Chapter 22 - Dividend Policy (1)

8/4/2019 Chapter 22 - Dividend Policy (1)

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UnitUnit - -VVDividend PolicyDividend Policy


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Dividend Policy - 2

Lecture AgendaLecture Agenda

Learning ObjectivesLearning Objectives Important TermsImportant Terms Mechanics of Dividend PaymentsMechanics of Dividend Payments Cash Dividend PaymentsCash Dividend Payments M&Ms Dividend Irrelevance TheoremM&Ms Dividend Irrelevance Theorem The Bird in the Hand Argument The Bird in the Hand Argument Dividend Policy in PracticeDividend Policy in Practice Relaxing the M&M AssumptionsRelaxing the M&M Assumptions Stock Dividends and Stock SplitsStock Dividends and Stock Splits Share RepurchasesShare Repurchases Summary and ConclusionsSummary and Conclusions

Concept Review Questi onsCo ncept Review Questi ons


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Dividend Policy - 3

Learning ObjectivesLearning Objectives

You should understand the following:You should understand the following: The mechanics of dividend payments and why they areThe mechanics of dividend payments and why they are

different from interest paymentsdifferent from interest payments The difference between a stock split and a stock dividendThe difference between a stock split and a stock dividend Under what assumptions a dividend payment is irrelevant andUnder what assumptions a dividend payment is irrelevant and

what a homemade dividend iswhat a homemade dividend is Why dividend payments generally reflect the business risk of Why dividend payments generally reflect the business risk of

the firmthe firm How transactions costs, taxes and information problems giveHow transactions costs, taxes and information problems give

value to corporate dividend policiesvalue to corporate dividend policies How stock dividends and stock splits differHow stock dividends and stock splits differ How a share repurchase program can substitute for aHow a share repurchase program can substitute for a

dividend payout policy.dividend payout policy.


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Dividend Policy - 4

Im portant Ch apter Ter m sIm portant Ch apter Ter m s

Agency theoryAgency theory Bird in the hand argument Bird in the hand argument Cash cowCash cow Declaration dateDeclaration date Dividend reinvestment plansDividend reinvestment plans Dividend yieldDividend yield Equity market capitalizationEquity market capitalization

ExEx--dividend datedividend date

Free cash flowFree cash flow Holder of recordHolder of record Homemade dividendsHomemade dividends Income strippingIncome stripping Odd lotsOdd lots Residual theory of dividendsResidual theory of dividends Special dividendSpecial dividend Split sharesSplit shares Stock dividendStock dividend Stock split Stock split Tax clientelesTax clienteles


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What is Dividend P olicy?

What is Dividend P olicy?

Dividend PolicyDividend Policy


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Dividend Policy - 6

Dividend P olicyDividend P olicyW hat is It?W hat is It?

Dividend Policy refers to the explicit or implicit Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding thedecision of the Board of Directors regarding theamount of residual earnings (past or present)amount of residual earnings (past or present)that should be distributed to the shareholdersthat should be distributed to the shareholdersof the corporation.of the corporation. Th is decisi on is c onsidered aTh is decisi on is c onsidered a financing decisionfinancing decision

because t he pr of its of the c orporation are anbecause t he pr of its of the c orporation are anim portant s ource of f inancing avai lab le t o the f ir m. im portant s ource of f inancing avai lab le t o the f ir m.


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Types of DividendsTypes of Dividends



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Dividend Policy - 8

Types of DividendsTypes of Dividends

Dividends are a permanent distribution of residualDividends are a permanent distribution of residualearnings/property of the corporation to its owners.earnings/property of the corporation to its owners.

Dividends can be in the form of:Dividends can be in the form of: Cas hCas h Additiona l Shares of Stock (st ock dividend) Additiona l Shares of Stock (st ock dividend) Pr opertyPr operty

If a firm is dissolved, at the end of the process, a finalIf a firm is dissolved, at the end of the process, a finaldividend of any residual amount is made to thedividend of any residual amount is made to theshareholdersshareholders this is known as athis is known as a liquidating dividendliquidating dividend. .


