STUDY GUIDE E4: INTERNAL SOURCES OF FINANCE

AND DIVIDEND POLICY

 Get through Intro
A company that earns large amounts of cash profits can pay them to shareholders by way of dividends, retain
them in the business as reserves or re-invest them. Management must keep a track of how much profit has been
earned and how it has been utilized. This cash profit has the potential to provide substantial finance to the
company for investing in various projects.

Generated profits should not be tied up unproductively in excess current assets, for example, trade receivables
and inventories. On the contrary, it should be the Endeavour of the financial manager to minimize investment in
these current assets and free additional cash for investment purposes.

Traditionally, only the external sources of finance were evaluated separately under financial management. Now
the internal sources of finance are also being evaluated. We will take a look at these internal sources in this
Study Guide.

 Learning Outcomes
a) Identify and discuss internal sources of finance, including:
i. retained earnings
ii. Increasing working capital management efficiency.
b) Explain the relationship between dividend policy and the financing decision.
c) Discuss the theoretical approaches to and the practical influences on, the dividend decision, including
i. legal constraints
ii. liquidity
iii. shareholder expectations
iv. alternatives to cash dividends
 Case Study
In 20X8, the largest quad bike manufacturer in the US. Survivor Ltd announced a massive 900% dividend
following a 12.7% increase in its net sales, and 30% increase in its net profits. The company declared a final
dividend of $0.60 per share and a special dividend of $0.30 per share. This payout amounted to almost 60% of
the profits of 20X8.
Its chairman explained that although management did consider buyback, it did not believe that this option
would increase shareholders’ value. Rather than benefiting the promoters, management decided to give higher
dividends in order to earn the shareholders’ goodwill.

This case study offers a glimpse of how important decisions about dividends are made and the various aspects
that need to be considered.

1. Identify and discuss internal sources of finance, including:(2)

i. retained earnings
ii. increasing working capital management efficiency
[Learning Outcome a]

Can the necessary finance be provided from internal sources?

The company needs to consider the following factors to decide whether internal sources of finance can provide
the necessary finance.
➢ Current cash position
The company needs to consider the amount held in current cash balances and short-term investments and how
much of this will be needed to support existing operations. If spare cash exists, it is the most obvious source of
finance for the new project.
➢ Future expected cash flow
If the required cash cannot be provided from the current cash balances, then the company should consider its
future cash flow. The company should prepare a cash budget.
➢ Working capital management
If the company’s projected cash flow is not sufficient to fund the new project then it could consider tightening
its control of the working capital to improve its cash flow position.
Effective working capital management includes persuading the customers for timely or even early payment of
dues, lengthening the payment period to suppliers, running down the stock levels, etc. This will help to increase
the cash resources.
If the necessary finance cannot be provided internally, then the company will have to consider raising finance
externally.
The following are the different sources for internal financing:
1.6 Retained earnings
Some time ago, financial management revolved mainly around decisions on financing from external sources and
investments. Internal sources of finance were not considered to be significant sources of finance. However, the
perspective has changed and now internal finance is being tapped by management.
Why is it called a source of finance?
Money represented by earnings that are retained in hand, rather than paid to shareholders as a dividend is
indirectly a source of finance. If the money was paid as a dividend, in spite of good investment opportunities
being available, then the company would have to raise the same amount from external sources.
It is worth emphasizing that the retained earnings which appear in the SOFP are not necessarily a potential
source of finance. They can be a source of finance only to the extent they are represented by cash in hand or
liquid assets that can be invested. If those earnings are already invested in other assets, they are no longer
available as a source of finance for new investments.
 Example
Foseco Lic earned $10m in profits after tax during 20X9. Its SOFP shows total retained earnings of $20m,
including the retained earnings of earlier years. Its assets include a bank balance of $4m and liquid assets worth
$3m. Foseco can finance investments worth $7m (4 + 3), from retained earnings. Therefore the figures of $10m
or $20m are irrelevant.
Furthermore, the amount of dividend the company pays, will affect the amount of internal resources available
for investment. For example, if Foseco pays a dividend of $2m, the cash available for investment will be reduced
from $7m to $5m.

