Debt Funding and Shareholder Dividends (AQA Paper 1 2019, Q19)

Here's a suggested answer for the 9-mark question on the effect on shareholder dividends of increased debt funding in a business.

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Possible response

Although financing the new project using long-term debt will mean higher interest costs on the new loans (thereby reducing the profit available for distribution to shareholders as dividends), this does not necessarily mean that shareholders will receive a lower level of dividends. This is because the new project will hopefully, in time, earn a higher return than the interest costs of the debt used to fund it, thereby increasing profits overall and enabling the business to pay out higher dividends. Also, if the debt is not all used at once on the new project (perhaps some of the cash outflows arise later in the project), the business may in the short-term have increased cash balances available to pay out dividends on profits retained from previous years, if it wishes to do so.