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Dividends and Co rporate FinancingDividends and Co rporate Financing



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Dividend Policy - 10

In the absence of dividends, c orporate earnings accrue t o the bene f it of In the absence of dividends, c orporate earnings accrue t o the bene f it of share hol ders as retained earnings and are aut om atica lly reinvested inshare hol ders as retained earnings and are aut om atica lly reinvested inthe f ir m.the f ir m.

W hen a cas h dividend is dec lared, t ho se f unds leave t he f ir m W hen a cas h dividend is dec lared, t ho se f unds leave t he f ir m per m anent ly and irreversib ly.per m anent ly and irreversib ly.

Distribution of earnings as dividends m ay starve t he c om pany of f undsDistribution of earnings as dividends m ay starve t he c om pany of f undsrequired for gr owth and expansi on, and t h is m ay cause t he f ir m to seekrequired for gr owth and expansi on, and t h is m ay cause t he f ir m to seekadditi ona l externa l capita l.additi ona l externa l capita l.

Co rporate Pr of its Af ter Tax Retained Earnings

Dividends

Dividends a Financing Decisi onDividends a Financing Decisi on


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Dividends versus Interest Ob ligationsDividends versus Interest Ob ligations

Interest Interest Interest is a payment to lenders for the use of their funds for a givenInterest is a payment to lenders for the use of their funds for a given

period of timeperiod of time Timely payment of the required amount of interest is a legal obligationTimely payment of the required amount of interest is a legal obligation Failure to pay interest (and fulfill other contractual commitments underFailure to pay interest (and fulfill other contractual commitments under

the bond indenture or loan contract) is an act of bankruptcy and thethe bond indenture or loan contract) is an act of bankruptcy and thelender has recourse through the courts to seek remedieslender has recourse through the courts to seek remedies Secured lenders (bondholders) have the first claim on the firms assets inSecured lenders (bondholders) have the first claim on the firms assets in

the case of dissolution or in the case of bankruptcythe case of dissolution or in the case of bankruptcy

DividendsDividends A dividend is a discretionary payment made to shareholdersA dividend is a discretionary payment made to shareholders The decision to distribute dividends is solely the responsibility of theThe decision to distribute dividends is solely the responsibility of theboard of directorsboard of directors Shareholders are residual claimants of the firm (they have the last, andShareholders are residual claimants of the firm (they have the last, and

residual claim on assets on dissolution and on profits after all otherresidual claim on assets on dissolution and on profits after all otherclaims have been fully satisfied)claims have been fully satisfied)


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The Mec hanics of Dividend Paym

entsThe Mec hanics of Dividend Paym

ents



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Dividend Pay m entsDividend Pay m entsMechanics of Cas h Dividend Pay m entsMechanics of Cas h Dividend Pay m ents

Declaration DateDeclaration Date Holder of Record DateHolder of Record DateExEx--dividend Datedividend Date Payment DatePayment Date


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Dividend Pay m entsDividend Pay m entsMechanics of Cas h Dividend Pay m entsMechanics of Cas h Dividend Pay m ents

Declaration DateDeclaration Date th is is t he date on wh ich the B oard of Direct ors m eet and dec lare t he dividend . In their th is is t he date on wh ich the B oard of Direct ors m eet and dec lare t he dividend . In their

res olution the B oard wi ll set t heres olution the B oard wi ll set t he date of rec orddate of rec ord, t he, the date of pay m entdate of pay m ent and t heand t he a m ount of thea m ount of thedividenddividend for eac h share c lass .for eac h share c lass .

when C ARR IED, th is res olution m akes t he dividend a current liabi lity for the f ir m.when C ARR IED, th is res olution m akes t he dividend a current liabi lity for the f ir m.

Date of RecordDate of Record is the date on wh ich the s hare hol ders register is c losed a f ter t he trading day and a ll tho seis the date on wh ich the s hare hol ders register is c losed a f ter t he trading day and a ll tho se

who are listed wi ll receive t he dividend .who are listed wi ll receive t he dividend .

