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8/3/2019 Determinants and Aspectsof Dividend Policy
There are many empirical studies, (e.g. Lintrer) to support the contention that
companies pursue a stable dividend policy.
According to John Lintrer¶s study, dividends are µsticky¶ in the sense that theyare slow to change and lag behind shifts in earnings by one or more periods.
This leads to the pattern of stable dividend per share during the periods of
fluctuating earnings per share and a rising step-function pattern of dividends
per share during increasing earnings per share periods.
Dt± D
t±1= a
0+ c (D
t
* ± Dt ± 1
) (1)
where Dt = Dividend amount under consideration
Dt±1= Dividend paid in the previous year
a0 = A constant which may have value of zero, but never negative
and generally has a positive value to reflect the greater
reluctance to reduce than to raise dividendsc = Speed of adjustment
Dt* = Target payout ratio = dividend payout ratio (r) multiplied by profit
after taxes (p) = rp
Dt ± Dt±1= Change in dividend payout (D)
8/3/2019 Determinants and Aspectsof Dividend Policy
Legal enactments limit the amount of cash dividends that a firm may pay. A firm
cannot pay dividends out of its paid-up capital, otherwise there would be a
reduction in the capital adversely affecting the security of its lenders. Therationale of this rule lies in protecting the claims of preference shareholders and
creditors on the firm¶s assets by providing a sufficient equity base since the
creditors have originally relied upon such an equity base while extending credit.
(b) Net Profits
The net profits requirement is essentially a corollary of the capital impairmentrequirement, in that it restricts the dividend to be paid out of the firm¶s current
profits plus past accumulated retained earnings. Alternatively, a firm cannot pay
cash dividends greater than the amount of current profits plus the accumulated
balance of retained earnings.
(c) InsolvencyA firm is said to be insolvent in two situations: first, when its liabilities exceed the
assets; and second, when it is unable to pay its bills. The rationale of the rule is to
protect the creditors by prohibiting the liquidation of near-bankrupt firms through
cash dividend payments to the equity owners.
8/3/2019 Determinants and Aspectsof Dividend Policy
Internal ConstraintsInternal ConstraintsLiquid Assets Once the payment of dividend is permissible on legal and
contractual grounds, the next step is to ascertain whether the firm has sufficientcash funds to pay cash dividends.
Growth Prospects Another set of factors that can influence dividend policyrelates to the firm¶s growth prospects. The firm is required to make plans for financing its expansion programmes.
Financial Requirements Financial requirements of a firm are directly related to
its investment needs. The firm should formulate its dividends policy on the basisof its foreseeable investment needs
Availability of Funds The dividend policy is also constrained by the availabilityof funds and the need for additional investment. In evaluating its financialposition, the firm should consider not only its ability to raise funds but also thecost involved in it and the promptness with which financing can be obtained.
Earnings Stability The stability of earnings also has a significant bearing on the
dividend decision of a firm. Generally, the more stable the income stream, thehigher is the dividend payout ratio.
Control Dividend policy may also be strongly influenced by the shareholders¶ or the management¶s control objectives. That is to say, sometimes managementemploys dividend policy as an effective instrument to maintain its position of command and control.
8/3/2019 Determinants and Aspectsof Dividend Policy
Owner¶s ConsiderationsOwner¶s ConsiderationsTaxes The dividend policy of a firm may be dictated by the income taxstatus of its shareholders. If a firm has a large percentage of owners who
are in high tax brackets, its dividend policy should seek to have higher
retentions. Such a policy will provide its owners with income in the form
of capital gains as against dividends. Since capital gains are taxed at a
lower rate than dividends, they are worth more, after taxes, to the
individuals in a high tax bracket.Opportunities The firm should not retain funds if the rate of return earned
by it would be less than one which could have been earned by the
investors themselves from external investments of funds.
Dilution of Ownership The financial manager should recognise that a
high D/P ratio may result in the dilution of both control and earnings for
the existing equity holders. Dilution in earnings results because lowretentions may necessitate the issue of new equity shares in the future,
causing an increase in the number of equity shares outstanidng and
ultimately lowering earnings per share and their price in the market. By
retaining a high percentage of its earnings, the firm can minimise the
possibility of dilution of earnings.
8/3/2019 Determinants and Aspectsof Dividend Policy
Yet another set of factors that can strongly affect dividend policy is the
extent to which the firm has access to the capital markets. In case the firmhas easy access to the capital market, either because it is financially strong
or large in size, it can follow a liberal dividend policy. However, if the firm
has only limited access to capital markets, it is likely to adopt low dividend
payout ratios. Such firms are likely to rely more heavily on retained earnings
as a source of financing their investments.Inflation
Finally, inflation is another factor which affects the firm¶s dividend decision.
With rising prices, funds generated from depreciation may be inadequate to
replace obsolete equipments. These firms have to rely upon retained
earnings as a source of funds to make up the shortfall. This aspect becomesall the more important if the assets are to be replaced in the near future.
Consequently, their dividend payout tends to be low during periods of
inflation.
8/3/2019 Determinants and Aspectsof Dividend Policy
The corporate enterprises in India seem to have a tendency to pay relatively
less dividends. In fact, a fairly large number of them hardly pay any
dividend. The foreign controlled companies seem to follow a policy of larger distribution of profits relative to the domestic companies. Retained earnings
are a significant source of corporate finance.
The vast majority of the Indian corporates follows a stable dividend policy in
the sense that they pay either constant dividend per share in the following
year with fluctuating EPS or increased dividend with increase in EPS.
