Question 9.E.5: Fellingham plc has 20 million ordinary £1 shares in issue. N...
Fellingham plc has 20 million ordinary £1 shares in issue. No shares have been issued during the past four years. The business’s earnings and dividends record taken from the past financial statements showed:
\begin{matrix}&Year\ 1&Year\ 2&Year\ 3& Year\ 4(most recent)\\Earnings\ per\ share&11.00p&12.40p& 10.90p& 17.20p\\Dividend\ per\ share& 10.00p& 10.90p& 11.88p&12.95p\end{matrix}At the annual general meeting for Year 1, the chairman indicated that it was the intention to consistently increase annual dividends by 9 per cent, anticipating that, on average, this would maintain the spending power of shareholders and provide a modest growth in real income.
In the event, subsequent average annual inflation rates, measured by the general index
of prices, have been:
The ordinary shares are currently selling for £3.44, excluding the Year 4 dividend.
Required:
Comment on the declared dividend policy of the business and its possible effects on both Fellingham plc and its shareholders, illustrating your answer with the information provided.
The dividends over the period indicate a 9 per cent compound growth rate and so the chairman has kept to his commitment made in Year 1. This has meant that there has been a predictable stream of income for shareholders. However, during the period, inflation reached quite high levels and in order to maintain purchasing power the shareholders would have had to receive dividends adjusted in line with the general price index. These dividends would be as follows:
\begin{matrix}Year\ 2&10.00 \times 1.11 = 11.10p\\Year\ 3&11.10 \times 1.10 = 12.21p\\Year\ 4&12.21 \times 1.08 = 13.19p\end{matrix}We can see that the actual dividends (Year 2, 10.90p; Year 3, 11.88p; Year 4, 12.95p) have fallen below these figures and so there has been a decline in real terms in the dividend income received by shareholders. Clearly, the 9 per cent growth rate did not achieve the anticipated maintenance of purchasing power plus a growth in real income that was anticipated.
However, the 9 per cent dividend growth rate is already high in relation to the earnings of the business, and a higher level of dividend to reflect changes in the general price index may have been impossible to achieve. The dividend coverage ratio for each year is:
Dividend coverage (EPS/DPS)
\begin{matrix}Year\ 1&1.1\\Year\ 2&1.1\\Year\ 3&0.9\\Year\ 4&1.3\end{matrix}
We can see that the earnings barely cover the dividend in the first two years and that, in the third year, earnings fail to cover the dividend. The existing policy seems to be causing some difficulties for the business and can be maintained only if earnings grow at a satisfactory rate.