2201AFE Corporate Finance

Week 12: Dividends and Dividend Policy Readings: Chapter 18

Agenda
Last Week Dividends and Dividend Policy
Key Concepts and Skills

Final Exam Formulae Sheet and Practice Questions.

Start doing the practice questions, we will go through this in the revision lecture. Answers to short answers questions can be found throughout the lecture notes (will not be provided).

Reminder for Quizzes on McGraw-Hill Connect website.

Last Lecture
Capital Structure Effect of Financial Leverage M&M propositions I and II
Case 1 No Costs Case 2 With Taxes Case 3 With Taxes and Bankruptcy Costs

Bankruptcy Costs
Direct & Indirect

Optimal Capital Structure

Dividends and Dividend Policy

Chapter 18

1. Introduction & Financial Statements

7. Mid-semester Exam 8. Some Lessons from Capital Market History

2. Time Value of Money 9. Return, Risk & the Security Market Line

3. Valuing Shares & Bonds

4. Net Present Value & Other Investment Criteria

10. Cost of Capital

5. Making Capital Investment Decisions & Project Analysis

11. Financial Leverage & Capital Structure Policy 12. Dividends & Dividend Policy

6. Revision for Mid-sem Exam

13. Options & Revision

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Key Concepts and Skills

Cash Dividends and Dividend Payment Does Dividend Policy Matter? Some Real-World Factors Favoring:
Low Payout High Payout

A Resolution of Real-World Factors Establishing a Dividend Policy Stock Repurchase: An Alternative to Cash Dividends Stock Dividends and Stock Splits

Cash Dividends
Regular cash dividend
cash payments made directly to stockholders, usually each quarter

Extra cash dividend

indication that the extra amount may not be repeated in the future

Special cash dividend

similar to extra dividend, but definitely wont be repeated

Liquidating dividend
some or all of the business has been sold
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Dividend Payment Chronology

Declaration Date
Board declares the dividend and it becomes a liability of the firm

Ex-dividend Date
Four business days before date of record Stock bought on or after this date, will not receive the dividend Stock price generally drops by about the amount of the dividend

Date of Record
Holders of record are determined

Date of Payment
Cheques are mailed
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Example
Divided Airlines has declared a $2.50 dividend per share payable on Tuesday, May 30, to shareholders of record as of Tuesday May 9. An investor buys 100 shares of this company on April 27 for $150 each. What is the ex-date? What are the events happening with respect to the dividend and stock price?

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Example continued
April 27 Purchase May 3 Ex-date May 9 Record date May 30 Payment

Purchase date: Ex-date:

April 27

do not count non-working days

4. Wednesday, May 3 3. Thursday, May 4 2. Friday, May 5 Saturday, May 6 Sunday, May 7 1. Monday, May 8
May 9 May 30

Date of record: Cheques mailed:

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Example continued
Value of stock around ex-dividend date
$150 -t $147.50 . t

$2.50 ex-dividend price drop

Investors wealth at dividend payment date: $147.50 100 shares = $14,750 $2.50 100 shares = $ 250 Total = $15,000
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Does Dividends and Dividend Policy Matter?

Dividends matter!!!
The value of the stock is based on the present value of expected future dividends.

Dividend policy may not matter

Pay larger dividends and reinvest less vs. Pay smaller dividends and retain funds to reinvest more in the firm.
In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future.

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Irrelevance Theory
Modigliani and Millers (1961) irrelevance theory makes use of home-made dividends and relies on a number of assumptions:
No company taxes, no transaction costs or market imperfections. No personal taxes A fixed capital budgeting program

The value of a firm:

is determined by the earning power of the firms assets

is not affected how the income is split between dividends and retained earnings.

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Illustration of Irrelevance
Palm Inc. is a firm with 2 year life and 100 shares
Policy 1: pay out dividends of $100 each year Policy 2: pay $90 dividend year 1, reinvest the other $10 into the firm and then pay $111.20 next year. Investors require a 12% return.

Which policy is the best?

It doesnt matter !! Value is the same
Market Value with constant dividend = $16,900.51 PV = 10,000 / 1.12 + 10,000 / 1.122 = 16,900.51 Market Value with reinvestment = $16,900.51 PV = 9000 / 1.12 + 11,120 / 1.122 = 16,900.51
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Irrelevance of Dividend Policy Example

Operating CF = $10,000; Net Investment = $8,000 Shares Outstanding = 1,000 Shares;

Price per share = $42. Firm has a finite life.