An overwhelming majority of corporates have a long-run target DIP ratio.The dividend changes follow shift in long-run sustainable earnings. Their
dividend policy is in agreement with the findings of Lintner¶s study on
dividend policy.
Firms which are creating shareholder value are significantly more willing to
rescind dividend increase in the event of growth opportunities available to
them. The larger firms are significantly less willing to rescind dividend
increase than the small firms.
Dividend policy provides a signalling mechanism of the future prospects of
the firm and thus affects its market value. The investors are not indifferent
between receiving dividend income and capital gains.
CONT D.
8/3/2019 Determinants and Aspectsof Dividend Policy
LEGAL, PROCEDURAL AND TAX ASPECTSLEGAL, PROCEDURAL AND TAX ASPECTS
Legal Aspects
The amount of dividend that can be legally distributed is governed by companylaw, judicial pronouncements in leading cases, and contractual restrictions. Theimportant provisions of company law pertaining to dividends are described below.
1) Companies can pay only cash dividends (with the exception of bonusshares). Apart from cash, dividend may also be remitted by cheque or bywarrant.
2) Dividends can be paid only out of the profits earned during the financial year after providing for depreciation and after transferring to reserves suchpercentage of profits as prescribed by law.
3) Due to inadequacy or absence of profits in any year, dividend may be paidout of the accumulated profits of previous years.
4) Dividends cannot be declared for past years for which accounts have beenadopted by the shareholders in the annual general meeting.
5) Dividend declared, interim or final, should be deposited in a separate bankaccount within 5 days from the date of declaration and dividend will be paidwithin 30 days from such a date.
6) Dividend including interim dividend once declared becomes a debt. While thepayment of interim dividend cannot be revoked, the payment of final dividendcan be revoked with the consent of the shareholders.
8/3/2019 Determinants and Aspectsof Dividend Policy
X Cement Ltd requires you, as their financial consultant, to advise them withrespect to the dividend policy they have to follow for the current year. The
cement industry has been through a very trying period in the last five years and
the constraints on operations have been removed in the early part of the year.
The company hopes to improve its position in the years to come and has plans
to put up an additional plant in the neighbourhood of the present factory. The
increased profits, due to expansion in capacity, are expected to be 25 per cent
of the additional capital investment after meeting interest charges but before
depreciation on the additional plant installed. The shares of X Cement Ltd are
widely held and there is a large majority of holdings in the hands of middle
class invesotrs whose average holdings do not exceed 500 shares. The
following further data is also made available to you:
8/3/2019 Determinants and Aspectsof Dividend Policy
Given the improved record of earnings in the current year and the trend which is
likely to continue in future years, coupled with favourable liquidity position, a rise in
dividend is commended for the undermentioned reasons.
(a) The investors would receive dividend income free of tax, especially if this
category of investors includes retired persons who need the current income for living expenses and do not wish to sell even a small portion of their shares
either because of transaction costs involved or because they are reluctant to
µeating their own capital¶.
(b) The investors must be expecting a substantial rise in dividend in the light of the
current market price of Rs 140 compared to Rs 60 last year. Failure to pay
dividend commensurate to the shareholder¶s expectation will have an adverseeffect on share prices.
(c) Cement industry with stable sales and earnings can afford high leverage ratios.
The company is not likely to encounter any major difficulty in raising funds to
finance an additional plant due to bright future prospects.
(d) The payment of dividend resolves uncertainty; investors in general are risk
averters; they prefer current dividends to larger deferred dividends.The payment was 50 per cent in Year 1; the payment of 60 per cent is recommeded
this year, assuming that target dividend payout ratio is 75 per cent. Moreover, the
company through advertisements should make the investors aware of the growth
prospects and the investment opportunities ahead which would have a positive
effect on share prices.
8/3/2019 Determinants and Aspectsof Dividend Policy
Solution The Infosys Ltd appears to be following a stable dividend policy. The
dividend per share (DPS) have consistently increased from Rs 3.5 in 1993-94 to Rs
7.56 in 1998-99 and, further, to Rs 40.02 in 2001-02. Though the DPS has shown a
significant increase over the years, the dividends paid are low in relation to the
market price of its share (MPS). The dividend yield (DPS/MPS) is less than one per cent in most of the years. In 2001-02, when dividends paid were maximum, the
dividend yield was 1.1 per cent only. The dividend payout (D/P) ratios is also a
pointer towards the same, varying in the range of 8.95 per cent (1993-94) and 17.34
per cent (2001-02). The D/P ratios of less than 20 per cent, for a
software/information technology company is below the mark.
The DPS are also not commensurate with the pronounced increase in the EAT as
well as the EPS over the years particularly since 1998-99. For instance, while EPS
was Rs 196.32 and Rs 244.32 in 2001 and 2002 respectively, the corresponding DPS
in these years were Rs 20.65 and Rs 40.02 only. However, Infosys has virtually
doubled the payment of DPS in 2002 over 2001. Given the improved record of
earnings, particularly since 1998-99 and the trend which is likely to continue infuture years in view of increased level of projects from the US, Infosys would be
well advised to pay higher dividend.
All along the period under reference, the market price of its shares seem to be over-
valued as reflected in the market price/book value (net worth) ratio (P/B ratio) as
shown below:
8/3/2019 Determinants and Aspectsof Dividend Policy
The P/B ratio indicates that the MPS of Infosys' shares is substantially
overvalued. It was maximum (26.49 times) in 1999-2000. The reason may behigher expected of growth of software industry by the investors in view of large
number of project and service outsourcing done from India by the USA.
