Dividend irrelevance theory vs the traditional view
On the back of the assumption of a perfect market, the dividend irrelevance theory of Modigliani and Miller explains that the level of dividend does not affect the wealth of shareholders.
Based on the argument of imperfections in the market, the traditional view (dividend relevance theory) explains that the level of dividend payment affects the wealth of shareholders. Thus, dividend policy can be designed to maximise the value of shareholders.

The clientele effect:
On the recognition of differences in tax treatments of dividends and capital gains and the existence of transaction costs, the clientele effect explains that investors would prefer the dividend policy that provides the most advantages in terms of taxes and transaction costs relating to investments in shares. Thus, companies should consistently apply the dividend policy that attracts to them a clientele of investors who like the policy.

The bird-in-hand effect:
This explains that investors, in general, prefer dividends to capital gains because a dividend now is more certain than either a promised future dividend from reinvested profit or a capital gain in the future. Thus, companies should pay some dividends now.

Dividend signalling effect:
Dividend payment decisions give signals about the company’s future financial performance. In general, a higher than expected dividend signal that the directors are confident about future financial performance, which may result in an increase in the stock price. A lower than expected dividend may be a signal of financial difficulty in the future, which may cause the stock price to fall.

(2 theories @ 1.5 marks each = 3 marks)

The degree of operating leverage (DOL)
The DOL of Firm A is 1.26, and that of Firm B is 1.76:

Alternative formula:
The DOL may be computed as under using figures from the previous year (but not the new year)

Implication:
The DOL assesses the volatility in operating profit to changes in revenue. It is high when the firm uses more fixed costs than variable costs in its operating cost structure. Firm B, which has a higher DOL, presents a higher business risk to Groupe Trojan than Firm A, which has the lower DOL. The implications for the capital structure decision is that Firm A, which has the lower DOL, could have higher debt in its capital structure than Firm B, which has a higher DOL.

[Marks allocation: Computation of DOL = 2 marks each; advice on risk and implications for capital structure design = 1 mark]

The degree of financial leverage (DFL)
The DFL of Firm A is 1.3 and Firm B is 2.84:

Alternative formula:
The DFL may be computed as under using figures from the previous year (but not the new year)

Implication:
The DFL assesses the volatility in net income to changes in operating profit. It indicates the level of financial risk. Firm B, which has a higher DFL, presents a higher business risk to Groupe Trojan than Firm A, which has the lower DFL. The implications for the capital structure decision is that Firm A, which has the lower DFL, could have higher debt in its capital structure than Firm B, which has a higher DFL.

[Marks allocation: Computation of DFL = 2 marks each advice on risk and implications for capital structure design = 1 mark]

• Easier access to funds: Managers prefer sources of finance that are relatively easier to access to those that are relatively difficult to access. Retained earnings, the easiest to access and use, is first choice while new equity offers, the most difficult to access and use, is the last resort.
• Issue costs: Managers prefer sources with lower issue costs to those with higher issue costs. There are no issue costs when retained earnings is used, that is why it is the most preferred. Issue costs relating to debt offers are lower than those relating to equity offers. Therefore, debt offers are preferred to equity offers.
• Investors’ preference for safer securities: As debt stocks offer more secured income streams to investors than equity stocks offer, it is easier for firms to raise funds through debt offers than equity offers.
• Signalling effect: Managers believe debt issue has a better signalling effect than equity offer. Investors may interpret debt issue to mean that managers are confident that the investments will produce profit. Equity offer, on the other hand, may be interpreted by investors as lack of management confidence in the investment producing profits. Thus, managers prefer debt offer to equity offer.

• Business risk: Business risk refers to the risk inherent in business operations in the absence of debt financing. A higher business risk implies a small drop in sales revenue will cause operating profit to drop so low that the company cannot meet its interest obligation. If Moore Plastic Ltd faces high business risk, the new capital structure should have more equity than debt. If business risk is low, a structure of more debt than equity is reasonable.
• Financial risk: Financial risk refers to the additional risk shareholders face as the company uses debt capital. When financial risk is already high, the proportion of equity should be more than that of debt in the new structure.
• Tax position: The tax-benefit from the use of debt financing is high when the company falls into a higher tax bracket. If the company is in a higher tax bracket, a financing structure with more debt than equity would be reasonable.
• Clientele effect: An investor would prefer a particular capital structure to another. So when redesigning capital structure, directors should consider how present and prospective investors will react to the new capital structure.