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AG215 Business Finance, Week 11 Tutorial
Tutorial sessions to cover questions 1, 2 and 5. Remaining materials for revision purposes and solutions provided online.
Question 1
Miller plc paid a dividend of 80pence per share last year. Their earnings per share for the next year are forecast to be 300p. Forecast earnings in years two are 400p, year three earnings are forecast as 450p, year four earnings are forecast at 500p, and year five earnings are also forecast at 500p.
a. The company’s dividend policy is described well by Lintner’s model, with a long term payout goal of 40 per cent and an adjustment factor of 60 per cent. On this basis determine the likely dividend per share for each of the next five years.
Dt = Dt-1 + a [EPS (^) t x Z – D (^) t-1 ]
D 1 = 80 + 0.60 [300 x 0.4 - 80]
= 80 + 24 = 104
D 2 = 104 + 0.60 [400 x 0.4 - 104]
= 104 + 33.6 = 137.
D 3 = 137.6 + 0.60 [450 x 0.4 – 137.6]
= 137.6 + 25.44 = 163.
D 4 = 163.04 + 0.60 [500 x 0.4 – 163.04]
= 163.04 + 22.176 = 185.
D 5 = 185.216 + 0.60 [500 x 0.4 – 185.216]
= 185.216 + 8.8704 = 194.
b. If earnings per share remain at 500pence for the foreseeable future, what will the firm’s annual dividend gradually converge towards?
The dividend will eventually converge towards 200 pence per share, or 40 per cent of the firm’s sustained earnings per share of 500 pence.
c. Explain the main factors that determine the speed of adjustment and the target payout ratio under the Lintner model.
Speed of adjustment is determined by volatility of earnings and liquidity of the firm. Payout ratio is determined by the volatility of earnings and the firm’s investment opportunities. Credit is given for being able to expand on the basic statements and explain why these affect the payout ratio. I.e. investment opportunities are negatively related to payout ratio because firm’s with positive NPV projects should retain cash for reinvestment rather than paying out in the form of dividends.
Required capital / Ex-dividend share price = £2,000 / £40 = 50 shares
Question 3
An investor owns 500 shares in a company and the company’s shares are trading at $44 per share. The company has announced that it intends paying a dividend of $4 per share. This investor would prefer the company to adopt a higher payout so as to receive a dividend of $ per share. What action can the investor take to obtain the additional net cash inflow? Demonstrate that the investor will be just as well off if the company had paid a dividend of $6 per share.
Assume perfect markets and a fall in the price of a share equivalent to the dividend paid. For the company’s proposed dividend the price will fall by $4 to $40. A dividend of $6 will push the price down to $38.
Evaluation of company’s current policy, augmented by sale of shares Ex dividend value of share = $
Dividend income $4 x 500 = $ Sell 25 shares at $40 = $ Cash inflow = $ Value of remaining shares (475 at $40) = $ Total wealth = $
Evaluation of position if company increases dividend Ex dividend value of share = $
Dividend income $6 x 500 = $ Cash inflow = $ Value of remaining shares (500 at $38) = $ Total wealth = $
The investor would be better to sell the shares before they go ex-dividend.
Question 5
Martin acquired shares in Aviva PLC one year ago at a price of 260pence, and the current price is 325pence. The company has announced its intention of paying a dividend of 30pence per share. If the shares are sold immediately the investor will be liable for capital gains tax on the increase in share price at a rate of 30 per cent. Past experience suggests that the UK share prices will fall by 60 percent of the dividend when a share goes ex-dividend. Income on dividends will be taxed at a rate of 50 per cent for Martin.
a. (^) Martin has decided to sell the shares but does not know whether he should do so before or after the dividend payment. Determine whether he should sell the shares before or after the share goes ex-dividend.
Gain if Martin sells before the share goes ex-dividend:
= (PB – P (^) 0)(1 – TCG)
= (325 – 260)*(1 – 0.30)
= 45.5pence
Gain if Martin sells after the share goes ex-dividend:
Ex-dividend price:
PX = PB – 0.6D
PX = 325 – 0.6*
PX = 325 – 18 = 307pence
After-tax gain:
= (PX – P0)(1 – T (^) CG) + D(1 – TE )
= (307 – 260)*(1 – 0.3) + 30(1 – 0.50)
= (47 * 0.70) + (30 * 0.5)
= 32.9 + 15 = 47.
Martin would be better to sell the shares after they go ex-dividend.
gains and offset these against capital losses on other assets. No such deductions exist with dividend income. The extent of this problem depends on the personal tax system in place, but is likely to be non-trivial in classical or partial imputations tax systems, and less so in full imputations systems.
Free cash flow theories argue that managers should pay high dividends because it forces them into equity markets more frequently by reducing free cash outstanding. However, raising equity capital is costly due to the direct issuance costs (such as merchant bank fees) and the indirect asymmetric information costs that lead to stock price declines on average when companies announce seasoned equity offers. Moreover, paying dividends and recycling these back into the company through equity offers comes at a tax disadvantage relative to retentions for the reasons outlined above.
Question 6
An investor bought some shares in Roberts plc for 150p six months ago and the price today is 220p. The payment of a dividend of 30p per share has been proposed. Following the payment of the dividend the share is expected to fall by 80 per cent of the value of the dividend. If the effective capital gains tax rate is 10 per cent what rate of tax on the dividend payment would justify a decision to sell the shares prior to the dividend payment?
Sell before ex-dividend, after tax gain:
= (PB – P0)(1-TCG) = (220 – 150)(1 – 0.10) = 70 * 0.90 = 63
Ex-dividend price:
PX = PB – 0.8D = 220 – 0.8*30 = 220 – 24 = 196pence
Set after-tax gain to 63p:
63 = (PX – P0)(1 – T (^) CG) + D(1 – TE )
63 = (196 – 150)*(1 – 0.1) + 30(1 – TE )
63 = (46 * 0.90) + 30(1 – 0. TE )
63 = 41.4 + 30(1 – TE )
21.6 = 30(1 – T (^) E)
(1 – TE ) = 21.6/30 = 0.
TE = 0.