However, the MPS is not warranted by the fundamental factors such as EPS,
DPS, NWPS, P/B ratio and so on.
8/3/2019 Determinants and Aspectsof Dividend Policy
Institutional Features of Institutional Features of
DividendsDividends
nn Dividend Declaration ProceduresDividend Declaration Proceduresnn Interim and finalInterim and final
nn In Australia, if dividends are paid, we typically findIn Australia, if dividends are paid, we typically findtwo sorts, a final dividend is paid after the end of two sorts, a final dividend is paid after the end of the accounting or reporting year.the accounting or reporting year.
nn An interim dividend can be paid any time before An interim dividend can be paid any time beforethe final report is released, usually after the half the final report is released, usually after the half--
nn Date board of directors pass a resolutionDate board of directors pass a resolutionto pay a dividend.to pay a dividend.
nn Record (Books Closing) DateRecord (Books Closing) Datenn The date on which holders of record areThe date on which holders of record are
designateddesignatedto receive a dividend.to receive a dividend.
nn This is 4 days after the exThis is 4 days after the ex--dividend date.dividend date.
nn The idea is that if shares are traded cumThe idea is that if shares are traded cum--dividend, brokers have time to notify thedividend, brokers have time to notify the
share register to ensure the newshare register to ensure the new
Institutional Features of Dividends (cont.)Institutional Features of Dividends (cont.)
8/3/2019 Determinants and Aspectsof Dividend Policy
Institutional Features of Dividends (cont.)Institutional Features of Dividends (cont.)
nn Dividend ImputationDividend Imputation
nn Franked dividendFranked dividend
nn Carries a credit for income tax paid by theCarries a credit for income tax paid by the
company.company.nn Franking creditFranking credit
nn Credit for Australian company tax paid which,Credit for Australian company tax paid which,when distributed to shareholders, can be offsetwhen distributed to shareholders, can be offset
against their tax liability.against their tax liability.nn Withholding taxWithholding tax
nn Tax deducted by a company from the dividendTax deducted by a company from the dividendpayable topayable to
a nona non--resident shareholder.resident shareholder.
8/3/2019 Determinants and Aspectsof Dividend Policy
nn Over the past decade, popularity of Over the past decade, popularity of Australian companies buying back their Australian companies buying back their
own shares has grown as a means of own shares has grown as a means of returning excess capitalreturning excess capitalto shareholders.to shareholders.
nn Types of share buybackTypes of share buybacknn Equal access buybackEqual access buyback ²² propro--rata to allrata to all
shareholders.shareholders.
nn Selective buybackSelective buyback ²² repurchase fromrepurchase fromspecific, limited number of shareholders.specific, limited number of shareholders.
nn OnOn--market bu backmarket bu back ²² re urchase throu hre urchase throu h
8/3/2019 Determinants and Aspectsof Dividend Policy
nn Residual dividend policyResidual dividend policy
nn Pay out as dividends any profit thatPay out as dividends any profit that
management does not believe can bemanagement does not believe can beinvested profitably.invested profitably.
nn Smoothed dividend policySmoothed dividend policynn Target proportion of annual profits to be paidTarget proportion of annual profits to be paid
out as dividend. Aim for dividends to equal theout as dividend. Aim for dividends to equal thelonglong--run difference between expected profitsrun difference between expected profits
and expected investment needs.and expected investment needs.
8/3/2019 Determinants and Aspectsof Dividend Policy
nn Value of firm is determined solely by theValue of firm is determined solely by theearning power of the firm¶s assets, and theearning power of the firm¶s assets, and the
manner in which the earnings stream ismanner in which the earnings stream issplit between dividends and retainedsplit between dividends and retainedearnings does not affect shareholders¶earnings does not affect shareholders¶
wealth.wealth.
8/3/2019 Determinants and Aspectsof Dividend Policy
Modigliani and Miller (1961)Modigliani and Miller (1961)
nn Given the investment decision of the firm,Given the investment decision of the firm,the dividend payout ratio is a mere detail.the dividend payout ratio is a mere detail.
It does not affect the wealth of It does not affect the wealth of shareholders.shareholders.
nn Assumptions Assumptionsnn No taxes, transaction costs, or other marketNo taxes, transaction costs, or other market
imperfections.imperfections.
nn A fixed investment or capital budgeting A fixed investment or capital budgeting
8/3/2019 Determinants and Aspectsof Dividend Policy
nn Dividend policy is a tradeDividend policy is a trade--off betweenoff betweenretaining profit, paying dividends andretaining profit, paying dividends and
making new share issues to replace cashmaking new share issues to replace cashpaid out.paid out.
nn Paying a dividend and issuing new sharesPaying a dividend and issuing new sharesto replace the cash:to replace the cash:
nn Does not change the value of the company;Does not change the value of the company;
andand
8/3/2019 Determinants and Aspectsof Dividend Policy
nn If a company increases its dividends, itIf a company increases its dividends, itmust replace the cash by making a sharemust replace the cash by making a share
issue.issue.
nn Old shareholders receive a higher currentOld shareholders receive a higher current
dividend, but a proportion of futuredividend, but a proportion of futuredividends must be diverted to the newdividends must be diverted to the newshareholders.shareholders.
8/3/2019 Determinants and Aspectsof Dividend Policy
nn The MM dividend irrelevance propositionThe MM dividend irrelevance propositionis validis valid
in a perfect capital market with no taxes.in a perfect capital market with no taxes.
nn Therefore, if dividend policy is important inTherefore, if dividend policy is important in
practice, the reasons for its importancepractice, the reasons for its importancemust relate to factors that MM excludedmust relate to factors that MM excludedfrom their analysis.from their analysis.