1.5 Increasing working capital management efficiency

As seen earlier in Study Guide C1, working capital is represented by a company’s investments in net current
assets, i.e. current assets such as trade receivables and inventories, minus current liabilities, such as trade
payables.
If working capital is managed efficiently, it provides the following benefits:
1. A reduction in the net investment in current assets, cash for other higher earnings investments.
2. The cash released by a reduction in net current assets may also be used to reduce or avoid a bank overdraft,
thereby saving interest costs.
In this sense, improving working capital management can generate funds.

Example
The present investment of a company in working capital is a follows:
Inventories $5m
Trade receivables $4m
Trade payables $2m
Net working capital investment is $7m ($5 + $4 - $2)
The company improves its working capital management in order to reduce inventories to $4.5m and trade
receivable to $3.5m. Trade payables remain at the same level.
The new net working capital investment is $6m ($4.5 + $3.5 - $2).
An amount of $1m has been freed from working capital. This can be used towards investment in a better project
or to reduce the bank overdraft and save interest.

2. Explain the relationship between dividend policy and the financing decision. (2)
[Learning Outcome b]
2.6 The meaning of dividend and its relationship with financing
A dividend is a distribution of post tax profits to shareholders, on a periodical basis. As in any other form of
business, the owners want to withdraw the profits earned by the business. It effectively rewards shareholders
for the risks undertaken by investing in the business and allows them to share in the prosperity of the business.
Section 1.1 showed how the retained earnings that are kept in the business, rather than being distributed as a
dividend, are an internal source of finance, to the extent they are represented by cash. Consequently a dividend
policy that encourages lower dividends will provide higher internal finance by way of retained earnings. The
need for the company to obtain finance from external sources is reduced.

Example
Continuing the example of Foseco
If the company’s dividend policy enables it to omit paying a dividend if there are good investment opportunities
available, the company has internal resources to the tune of $7m (i.e. the full amount to retained earnings
without reducing any dividend). However, if the company’s dividend policy requires it to increase the amount of
dividend to $3m, rather than $2m the funds available from internal sources will only be $4m ($7 - $3)
Similarly, if the company decides to invest $6m, it can use the residual amount of money i.e. $1m ($7m - $6m)
towards paying a dividend.

The above example explains the numerical relationship between the amount of dividend distributed and the
amount that can be invested out of the retained earnings. However, the two decisions (dividends and
investments) may be subject to separate considerations, as the earnings of the company may not be sufficient
enough to cover both. It is possible that a company decides the two independently, and then manages the
shortfall through external borrowings.

Case Study
Experts argue that firms must adopt independent dividend and investment policies. Empirical evidence supports
this argument. Adequate debt finance is usually raised to satisfy the financial demands created by dividend and
investment decisions. As a result, it is possible to have independent dividend and investment policies.

2.5 Alternative dividend policies

The following are the main alternative policies regarding dividends.
1. Fixed percentage payout ratio
Dividend payout ratio is calculated as follows:

Total devidend paid to ordinary shareholders

× 100
Earnings after tax and preference dividends

This policy maintains a constant payout ratio. It is simple to operate and helps the company to send clear signals
to the shareholders about the company’s operating results.
Obviously, this policy is not suitable for a company with volatile profits, especially if the shareholders expect
stable dividends. Furthermore, this takes away from management the flexibility of retaining higher profits if they
are required for investment purposes.

2. Constant or increasing dividend

A dividend can be kept constant or increasing in:
a) Money terms (without considering inflation) or
b) Real terms (after removing the effect of inflation).
If a company expects long-term sustainable growth in earnings, it may decide to follow a policy of increasing the
dividend. Management’s main aim is to avoid volatility. A reduction in dividend payouts may reduce the share
price, which is something that they would want to avoid. Accordingly, any increase in the dividend is planned in
a conservative manner.

Example
A company achieved a 20% increase in profits in the current year and hopes to maintain the rate of growth.
However, it only increases dividends by 10%. Only when the company is confident that this earning is actually
sustained, will it raise dividends further.