Ex dividend DateEx dividend Date is the date t hat t he va lue of the f ir ms c omm on s hares wi ll re flect t he dividend pay m ent (ie . is the date t hat t he va lue of the f ir ms c omm on s hares wi ll re flect t he dividend pay m ent (ie .

f a ll in va lue)f a ll in va lue) ex m eans wit ho ut .ex m eans wit ho ut . At the start of trading on the ex At the start of trading on the ex--dividend date, t he s hare price wi ll nor m a lly open for tradingdividend date, t he s hare price wi ll nor m a lly open for trading

at t he previ ous days c lose, less t he va lue of the dividend per s hare . Th is re flects t he f actat t he previ ous days c lose, less t he va lue of the dividend per s hare . Th is re flects t he f actthat purc hasers of the st ock on the exthat purc hasers of the st ock on the ex--dividend date and bey ond W ILL NOT receive t hedividend date and bey ond W ILL NOT receive t hedec lared dividend .dec lared dividend .

Date of Payment Date of Payment is the date t he c heques for the dividend are m ailed out to the s hare hol ders .is the date t he c heques for the dividend are m ailed out to the s hare hol ders .


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Dec larati on DateDate of Rec o rd

Date of Pay m ent

Ex Dividend Date is deter m inedby the Date of Rec ord .The m arket va lue of the s haresdr ops by t he va lue of the dividendper s hare on m arket openingc om paredto the previ ous day s c lose .

The B oard Meetsand passes t hem o tion to createthe dividend

2 business days prior to the Date of Record

Dividend Dec larati on Tim e LineDividend Dec larati on Tim e Line


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Changes in the Settlement CycleChanges in the Settlement Cycle In June 1995 the settlement cycle for all nonIn June 1995 the settlement cycle for all non- -moneymoney--market Canadian andmarket Canadian and

U.S. securities was reduced from five business days (T + 5) toU.S. securities was reduced from five business days (T + 5) to three businessthree businessdaysdays (T + 3).(T + 3).

The rationale for the change stems from the 1987 stock market crash when it The rationale for the change stems from the 1987 stock market crash when it was realized that a securities market failure could result in a credit market was realized that a securities market failure could result in a credit market failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham failure. The gridlock created in 1990 by the bankruptcy of Drexel BurnhamLambert, a large U.S. broker, increased the need to minimize the risksLambert, a large U.S. broker, increased the need to minimize the risksinvolved in the clearing and settlement of securities.involved in the clearing and settlement of securities.

The shortened settlement cycle requires that the payment of funds and theThe shortened settlement cycle requires that the payment of funds and thedelivery of securities take place on thedelivery of securities take place on the third business daythird business day after the tradeafter the tradedate. This will reduce credit, market and liquidity risks by decreasing post date. This will reduce credit, market and liquidity risks by decreasing post- -trade settlement exposure.trade settlement exposure.

Ex Dividend DateEx Dividend Date The date is not chosen by the board of directors, rather it is determined as aThe date is not chosen by the board of directors, rather it is determined as a

result of the exchanges settlement practices and is a function of the date of result of the exchanges settlement practices and is a function of the date of record.record.

Trade Sett le m ent and t he Ex DividendTrade Sett le m ent and t he Ex DividendDateDate


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Dividend Decisi on and t he B oard of Dividend Decisi on and t he B oard of Direct orsDirect ors



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Dividend P olicyDividend P olicyDividends, S hare hol ders and t he B oard of DirectorsDividends, S hare hol ders and t he B oard of Directors

There is no legal obligation for firms to pay dividends toThere is no legal obligation for firms to pay dividends tocommon shareholderscommon shareholders

Shareholders cannot force a Board of Directors toShareholders cannot force a Board of Directors todeclare a dividend, and courts will not interfere with thedeclare a dividend, and courts will not interfere with theBODs right to make the dividend decision because:BODs right to make the dividend decision because: Board m e m bers are j o intly and severa lly liab le for any da m agesBoard m e m bers are j o intly and severa lly liab le for any da m ages

they m ay causethey m ay cause Board m e m bers are c onstrained by lega l rules a ff ectingBoard m e m bers are c onstrained by lega l rules a ff ecting

dividends inc luding:dividends inc luding:N o t paying dividends out of capita lNo t paying dividends out of capita lN o t paying dividends w hen t hat decisi on c ould cause t he f ir m to No t paying dividends w hen t hat decisi on c ould cause t he f ir m to bec om e ins olventbec om e ins olvent