Bianchi Inc. Policy 1 ($2 dividends) Policy 2 ($3 dividends)

Dividends Ex-dividend Price per share New equity issued Shares outstanding Value of the firm

$2,000 $40 $0 1,000 $40,000

($40 x 1,000)

$3,000 $39 $1,000 1,025.64 $40,000

($39 x 1,025.64)

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Homemade Dividend Policy

Investors will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends. Homemade Dividend Policy = Tailored dividend policy created by individual investors to undo corporate dividend policy.

Homemade dividends selling shares in the appropriate proportion to create an equivalent cash flow to receiving the dividend stream you want. If you receive dividends that you dont want, you can purchase additional shares using the cash.
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Homemade Dividends Example

A company has a choice between 2 dividend policies. Required rate of return is 10%
Year 1 Year 2 Policy 1 $100 $100 Policy 2 $110 $89

The company implements Policy 2 pay $110 now Investor X prefers Policy 1 he wants $100 each year
Homemade Dividend:
X can retain only $100 and reinvest the extra $10. At 10% it will grow to $11. In year 2, X receives $89 + $11 = $100, the desired amount.
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Homemade Dividends Example

Bianchi Inc. (slide 16) is a $42 stock about to pay a $2 dividend. Bob Investor owns 80 shares and prefers $3 dividend. Bobs homemade dividend strategy:
Sell 2 shares ex-dividend
Bianchi Inc. If company pays $2 homemade dividends Same as if company paid $3 dividends

Cash from dividends

$160

$240

Cash from selling stock

Total cash desired Value of stock holdings Total wealth

$80
$240 $40 78 = $3,120 $3,360

$0
$240 $39 80 = $3,120 $3,360
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Dividend Policy is Irrelevant

Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm. In the above example, Bob Investor began with total wealth of $3,360: 80 shares $42 = $3,360 After a $3 dividend, his total wealth is still $3,360: $240 + (80 shares $39) = $3,360 After a $2 dividend, and sale of 2 ex-dividend shares, his total wealth is still $3,360: $160 + (2 shares $40) + (78 shares $40) = $3,360
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Contrary Views
Others believe dividend policy is relevant.

They argue that:

Investors prefer high dividend policy because dividends are cash, and so are less risky than capital gains that depend on future market sentiment. Differential tax treatment for dividends and capital gains can either favour or penalise a dividend policy.

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Low Payout Please

Why might a low payout be desirable?
Individuals in upper income tax brackets might prefer lower dividend payouts, given the immediate tax liability, in favor of higher capital gains with the deferred tax liability. Flotation costs low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs for the firm (the cash can be used for new projects by the firm). Dividend restrictions debt contracts (by the lender) might limit the percentage of income that can be paid out as dividends.
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Dividend Imputation
The imputation system results in shareholders receiving a tax credit with their dividend for the tax actually paid by the company. Imputation credits can be offset against income tax on the income of shareholders. Franked dividends are dividends that are paid out of company profits on which tax has been levied. Dividends are declared as:
fully franked (30% as company tax rate) partially franked (below 30%) Unfranked (0%)
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High Payout Please

Why might a high payout be desirable?
Desire for current income
Individuals that need current income, i.e. retirees. Groups that are prohibited from spending principal (trusts and endowments).

Uncertainty resolution no guarantee that the higher future dividends will materialize.
Taxes
Dividend income taxed less for corporation shareholders. Tax-exempt investors dont have to worry about differential treatment between dividends and capital gains.
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Dividends and Signals

Asymmetric information managers have more information about the health of the company than investors. Information Content Effect > Changes in dividends convey information > Cause market reaction. Changes in dividends can either be an increase or decrease in dividend payout what sort of signal does it send out?

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Dividends and Signals

Changes in dividends
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.
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Clientele Effect
Some investors (like high income earners) prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts. Some investors (like low income earners) prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts. If a firms changes the dividend policy from low to high or vice versa, it doesnt matter, but changes its investors, this is called clientele effect . Dividend policy doesnt matter as long as clientele effect exists.
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Five Types of Dividend Policies

Residual dividend policy. Constant growth dividend policy
Dividends increased at a constant rate each year.

Constant payout ratio

Pay a constant percent of earnings (net income) each year.

Compromise dividend policy. Dividend Reinvestment Plans DRPs.

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Residual Dividend Policy

Determine capital budget. Determine target capital structure (D/E ratio). Finance investments with a combination of debt and equity in line with the target capital structure.
Remember that retained earnings are equity. If additional equity is needed, issue new shares.

If there are excess earnings, then pay the remainder out in dividends.
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Example Residual Dividend Policy

Given:
Need $5 million for new investments. Target capital structure: D/E = 2/3 Net Income = $4 million

How much required for investment?

40% financed with debt ($2 million) 60% financed with equity ($3 million)

How much remained for dividend?

