Appendix 4 • Suggested answers to selected problem questionsshareholders can employ the cash more effectively than the business can. This assumes that
shareholders are indifferent between receiving dividends and the business investing avail-
able cash at the relevant cost of capital.Other factors
MM said that since the profits belong to the shareholders they would be indifferent as
to whether they receive a dividend or whether the business retains the assets concerned,
all other things being equal. Thus, provided that the business can invest the funds at a
rate above that which is available to the shareholders, the shareholders will prefer it
to invest these funds rather than to pay dividends. If it can only achieve an investment
return equal to the rate available to shareholders on other investments, shareholders
will be indifferent as to whether they receive a dividend or whether the business invests
the available funds. Only where the business cannot achieve investment returns as high
as the shareholders can achieve, will the shareholders have a positive preference for
dividends. This means that, in theory, the business should make all investments that
yield a positive NPV when discounted at the opportunity cost of capital, up to a max-
imum of the funds available. Any funds that it cannot invest at the opportunity cost of
capital should be returned to the shareholders as dividends, enabling them to make
their own investments. Thus the level of dividends is a residual, that is, it is what is left
after the business has made all of the beneficial investments available. In the case of Images
plc, the dividend should be what is left after making the two advantageous investments
(II and IV).
This assumes that the shareholders will always wish to invest all of their wealth. In
fact they may wish to consume some of it, and may find the level of dividends insuf-
ficient for their consumption requirements. MM argued that any shareholder who
wished to consume could sell as many shares as necessary to provide the cash required
for consumption. It can easily be shown that such shareholders will be better off if the
business invests in Projects II and IV because the price of the shares will be enhanced
by making these investments, meaning that shareholders will need to sell fewer shares to
produce the amount of cash that they wish to consume. The following points also need to
be raised:l Availability of cash. Profit does not equal cash. Given the business’s steady level of profit,
however, net cash inflows should exceed profit, unless there has been new investment
in non-current or current assets or a net repayment of finance.
l Clientele effect. It is claimed by some that investors are attracted to buy the shares in one
business rather than another because of its dividend policy. Thus many of the share-
holders of Images plc may be attracted by the generous dividend policy. If this policy is
now altered, they may feel disadvantaged. As MM pointed out, it is open to them to cre-
ate ‘dividends’ by selling some of their shares. However, dealing charges are not trivial
in amount, and a disposal of some shares could trigger a capital gains tax charge, which
would otherwise be delayed or even avoided.
This means that a change in the dividend policy of Images plc could be disadvanta-
geous to its shareholders. This might outweigh the advantage to them of the business
investing in Projects II and IV. The shareholders’ best interests may lie with Images pay-
ing the usual level of dividend and investing the balance of available funds.
l Taxation. Dividends are subject to income tax, whereas retained profit, leading to higher
share prices, attracts capital gains tax. Although the legislation has sought recently to
equalise the effect of these two taxes in the UK, there are still significant differences
between them. Perhaps the most important of these is the fact that capital gains only
come within the scope of taxation when the shares are disposed of, whereas the tax on
dividends bites when the dividend is paid.BUSF_Z03.qxd 11/19/08 10:33 Page 494