N o t paying dividends in c ontraventi on of contractua l comm itm entsNo t paying dividends in c ontraventi on of contractua l comm itm ents(suc h as debt c ovenant agree m ents)(suc h as debt c ovenant agree m ents)


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Dividend Pay m entsDividend Pay m ents



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Dividend Pay m entsDividend Pay m entsDividend Reinvest m ent P lans (DR IPs)Dividend Reinvest m ent P lans (DR IPs)

Involve shareholders deciding to use the cashInvolve shareholders deciding to use the cashdividend proceeds to buy more shares of the firmdividend proceeds to buy more shares of the firm DRIPs wi ll buy as m any s hares as t he cas h dividend a llows with DRIPs wi ll buy as m any s hares as t he cas h dividend a llows with

the residua l dep osited as cas hthe residua l dep osited as cas h Leads t o share hol ders owning odd lots ( less t han 100 s hares)Leads t o share hol ders owning odd lots ( less t han 100 s hares)

Firms are able to raise additional common stockFirms are able to raise additional common stockcapital continuously at no cost and fosters an oncapital continuously at no cost and fosters an on- -going relationship with shareholders.going relationship with shareholders.


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Dividend Pay m entsDividend Pay m entsStock DividendsStock Dividends

Stock dividends simply amount to distribution of Stock dividends simply amount to distribution of additional shares to existing shareholdersadditional shares to existing shareholders

They represent nothing more than recapitalizationThey represent nothing more than recapitalizationof earnings of the company. (that is, the amount of of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/Ethe stock dividend is transferred from the R/Eaccount to the common share account.account to the common share account.

Because of theBecause of the capital impairment rulecapital impairment rule stockstockdividends reduce the firms ability to pay dividendsdividends reduce the firms ability to pay dividendsin the future.in the future.


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Dividend Pay m entsDividend Pay m entsStock DividendsStock Dividends

ImplicationsImplications reducti on in t he R/E acc ountreducti on in t he R/E acc ount reduced capacity t o pay f uture dividendsreduced capacity t o pay f uture dividends pr oportionate s hare owners h ip re m ains unc hangedpr oportionate s hare owners h ip re m ains unc hanged s hare hol der s wea lth (the oretica lly) is una ff ecteds hare hol der s wea lth (the oretica lly) is una ff ected

Effect on the CompanyEffect on the Company conserves cas hconserves cas h serves t o lower t he m arket va lue of f ir ms st ock m odest lyserves t o lower t he m arket va lue of f ir ms st ock m odest ly pr om o tes wider distributi on of s hares t o the extent t hat current owners divest t he m se lves of pr om o tes wider distributi on of s hares t o the extent t hat current owners divest t he m se lves of

s hares ... because t hey have m ores hares ... because t hey have m ore adjusts t he capita l acc ountsadjusts t he capita l acc ounts dilutes EPSdilutes EPS

Effect on ShareholdersEffect on Shareholders pr oportion of owners h ip re m ains unc hangedpr oportion of owners h ip re m ains unc hanged to ta l va lue of hol dings re m ains unc hangedto ta l va lue of hol dings re m ains unc hanged if for m er DPS is m aintained, t h is rea lly represents an increased dividend pay outif for m er DPS is m aintained, t h is rea lly represents an increased dividend pay out


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Dividend Pay m entsDividend Pay m entsStock Dividend Exa m pleStock Dividend Exa m ple

ABC CompanyABC CompanyEquity AccountsEquity Accounts

as at February xx, 20x9as at February xx, 20x9Common stock (215,000)Common stock (215,000) $5,000,000$5,000,000Retained earningsRetained earnings 20,000,00020,000,000Net WorthNet Worth $25,000,000$25,000,000

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

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

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

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

next page...next page...


