e)

The exploration division of the company has confirmed that several ore
deposits are economically viable and ready for development into mines.
15 [LO 6] Allen and Michaely (2003) conclude that if company managers do use
dividends to signal, ‘the signal is not about future growth in earnings or cash
flows’. Outline evidence that supports this conclusion. If Allen and Michaely are
correct, how can the usual market responses to announcements of changes in
dividends be explained?
16 [LO 6] The ‘maturity hypothesis’ has been proposed as an explanation for the
nature of the information conveyed by dividend changes. Outline the key aspects
of this hypothesis.
17 [LO 7] The payment of dividends is said to have a role in reducing agency
costs. Outline the ways in which the payment of dividends can limit the extent of
agency problems.
18 [LO 7] Dividends and control may be substitute mechanisms for monitoring
management. Explain.
19 [LO 2, 4, 6, 7] In an article titled ‘BP should resist slashing dividend’ (Wall
Street Journal, 9 June 2010), Liam Denning noted that UK-based oil company
BP was under pressure to reduce or omit dividends on its ordinary shares as a
result of a major oil spill from one of its exploration wells in the Gulf of Mexico.
Subsequently, BP announced that it would omit some of its quarterly dividend
payments. Carefully examine why the reduction in, or omission of, BP’s dividends
may harm its shareholders.
20 [LO 8] Explain what is meant by catering theory and explain the importance of
incorporating risk into tests of this theory.
21 [LO 9] The imputation system encourages payment of high dividends.
Companies that do so may be left short of cash. Comment on this statement.
22 [LO 7, 10] The nature of the investment opportunities available to a company
is likely to have an important influence on dividend decisions. Discuss.
23 [LO 10] A company’s payout policy can be expected to change over time as
Copyright © 2014. McGraw-Hill Australia. All rights reserved.

the company moves through its life cycle. Explain the life-cycle theory of payout
policy.

PROBLEMS
1 Analysing dividend policy [LO 1]
As noted in Section 11.2.2, investors may attempt to infer a company’s dividend

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 policy by observing its profits, dividends and payout ratio over time. Data
collected from the annual reports of the listed company Cabcharge Australia
Limited are shown in the following table.

Year to 30 Profit after tax Dividend per share Dividend payout ratio
June ($m) (cents) (%)

2002 16.1 10.0 68.9

2003 20.3 12.0 66.8
2004 23.1 13.75 66.7
2005 27.8 17.0 68.7
2006 38.0 23.0 67.9
2007 51.8 30.0 68.0
2008 59.0 34.0 68.5
2009 61.4 34.0 66.7
2010 57.6 34.0 71.0
2011 46.1 30.0 70.5
2012 60.0 35.0 74.3
2013 60.6 30.0 71.6

a) Based on the dividend payout ratio data for the period 2002 to 2009, how
would you describe Cabcharge’s dividend policy?
b) When the figures for 2010 to 2013 are included, how might your inferences
about the company’s dividend policy change? Give reasons.

2 Dividend payment policy [LO 4]

The Dromana Dredging Company has asked your advice on its dividend policy.
There has been only a small change in earnings and dividends over the years and
the company’s share price has also been relatively stable during the same period.
It has been suggested that the company should expand its activities from
dredging into providing services for offshore oil exploration companies. To
undertake the proposed expansion activity the company intends to make a rights
Copyright © 2014. McGraw-Hill Australia. All rights reserved.

issue. As the expansion is expected to average approximately 25 per cent return

on investment each year, it is not expected that there will be any difficulty in
convincing shareholders to take up their rights. Below are data on earnings,
dividends and share prices for the years 2011–14 and the expected figures for
2015.

Dromana Dredging Company: data for 2011–14 and expected figures for 2015 ($)

2011 2012 2013 2014 2015

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 Earnings per share 0.40 0.42 0.44 0.43 0.44
Cash available per share 0.60 0.67 0.67 0.66 0.66
Dividend per share 0.20 0.20 0.22 0.22 ?
Average market price of ordinary shares 4.00 4.10 4.40 4.35 4.40

Make a recommendation on the dividend payment for 2015. Give reasons.

3 Ex-dividend share price drop [LO 5]

Dribnor Ltd has announced a fully franked dividend of $1 per share. The company
tax rate is 30 per cent. By how much should the share price fall on the ex-
dividend date if:
a) franking credits are of no value
b) franking credits are fully valued?

4 Dividend payment policy [LO 4, 5, 6]

The Wrex Manufacturing Company has a history of rapid growth, with a rate of
return on assets of about 20 per cent per annum. For the past 5 years its
dividend-payout ratio has been approximately 60 per cent. A high payout has
been justified on the grounds that the company is operated in the shareholders’
interests and dividends paid by the company have a beneficial effect on the
company’s share price. What factors would you take into consideration when
deciding on the appropriate dividend policy for the company? Is the current
dividend policy justified?

5 Information effects of dividends [LO 6]

Examine the daily share price behaviour of any company in the 4-week period
before and after its most recent change in cash dividends. What conclusions can
you draw from the movements in the share price?

4 Share buybacks and earnings per share [LO 9]

Share buybacks are sometimes motivated by the desire to increase earnings per
share. Falcon Ltd recorded an operating profit of $2 million in the last financial
Copyright © 2014. McGraw-Hill Australia. All rights reserved.

year. It has 4 million shares on issue and the market price of the shares is $5
each. Falcon announces that it will repurchase 10 per cent of each shareholder’s
shares at $5 per share.
a) Calculate Falcon’s price–earnings ratio before the buyback.
b) An observer comments as follows: ‘Falcon’s buyback should boost its earnings
per share from 50 cents to 55 cents, so with the price–earnings ratio
remaining the same, the share price should increase’.
i) If the observer’s argument is correct, what will Falcon’s share price be after the buyback?
ii) Critically evaluate the observer’s argument.

Peirson, Graham, et al. Business Finance, McGraw-Hill Australia, 2014. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/murdoch/detail.action?docID=5471317.
Created from murdoch on 2022-03-16 08:18:17.