Question

Part a

Suppose management of Lilydale Sports Corporation decides to use cash to pay a dividend of $8,000,000, and then issues more shares to new shareholders to replace the cash. What will happen to the market value of the existing shares and shareholders’ wealth? Explain your answer clearly.                                                                                    

Part b.

Deakin Ltd has announced a fully franked dividend of $1 per share. The company tax rate is 27.5 per cent. By how much should the share price fall on the ex-dividend date, if franking credits are fully valued?

                                                                                                                        

Part c.

Explain the likely effects on dividend-payout ratios of each of the followings.

1. Interest rates increase substantially;
2. Company profitability increases;
3. Prospectus requirements are tightened, increasing the cost of share issue;
4. Personal income (but not capital gains) tax are increased;

Part c.

The imputation system encourages payment of high dividend. Companies that pay significant dividend may be left short of cash. Comment on this statement.

Answer 1

Part (a)

Suppose management of Lilydale Sports Corporation decides to use cash to pay a dividend of $8,000,000, and then issues more shares to new shareholders to replace the cash. What will happen to the market value of the existing shares and shareholders’ wealth? Explain your answer clearly.

Solution:

When Lilydale Sports Corporation pays dividend, the stock in some time will go ex-dividend i.e. the stock prices will go down by the amount of dividend paid. So, the value of shares will go down by $8000000.

Now, new shares are issued to replace the cash. This will lead to dilution of shares i.e. ownership proportion of the existing shareholders is reduced. This will also lead to reducing of voting power for the existing shareholders. Shareholders will view this as negative. Now, this will also lead to dilution of Earning per share of the company.i.e. EPS will be reduced as earning will be same and number of shares is increased. And issue of new shares will also lead to increase in cost of capital of the company. Equity is the costliest source of fund for a company because they bear highest risk for the company. This will affect the overall profitability of the firm.

Thus, market value of shares and shareholders wealth will have a negative impact and they will decrease.

Part c.

The imputation system encourages payment of high dividend. Companies that pay significant dividend may be left short of cash. Comment on this statement.

Solution:

Dividend Imputation:

Dividend Imputation system decreases or eliminates taxes on dividend income on the grounds that corporates have already paid taxes on the income attributed to equity shareholders as dividends.

In classical system, The residual income after tax of the company will get distributed to the shareholders and after receipt of the dividend, this income will again be taxed in the hands of the shareholders. This leads to double taxation of the same income. To eliminate this issue, dividend imputation system was adopted, Where the individual receiving the dividend will receive the tax credit. This solves the problem of double taxation.

If the income is taxed in the classical manner (double taxation), company will not want to pay more dividends because the dividend will be again taxed and the benifit received by the shareholders will be less. And with the imputation system, income is taxed only once and so, benifit to the shareholders is more as compared to the earlier.

Now, income after taxes of a company is either paid out to the owners (shareholders) or is retained. Part of the income which is retained acts as a cushion for the company. It helps a company to have appropiate liquidity position. This retained earnings is used by company against any unwanted events or for investment in new projects.

If the company pays significant dividends, without retaining adequate earnings, it won't have a cushion. And in case of an unwanted event, Company will not have liquid assets i.e. the company will be left out of cash.

Conclusion:

A company needs to pay adequate amount of dividends to its shareholders, maintaining certain level of liquid funds(cash), for any future need of the company.