BBK34133 | Investment Analysis Prepared by Khairul Anuar

BBK34133 | Investment AnalysisPrepared by Khairul Anuar

L6 – Dividend and Dividend Policy

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What is Dividend Policy

• Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation.

– This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.

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Types of Dividends

• Dividends are a permanent distribution of residual earnings of the corporation to its owners.

• Dividends can be in the form of:– Cash– Additional Shares of Stock (stock dividend)

• If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders – this is known as a liquidating dividend.

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Distributions to Shareholders

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The “clientele effect”

• Different groups of investors, or clienteles, prefer different dividend policies.

• Firm’s past dividend policy determines its current clientele of investors.

• Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies due to a change in payout policy.

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The “information content,” or “signaling,” hypothesis

• Investors view dividend changes as signals of management’s view of the future. Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable.

• Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

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• In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm.

• When a cash dividend is declared, those funds leave the firm permanently and irreversibly.

• Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.

Dividends a Financing Decision

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Dividends characteristics

• A dividend is a discretionary payment made to shareholders

• The decision to distribute dividends is solely the responsibility of the board of directors

• Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)

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Distributions to Shareholders• The company’s board of directors declares the dividend that

will be paid and decides when the payment will occur:• Ex-dividend date• Record date• Payment date

• Some companies pay dividends once year while others pay dividends twice a year –usually as an interim and a final dividend.

• Occasionally, a firm may pay a one-time, special dividend that is usually much larger than a regular dividend.

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Mechanics of Cash Dividend PayDeclaration Date

– this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class.

– when CARRIED, this resolution makes the dividend a current liability for the firm.

Date of Record – is the date on which the shareholders

register is closed after the trading day and all those who are listed will receive the dividend.

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Mechanics of Cash Dividend PayEx dividend Date

– is the date that the value of the firm’s common shares will reflect the dividend payment (ie. fall in value)

– ‘ex’ means without.– At the start of trading on the ex-dividend date,

the share price will normally open for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend.

Date of Payment – is the date the cheques for the dividend are

mailed out to the shareholders.

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Declaration DateDate ofRecord

Date ofPayment

Ex Dividend Date is determined by the Date of Record.The market value of the sharesdrops by the value of the dividendper share on market opening…comparedto the previous day’s close.

The Board Meetsand passes themotion to createthe dividend

x business days prior to the Date of Record

Dividend Declaration Time Line

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Dividend Policy• There is no legal obligation for firms to pay dividends to

common shareholders

• Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because:

Board members are jointly and severally liable for any damages they may cause

Board members are constrained by legal rules affecting dividends including:Not paying dividends out of capitalNot paying dividends when that decision could cause

the firm to become insolventNot paying dividends in contravention of contractual

commitments (such as debt covenant agreements)

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Dividend Reinvestment Plans (DRIPs)• Also referred to as stock dividends

• Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm DRIPs will buy as many shares as the cash dividend

allows with the residual deposited as cash Shareholders can automatically reinvest their dividends

in shares of the company’s common stock.

• Firms are able to raise additional common stock capital

continuously at no cost and fosters an on-going relationship with shareholders.

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Stock Dividends • Stock dividends simply amount to distribution of

additional shares to existing shareholders

• They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account.

• Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future.

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Stock DividendsImplications

– reduction in the Retained earnings account– reduced capacity to pay future dividends– proportionate share ownership remains unchanged– shareholder’s wealth (theoretically) is unaffected

Effect on the Company– conserves cash– serves to lower the market value of firm’s stock modestly– promotes wider distribution of shares to the extent that

current owners divest themselves of shares...because they have more

– adjusts the capital accounts– dilutes EPS

Effect on Shareholders– proportion of ownership remains unchanged– total value of holdings remains unchanged– if former DPS is maintained, this really represents an

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Stock Dividends Example

ABC CompanyEquity Accounts

as at February xx, 20x9

Common stock (21,500) $5,000,000Retained earnings 20,000,000Net Worth $25,000,000

The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share.

This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is:

$40.00 (21,500) = $860,000

This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:

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Share Repurchases

• Repurchases: Buying own stock back from stockholders.

