Fundamentals of Corporate Finance/3e,ch19

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

19-1

Chapter Nineteen

Dividends and Dividend Policy


19-2

19.1 Cash Dividends and Dividend Payment

19.2 Does Dividend Policy Matter?

19.3 Real-world Factors Favouring a Low Payout

19.4 Real-world Factors Favouring a High Payout

19.5 A Resolution of Real-world Factors?

19.6 Establishing a Dividend Policy

19.7 Share Repurchase: An Alternative to Cash

Dividends

19.8 Share Dividends and Share Splits

19.9 Employee Share Ownership Plans

19.10 Summary and Conclusions

Chapter Organisation


19-3

Chapter Objectives• Know the different forms of dividends and the appropriate

dividend payment terminology.• Outline the arguments supporting the case for dividend

irrelevance.• Discuss factors favouring a low or a high payout.• Explain the residual dividend policy.• Illustrate the situation of share repurchases vs paying a cash

dividend.• Understand both bonus issues and share splits.• Outline the various employee share ownership plans.


19-4

Types of Dividends

• A dividend is a payment made out of a firm’s earnings to its owners (shareholders).

• Dividends are usually paid in the form of cash.

• Types of cash dividends include:– regular cash dividends– extra dividends– special dividends– liquidating dividends.

• Share dividends are also paid, and share repurchases are a dividend alternative.


19-5

Procedure for Dividend Payment

Days

Thursday, Wednesday, Friday, Monday,January January January February

15 28 30 16

Declaration Ex-dividend Record Paymentdate date date date


19-6

Procedure for Dividend Payment

• Declaration date: the board of directors declares a payment of dividends.

• Ex-dividend date: if you buy the share on or after this date the seller is entitled to keep the dividend. Under ASX rules, shares are traded ex-dividend on and after the seventh business day before the record date.

• Record date: declared dividends are distributable to shareholders of record on a specific date.

• Payment date: the dividend cheques are mailed to shareholders of record.


19-7

The Ex-date Price Drop

Ex date

Price =$10

Price =$9

-t . . . –2 –1 0 +1 +2 . . . t

The share price will fall by the amount of the dividend on the exdate (Time 0). If the dividend is $1 per share, the price will be

equal to $10 – 1 = $9 on the ex date.

Before ex date (Time –1) Dividend = $0 Price = $10

On ex date (Time 0) Dividend = $1 Price = $9


19-8

Do Dividends Matter?

• Yes: the value of a share is based on the present value of expected future dividends.

• No: the value of a share is not affected by a switch in dividend policy.


19-9

Does Dividend Policy Matter?

Dividend policy versus cash dividendsAn illustration of dividend irrelevance

Original dividends

0 1 2

$1000 $1000

If RE = 20%: P0 = $1000/1.2 + $1000/1.22 = $1527.78


19-10

Does Dividend Policy Matter?

0 1 2

$1000 $1000

+200 –240

$1200 $760

Assume an additional $200 of dividends is offered, financed by an issue of debt or shares. New dividend plan:

P0 = $1200/1.2 + $760/1.22 = $1 527.78


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Dividend Policy Irrelevance

• Any increase in dividends at one point is offset exactly by a decrease somewhere else.

• An alternative explanation is home-made dividends. Individual investors can undo corporate dividend policy by reinvesting dividends or selling shares.

• Companies may help with creating home-made dividends by offering shareholders automatic dividend reinvestment plans (DRIPs).


19-12

Dividends and the Real World

A low payout is better if one considers:• Taxes: Optimal dividend policy is determined by various

shareholder situations. Some shareholders prefer high franked dividends, others prefer the company to pay no dividend and retain the funds for reinvestment (tax on dividend income vs capital gains tax).

• Flotation costs: Higher dividend payouts may require a new share issue, which could be expensive and decrease the value of the firm.

• Dividend restrictions: Debt contracts might limit the percentage of income that can be paid out as dividends.


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Dividends and the Real World

A high payout is better if one considers:

• Desire for current income instead of capital gain.

• Uncertainty resolution: ‘bird-in-hand’ story.

• Tax benefits: There are some investors who do receive favourable tax treatment from holding high dividends (e.g. corporate investors).

• Legal benefits.


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Examples of Imputed Tax CreditsShareholders’ level of taxable income

6 001 to

20 000

20 001 to

50 000

50 001 to

60 000

60 000 +

Marginal tax rate (1 July 2000)

17% 30% 42% 47%

Corporate tax Dividend paid

$30 70

$30 70

$30 70

$30 70

Taxpayer’s additional assessable income

$100

$100

$100

$100

Tax on assessable income Credit for company tax

$17 30

$30 30

$42 30

$47 30

Net credit (payment) $13 nil ($12) ($17) Tax to be paid on dividends

($13)

nil

$12

$17


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To Date …

• Based on the home-made dividend argument, dividend policy is irrelevant.

