Dividend issues

THE UNIVERSITY OF FAISALABADSCHOOL OF MANAGEMENT STUDIES

Subject: Corporate Governance Presentation: Dividend Issues

SUBMITTED BY: SUBMITTED TO: Hasan Mukhtar Bajwa SIR Awad Raheel Hafiz Jawad Mehtab Wajid Ali Afraz Hamid

Corporate Governance Dividend Issues

Dividend is distribution of value to the shareholders. Usually, firms pay dividends in the form of cash or additional stock.

There are several important dates to note when a firm’s board of directors declares that a dividend . These include

Declaration Date: This is the date on which company’s board of directors declares that a dividend will be paid. The board determines the amount of dividend, the board declare a dividend payment either in cash dividend, stock split option or stock repurchase.

Dividend

Record Date: This is the date on which a company reviews its book to determine its shareholders of record. Shareholders who hold a particular stock on this date will receive the firm’s dividend payment.

Ex-Dividend Date : After the record Date has been determined, it is two business days prior to the record date. If an investor buys a stock before ex-dividend date, then he or she will receive the dividend payment. If an investor purchases the stock on or after the ex-dividend date, then he or she is not entitled to receive the dividend.

Dividend (Cont…)

Payment Date : The dividend checks are mailed to shareholders of record.

Dividend (Cont…)

The Importance of Payout Policy to Shareholders

A company’s business decisions involve investment, financing and payout policies.

Directors of companies must decide how much cash, if any, to pay to shareholders and whether the payment should be in the form of dividends or repurchase shares.

The amount of money involved in payment suggests payout decision is a significant issue in many companies operation.

It is evident from empirical studies that investors supply capital to business only because they have the reasonable expectation of eventually receiving payouts from company in one form or another. (De Anglo & De Anglo, 2007)

The decision on the company’s payout policy should be consistent with the overall financial objective of maximising shareholders’ wealth.

Managers can do two things with current year’s earning

Distribute as cash dividend or Retain them in company

With retain earning Make additional investments Pay down debt

Why Pay Cash Dividend?

Managers and Payout Decisions

Dividends are an active decision variable (Lintner). In a much larger study, some of the findings by Bray et. al. (2005) were consistent with those of Lintner:

◦ Maintaining current level of dividend per share is a high priority and is of similar importance to investment decisions.

◦ Managers see little reward for increasing dividends.

◦ Dividends are inflexible and smoothed relative to profits.

◦ Share repurchases are very flexible with no need for smoothing — repurchases are made using the residual cash flow after investment spending.

Asymmetric Information: A situation in which one party in a transaction has more or superior

information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party's lack of knowledge.

AGENCY COST: A type of internal cost that arises from, or must be paid to, an agent

acting on behalf of a principal. Agency costs arise because of core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders.

corporate governance mechanisms are designed to mitigate agency costs, they may accomplish this by reducing asymmetric information. This can happen directly through incentives that encourage managers to reveal information concerning their level of effort and perquisite consumption, in order to qualify for incentive payments. This can also happen indirectly, as many corporate governance mechanisms are designed to improve monitoring, making it difficult for managers to conceal the extent of their shirking and of their perquisites consumption.

Solving Informational Asymmetry:

Independent and active boards, a greater reliance on performance related payment systems, and the use of debt financing all reduce asymmetric information, whereas greater ownership concentration is associated with increased information asymmetry.

Number of non-executive directors serving in the board, the number of audit committee meetings per year, the ratio of CEO benefits to total CEO income, the fraction of outstanding shares held by block-holders and the total debt ratio are the most important factors in mitigating information asymmetry.

If you are a stockholder in Willamette Industries, how much information do you have about its worldwide operations and its competitors?

How much can you really find out about its future prospects by reading current financial statements or, these days, Web page message boards?

Answer : Best answer is to send cash dividend checks with reflect the company’s prospects and financial position.

Solving Informational Asymmetry problems

Managers are reluctant to lose control over this cash. Managerial compensation, power and status are related to the size of

firm. Managers are more interested in “growth of firm”, instead of

shareholder value. Cash dividends, therefore are a way of removing free cash flow from

managerial control in firms that face limited investment opportunities.

Dividends, Free Cash flow, and Conflicts of Interest

Mature and declining industries will have limited investment opportunities.

New and expanding industries have more growth opportunities.

Shareholder of mature and declining industries will expect more cash dividend, because of negative NPV.

On other hand the shareholders of new and expanding industries are less concerned with cash dividends.

