14 Evaluation of dividend policies and share repurchase. DIVS plc is a large international company with widespread interests in advertising, media and various consultancy activities associated with sales promotion and marketing. In recent years the company’s earnings and dividend payments, in real terms, have grown on average by 15 per cent and 12 per cent per year, respectively.

The company is likely to have substantial cash surpluses in the coming year, but a number of investment opportunities are being considered for the subsequent two years. The senior managers of the company are reviewing their likely funding requirements for the next two to three years and the possible consequences for dividend policy.

At present the company has a debt:equity ratio of 1:5, measured in market value terms. It does not want to increase this ratio at the present time but might need to borrow to pay a maintained dividend in the future.

The senior managers of the company are discussing a range of issues concerning financial strategy in general and dividend policy in particular.

Required:

Assume that you are an independent financial advisor to the Board of DIVS plc.

Write a report to the board which discusses the following issues:

(i) The repurchase of some of the company’s shares in the coming year using the forecast surplus cash, the aim being to reduce the amount of cash needed to pay dividends in subsequent years. Other implications of share repurchase for the company’s financial strategy should also be considered.

(ii) The advisability of borrowing money to pay dividends in years 2 and 3.

(iii) The likely effect on the company’s cost of equity if the company decides on share repurchase and/or further borrowing.