If a dividend is kept constant or increasing in money terms, during a period of inflation, the dividend in real
terms may be decreased. During a period of deflation the dividend in real terms may be increased.
One disadvantage of this policy is that shareholders expect the trend of increasing dividends to continue
indefinitely. When management wants to use the funds for profitable investments, they may want to reduce
dividend payments, but may not be able to do so.
3. Zero dividend
Zero dividends cannot be a long-term policy. A new company may wish to first stabilize by reinvesting
substantial profits over the initial years, and then start paying out dividends. The company can follow a zero
dividend policy for a short period.
Although a small minority of shareholders may accept it as a policy for reasons such as tax benefits for capital
gains, the majority of shareholders would like to get some dividends. In fact, the large institutional investors
who control the bulk of shareholdings these days rely on dividend income. They are unlikely to be happy with a
zero dividend policy.
The benefits of this policy are that it is simple to follow and it involves no administrative costs associated with
the payment of dividends.
2.3 Dividend: is it relevant or irrelevant for determining share prices?
Dividend irrelevance
Miller and Modigliani are the proponents of a school of thought that dividends are irrelevant as far as share
prices are concerned. They contended that share prices depend on the level of corporate earnings which in turn
depend on the company’s investment decisions.
Investors are rational and they look to maximize their wealth. The extent and timing of dividend payouts is
irrelevant. Investors are indifferent to whether they receive their earnings by way of dividends capital gains.
Since prime importance is given to investment decisions, dividends are determined as a residual amount. There
may even be no dividends if the retained earnings are consumed by investment projects. However, the expected
future earnings of the company will push the share prices up. In this manner, a shareholder gains in capital
appreciation even if he does not receive dividend payments.
It was argued that if shareholders needed cash when no dividends were declared, they could sell some of their
shares and generate cash.
Assumptions
This theory is based on the following assumption:
1. Capital markets are prefect.
2. There are no taxes at the corporate or personal level.
3. There are no issue costs for the securities.
Dividend relevance
This is an even earlier school of thought, who was prevalent before Miller and Madigliani published their theory.
The dividend relevance theory is exactly the opposite of the irrelevance theory. It argues that dividend policies
are relevant for share valuations. The main proponents of this theory were Litner and Gordon.
The argument is that dividends, being receivable in the present and certain, are preferred to capital gains, being
receivable in the future and uncertain. If a company pays lower dividends compared to industry averages the
share price of the company will decline. This is because investors will sell their shares in order to replace them
with those paying better dividends.
➢ Signals to Shareholders
Shareholders do not have as much information as managers. They perceive dividend decisions as
communicating some new information about the company. A dividend increase may be seen as good news and
a dividend decrease, as bad news. This affects the share price.
Empirically it has been found that the share price does decrease if dividends have been reduced. The following
abstract provides an insight into the effect of dividend announcements on share prices.

Case Study
Title: The stock market reaction to dividend announcements: A UK study of complex market signals
Author(s): A.A. Lonie, G. Abeyrathna, D.M. Power, C.D. Sinclair
Journal: Journal of Economic Studies
Abstract: Investigates the stock market response to interactive dividend and earnings announcements by a
sample of 620 UK companies over the period January to June 1991. First, examines the possibility that the
response to a dividend announcement may be influenced by whether the dividend is being increased, decreased
or left unchanged. US studies suggest that this may indeed be the case and acknowledge the role of the
dividends as a signal to investors; dividend increases tend to be associated with positive abnormal returns, and
dividend decrease tend to be associated with negative abnormal returns around the time of the dividend
announcement. Second, recognizes that identifying a unique dividend information announcement effect is
particularly difficult in the UK because UK dividends are almost invariably announced simultaneously with
information about corporate earnings. Addresses this problem by focusing on those occasions when the signals
associated with these announcements conflict with one another – where dividends are increased and earnings
decrease or vice versa. The influence of combinations of dividend and earnings news is found to be important in
explaining the share price reaction on the announcement day.
(Source: http://www.emeraldinsight.com)
➢ Shareholders as clients
For liquidity and taxation reasons, some shareholders like to get their income in the form of dividends while
others may like to get it in the form of capital gains. Each company will have its own loyal shareholders who are
satisfied with its dividend policy. As such, shareholders may be dissatisfied with sudden changes in the dividend
policy and this may bring downward pressure on the price of the company’s shares.
SUMMARY