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Dividend Pay m entsDividend Pay m entsStock Dividend Exa m pleStock Dividend Exa m ple

After the stock dividend:After the stock dividend:

ABC CompanyABC CompanyEquity AccountsEquity Accounts

as at March 1, 20x9as at March 1, 20x9

Common stock (236,500)Common stock (236,500) $5,860,000$5,860,000Retained earningsRetained earnings 19,140,00019,140,000Net worthNet worth $25,000,000$25,000,000

The market price of the stock will be affected by the stock dividend:The market price of the stock will be affected by the stock dividend:

New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36

The individual shareholders wealth will remain unchanged.The individual shareholders wealth will remain unchanged.


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Dividend Pay m entsDividend Pay m entsStock Sp litsStock Sp lits

Although there is no theoretical proof, there is some whoAlthough there is no theoretical proof, there is some whobelieve that an optimal price range exists for abelieve that an optimal price range exists for acompanys common shares.companys common shares.

It is generally felt that there is greater demand forIt is generally felt that there is greater demand forshares of companies that are traded in the $40shares of companies that are traded in the $40 - - $80$80dollar range.dollar range.

The purpose of a stock split is to decrease share price.The purpose of a stock split is to decrease share price. The result is:The result is:

increase in t he nu m ber of share outstandingincrease in t he nu m ber of share outstanding

theoretica lly, n o change in s hare hol der wea lththeoretica lly, n o change in s hare hol der wea lth Reasons for use:Reasons for use: better s hare price trading rangebetter s hare price trading range psyc holo gica l appea l (signa lling a ff ect)psyc holo gica l appea l (signa lling a ff ect)


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Dividend Pay m entsDividend Pay m entsStock Sp lit Exa m pleStock Sp lit Exa m ple

The Board of Directors of X YZ Company is considering using a stock split The Board of Directors of X YZ Company is considering using a stock split to put its shares into a better trading range. They are confident that theto put its shares into a better trading range. They are confident that the firms stock price will continue to rise given the firms outstanding firms stock price will continue to rise given the firms outstanding financial performance. Currently, the companys shares are trading for financial performance. Currently, the companys shares are trading for$150 and the companys shareholders equity accounts are as follows:$150 and the companys shareholders equity accounts are as follows:

Commons shares (100,000 outstanding)Commons shares (100,000 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000

A 2 for 1 Stock Split:A 2 for 1 Stock Split:

New Share Price = PNew Share Price = P 00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00The firms equity accounts:The firms equity accounts:



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Dividend Pay m entsDividend Pay m entsFurther St ock Sp lit Exa m plesFurther St ock Sp lit Exa m ples

A 4 for 3 Stock Split:A 4 for 3 Stock Split:New Share Price = PNew Share Price = P 00[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50

The firms equity accounts:The firms equity accounts:Commons shares (133,333 outstanding)Commons shares (133,333 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000

A 3 for 4 Reverse Stock Split:A 3 for 4 Reverse Stock Split:New Share Price = PNew Share Price = P 00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00

The firms equity accounts:The firms equity accounts:


Clearly the Board can use stock splits and reverse stock splits to place the firms stockClearly the Board can use stock splits and reverse stock splits to place the firms stockin a particular trading range.in a particular trading range.


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Dividend Pay m entsDividend Pay m entsStock Sp lit Eff ectsStock Sp lit Eff ects

shareholders wealth should remain unaffected:shareholders wealth should remain unaffected:Original Holdings: (100 shares @ $150/share) = $15,000Original Holdings: (100 shares @ $150/share) = $15,000

After a 4 for 1 split: (400 shares @ $37.50/share) =After a 4 for 1 split: (400 shares @ $37.50/share) =$15,000$15,000

the above will hold true if there is no psychologicalthe above will hold true if there is no psychologicalappeal to the stock split.appeal to the stock split.

There is some evidence that the share price of There is some evidence that the share price of companies which split stock is more bouyant companies which split stock is more bouyant because of a positive signal being transferred to thebecause of a positive signal being transferred to themarket by this action.market by this action.


