Dividend Decisions and Dividend Policy Essay Example

Dividend Decisions and Dividend Policy

Question 1

Increase in Dividends sends a positive signal to the market that there is the prospect of a good cash flow in the near future and hence investors rush to buy the stocks of the company (Dayananda, 2002). With increased demand for the stock of the company, the price will obviously rise to cater for the high demand against limited supply. The market will always believe the signal since no company that is experiencing shrinking income and negative performance can declare dividends. Dividends is declared when the firm has met its financial obligations and even ploughed back some of its profit into the business (Ehrhardt, 2013 It is believed increase in dividends is a strong indicator that the firm is performing well and its prospects for success are high. This is a clear indicator for outside investors on the performance of the company.

Question 2

	‘000,000’	‘000,000’
Net income
Add: Depreciation
Less: noncash w. capital
Less: capital expenditure
Cash flow to equity

Free cash flow to equity is $35 million (Quiry et al, 2011).

	‘000,000’
Cash flow to equity
Less: dividend paid
Add: stock purchase
Cash balance

The cash balance during the year will increase by $5 million to $60 million from the previous $55 million (Greenwood, 2002).

	‘000,000’
End of year debt
Beginning of the year debt
Financing expenditure

The financing expenditure will be $15million.

Answer to (a) will change to: $(55-15) million = $40 million cash flow to equity.

Answer to (b) will change to: $(60-15) million = $45 million cash balance

The cost of equity is 10% while the return to equity is 5%. In the long term the Lube Oil Company will end up incurring losses. The dividend policy needs to change. The company has to reduce its dividend payout in effort to reduce cost of equity. The company can give out stock gains instead of dividends. Moreover, a small dividend can be declared or not declared at all until the performance of the company stabilizes to accommodate such dividend payout (Damodaran, 2010).

Question 3

Cash flow to the firm = net income + depreciation-noncash working capital-capital expenditure

Net income
Add: depreciation
Less: noncash working capital
					(6.2208)
Less: capital expenditure
Cash flow to the firm				(12.096)	(14.5152)

Present values

Year 1 PV= 7/(1.12)¹ = $6.25 millions

Year 2 PV= 8.4/(1.12)² = $6.70 Millions

Year 3 PV = 10.08/(1.12)³= $7.17millions

Year 4 PV = 12.096/(1.12)⁴= $7.69millions

Year 5 PV = 14.5152/(1.12)⁵= $8.24 millions

(Feibel, 2003). 

Net income
Add: depreciation
Less: noncash working capital
	(6.2208)
Less: capital expenditure
	(14.5152)

The terminal value of the firm will be $9.57 million

Operating assets = capital expenditure + noncash working capital = (5.44+0.21) =$5.65millions

References

Damodaran, A., 2010. Applied Corporate Finance, John Wiley & Sons, New York.

Ehrhardt, M.C., 2013. Corporate Finance: A Focused Approach, Cengage Learning, New York.

Dayananda, D., 2002. Capital Budgeting: Financial Appraisal of Investment Projects, Cambridge University Press, Cambridge.

Feibel, B. J., (2003). Investment Performance Measurement, New York: Wiley

Greenwood, R.P. (2002). Handbook of Financial Planning and Control, Ottawa: Gower Publishing, Ltd

Quiry, P., Salvi, A., Dallochio, M., & Vernimmen, P. (2011). Corporate Finance: Theory and Practice, New York: John Wiley & Sons