8/3/2019 Determinants and Aspectsof Dividend Policy
nn Differential tax treatment of dividendDifferential tax treatment of dividendincome versus capital gains arising fromincome versus capital gains arising from
retainedretainedprofits can either favour or penaliseprofits can either favour or penalisepaymentpayment
of dividends.of dividends.
nn This difference in tax treatment isThis difference in tax treatment is
understoodunderstood
8/3/2019 Determinants and Aspectsof Dividend Policy
Classical Tax SystemClassical Tax Systemnn In a classical tax system:In a classical tax system:
nn Company profits are taxed at theCompany profits are taxed at thecorporate tax rate,corporate tax rate, t t cc, leaving (1, leaving (1± ± t t c c ) to be) to bedistributed as a dividend.distributed as a dividend.
nn Dividends received by shareholders areDividends received by shareholders arethen taxed atthen taxed atthe shareholder¶s personal marginal taxthe shareholder¶s personal marginal taxrate,rate, t t p p..
nn The consequence is that, from a dollar of The consequence is that, from a dollar of company profit, the shareholder ends upcompany profit, the shareholder ends upwith (1with (1± ± t t cc)x (1)x (1± ± t t pp) dollars of ) dollars of after after--tax dividend in a classical taxtax dividend in a classical tax
system.system.
8/3/2019 Determinants and Aspectsof Dividend Policy
nn A system under which Australian resident A system under which Australian residentequity investors can use tax creditsequity investors can use tax credits
associated with franked dividends to offsetassociated with franked dividends to offsettheir personal tax.their personal tax.
nn The system eliminates the double taxationThe system eliminates the double taxationinherent in the classical tax system.inherent in the classical tax system.
nn Company tax is assessed on the corporateCompany tax is assessed on the corporate
profits in the normal way, at the corporateprofits in the normal way, at the corporate
8/3/2019 Determinants and Aspectsof Dividend Policy
Imputation Tax System (cont.)Imputation Tax System (cont.)
nn For each dollar of franked dividends paidFor each dollar of franked dividends paidby the company, resident shareholders willby the company, resident shareholders will
be taxed at their marginal rate (be taxed at their marginal rate (t t pp) on an) on animputed dividend of $imputed dividend of $DD / (1/ (1 ± ± t t cc).).
nn This is referred to as the µgrossedThis is referred to as the µgrossed--upup
dividend¶.dividend¶.nn The grossedThe grossed--up dividend is equal to theup dividend is equal to the
dividend plus the franking credit.dividend plus the franking credit.
nn Franking credit is given by:Franking credit is given by:
c
c
t
t
v!
1dividendcreditImputation
8/3/2019 Determinants and Aspectsof Dividend Policy
Imputation Tax System (cont.)Imputation Tax System (cont.)
nn The result is that franked dividends areThe result is that franked dividends areeffectively taxeffectively tax--free to Australian residents,free to Australian residents,
if the investor¶s marginal tax rate is equalif the investor¶s marginal tax rate is equalto the corporate tax rate.to the corporate tax rate.
nn If the investor¶s marginal tax rate is lessIf the investor¶s marginal tax rate is lessthan the corporate rate, then the investor than the corporate rate, then the investor will have excess tax credits which can bewill have excess tax credits which can be
used to reduce tax on other income, or used to reduce tax on other income, or
I t ti T S tI t ti T S t
8/3/2019 Determinants and Aspectsof Dividend Policy
(cont.)(cont.) If the investor¶s marginal tax rate isIf the investor¶s marginal tax rate is
greater thangreater thanthe corporate rate, some tax will bethe corporate rate, some tax will bepayable by the investor on thepayable by the investor on thedividend.dividend.
Investors pay tax, at their marginalInvestors pay tax, at their marginal
rate, on any unfranked dividendsrate, on any unfranked dividendsreceived.received.
Since 1 October 2003, Australian andSince 1 October 2003, Australian and
8/3/2019 Determinants and Aspectsof Dividend Policy
Imputation and Capital GainsImputation and Capital Gains
TaxTaxnn If companies retain profits, their shareIf companies retain profits, their shareprice is likely to rise relative toprice is likely to rise relative tocompanies that distribute profits, givingcompanies that distribute profits, givingrise to capital gains tax liabilities for rise to capital gains tax liabilities for shareholders if and when the sharesshareholders if and when the sharesare sold.are sold.
nn Capital gains receive preferential taxCapital gains receive preferential taxtreatment compared to µordinary¶treatment compared to µordinary¶income.income.
8/3/2019 Determinants and Aspectsof Dividend Policy
Imputation and Capital Gains Tax (cont.)Imputation and Capital Gains Tax (cont.)
nn Consequently, effective rates of CGT areConsequently, effective rates of CGT arelikelylikely
to be relatively low for many investors.to be relatively low for many investors.
nn However, where a capital gain arises fromHowever, where a capital gain arises fromretention of profits which have been taxed,retention of profits which have been taxed,any CGT that is payable will be in additionany CGT that is payable will be in additionto the tax already paid by the company.to the tax already paid by the company.
nn In other words, retention of profits canIn other words, retention of profits can
8/3/2019 Determinants and Aspectsof Dividend Policy
PolicyPolicynn If all company shares were held byIf all company shares were held by
resident investors with marginal tax ratesresident investors with marginal tax rates
less than company tax rates, then theless than company tax rates, then theoptimal dividend policy for an Australianoptimal dividend policy for an Australiancompany is one that at least payscompany is one that at least pays
dividends to the limit of its frankingdividends to the limit of its frankingaccount balance.account balance.