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-- lowers stock price slightlylowers stock price slightly - - large drop in stock pricelarge drop in stock price-- little psychological appeallittle psychological appeal - - much stronger potentialmuch stronger potential

signalling effect signalling effect -- recapitalization of earningsrecapitalization of earnings - - no recapitalizationno recapitalization-- no change in proportionalno change in proportional - - samesame

ownershipownership

-- odd lots createdodd lots created - - odd lots rareodd lots rare-- theoretically, no value totheoretically, no value to - - samesame

the investorthe investor

Stock Dividends versus St ock Sp litsStock Dividends versus St ock Sp lits

St ock Dividends St ock Sp lits


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Cas h Dividend Pay m entsCas h Dividend Pay m entsThe Macr o PerspectiveThe Macr o Perspective

FigureFigure --1 illustrates:1 illustrates: Aggregate a f ter Aggregate a f ter--tax pr of its run at appr oxim ate ly 6% of GDP buttax pr of its run at appr oxim ate ly 6% of GDP but

are h ighly variab leare h ighly variab le Aggregate dividends are re lative ly stab le w hen c om pared t o Aggregate dividends are re lative ly stab le w hen c om pared t o

a f ter a f ter--tax pr of its.tax pr of its.T hey are sustained in t he f ace of dr ops in pr of it during recessi onsThey are sustained in t he f ace of dr ops in pr of it during recessi onsT hey are he ld reas onab ly constant in t he f ace of peaks in aggregateThey are he ld reas onab ly constant in t he f ace of peaks in aggregatepr of its .pr of its .

(S ee Figure(S ee Figure - - 1 on the following slide)1 on the following slide)


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Cas h Dividend Pay m entsCas h Dividend Pay m entsThe Macr o PerspectiveThe Macr o Perspective - - Questi onQuesti on

Why are dividends smoothed and not matchedWhy are dividends smoothed and not matchedto profits?to profits?


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Cas h Dividend Pay m entsCas h Dividend Pay m entsThe Micr o PerspectiveThe Micr o Perspective

The c om panies c ho sen here i llustrate t he dra m aticThe c om panies c ho sen here i llustrate t he dra m aticdiff erences between c om panies:diff erences between c om panies:

S om e pay n o dividendsSom e pay n o dividendsS om e pay c onsistent cas h dividends representing substantia l Som e pay c onsistent cas h dividends representing substantia l yields on current s hares pricesyields on current s hares prices

The h ighest yie lds are found in t he case of Inc om e Trusts andThe h ighest yie lds are found in t he case of Inc om e Trusts andlarge stab le bluelarge stab le blue--ch ip f inancia ls and uti litiesch ip f inancia ls and uti lities


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Cas h Dividend Pay m entsCas h Dividend Pay m entsDividend Yie ldsDividend Yie lds

3 Average% % % % % % % % % %

CE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31Ce lesti a In . 0 0 0 0 0 0 0 0 0 0 0.00CI C 3.67 3.07 2.85 3.37 3.17 2.9 3.48 3.28 3.31 3.57 3.27C tt C rp r ation 0.23 0.53 0.54 0 0 0 0 0 0 0 0.13Kinr oss o ld Corpor ation 0 0 0 0 0 0 0 0 0 0 0.00Tr ans lta Corpor ation 6.22 5.16 4.52 5.35 5.59 4.06 4.92 5.73 5.88 4.51 5.19Ye llo Pa es In o m e nd 7.34 7.09 7.22

Table - S&P/TSX Index Dividend Yield


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Modigliani and Mi ller s DividendModigliani and Mi ller s DividendIrre levance T heore mIrre levance T heore m

M&M, Dividends and Firm ValueM&M, Dividends and Firm Value


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Modigliani and Mi ller s Dividend Irre levanceModigliani and Mi ller s Dividend Irre levanceTheore mTheore m

The value of M&Ms Dividend IrrelevanceThe value of M&Ms Dividend Irrelevanceargument is that in the end, it shows whereargument is that in the end, it shows wherevalue can be created with dividend policy andvalue can be created with dividend policy andwhy.why.


