- 15 Marks
FM – L2 – Q34 – Dividend policy
Question
Question Tags: Dividend policy, Share valuation, Earnings retention, Shareholder returns, Financial strategy
Question Short Summary: Analyze dividend policy of Kumasi Freight Plc from 20X1-20X5 and estimate share price under four dividend options.
———————————————————–
Question:
The table below shows earnings and dividends for Kumasi Freight Plc over the past five years.
| Year | Net earnings per share | Dividend per share |
|---|---|---|
| GH¢ | GH¢ | |
| 20X1 | 1.40 | 0.84 |
| 20X2 | 1.35 | 0.88 |
| 20X3 | 1.35 | 0.90 |
| 20X4 | 1.30 | 0.95 |
| 20X5 | 1.25 | 1.00 |
There are 10,000,000 shares issued and the majority of these shares are owned by private investors. There is no debt in the capital structure.
It is clear from the table that the company has experienced difficult trading conditions over the past few years. In the current year, net earnings are likely to be GH¢10 million, which will be just sufficient to pay a maintained dividend of GH¢1 per share.
Members of the board are considering a number of strategies for the company, some of which will have an impact on the company’s future dividend policy.
The company’s shareholders require a return of 15% on their investment.
Four options are being considered, as follows:
(1) Pay out all earnings as dividends.
(2) Pay a reduced dividend of 50% of earnings and retain the remaining 50% for future investment.
(3) Pay a reduced dividend of 25% of earnings and retain the remaining 75% for future investment.
(4) Retain all earnings for an aggressive expansion programme and pay no dividend at all.
The directors cannot agree on any of the four options discussed so far. Some of them prefer option (1) because they believe to do anything else would have an adverse impact on the share price. Others favour either option (2) or option (3) because the company has identified some good investment opportunities and they believe one of these options would be in the best long-term interests of shareholders. An adventurous minority favours option (4) and thinks this will allow the company to take over a small competitor.
Required:
(a) Comment on the company’s dividend policy between 20X1 and 20X5 and on its possible consequences for earnings.
(b) Advise the directors of the share price for Kumasi Freight Plc which might be expected immediately following the announcement of their decision if they pursued each of the four options, using an appropriate valuation model. You should also show what percentage of total return is provided by dividend and capital gain in each case. You should ignore taxation for this part of the question. Make (and indicate) any realistic assumptions you think necessary to answer this question.
Answer
(a) The dividend policy between 20X1 and 20X5 has been to pay a slightly increased net dividend per share each year, regardless of that year’s actual earnings figure. The purpose of such a policy is to convince the market that the policy will be maintained in perpetuity, to enhance the predictability and therefore the ‘quality’ of the company’s dividend stream. This should lead to an improved share price.
However, in the period under review the net earnings per share have been on a declining trend each year. In 20X1 the pay-out proportion was 60% of net earnings; by 20X5 it had reached 80%. The policy is not sustainable if these trends continue. A new policy must be formulated.
In the absence of any capital changes, the existing dividend policy will reveal declining earnings figures, earnings per share and return on capital figures. This is contrary to what the management would want to be declaring, so again some change in policy is called for.
(b) We are told that the company’s shareholders currently require a return of 15% on their investment. Assume that this percentage continues in the future and that it is also the return required on funds reinvested within the business.
Option 1
Assume that the GH¢1 net dividend per share can be maintained in perpetuity.
Share price = present value of a perpetuity of GH¢1 pa at 15% discount rate = GH¢1 / 0.15 = GH¢6.67.
The expected share price is GH¢6.67, the total return being provided by a 15% dividend return and zero capital gain.
Option 2
Half the earnings are now paid out while the other half are reinvested within the business to increase the share price in the future. If the rate earned on reinvested funds is 15% pa as assumed earlier, the share price following announcement of the decision will be GH¢6.67 with the total return comprising a 7.5% dividend return and a 7.5% annual capital gain.
Option 3
With the same assumptions, the share price following announcement of the decision will be GH¢6.67 with the total return comprising a 3.75% dividend return and an 11.25% annual capital gain.
Option 4
With the same assumptions, the share price following announcement of the decision will be GH¢6.67 with the total return comprising a 15% expected annual capital gain.
The above answers are only estimates since we do not know the real rate of return that will be earned on reinvested funds. If this rate exceeds 15%, the share price in options 2 to 4 will be higher than GH¢6.67. If this rate is less than 15%, the share price in options 2 to 4 will correspondingly be lower than GH¢6.67.
- Topic: Dividend policy
- Uploader: Samuel Duah