8/3/2019 Determinants and Aspectsof Dividend Policy
Imputation and Dividend Policy (cont.)Imputation and Dividend Policy (cont.)
nn This policy will benefit resident investorsThis policy will benefit resident investorsin two ways:in two ways:
nn The franking credits attached to frankedThe franking credits attached to franked
dividends can be used to reduce investors¶dividends can be used to reduce investors¶personal tax liabilities.personal tax liabilities.
nn Since the alternative to dividends is capitalSince the alternative to dividends is capitalgains, which are subject to company taxgains, which are subject to company tax
and CGT, higher dividends will mean thatand CGT, higher dividends will mean thatless CGT is payable by investors.less CGT is payable by investors.
nn If all franking credits are not paid out,If all franking credits are not paid out,
8/3/2019 Determinants and Aspectsof Dividend Policy
Imputation and Dividend Policy (cont.)Imputation and Dividend Policy (cont.)
nn Complicating factors for optimalComplicating factors for optimaldividend policy:dividend policy:
nn Shares are held by both resident and nonShares are held by both resident and non--resident individuals.resident individuals.
nn Many individuals have personal marginalMany individuals have personal marginaltax rates that are greater than thetax rates that are greater than thecompany tax rate and may have a taxcompany tax rate and may have a tax--based preference for retention of profits.based preference for retention of profits.
nn Since July 2000, resident investors thatSince July 2000, resident investors thatare taxare tax--exempt have excess frankingexempt have excess frankingcredits refunded.credits refunded.
8/3/2019 Determinants and Aspectsof Dividend Policy
nn Investors choosing to invest in companies thatInvestors choosing to invest in companies that
have policies meeting their particular have policies meeting their particular requirements.requirements.
nn For example: Investors who require highFor example: Investors who require highcurrent income may choose to invest incurrent income may choose to invest incompanies that have high dividend payouts.companies that have high dividend payouts.
nn Also, companies paying fully Also, companies paying fully--frankedfrankeddividends would attract shareholders whodividends would attract shareholders who
receive the greatest valuereceive the greatest value
8/3/2019 Determinants and Aspectsof Dividend Policy
Value of Franking CreditsValue of Franking Credits
nn The argument that investors will prefer taxThe argument that investors will prefer taxcredits to be distributed rather thancredits to be distributed rather than
retained assumes that tax credits areretained assumes that tax credits arevaluable to investors.valuable to investors.
nn Supporting evidence from the dividendSupporting evidence from the dividenddropdrop--off ratio:off ratio:
nn µDropµDrop--off ratio¶: ratio of the decline in theoff ratio¶: ratio of the decline in theshare priceshare price
--
8/3/2019 Determinants and Aspectsof Dividend Policy
Value of Franking CreditsValue of Franking Credits
(cont.)(cont.)nn Walker and Partington (1999) study dropWalker and Partington (1999) study drop--
off ratios:off ratios:
nn 1 January 19951 January 1995 ± ± 1 March 1997, when ASX1 March 1997, when ASXallowed trading in cumallowed trading in cum--dividend shares after dividend shares after the exthe ex--dividend date.dividend date.
nn Find a dropFind a drop--off ratio of 1.23, implying that $1off ratio of 1.23, implying that $1of of fullyfully--franked dividends is worth more than $1.franked dividends is worth more than $1.
nn Some variability because of differentSome variability because of different
Value of Franking CreditsValue of Franking Credits
(cont.)(cont.)nn Cannavan, Finn and Gray (2004) alsoCannavan, Finn and Gray (2004) also
studystudy
dropdrop--off ratios:off ratios:nn Use futures contracts on dividend payingUse futures contracts on dividend paying
sharessharesto compare with actual shares.to compare with actual shares.
nn Futures contract does not entitle holder toFutures contract does not entitle holder todividends so difference should reflect marketdividends so difference should reflect marketvalue of dividend and associated frankingvalue of dividend and associated franking
credit.credit.
8/3/2019 Determinants and Aspectsof Dividend Policy
NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend PolicyDividend Policy
nn Information effects and signalling toInformation effects and signalling toinvestors:investors:
nn Evidence suggests share price changesEvidence suggests share price changesaround the time of the announcement of around the time of the announcement of dividend changes are positively related to thedividend changes are positively related to thechange in the dividend.change in the dividend.
nn MM claim that this does not invalidateMM claim that this does not invalidateirrelevance theory. The price change is theirrelevance theory. The price change is theresult of the information content associatedresult of the information content associatedwith the dividend announcement.with the dividend announcement.