fixed percentage payout ratio a constant payout ratio is

maintained

the company follows this policy

Constant or increasing dividend if it expects long-tem
Dividend policies sustainable growth in earnings

the company invests its earnings

zero dividend in profitable projects for the
future and avoids paying dividend

Test Yourself 1
Energy Plc distributed four regular quarterly dividend payments of $0.25 each, for a total annual dividend
payment of $2.00 per share. Over the same period, Energy Plc reported net earnings of $10 per share.
Required:
Calculate the dividend payout ratio and comment on it.

3. Discuss the theoretical approaches to, and the practical influences on, the dividend decision,
including:(2)
i. Legal constraints
ii. liquidity
iii. shareholder expectations
iv. alternatives to cash dividends
[Learning Outcome c]
In section 2.1, we discussed that a company may not have enough internal funds to satisfy its dividend and
finance objectives at the same time. However, while deciding on dividends and their related policies, there are
many other factors that need to be considered.
3.1 Legal constraints
Company law in many countries stipulates that dividends can only be paid out of accumulated net realized
profits. Accumulated profits will include the profits for the current year as well as those for earlier years.
How are the profits to be calculated?
Profits will be calculated using the applicable accounting standards and after deducting accumulated losses.
Other limitations
In some jurisdictions, local governments have stipulated additional requirements for dividends.
 Example
A company must transfer a certain proportion of its profits into its reserves before distributing dividends. The
proportion of profits to be transferred into the reserves in dependent upon the dividend payout ratio.

3.2 Liquidity
Dividends are to be paid out of cash. However, as seen in Section 1.1, retained earnings or a profit earned does
not necessarily mean an availability of cash. Profits earned from day-to-day operations are not kept separately
in a cash box or bank account.
In fact, there is a continuous flow of working capital where one asset gets changed into another or is used to pay
off a liability. If you crystallize and compare the SOFP for two dates, you can trace where the cash has gone. It
might have been used to increase a bank balance, to increase an investment in debtors or inventories, or to
reduce the trade payables level.
It is clear from discussions that management needs to check the availability of cash, i.e. liquidity, before deciding
upon the amount of dividends. If the cash available is less than the dividend the company wants to distribute,
then it has to decide how to source the amount represented by the shortfall.

Example
Aqua has an ordinary share capital of $20m. It wants to distribute a dividend of 10%. Cash and liquid assets are
available to the tune of $1.5m.
The cash requirement for the dividend payout is $2m. The company will therefore have to raise additional
finance of $0.5m, before it can distribute and dividends.

3.3 Shareholder expectation

It is the financial manager’s duty to keep him informed of the shareholders’ general expectations about
dividends. Dissatisfied shareholders are likely to sell their shares. This increases the risk of the company being
taken over by outsiders.
Shareholders’ expectations centre on the following areas:
1. Taxation
2. Investment opportunities
3. Ownership dilution
However, at the outset it should be noted that it is impossible to satisfy all the shareholders at the same time.
Instead, attempts will be made to satisfy the expectations of the majority of shareholders, in order to increase
their wealth.
1. Taxation
The local tax laws will influence the expectations of shareholders. In the majority of cases dividend income is
taxed differently from capital gains.
If a company has a large proportion of shareholders in a high tax bracket, they will prefer to receive their income
in the form of capital gains rather than dividends. The investors will be able to minimize their tax payments by
choosing the timing of the capital gains (remember, capital gains are realized when investments are liquidated).
Alternatively, low rate tax payers would prefer their return in the form of dividends.

Example
In some jurisdictions, dividend payments are treated as exempted income for shareholders, provided the
company pays dividend distribution tax, which is lower than the normal tax rate. In this case the shareholders
may prefer to get more dividends.