Dividends and Growth opportunities

Common law countries: stronger investor protection law. Civil law countries: Less stronger then common law countries. Divided payout ratios of new and expanding companies, measured by

growth in sales, were lower than those of mature companies in common law countries.

Dividend payout ratio of mature companies in civil law countries were significantly lower than those of mature companies in common law countries.

Note: Combination of governance structure and investor protection laws result in reducing agency cost.

Dividends and legal systems

Share buyback Effects of tax : 40 per on cash dividend and 20 per on capital gains Lump-sum buyback sees increase by 20 % in price of stock Over time, depending on market conditions, price go up by 3%.

Dividends, Taxes, and Share repurchases

Use firm’s excess cash to buy stock back Repurchases are an alternative to dividends for

distributing cash to shareholders, with some advantages over paying cash

Advantages of Stock Repurchases:1. Cash is distributed to shareholders who want it

• Only shareholders who decide to sell get cash

2. As repurchases are usually done over time, firm has flexibility to scale back or reverse decision

Stock Repurchase

3. Tax advantage to shareholders since cash distributed comes to shareholders as a capital gain rather than classified as dividend – dividends are taxed at higher rate

4. Purchasing stock provides signal to market that firm believes share undervalued – typically results in increase in share price

5. In some firms, control by certain shareholders is important and a reduction in number of shares increases their percentage ownership

Assume that any investments a firm makes are NPV = 0

Investments themselves would not create or destroy value.

As before, dividends then merely determine where an investor gets income from – dividends versus capital gains

Is dividend policy irrelevant in this case? Do investors care how they get income?

Are investors really indifferent between dividends and capital gains?

Dividend policy determines how investors receive income.

This is an important issue because dividends are taxed more heavily than capital gains.

In Canada: Only 50% of a capital gain is taxableDividends are taxed as regular income, although dividend tax

credit reduces the excess taxation

Ceteris paribus, investors prefer income to be in form of capital gains.

Dividend Policy and Taxes

Because dividends are taxed more highly than capital gains, taxable investors prefer small or no dividends (all else being equal).

Firm’s which pay dividends have to offer higher before tax returns in order to compensate investors for the higher tax they must pay.

Implication: Firm’s with high dividends should have lower share prices than identical firms with lower dividends.

Dividend policy does matter.

Implication: Tax free investors (e.g. pension funds) will prefer to invest in high dividend stocks.

Dividend Policy and Taxes

Note: even if dividends and capital gains are taxed at same rate, there is still a tax advantage in capital gains

Tax timing optionTaxes on capital gains are only paid when realizedInvestors can therefore decide when to sell shares and pay tax

Valuable option Investors can sell shares and realize gain when most advantageous for

tax purposes Dividends do not have this option

Also means that taxes on capital gains can be delayed Present value of taxes to be paid is less if the shares are to be sold far

into the future

Dividend Policy and Taxes

In the extreme, the tax disadvantage of dividends means that firms should pay no dividends

As long as they have NPV > 0 or NPV = 0 projects to invest in, investors prefer not to get any dividends paid to them.

What mitigates the tax effect? Why do firms pay dividends?

Dividend Policy and Taxes

Why Companies Repurchase Shares? Dividend substitution

◦ If capital gains are taxed more favorably than dividends.◦ Some supporting evidence from the US, where dividend payout

ratios have been falling in the 1980s and 1990s. Improved performance measures

◦ EPS may rise, but if cash is returned rather than used to retire debt, financial risk is increased and P/E ratio along with share price may fall.

◦ Return of funds that cannot be profitably used will raise share price.

Signalling and undervaluation◦ Managers buying back company stock indicates that

they believe the stock is undervalued by the market.◦ Alternatively, a buy-back announcement could be accompanied by

some new information, e.g. sale of unprofitable asset/division.

Why Companies Repurchase Shares? (cont.) Resource allocation and agency costs

◦ Share repurchase returns capital to shareholders, who can reallocate funds into profitable activities through the capital market.

◦ Reduces the potential for managers to inefficiently use free cash (i.e. reduces agency costs).

Financial flexibility◦ Payment of dividends is a long-term commitment, and sudden major changes

(especially decreases) in dividend policy are unappreciated by market.◦ Buy-backs offer an alternative way to make distributions that may not be permanent.

Employee share options◦ Unlike paying dividends, share repurchases do not lead to the ex-dividend price drop-

off.◦ Option holders (typically management) prefer a share repurchase to a dividend payout

as a means of distributing profits to shareholders.

THANKS