• Because of high taxation of some individual investors, a high-dividend policy may be best.

• Because of new issue costs, a low-dividend policy is best.


19-16

Dividends and Signals• Changes in dividends convey information

– Dividend increases: Management believes it can be sustained. Expectation of higher future dividends, increasing present

value. Signal of a healthy, growing firm.

– Dividend decreases: Management believes it can no longer sustain the current

level of dividends. Expectation of lower dividends indefinitely; decreasing present

value. Signal of a firm that is having financial difficulties.

– The information content makes it difficult to interpret the effect of the dividend policy of the firm.


19-17

Clientele Effect

• Shares attract particular groups based on dividend yield and the resulting tax effects.

• Some investors prefer low dividend payouts and will buy shares in those companies that offer low dividend payouts.

• Some investors prefer high dividend payouts and will buy shares in those companies that offer high dividend payouts.


19-18

Residual Dividend Policy

• Issue costs eliminate any indifference between financing by internal capital and new shares.

• Dividends are paid only if profits are not completely used for investment purposes.

• Desired debt-to-equity ratio is maintained.


19-19

Residual Dividend Policy


19-20

Relationship Between Dividends and Investment

-333

0

333

666

999

0 500 1000 1500 2000 2500 3000

Dividends

New investment


19-21

Key Concepts in Dividend Policy• Dividend stability—dividends are only increased if the increase is

sustainable.

• Dividend streaming—shareholders can choose different dividend schemes to suit their tax position (franked vs unfranked dividends)

• Special dividends—‘one-off’’ extra dividends.

• Dividend reinvestment schemes—company reinvests individuals’ dividends into fully paid shares of the company. Avoids transactions costs and need for prospectus, and shares are usually offered at a discount.


19-22

Australian Equity Raisings 2001

Source: Australian Stock Exchange


19-23

Share Repurchases

• Company buys back its own shares.

• Similar to a cash dividend in that it returns cash from the firm to the shareholders.

• This is another argument for dividend policy irrelevance in the absence of taxes or other imperfections.


19-24

Share Repurchases

• Equal access purchase

Offer made by company to all shareholders to purchase shares in the same proportion as their holdings.

• On-market purchase

Purchase by a company of its own shares on the open market.• Employee share purchase

Repurchase shares from employees that were issued under employee incentive scheme.

• Selective purchase

Repurchase of shares from specific shareholders.• Odd-lot purchase

Repurchase of small parcels of shares.


19-25

Cash Dividend versus Share Repurchase

Assume no taxes, commissions or other market imperfections.

Consider a firm with 50 000 shares outstanding, net profit of $100 000 and the following balance sheet.


19-26

Cash Dividend versus Share Repurchase (continued)

• Price per share is $20 ($1 000 000/50 000).

• EPS = $2.00 ($100 000/50 000).

• PE ratio = 10.

• The firm is considering either:– Paying a $1 per share cash dividend.

OR – Repurchasing 2500 shares at $20 a share.


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Price per share is $19.00 ($950 000/50 000).

EPS = $2.00 ($100 000/50 000).

PE ratio = 10.

Cash Dividend Option

Cash $ 50 000 $ 0 Debt

Other Assets 900 000 950 000 Equity

Total $ 950 000 $ 950 000 Total


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Price per share is $20.00 ($950 000/47 500).

EPS = $2.10 ($100 000/47 500).

PE ratio = 9.5.

Share Repurchase Option

Cash $ 50 000 $ 0 Debt

Other Assets 900 000 950 000 Equity

Total $ 950 000 $ 950 000 Total


19-29

Share Dividends and Share Splits

Bonus shares and share splits:• involve issuing new shares on a pro-rata basis to the current

shareholders

• do not change the firm’s assets, earnings, risk assumed and investors’ percentage of ownership in the company

• increase the number of shares outstanding

• reduce the value per share

A common explanation is to adjust the share price to a ‘more desirable trading range’.


19-30

Reverse Splits

• The firm reduces the number of shares outstanding.

• Reasoning:– reduction in transaction costs– increase in share marketability (trading range)– regain respectability.


19-31

Share Ownership Plans

• Encourage the financial participation of employees in the company, including:

– fully paid shares– partly paid shares– special classes of shares– options– phantom or shadow shares– employee share trusts.

Fundamentals of Corporate Finance/3e,ch19

Economy & Finance