8/3/2019 Determinants and Aspectsof Dividend Policy
NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend Policy (cont.)Dividend Policy (cont.)nn Three implications of dividendThree implications of dividend
information and signalling hypothesis:information and signalling hypothesis:
nn Unanticipated dividend changes should beUnanticipated dividend changes should be
followed by share price changes in thefollowed by share price changes in thesame direction.same direction.
nn Empirical support for this implication foundEmpirical support for this implication foundin US studiesin US studies
by Grullon, Michaely and Swaminathanby Grullon, Michaely and Swaminathan(2002), Michaely, Thaler and Womack(2002), Michaely, Thaler and Womack(1995), and Healy and Palepu (1988).(1995), and Healy and Palepu (1988).
nn Australian evidence supports this Australian evidence supports this
im lication as well: Balachandaran andim lication as well: Balachandaran and
8/3/2019 Determinants and Aspectsof Dividend Policy
NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend Policy (cont.)Dividend Policy (cont.)
nn Three implications of dividend informationThree implications of dividend informationand signalling hypothesis (cont.):and signalling hypothesis (cont.):
nn Unanticipated dividend changes should beUnanticipated dividend changes should befollowed by market revision of expectations of followed by market revision of expectations of future earnings in the same direction.future earnings in the same direction.
nn Empirical evidence also supports thisEmpirical evidence also supports thisimplication, for example Ofer and Seigelimplication, for example Ofer and Seigel(1987).(1987).
nn Analysts revisions of earnings forecasts are Analysts revisions of earnings forecasts are
positively related to dividend changes.positively related to dividend changes.
8/3/2019 Determinants and Aspectsof Dividend Policy
NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend Policy (cont.)Dividend Policy (cont.)nn Three implications of dividendThree implications of dividend
information and signalling hypothesisinformation and signalling hypothesis(cont.):(cont.):nn Changes in dividends should be followedChanges in dividends should be followed
by changesby changesin earnings in the same direction.in earnings in the same direction.
nn Evidence on this implication is mixed andEvidence on this implication is mixed anddoes notdoes not
strongly support it.strongly support it.nn Watts (1973) and Penman (1983) find littleWatts (1973) and Penman (1983) find little
support for implication.support for implication.
nn Healy and Palepu (1988) find supportHealy and Palepu (1988) find support
when focusinwhen focusin
8/3/2019 Determinants and Aspectsof Dividend Policy
NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend Policy (cont.)Dividend Policy (cont.)nn Three implications of dividend information and signallingThree implications of dividend information and signalling
hypothesis (cont.):hypothesis (cont.):nn Changes in dividends should be followed by changes inChanges in dividends should be followed by changes in
earnings in the same direction.earnings in the same direction.
nn De Angelo, De Angelo and Skinner (1996) also find no linkDe Angelo, De Angelo and Skinner (1996) also find no linkbetween dividend increases and future positive profit surprises.between dividend increases and future positive profit surprises.
nn Signalling argument, the third implication, is not supportedSignalling argument, the third implication, is not supportedby empirical evidence.by empirical evidence.
nn Signal is not of continued dividend growth but rather of Signal is not of continued dividend growth but rather of permanence of current increase in dividend.permanence of current increase in dividend.
nn Alternatively, increased dividend may signal reduced risk Alternatively, increased dividend may signal reduced riskassociated with profits and cash flows, thereby reducingassociated with profits and cash flows, thereby reducingdiscount rate and raising share price.discount rate and raising share price.
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NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend Policy (cont.)Dividend Policy (cont.)nn Three implications of dividendThree implications of dividend
information and signalling hypothesisinformation and signalling hypothesis(cont.):(cont.):
nn Alternative interpretations of information Alternative interpretations of informationconveyed.conveyed.
nn Benartzi, Michaely and Thaler (1997)Benartzi, Michaely and Thaler (1997)argue that theargue that the
signal is not of continued dividend growthsignal is not of continued dividend growthbut of permanence of current increase inbut of permanence of current increase individend.dividend.
nn Alternatively, Grullon, Michaely and Alternatively, Grullon, Michaely andSwaminathan 2002 ar ue that anSwaminathan 2002 ar ue that an
8/3/2019 Determinants and Aspectsof Dividend Policy
NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend Policy (cont.)Dividend Policy (cont.)nn Agency costs and corporate Agency costs and corporate
governance (cont.)governance (cont.)
nn Lie (2000) and Grullon, Michaely andLie (2000) and Grullon, Michaely and
Swaminathan (2002) provide empiricalSwaminathan (2002) provide empiricalevidence that increased payouts either evidence that increased payouts either as special dividends, increased ordinaryas special dividends, increased ordinarydividends or a share repurchase programdividends or a share repurchase program
signal reduced opportunity to over invest,signal reduced opportunity to over invest,free cash flow hypothesis.free cash flow hypothesis.
nn Firms with limited investment opportunitiesFirms with limited investment opportunitiesexhibit aexhibit a
bigger abnormal return to thebigger abnormal return to the
8/3/2019 Determinants and Aspectsof Dividend Policy
NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend Policy (cont.)Dividend Policy (cont.)
nn Agency costs and corporate governance Agency costs and corporate governance(cont.)(cont.)
nn La Porta, LopezLa Porta, Lopez--DeDe--Silanes, Shleifer andSilanes, Shleifer andVishny (2000) provide empirical evidence thatVishny (2000) provide empirical evidence thatin countries where investors¶ interests arein countries where investors¶ interests arerelatively well protected, dividends are lessrelatively well protected, dividends are less
likely to be a mechanism to reduce agencylikely to be a mechanism to reduce agencycosts.costs.
nn WellWell--protected investors are willing to forgoprotected investors are willing to forgodividends now in return for growth.dividends now in return for growth.