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M&Ms Dividend Irre levance T heore mM&Ms Dividend Irre levance T heore mM&M, Dividends, and Fir m Va lueM&M, Dividends, and Fir m Va lue

Start with the singleStart with the single- -period DDM:period DDM:

1

110 ) K (

P D P

e

![ -1]


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Multiply by the number of shares outstandingMultiply by the number of shares outstanding((mm) to convert the single stock price model to a) to convert the single stock price model to amodel to value the whole firm:model to value the whole firm:

1

)( 1100 )(

mV m

e

!![ -2]


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M&Ms Dividend Irre levance T heore mM&Ms Dividend Irre levance T heore m Assu m ptions Assu m ptions

No TaxesNo Taxes Perfect capital marketsPerfect capital markets

large nu m ber of individua l buyers and se llerslarge nu m ber of individua l buyers and se llers cost less in for m ationcost less in for m ation no transacti on costsno transacti on costs

All firms maximize valueAll firms maximize value There is no debt There is no debt


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Without debt, sources and uses of funds identityWithout debt, sources and uses of funds identity(sources = uses) can be expressed as:(sources = uses) can be expressed as:

Where:Where:X X represents cas h flow f r om operati onsrepresents cas h flow f r om operati onsI I represents invest m entrepresents invest m entX X I I is free cash flow is free cash flow mDmD 11 is dividend t o current s hare hol ders at ti m e 1is dividend t o current s hare hol ders at ti m e 1

1111m D I nP X ![ -3]


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Solving for dividends paid out (Solving for dividends paid out (mD mD11 ):):

1111 I nP X m D !


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If a firm pays out dividends that exceeds its free cashIf a firm pays out dividends that exceeds its free cash flow (X flow (X I), then it must issue new common shares to payI), then it must issue new common shares to pay for these dividends. for these dividends.

Substituting into EquationSubstituting into Equation 2 we get:2 we get:

The value of the firm is the value of the next periods freeThe value of the firm is the value of the next periods freecash flow (cash flow (XX11 II11) plus the next periods equity market ) plus the next periods equity market valuevalue

)1(

])[(X 11110 K

P nm I !![ -4]


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The firm value is determined as the present value of theThe firm value is determined as the present value of the free cash flows to the equity holders: free cash flows to the equity holders:

The dividend is equal to the free cash flow each period,The dividend is equal to the free cash flow each period,and dividends are therefore a residual after the firm hasand dividends are therefore a residual after the firm hastaken care of all of its investment requirementstaken care of all of its investment requirements this isthis isthethe Residual Theory of DividendsResidual Theory of Dividends

)1(1

0 !

!

E

t

t

t t

K I X [ -5]

V lue h sno thin

to do wi thdividends


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M&Ms Dividend Irre levance T heore mM&Ms Dividend Irre levance T heore mResidua l Theory of DividendsResidua l Theory of Dividends

TheThe Residual Theory of DividendsResidual Theory of Dividends suggests that suggests that logically, each year, management should:logically, each year, management should:

Identi f y f ree cas h flow generated in t he previ ousIdenti f y f ree cas h flow generated in t he previ ousperi odperi od

Identi f y invest m ent pr o jects t hat have p ositive NPVsIdenti f y invest m ent pr o jects t hat have p ositive NPVs Invest in a ll positive NPV pr o jectsInvest in a ll positive NPV pr o jects

If f ree cas h flow is insu ff icient, t hen raise externa l capita l If f ree cas h flow is insu ff icient, t hen raise externa l capita l ininth is case n o dividend is paidth is case n o dividend is paidIf f ree cas h flow exceeds invest m ent require m ents, t heIf f ree cas h flow exceeds invest m ent require m ents, t heresidua l a m ount is distributed in t he for m of cas h dividends .residua l a m ount is distributed in t he for m of cas h dividends .


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M&Ms Dividend Irre levance T heore mM&Ms Dividend Irre levance T heore mResidua l Theory of DividendsResidua l Theory of Dividends -- Im plicationIm plication

The implication of theThe implication of the Residual Theory of DividendsResidual Theory of Dividends are: are:

Invest m ent decisi ons are independent of the f ir ms dividendInvest m ent decisi ons are independent of the f ir ms dividendpolicypolicy

N o f ir m would pass on a p ositive NPV pr o ject because of the lackNo f ir m would pass on a p ositive NPV pr o ject because of the lackof f unds, because, by de f inition the incre m enta l cost of tho seof f unds, because, by de f inition the incre m enta l cost of tho sef unds is less t han t he IRR of the pr o ject, s o the va lue of the f ir m isf unds is less t han t he IRR of the pr o ject, s o the va lue of the f ir m ism axim ized only if the pr o ject is undertaken .m axim ized only if the pr o ject is undertaken .If the f ir m can t m ake g oo d use of f ree cas h flow (If the f ir m can t m ake g oo d use of f ree cas h flow (ieie . It has n o . It has n o pr o jects wit h IRRs > c ost of capita l) then t ho se f unds s ho uld bepr o jects wit h IRRs > c ost of capita l) then t ho se f unds s ho uld bedistributed back t o share hol ders in t he for m of dividends for the m distributed back t o share hol ders in t he for m of dividends for the m to invest on their own.to invest on their own.