2. Investment opportunities
The shareholders will expect higher dividend payouts when the company earns a lower rate of return than the
rate of return available to them by investing in other securities.
3. Ownership dilution
A high dividend payout means lower internal funds are available for investment opportunities. In order to seize
investment opportunities, the company may have to resort to an equity issue. If the existing shareholders do not
take up the new shares, the ownership and control status will change.
3.4 Alternatives to cash dividends
Dividends are a way of distributing profits to shareholders. Dividends are often paid in the form of cash.
However, if the liquidity situation or any other reason demands that dividends should be distributed in forms
other than cash, the financial manager can consider the following alternatives:
1. Scrip dividends
Instead of paying cash, shareholders are offered additional ordinary shares. They are normally given a choice to
take either cash or scrip. They exercise this choice based on their tax position and liquidity.
Companies that need cash for investment in new projects try this alternative. There is a possibility that, due to
tax considerations, some shareholders may not opt for the scrip dividends. To overcome this, companies
sometimes work out the dividend in such a manner that the value of the scrip dividend is ‘enhanced’ or higher
than the cash dividends.
Scrip dividends also allow the company to decrease its gearing ratio. Gearing is discussed in detail in Study Guide
E5.
2. Concessions in the price charged by a company for its goods and services
Some companies allow their shareholders a special discount on the company’s goods and services as compared
to the price charged to outside buyers. In this way, benefits are passed on to the shareholder, without involving
a direct cash payment.

Example
Jac Co sends discount coupons to its shareholders. These coupons entitle the holder to buy any of company’s
products, at a special discount 15%.

3. Share buyback
Share buyback or repurchase is also a way of rewarding shareholders. This was explained in Study Guide E2. This
option does not however, avoid cash outflow. Instead of payment towards dividends, payment is made towards
the repurchase of shares.
The shareholders realize capital appreciation in the shares of their own company. As far as the SOFP is
concerned, there is a reduction in the share capital, comparable to the reduction in retained earnings when
dividends are distributed.
Diagram 1: Alternatives to cash dividends

Alternative to cash dividends

To offer additional
To offer a special discount on the ordinary shares
company’s goods and services

to pay for the repurchase of

shares instead of dividends
3.5 Interest payment commitments
Accrual of profits
Interest payments are a charge against profits. They must be deducted before the profits available for dividend
can be calculated. The effect of interest on the amount of dividend depends upon the gearing of the company,
the rate of return on investment and the interest rate on debt. Gearing is discussed in detail in Study Guide E5.
3.6 Investment opportunities available
If attractive investment opportunities are available, a company may be tempted to restrict or even to reduce its
dividend payments, so that it can finance the investments from retained earnings to the maximum possible
extent.UK companies have traditionally used these investments as a substantial source of finance.
However, the extent to which a company may be able to do this depends upon certain factors as follows:
1. Whether external finance is available and, if it is at what cost.
2. The expectations of shareholders, as discussed in paragraph 3.3 above
3. The attitude of capital markets towards dividends.
4. The volume of funds required, compared to the availability of retained earnings.
Diagram 2: Company’s investment opportunity

A company’s
investment opportunity
depends on:

External Shareholder’s capital Retained

funds attitude market earning
available situation

3.7 Other sundry issues affecting the dividend decision

1. Long-term profitability of a company
Sustained long-term profitability is essential. A company can pay dividends out of past retained earnings
only for a limited period.
2. Restraints stipulated in loan agreements (loan covenants)
Sometimes loan agreements stipulate restriction on dividends, for example the dividend rate should not
exceed a certain percentage.
3. Gearing level of the company
Gearing is considered in the next Study Guide E5.
3.8 Ratios related to dividends and earnings
1. Earnings per share (EPS): the calculation, analysis, interpretation and limitations of Earnings per share have
been explained in detail in Study Guide C11, of Paper F7. The example below will serve as a revision.

Example
The following information is available for Maple Inc.
$
Profits after interest and tax 140,650
Preference dividend (25,317)
Profits available for distribution to ordinary shareholders 115,333
Number of shares of $1 each 100,000
 Profits available for distribution to ordinary shareholders
Earnings per share =
Number of shares

$115,333
Earnings per share =
100,000
= $1.15

This means that every $1.15 of profits is attributable to each share held.

Tip
Rule of thumb for analysis purpose: the higher the EPS ratio the better for the investor.