8/3/2019 Determinants and Aspectsof Dividend Policy
NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend Policy (cont.)Dividend Policy (cont.)
nn Agency costs and corporate governance Agency costs and corporate governance(cont.)(cont.)
nn Correia Da Silva, Goeregen and RenneboogCorreia Da Silva, Goeregen and Renneboog(2004) argue that dividend policy may be(2004) argue that dividend policy may beinfluenced by corporate governance regimes.influenced by corporate governance regimes.
nn Market based and blockMarket based and block--holder basedholder basedregimes of corporate governance.regimes of corporate governance.
nn The presence of large (block) shareholdersThe presence of large (block) shareholdersreducesreduces
the impetus to pay out dividends (consider the impetus to pay out dividends (consider
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nn Differences in the nature of investmentDifferences in the nature of investmentopportunitiesopportunitieswill influence corporate financial decisions,will influence corporate financial decisions,including dividends.including dividends.
nn Lots of investment opportunitiesLots of investment opportunities ²² lowlow
dividends.dividends.
nn Jones and Sharma (2001) rank AustralianJones and Sharma (2001) rank Australiancompaniescompanies
8/3/2019 Determinants and Aspectsof Dividend Policy
NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of
Dividend Policy (cont.)Dividend Policy (cont.)
nn Dividend clientelesDividend clienteles
nn Groups of investors who choose to invest inGroups of investors who choose to invest in
companies that have dividend policies whichcompanies that have dividend policies whichmeet their particular requirements.meet their particular requirements.
nn If equilibrium exists in terms of the supply andIf equilibrium exists in terms of the supply anddemanddemandfor particular dividend policies, the price of afor particular dividend policies, the price of acompany¶s shares will be independent of itscompany¶s shares will be independent of itsdividend policy.dividend policy.
8/3/2019 Determinants and Aspectsof Dividend Policy
Share RepurchasesShare Repurchasesnn A share buyback is when a company purchases its own shares A share buyback is when a company purchases its own shares
on the stock market and then proceeds to either cancel themon the stock market and then proceeds to either cancel them(Aust.) or retain them as treasury stock (US).(Aust.) or retain them as treasury stock (US).
nn There are legal requirements associated with buybacks,There are legal requirements associated with buybacks,but generally companies can repurchase up to 10%but generally companies can repurchase up to 10%
of their ordinary shares in a 12of their ordinary shares in a 12--month period.month period.
nn Rapid growth in repurchases in Australia, $770m in the 1995Rapid growth in repurchases in Australia, $770m in the 1995financial year, up to $7.7b in the 12 months to June 2004.financial year, up to $7.7b in the 12 months to June 2004.
nn In 1999 and 2000, US industrial companies distributedIn 1999 and 2000, US industrial companies distributedmore cash to shareholders through share repurchasesmore cash to shareholders through share repurchasesthan dividends.than dividends.
8/3/2019 Determinants and Aspectsof Dividend Policy
nn Payment of dividends is a longPayment of dividends is a long--termterm
commitment and sudden major changescommitment and sudden major changes(especially decreases) in dividend policy are(especially decreases) in dividend policy areunappreciated by market.unappreciated by market.
nn buybacks offer an alternative way to makebuybacks offer an alternative way to makedistributions that may not be permanent.distributions that may not be permanent.
AustraliaAustraliann Five categories of share buyback:Five categories of share buyback:nn Equal access buybackEqual access buyback ²² propro--rata to allrata to all
shareholders.shareholders.
nn Selective buybackSelective buyback ²² repurchase fromrepurchase fromspecific, limited number of shareholders.specific, limited number of shareholders.
nn OnOn--market buybackmarket buyback ²² repurchaserepurchasethrough normal stock exchange trading.through normal stock exchange trading.
nn Employee share scheme buyback.Employee share scheme buyback.nn Minimum holding buybackMinimum holding buyback ²² buy backbuy back
small parcels of shares (transactionsmall parcels of shares (transactioncosts).costs).
8/3/2019 Determinants and Aspectsof Dividend Policy
AustraliaAustraliann Off Off--market buybacks can be structured to provide significantmarket buybacks can be structured to provide significanttax advantages with a large dividend and franking component.tax advantages with a large dividend and franking component.
(see for example Finance in Action: CBA¶s 2004 off (see for example Finance in Action: CBA¶s 2004 off--marketmarketshare buyback.)share buyback.)
nn Key point is that receipt of such a dividend is at the discretionKey point is that receipt of such a dividend is at the discretion
of the shareholder who sells the shares back to the company.of the shareholder who sells the shares back to the company.
nn ASX requires companies to justify buyback ASX requires companies to justify buyback ²² many onmany on--marketmarketbuybacks are justified on the basis that the market undervaluesbuybacks are justified on the basis that the market undervaluesthe company¶s shares.the company¶s shares.
nn Otchere and Ross (2002) find positive abnormal returns for Otchere and Ross (2002) find positive abnormal returns for companies, citing undervaluation as justification of a buyback.companies, citing undervaluation as justification of a buyback.
8/3/2019 Determinants and Aspectsof Dividend Policy
DefinitionDefinitionnn DRPs offer shareholders the option toDRPs offer shareholders the option toapply all or partapply all or partof their cash dividends to the purchase of of their cash dividends to the purchase of additional sharesadditional sharesin the company (in some cases at ain the company (in some cases at adiscount price).discount price).
nn The number of listed companies whichThe number of listed companies whichoperate dividend reinvestment plansoperate dividend reinvestment plansincreased from just 5 in late 1982increased from just 5 in late 1982to 14% of all listed companies by 1999.to 14% of all listed companies by 1999.
8/3/2019 Determinants and Aspectsof Dividend Policy
DRPs (cont.)DRPs (cont.)nn Benefits to investors:Benefits to investors:
nn Taxation benefits.Taxation benefits.
nn Flexibility.Flexibility.
nn Savings program.Savings program.
nn Shares are generally issued at a discount to marketShares are generally issued at a discount to marketprice and are free from brokerage and stamp duty.price and are free from brokerage and stamp duty.
nn Disadvantages to investors:Disadvantages to investors:
± ± Need to keep substantive and comprehensive recordsNeed to keep substantive and comprehensive recordsthroughout the period of ownership of assets affectedthroughout the period of ownership of assets affectedby capital gains tax.by capital gains tax.
