Corporate Financial Management

Answers for workshop questions Week 13 (Dividend Policy)

(Note: the answers given below are guideline only. Student will not get full mark for the
answers given for all theoretical questions. This is applicable for all week)

1. GJF, Review Question 12-4 (p. 527)

“Does following the residual theory of dividends lead to a stable dividend? Is

this approach consistent with dividend relevance?”

(From solutions manual)

“The residual theory of dividends suggests that the firm's dividend payment should be the
amount left over (the residual) after all acceptable investment opportunities have been
undertaken. Since investment opportunities would tend to vary year to year, this approach
would not lead to a stable dividend. This theory considers dividends irrelevant, representing
an earnings residual rather than an active policy component affecting the firm's value.”

2. GJF, Review Question 12-5 (p. 527)

“Contrast the basic arguments about dividend policy advanced by Miller and
Modigliani and by Gordon and Lintner.”

(From solutions manual)

The dividend irrelevance theory proposed by Miller and Modigliani (M and M) states that in
a perfect world, the value of a firm is not affected by dividends but is determined solely by
the earnings power and risk of the company’s assets. The proportion of retained earnings
used for dividends versus reinvestment also has no impact on value. M and M argue that
changes in share price following increases or decreases in dividends are the result of the
informational content of dividends, which sends a signal to investors that management
expects future earnings to change in the same direction as the change in dividends. Another
aspect of M and M’s theory is the clientele effect, which means that investors choose firms
with dividend policies corresponding to their own preferences. Since shareholders get what
they expect, share value is unaffected by dividend policy.

Conversely, Gordon and Lintner’s dividend relevance theory states that there is a direct
relationship between a firm’s dividend policy and its market value. According to their bird-
in-the-hand argument, investors are generally risk-averse, and current dividends (the bird in
the hand) reduce investor uncertainty by lowering the discount rate applied to earnings,
thereby increasing share value.

Although empirical studies of dividend relevance theory have not provided conclusive
evidence supporting this argument, it intuitively makes sense. In practice, it appears that
actions of managers and investors support dividend relevance.

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3. GJF, Review Question 12-12 (p. 542)

“How does the imputation system of dividend payment remove the double
taxation of dividends?”

(From solutions manual)

The imputation system of paying dividends removes the double taxation of dividends by
assigning to the shareholder (taxpayer) a credit for the tax paid by the company. This tax
credit can be used by the taxpayer to reduce their taxable income. Accordingly dividends will
not be fully taxed at both the company and taxpayer level. This effectively removes the
double taxation of dividends. Depending on the relative tax rates of the company and the
taxpayer, fully franked dividends can be tax free in the hands of the shareholder.

4 On Monday 3 June 2013, the directors of Abbco Pty. Ltd. declared a dividend of
$1.50 per share to be paid on Wednesday 17 July 2013, with a date of record of
Tuesday 25 June 2013. Just before the date of declaration of the dividend, the
firm had 20,000 shares on issue, a cash balance of $200,000, retained earnings of
$350,000 and no dividends payable. Determine the ex-dividend date and show
account values for cash, dividends payable and retained earnings at the following
three points in time: just before declaration of the dividend; just after the
declaration of the dividend; and just after payment of the dividend.

Counting back two business days (asper current ASX rules) from Tuesday 25 June, we find
an ex-dividend date of Wednesday Friday 21 June.

Just before declaration of the dividend:

Cash 200,000 Dividends Payable 0

Retained Earnings 350,000

After declaration of the dividend:

Cash 200,000 Dividends Payable 30,000

Retained Earnings 320,000

(Since 1. 5(20 , 000 )=30 , 000 )

After payment of the dividend:

Cash 170,000 Dividends Payable 0

Retained Earnings 320,000

Thus the final effect of the dividend payment is to reduce total assets and retained earnings
(shareholders equity) by $30,000.

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5. GJF, Problem 12-9 (p. 550)

“A firm has $800,000 in paid-in capital, retained earnings of $40,000 (including

the current year’s earnings) and 25,000 ordinary shares. In the current year, it
has $29,000 of earnings available for the ordinary shareholders.

(a) What is the most the firm can pay in cash dividends to each ordinary
shareholder? (Assume that legal capital includes all paid-up capital.)
(b) What effect would a cash dividend of $0.80 per share have on the firm’s
balance sheet entries?
(c) If the firm cannot raise any new funds from external sources, what do you
consider to be the key constraint with respect to the magnitude of the
firm’s dividend payments? Why?”

(From solutions manual)

(a) Maximum dividend: $40,000  25,000 = $1.60

(b) The result of an $0.80 per share dividend will be a $20,000 decrease in cash and
retained earnings.

(c) Cash is the key constraint, because a firm cannot pay out more in dividends than it has
in cash, unless it borrows.

6. Nancy Lau currently holds 10,000 shares in the Icicle Company that supplies air
conditioning systems. Icicle has issued a total of 250,000 ordinary shares and no
preference shares are issued. The firm most recently had earnings available for
ordinary shareholders of $750,000, and its ordinary shares have been selling for
$34.10 per share. The firm intends to retain these earnings and pay a 10 per cent
share dividend.
(a) What is the firm’s current earnings per share?
(b) What proportion of the firm does Nancy Lau currently own?
(c) What proportion of the firm will Nancy Lau own after the share
dividend?
(d) At what market price would you expect the firm’s ordinary shares to sell
after the share dividend?

(a)
750 , 000
EPS= =$ 3
250 , 000
(b)
10 , 000
= ×100=4 %
Percent ownership 250 , 000
(c)
Percent ownership after share dividend

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 11, 000
= ×100=4 %
275 , 000
Share dividends maintain the same ownership percentage. They do not have a real value.

(d)
34 . 10
= =$ 31
Expected new market price per share 1 .10 per share

7. Suppose an individual subject to a 30 per cent marginal rate of income tax has
2,500 shares in a company that is paying a partially franked dividend of 40 cents
per share, with a franking ratio of 0.70 (i.e. 70%). The individual is a resident
for taxation purposes. If the company tax rate is 30 per cent:

(a) What tax credit can the individual claim due to the partially franked
dividends?
(b) What is the tax on the taxable income (i.e. the grossed up dividend) due to
the partially franked dividend?
(c) What tax, if any, is payable by the individual out of the cash dividend
payment received?

(a)

Total cash dividend =0 . 40×2 ,500=$ 1, 000

TR
=dividend ×
1−T R ( )
× franking ratio

0. 3
Tax credit
¿ 1 ,000× ( 1−0 .3 )
×0 .70=$ 300
(b)
Tax on taxable income due to partially franked dividends
=0 . 30 (1 , 000+300)=$ 390
(c)

Tax payable out of cash dividend =390−300=$ 90

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8: Suppose a company pays out fully franked dividends of $70 each to investors with
marginal tax rates of 19%. The statutory company tax rate is 30%. How much tax will
each investor pay on his/her franked dividend?

Answer: d)
70 (0.30)  Dividend  TR 
The imputation credit for each investor   $30   
0.70  1  TR 
Therefore, grossed up dividend  $70  $30  $100
Gross tax on grossed  up dividend i ncome  19% of $100  $19
Net tax payable on dividend income  19  30  $11