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Hello Sir,
question 297 PAVLON in Kaplan 2022-2023 FM exam KIt
regarding the dividends and how the reduction will have affect on two types of shareholders
(ii) Discuss whether the proposed final dividend of 2.34 cents is likely to be an appropriate dividend:
? If the majority of shares are owned by wealthy private individuals; and
? If the majority of shares are owned by institutional investors such as
pension funds.I have a confusion in the following paragraph:
Depending on the tax regime they inhabit and their own personal needs, private individuals may pay income tax at a higher rate than capital gains tax due to available CGT annual exemptions. They may therefore prefer retentions to distributions and would not be disappointed with a cut in dividends.
Can you please explain me how they will prefer retention to distribution due to paying more tax on income.
Secondly, how the market imperfections work, like in this paragraph:
In the absence of market imperfections such as taxation and transaction costs, it could be argued that dividend policy has no impact on shareholder wealth.
Thanks for help Sir.
Sorry – I obviously missed your question last week (I was on vacation).
Greater retention means a lower dividend but an increase in share price (for the reasons I explain in my lectures). Depending on the tax rules in the particular country, dividends may be taxed at a different rate than capital gains. If dividends are taxed at a higher rate than capital gains, then investors might prefer lower dividend (and higher capital growth instead) because it will mean less tax payable.
In theory, shareholders should be indifferent between high retention (which means lower dividend but more growth) or low retention (which means higher dividend but lower growth). I explain this in my lectures. In practice this may not be the case because of several factors such as tax (for the reasons above), transaction costs (the costs of selling shares so as to get the benefit of capital growth), and whether or not they rely on the annual income or prefer capital growth.
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