± ± Familiarisation with plan and its tax consequences.Familiarisation with plan and its tax consequences. ± ± No control over the reinvestment price.No control over the reinvestment price.
± ± Discount disadvantages shareholders who do notDiscount disadvantages shareholders who do notparticipate in the DRP.participate in the DRP.
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nn Allow shareholders the option of receiving Allow shareholders the option of receivingtheir dividends in one or more of a number their dividends in one or more of a number
of forms.of forms.
nn For example, as bonus shares (deferringFor example, as bonus shares (deferring
tax),tax),nn or as dividends from overseas subsidiariesor as dividends from overseas subsidiaries
(foreign tax credits).(foreign tax credits).
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PolicyPolicynn Schools of thought:Schools of thought:
nn Dividend policy does not matter (MM).Dividend policy does not matter (MM).
nn A high dividend policy is best (agency costs, preference for A high dividend policy is best (agency costs, preference for current income and imputation tax system).current income and imputation tax system).
nn A low dividend policy is best (issue costs, transaction costs A low dividend policy is best (issue costs, transaction costsand tax considerations).and tax considerations).
nn Lease et al. (2000) conclude that shareholders¶ wealth isLease et al. (2000) conclude that shareholders¶ wealth isaffected by dividend policy due to market imperfections suchaffected by dividend policy due to market imperfections suchas taxes, agency costs and asymmetric information.as taxes, agency costs and asymmetric information.
nn Policy should be devised on a firm by firm case, dependingPolicy should be devised on a firm by firm case, dependingon imperfections that have the greatest impact on the firm.on imperfections that have the greatest impact on the firm.
8/3/2019 Determinants and Aspectsof Dividend Policy
ImputationImputationnn Strong incentives for taxStrong incentives for tax--payingpaying
companies to pay franked dividends.companies to pay franked dividends.
nn The benefits of doing so are greatest for The benefits of doing so are greatest for resident. shareholders subject to marginal taxresident. shareholders subject to marginal taxrates that arerates that arelower than the company tax rate.lower than the company tax rate.
nn On the other hand, shareholders withOn the other hand, shareholders withmarginal taxmarginal tax
rates that are higher than the company taxrates that are higher than the company tax
8/3/2019 Determinants and Aspectsof Dividend Policy
Dividend Policy Under Imputation (cont.)Dividend Policy Under Imputation (cont.)
nn If the company tax rate and top personalIf the company tax rate and top personaltax rate were equal, then the optimaltax rate were equal, then the optimal
dividend policy for Australian companiesdividend policy for Australian companiesowned by resident shareholders would beowned by resident shareholders would beto pay the maximum possible frankedto pay the maximum possible frankeddividends and adopt a DRPdividends and adopt a DRPto limit the outflow of cash.to limit the outflow of cash.
8/3/2019 Determinants and Aspectsof Dividend Policy
Agency CostsAgency Costsnn Payment of dividends has a role inPayment of dividends has a role in
reducingreducingagency costsagency costs ²² pay out of excess cashpay out of excess cashreduces opportunities for managers toreduces opportunities for managers to
destroy valuedestroy valueby over by over--investing.investing.
nn HighHigh--growth companies require capital,growth companies require capital,andanddividend policy should account for dividend policy should account for positivepositive
NPV investment opportunities, with aNPV investment opportunities, with a
8/3/2019 Determinants and Aspectsof Dividend Policy
Asymmetric InformationAsymmetric Informationnn Dividend and share repurchaseDividend and share repurchase
announcementsannouncementshave information content.have information content.
nn Market responds to changes inMarket responds to changes individends,dividends,special dividends, reductions in andspecial dividends, reductions in and
suspensionssuspensionsof dividends.of dividends.
A t i I f tiA t i I f ti
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(cont.)(cont.)nn Special dividend or buyback indicatesSpecial dividend or buyback indicatesreleasereleaseof temporary free cash flow.of temporary free cash flow.
nn Managers are cautious and will notManagers are cautious and will notexcessively raise ordinary dividends for excessively raise ordinary dividends for fear of having to reduce dividend infear of having to reduce dividend in
future, a strong negative signal.future, a strong negative signal.
nn Instead, a special dividend mayInstead, a special dividend may
Di id d P li d Fi LifDi id d P li d Fi Lif
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Dividend Policy and Firm LifeDividend Policy and Firm Life
CycleCyclenn A company¶s dividend payout policy A company¶s dividend payout policymay needmay needto change as it moves through it¶s lifeto change as it moves through it¶s lifecycle.cycle.
nn A new business with good growth A new business with good growthprospects is likely to require capital andprospects is likely to require capital and
unlikely to payout dividends.unlikely to payout dividends.
nn As the firm matures and has limited As the firm matures and has limited
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Summary (cont.)Summary (cont.)nn Dividend policy environment has beenDividend policy environment has been
changedchangedby recent alteration to capital gains taxby recent alteration to capital gains tax
laws, favouring capital gains over laws, favouring capital gains over dividends.dividends.
nn
Share buybacks have become anShare buybacks have become anincreasingly popular way to distributeincreasingly popular way to distributecash to shareholders.cash to shareholders.
8/3/2019 Determinants and Aspectsof Dividend Policy