ICAEW – ACA Equity sources and dividend policy and BPT Investment Exam Questions and verified Answers 2023/2024

ICAEW – ACA Equity sources and dividend policy and BPT Investment Exam Questions and verified Answers 2023/2024 What are the 3 main methods of raising the equity finance If a firm is looking to finance a project through equity - correct answer retained profits in which case dividends may be cut. Rights issues. New issues. What must you remember - correct answer that the cost of servicing the equity i.e. K.e will be the same regardless of the historic source of the funds. Why is this - correct answer because the return required on each £ of equity held by the company i.e. K.e depends on the risk suffered by the equity shareholder. It is irrelevant Where the funds originated. What is the conclusion of this - correct answer M&M used this logic to argue that the source of equity finance is irrelevant. Explain the traditional argument about dividend policy - correct answer A consistent dividend stream is important. Traditionally it was believed that it was better to have the certainty of a known dividend now than the uncertainty of having to wait known as the 'bird in the hand view'. State the m&m argument about the irrelevance of dividend policy - correct answer Consistency of the dividend stream was irrelevant. Explain the m&m argument about the irrelevance of dividend policy - correct answer As long as a dividend cut is being used to fund a positive N.P.V project, then the increased dividends in the future would be more than enough to compensate for the lower dividend today. Explain the D.I.Y theory - correct answer M&M suggested that where investors required a certain level of income, then if dividends were cut, they could simply sell a few shares, thus 'manufacturing dividends'. Dividend policy in the real world - correct answer Due to the fact that the assumptions made by M&M about the perfect market do not hold true in the real world, a number of arguments are put forward that dividend policy is relevant. Dividend signalling - correct answer M&M assumed investors had perfect information about the company. In practice, although this is true for small owner managed businesses, with listed companies, a reduction in dividend can convey 'bad news' to shareholders. The clientele effect - correct answer M&M assumed that investors were indifferent between dividends and capital growth, and that if an investor required cash then he could manufacture dividends by selling shares. In practice, tax differences and transaction costs mean this is not the case. Pecking order theory - correct answer a firm would generally choose in the following order if possible. 1. Retained profit since immediate with no issue costs. 2. Rights issue since some issue costs but no control or value given away. 3. As a last resort, a new issue since expensive, difficult to price. What happens in practice - correct answer most listed firms adopt a stable dividend policy paying out a stable, but rising, dividend per share. What must they do to be prudent - correct answer make sure dividends lag behind earnings so they can then be maintained even when earnings temporarily fall. Dividends are not the only way that a company can make distributions to their shareholders. Other methods include - correct answer share buybacks. Scrip or stock dividends.