Share capital

(what an actual cash dividend looks like)
DR Dividend (SOCE)
CR Cash


what are the advantages of dividends to company and shareholders for scrip dividends

The advantage to the shareholder of a scrip dividend is that they can painlessly increase their shareholding in the company without having to pay broker’s commissions or stamp duty on a share purchase.

The advantage to the company is that it does not have to find the cash to pay a dividend and in certain circumstances, it can save tax.

These may be useful when the company wants to retain cash in the business.


Scrip issues serve the purpose of reducing market values in return for more shares. This can make the shares more marketable

True or shares

100 shares @ 5= 500
10 new shares @0

still = 500

but 500/110 = 4.55

so less cost and therefore more markea


what are some practical influences on setting a dividend

▪ Does the company have sufficient distributable reserves to pay a dividend? Can a company legally pay a dividend?

e.g. even if profits are 100k, if it has lots of brought forward losses built up it means that even if it wanted to pay a dividend until it is able to build up enough equity to be able to cover those losses.

▪ Is there sufficient cash to pay the dividend?

there must be actual cash available to pay the dividend