• Simply another form of payout policy.

• An alternative to cash dividend where the objective is to increase the price per share rather than paying a dividend.

• Since there are rules against improper accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.

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Stock Repurchases

• Reasons for repurchases:– As an alternative to distributing cash as dividends.– To dispose of one-time cash from an asset sale.– To make a large capital structure change.– To use when employees exercise stock options.

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• called treasury stock • non-voting • may not receive dividends • if not retired, can be resold unlike the U.S., (in

some countries shares repurchased are cancelled eg. Canada)

Repurchased Shares

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Scenario: Company A: Current earnings=$4.4m, Current no of shares=1.1 m sharesCurrent share price = $20Repurchase = 100,000 shares (0.1 m shares)

Current EPS= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00

Current P/E ratio= $20 / $4 = 5X

EPS after repurchase of 100,000 shares= $4.4 m / 1.0 = $4.40

Expected market price after repurchase:= [p/e] x [EPSnew] = [5] x [$4.40] = $22.00 per share

Repurchase Example

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• EPS should increase following the repurchase if earnings after-tax remains the same

• should result with a higher market price per outstanding share

• shareholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the share price.

Effects of A Share Repurchase

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Share repurchase as a signal

• The announcement of an intended repurchase might send a signal that affects stock price, and the previous events that led to cash available for a distribution affect stock price

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Summary of Dividends vs. Repurchases

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Dividend Versus Retention of CashAgency costs of retaining cash

• There is no benefit to shareholders when a firm holds cash above and beyond its future investment or liquidity needs.

• Managers may use this cash inefficiently by continuing money-losing pet projects, paying excessive executive perks or overpaying for acquisitions.

• Leverage is one way to reduce a firm’s access cash.

• Paying out cash can boost the share price by reducing managers ability and temptation to waste resources.

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Advice for the Financial Manager

Overall, as a financial manager, you should consider the following when making payout policy decisions:

• For a given payout amount, try to maximise the after-tax payout to the shareholders. Repurchases and dividends are often taxed differently and one can have an advantage over the other.

• Repurchases and special dividends are useful for making large, infrequent distributions to shareholders - neither implies any expectation of repeated payouts.

• Starting and increasing a regular dividend is seen by shareholders as an implicit commitment to maintain this level of regular payout indefinitely.

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Advice for the Financial Manager

• Because regular dividends are seen as an implicit commitment, they send a stronger signal of financial strength to shareholders - However, this signal comes with a cost because regular payouts reduce a firm’s financial flexibility.

• Be mindful of future investment plans - There are transaction costs associated with both distributions and raising new capital, so it is expensive to make a large distribution and then raise capital to fund a project.

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Our Company intends to distribute yearly dividends of RM700 million or up to 90% of our normalized PATAMI, whichever is higher. Dividends will be paid only if approved by our Board out of funds available for such distribution. The actual amount and timing of dividend payments will depend upon our level of cash and retained earnings, results of operations, business prospects, monetization of non-core assets, projected levels of capital expenditure and other investment plans, current and expected obligations and such other matters as our Board may deem relevant.”

Dividend Policy

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Microsoft Boosts Dividend by 22%, Sets $40 Billion Buyback

Microsoft Corp moved to share more of its cash hoard with shareholders, boosting its quarterly dividend by 22% and renewing a $40 billion authorization to buy back its shares.Microsoft unveiled a $40 billion share buyback plan and boosted its quarterly dividend by 22%, continuing the shareholder-friendly moves it has pushed in recent years. The announcement Tuesday comes two days before a highly anticipated meeting with financial analysts and follow a series of surprise changes at the software giant, including a plan to seek a successor to Chief Executive Steve Ballmer and a $7 billion deal to buy Nokia Corp.'s 2.19% smartphone business.Microsoft has raised its dividend eight times since 2004, in announcements that typically come in September. But the latest increase was greater than predicted by some analysts, who see Microsoft's moves to return cash to shareholders as a way to defuse dissatisfaction with the company's share price.

Wall Street Journal, Updated Sept. 17, 2013

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