Net Income Equity financing = ($4m - $3m) = $1 million, paid out as dividends.
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Dividend Stability
Strict Residual Policy may lead to very unstable dividend payout.
Depends on profitable investment opportunities.

When earnings are seasonal, quarterly dividends can vary.

e.g. Department stores before/after Christmas.

Stable dividend policy is in the interest of the firm and its shareholders.
Decrease uncertainty of future dividends.

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Compromise Dividend Policy

Goals, ranked in order of importance
Avoid cutting back on positive NPV projects to pay a dividend. Avoid dividend cuts. Avoid the need to sell equity. Maintain a target debt/equity ratio. Maintain a target dividend payout ratio.

Companies want to accept positive NPV projects, while avoiding negative signals.

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Dividend Reinvestment Plans DRPs

Cash dividends are used to buy additional newly issued shares in the company. Advantages to the Company:
Cheap and effective means of raising capital and conserving cash. Promotes good shareholder relations.

Disadvantages to the company:

Administration costs. Promotion of the plan. May lead to excessive capital raising.
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Dividend Reinvestment Plans DRPs

Benefits to investors:
Taxation benefits. Flexibility. Savings program. No transaction costs involved. Sometimes offered at a discount.

Disadvantages to investors:
Non-participants get diluted when participants get new shares at a discount. Comprehensive records to be maintained. No control over the reinvestment price.
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Stock Repurchase
Company buys back its own shares of stock. Equal access purchase. On-market purchase. Employee share purchase. Selective purchase. Odd-lot purchase. Similar to a cash dividend in that it returns cash from the firm to the stockholders. Supports the argument for dividend policy irrelevance in the absence of taxes or other imperfections. In a world with taxes, repurchases may be more desirable due to the options provided to stockholders.
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Stock Repurchase vs. Dividend

Consider a firm that wishes to distribute $100,000 to its shareholders. Should company pay dividends? Or repurchase shares?
A. Original balance sheet Assets Cash Other assets Value of Firm Liabilities & Equity $150,000 Debt $850,000 Equity $1,000,000 Value of Firm $0 $1,000,000 $1,000,000

Shares outstanding = 100,000 Price per share = $1,000,000 / 100,000 = $10 If investor owns 100 shares: Total wealth: 100 $10 = $1,000
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Stock Repurchase vs. Dividend

If they distribute the $100,000 as cash dividend, the balance sheet will look like this:
B. After $1 per share cash dividend Assets Cash Other assets Value of Firm Liabilities & Equity $50,000 Debt $850,000 Equity $900,000 Value of Firm $0 $900,000 $900,000

Shares outstanding = 100,000 Price per share = $900,000 / 100,000 = $9 Investor receives dividend: $1 100 = $100 cash $9 100 = $900 share value Total Wealth = $1,000
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Stock Repurchase vs. Dividend

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:
C. After stock repurchased Assets Cash Other assets Value of Firm Liabilities & Equity $50,000 Debt $850,000 Equity $900,000 Value of Firm $0 $900,000 $900,000

Shares outstanding = 90,000 Price per share = $900,000 / 90,000 = $10 Investor participates in repurchase based on Repurchase Amount/Equity ratio = 100k/1m = 10%
Sells 10% of shares, 10 @ $10 = $100 cash received from repurchase Remaining shares: 90 $10 = $900 share value Total Wealth = $1,000

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Share Dividends
Pay additional shares instead of cash. Increases the number of outstanding shares. Small share dividend less than 20 to 25%. Large share dividend more than 20 to 25%. If you own 100 shares at $30 each, and the company declared a 10% share dividend: New total shares = old shares (1 + 10%) = 110 shares New price = old $ / (1 + 10%) = $27.27 Same value as before: $3,000 (110$27.27)
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Share Splits
Share splits essentially the same as a share dividend except expressed as a ratio. Share price is reduced when the share splits.
If have 100 shares @ $30 each.

A 2 for 1 share split is the same as a 100% share dividend.

New nr of shares = old no. x (new no. / old no.) = 200.

New price = old $ x (old / new) = $15.

Common explanation for split is to return price to a more desirable trading range.
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Share Splits
Reverse split number of share is reduced
If same data and have a 1 for 2 reverse split: New no. of shares = old no. x (new no. / old no.) = 50 New price = old $ x (old / new) = $60

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Conclusion
Dividends are important because the value of a share is determined by expectations about future dividends. There is no ideal dividend policy.

Boards must determine the dividend policy that best suits the type of business they are in, and the economic conditions they face.

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Next Week
We introduce the basics of Options. Final exam revision!
Very important that you attend this lecture. Please also attempt all the questions in the practice final exam questions.

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