Tip
Warning the EPS is not an objective measure that can be followed blindly. It is subjective in nature, because its
numerator is profit. The profits of a company are dependent upon accounting policies used and accounting
estimates prepared by management.

Example
In the above example, profits available for distribution are $115,333. These are arrived at after deducting
borrowing costs of $14,667. If these costs were capitalized instead and added to the cost of the asset then
profits available for distribution would be $130,000 (115,333 + 14,667).
Earnings per Share in this case will be:
Profits available for distribution to ordinary shareholders
Earnings per share =
Number of shares

$130,000
Earnings per share =
100,000

= $1.30
This means that $1.30 of profits is attributable to each share.
This shows that the EPS is a highly subjective ratio which changes with changes in accounting policies.

2. Price / Earnings ratio: This ratio helps assess the relative risk of an investment. It is calculated as:

Current market price per share

Price Earning ratio =
Earning per shares

Example
If the current market price of the shares of Maple Inc is $1.75 and the earnings per share is $0.50, then:
Current market price per share
Price Earning ratio =
Earning per shares
$1.75
=
$0.50
= 3.5

Tip
Warning: the parameters used for calculating the numerator and denominator are not consistent. The market
price is current and up-to-date. In addition the market price is influenced by factors beyond the control of the
company.
Example
A key director of Dreams Inc dies of a heart attack and is replaced by a less experienced person. This could lead
to a decline in the market price of the company’s shares if investor’s believe the company will not perform as
well with the new director.

3. Profit Retention ratio: This ratio measures what proportion of the profits earned by a company are retained
by it. It is calculated as:
Profits after dividend
Profit Retention ratio = × 100
Profits before dividend

Example
The following information is available for Maple Inc:
Profits after interest and tax 140,650
Dividend (25,317)
Profits after dividend 115,333

Profits after dividend

Price Retention ratio = × 100
Profits before dividend

115,333
Price Retention ratio = × 100
140,650

= 82%

Tip
Rule of thumb for analysis purpose: the lower the ratio, the higher the amount shareholders expect the
company to retain for further growth. In other words, the lower the ratio, the higher the expected growth.

4. Dividend Yield: measures the return on capital investment as a percentage of the current market price of
the share. It is calculated as:
Dividend per share
Dividend Yield = × 100
Market price per share

Example
The following information is available for Elegant Inc, whose market price per share is $6.50
Number of shares 500,000
Dividend $725,000

$725,000
Dividend per share = = $1.45
500,000

Dividend per share

Dividend Yield = × 100
Market price per share

$1.45
= × 100
$6.50

= 22.3%
 Tip
Rule of thumb for analysis purposes: The dividend yield is the return a shareholder expects on the current value
of his investment. The lower the ratio, the lower the return he expects.

Tip
Warning: The parameters used for calculating the numerator and denominator are highly subjective in nature.

It is possible that the management may declare a low dividend in spite of the company making a sufficient
amount of profit as it wants to retain profits for expansion.
Conversely, management could declare a high dividend in spite of the company not making sufficient profit as
it wants to maintain the level of dividend declared in the past.
Once again, the market price is influenced by factors beyond the control of the company.

Example
Continuing the example of Elegant Inc
It is possible that the management of Elegant Inc has declared a dividend of $725,000 when it could have
declared a dividend of $925,000. Management decides to use the difference of $200,000 for its expansion
programme.
If, however, Elegant inc had paid a dividend of $925,000 then the dividend yield would have been:
$925,000
Dividend per share = = $1.85
500,000

Dividend per share

Dividend Yield = × 100
Market price per share

$1.85
Dividend Yield = × 100
$6.50

= 28.5%
This shows that, although the Dividend Yield could have been better (28.5%), the management decision to
retain funds has led to a lower Dividend Yield of 22.3%.

5. Dividend Cover: measures the ability of the company to maintain its existing levels of dividends. It is
calculated as:
Profit after tax
Dividend Cover =
Dividend

Example
The following information is available for Maple Inc:
Profits after interest and tax 140,650
Dividend (25,000)
Profits transferred to SOFP 115,650

Profit after tax

Dividend Cover =
Dividend
140,650
Dividend Cover =
25,000

= 5.6 times
 Tip
Rule of thumb for analysis purposes: the higher the ratio:
➢ The better placed the company is to pay the fixed charge of interest.
➢ The more likely it will be for the company to maintain the dividend Yield and the level of dividends
declared in the past.

