Reading 31: Dividends and Share Repurchases: Analysis-LOS d 习 increase, following, management, 2011, class

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Session 8: Corporate Finance
Reading 31: Dividends and Share Repurchases: Analysis

LOS d: Discuss the factors that affect dividend policy.

 

 

Which of the following is most likely to prompt a company to increase dividend payments? A company’s management foresees:

A) reduced availability of credit in the market.

B) an immediate lack of profitable investment opportunities.

C) continued volatility of the company's earnings.

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When earnings are volatile, companies are more hesitant to increase dividends, as there are greater chances that a higher dividend may not be covered by future earnings. When there is reduced availability of credit in the market, a strong cash position—such as might be gained from cutting dividends—is a benefit. A company that foresees few profitable investment opportunities tends to pay out more in dividends, since these opportunities would otherwise be funded with cash flows from earnings.

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Tecnolotronix is an equipment manufacturer in a volatile, cyclical industry that employs a long-term residual dividend approach. A surprise increase in quarterly profits would be most likely to have which of the following immediate effects on the actual measured payout ratio?

A) An increase in the ratio.

B) A decrease in the ratio.

C) No change in the ratio.

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If a profit increase is seen by management to be a temporary increase, it is unlikely to prompt an increase in the level of dividend payout: a firm using the long-term residual dividend approach would not generally raise dividends in response to a short-run profit increase. Since payout ratio is calculated as Dividend / Earnings, and earnings have temporarily increased, the calculated payout ratio should fall in the short term.

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Which of the following would be least likely to prompt a decline in a company’s overall payout ratio?

A) A permanent decrease in company profitability.

B) A decrease in the capital gains tax rate.

C) An increase in interest rates.

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A permanent decrease in profits is expected to result in a decrease in the dividend payment level; however this would probably not lead to a decrease in the payout ratio. If interest rates were to increase, it would make retained earnings a more attractive way of financing new investment; as a result, the payout ratio would be more likely to decline. A decrease in the capital gains tax rate would (for investors that pay tax) make capital gains more appealing; accordingly, aggregate payout ratios would be expected to decline.

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Which of the following is least likely to discourage a company from making high dividend payouts? The company’s:

A) bondholders are protected by strong debt covenants.

B) flotation costs are high.

C) shareholders are primarily tax-exempt institutions.

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Taxes on dividends are one factor that sometimes discourages companies from paying dividends, however if most shareholders are tax exempt, tax considerations are unlikely to discourage a company from making dividend payouts. A company with high flotation costs is less likely to pay out high dividends, to ensure that projects can be financed through earnings and to thus avoid the expense of issuing new shares. Bondholders are often contractually protected from high dividend payouts; strong debt covenants are likely to prevent the company from making high dividend payouts.