Test Yourself 2
You have been given the following information for Prime Plc:
$
Equity shares of $100 each 500,000
12% preference shares of $10 each 250,000
Profit after tax 200,000
Equity dividend paid 20%
Market price of equity shares 80

Calculate the following ratios:

a) Dividend yield
b) Cover for equity and preference dividend
c) Earnings per share
d) Price earnings ratio

SUMMARY

legal constraints

liquidity ratio of the company availability of cash

taxation

shareholder’s expectations investment opportunities

ownership dilution

offered additional ordinary shares

offered special discount on

alternative to cash dividends company’s goods and services
Dividend decisions depend upon
instead of dividends, offered
repurchase of shares
external funds available

shareholder’s attitude
investment opportunities
capital market situation

retained earnings

earnings per share

price/earnings ratio
dividends and ratio profit retention ratio

dividend yield
dividend cover
 Answer to Test Yourself
Answer to TY 1
Total devidend paid to ordinary shareholders
Dividend payout ratio = × 100
Earnings after tax and preference dividends

Using the formula, Energy Plc’s dividend payout ratio is:

In other words, Energy Plc distributed 20% of its net income as dividends last year and retained the remaining
80% for other operating needs.
A ratio of 20% means that shareholders are only receiving a small amount for every dollar the company is
earning.
The real question is whether 20% is good or bad, and that is subject to interpretation. Growing companies will
typically retain more profits to fund growth and pay lower or no dividends.

Answer to TY 2

Calculation of profit available for shareholders:

$
Profit after tax 200,000
Less: Preference dividend 12% on $250,000 (30,000)
Profit available for equity shareholders 170,000
Equity dividend 20% on $500,000 = $100,000

Total devidend paid to ordinary shareholders

Dividend payout ratio = × 100
Earnings after tax and preference dividends
Dividend
Dividend per equity share =
Number of equity shares
$100,000
= = $20
5,000

Dividend per share

a) Dividend Yield on equity shares = × 100
Market price per share

20
= × 100 = 25%
80

Profit after tax

b) Cover of preference dividend =
Prefernce dividend

$200,000
= = 6.67 times
$30,000

Profit after tax and prefernce dividend

Cover for preference and equity dividend =
Equity dividend

$170,000
= = 1.70 times
$100,000

Profits available for equity shareholders

c) Earnings per share =
Number of equity shares

$170,000
= = $34
5,000
 Market price of equity share
c) Price Earning ratio =
EPS
$80
= = $2.35
$34

Quick Quiz
1. A company earned a profit of $2m in 20X9. It has liquid assets to the extent of $1.2m. How much investment
can it finance from internal sources?
2. How can working capital management efficiently generate internal sources of finance?
3. How does dividend affect a financing decision?
4. Explain a zero dividend policy.
5. How does taxation affect shareholders’ expectations about dividends?

Answers to Quick Quiz

1. Even if the company earned a profit of $2m in 20X9, it can finance investments from internal resources only
to the extent of the cash available i.e. $1.2m.
2. If working capital is managed efficiently it can reduce the net investment in current assets and release cash
for higher earning investments. In addition, the cash released by a reduction in the net current assets may
also be used to reduce a bank overdraft, thereby saving interest costs.
3. Dividend payment utilizes the available resources. The money available for alternative investments is
reduced by the extent of the dividend. The shortfall may have to be raised from other sources. Similarly, if
cash and liquid assets are not sufficient to pay the dividend amount determined, the company may have to
raise its own finance in order to pay the dividend.
4. A new company may wish to first stabilize itself by reinvesting substantial profits over the initial years before
starting to pay out dividends.
A small minority of shareholders may accept this policy for their own personal reasons such as tax benefits
for capital gains. The benefits of this policy are that it is simple to follow and it involves none of the
administrative costs associated with the payment of dividends. It also allows the company to retain cash in
its statement of financial position.
5. Dividend payments are treated as exempted income in the hands of shareholders, provided the company
pays dividend distribution tax which is lower than the normal tax rate. In this case, shareholders may prefer
to receive more dividends.

Self Examination Questions

Question 1
Explain whether the dividend decision is relevant to the market price of the shares.
Question 2
What are the alternatives to cash dividends?
Question 3
A company is capitalized as follows:
200,000 8% Preference shares at $1 each
600,000 Ordinary Shares at $1 each
The following is information for the recently ended financial year:
Profits after taxation at 50% $175,000
Ordinary dividend paid 20%
Market price of ordinary shares $5
Calculate the following ratios from the given data:
a) Earnings per share
b) P/E ratio
c) Dividend yield
d) Dividend cover

Answer to Self Examination Questions

Answer to SEQ 1
Miller and Modigliani are the proponents of a school of thought that dividends are irrelevant as far as share
prices are concerned. They contend that the share price depends on the level of corporate earnings, which in
turn depend on the company’s investment decisions.
Investors are rational and they look to maximize their wealth. The extent and timing of dividend payouts is
irrelevant. Investors are indifferent to whether they receive their earnings by way of dividends or capital gains.
Since prime importance is given to investment decisions, dividends are determined as a residual amount. There
may even be no dividends if the retained earnings are consumed by investment projects. However, the expected
future earnings of the company will push the share price up. In this manner, a shareholder gains in capital
appreciation even if he does not get dividend payments.

Dividend relevance
This school of thought was prevalent before Miller and Modigliani published their theory. The dividend
relevance theory is exactly opposite to the irrelevance theory. This School of thought argues that dividend
policies are relevant for share valuations. The main proponents of this theory were Litner and Gordon.

The argument is that dividends, being receivable in the present and certain, are preferred to capital gains, being
receivable in the future and uncertain. If a company pays lower dividends compared to industry averages, the
price of the shares of a company will decline. This is because investors will sell their shares in the company in
order to replace them with shares in a company that pays better dividends.

Answer to SEQ 2

Dividends are often distributed in cash. However, if the liquidity situation or other reasons demand that
dividends should be distributed in forms other than cash, the financial manager can consider the following
alternatives:
1. Scrip dividends
Instead of paying cash, shareholders are offered additional ordinary shares. They are normally given a choice to
take either cash or scrip. They exercise this choice based on their taxation and liquidity situation.
Companies that need cash for investment in new projects try this alternative. There is a possibility that, due to
tax consideration, some shareholders may not opt for the scrip dividend. To overcome this, companies
sometimes work out dividends in such a manner that the value of the scrip dividend is ‘enhanced’ or higher than
the cash dividend.
Scrip dividend allows the company to decrease its gearing ratio.

2. Concessions in the prices charged by a company for its goods and services
Some companies allow their shareholders a special discount on the company’s goods and services compared to
the price the company charges to outside buyers. In this way, benefits are passed on to the shareholder, without
involving a direct cash payment.

3. Share buyback
In this option, cash outflow is not avoided. Instead of payment towards dividends, the payment is made towards
repurchasing the shares.
The shareholders realize capital appreciation in the shares from their own company. As far as the SOFP is
concerned, there is a reduction in the share capital comparable to the reduction in retained earnings when
dividends are distributed.
Answer to SEQ 3

Profits afetr tax − Preference dividend

a) Earnings per share =
Number of ordinary shares

$175,000 − $16,000
=
600,000

= $0.265

Market price per share

b) Price/Earning ratio =
Earning Per Share

5
Price/Earning ratio = = 18.9
0.265

Dividend per share

c) Dividend Yield on ordinary shares = × 100
Market price per share

$0.20
= × 100 = 4%
$5

d) Dividend cover
Profit after tax
Cover of preference dividend =
Prefernce dividend

$175,000
= = 10.9 times
$16,000

Profits afetr tax and Preference dividend

Cover for ordinary dividend =
Equity dividend

$159,000
= = 1.33 times
$120,000

*($159,000 = Profit after tax $175,000 – Dividend on preference shares $16,000)