T he f ir m sho uld operate w here Margina l Co st equa ls Margina l The f ir m sho uld operate w here Margina l Co st equa ls Margina l Revenue as seen in FigureRevenue as seen in Figure on the following s lide:4 on the following s lide:


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M&Ms Dividend Irre levance T heore mM&Ms Dividend Irre levance T heore mInterna l Funds, Invest m ent, and DividendsInterna l Funds, Invest m ent, and Dividends

- 4 F GURE

$11,976Million

Rate of Return

W ACC

Interna l Funds Avai lab le

OP MAL NVE ST MENT

IOS

$177,607Million

MC= MR


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M&Ms Dividend Irre levance T heore mM&Ms Dividend Irre levance T heore mH om e m ade DividendsH om e m ade Dividends

Shareholders can buy or sell shares in anShareholders can buy or sell shares in anunderlying company to create their own cashunderlying company to create their own cash

flow pattern. flow pattern. They d ont need m anage m ent dec lare a cas h They d ont need m anage m ent dec lare a cas h dividend, t hey can create t heir own.dividend, t hey can create t heir own.

Co nc lusion: under t he assum

ptions of M&Ms

mode l,Co nc lusion: under t he assu

mptions of M&M

s

mode l,the invest or is indi ff erent t o the f ir ms dividend p olicy.the invest or is indi ff erent t o the f ir ms dividend p olicy.


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The BirdThe Bird--inin--thethe--H and Argu m entH and Argu m ent



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The BirdThe Bird--inin--thethe--H and Argu m entH and Argu m entM&Ms Assu m ptions Re laxedM&Ms Assu m ptions Re laxed

Risk is a real world factor.Risk is a real world factor. Firms that reinvest free cash flow, put that Firms that reinvest free cash flow, put that

money at riskmoney at risk there is no certainty of there is no certainty of investment outcomeinvestment outcome those forfeit dividendsthose forfeit dividendsthat are reinvestedcould be lost!that are reinvestedcould be lost!

Remember the twoRemember the two- -stage DDM?stage DDM?


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Remember the twoRemember the two- -stage DDM?stage DDM?

The f irst ter m is the present va lue of existing opportunitiesThe f irst ter m is the present va lue of existing opportunities(PVEO)(PVEO)

The sec ond ter m is the present va lue of gr owth opportunitiesThe sec ond ter m is the present va lue of gr owth opportunities(PVGO)(PVGO)

These forecast returns f ace risks of new m arket entrants t o These forecast returns f ace risks of new m arket entrants t o com pete for the excess pr of its forecast in e m erging opportunitiescom pete for the excess pr of its forecast in e m erging opportunitiesm aking PVGO extre m e ly vu lnerab le .m aking PVGO extre m e ly vu lnerab le .

)OE

()K (1

Inv 2

e

1

e

e

eK

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B PS ROE P

v![ -6]


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Myron Gordon suggests that dividends are more stableMyron Gordon suggests that dividends are more stablethan capital gains and are therefore more highly valuedthan capital gains and are therefore more highly valuedby investors.by investors.

This implies that investors perceive nonThis implies that investors perceive non- -dividend payingdividend paying firms to be riskier and apply a higher discount rate to firms to be riskier and apply a higher discount rate tovalue them causing the share price to fall.value them causing the share price to fall.

The difference between the M&M and Gordon argumentsThe difference between the M&M and Gordon argumentsare illustrated in Figureare illustrated in Figure - - 5 on the following slide:5 on the following slide: M&M argue t hat dividends and capita l gains are per f ectM&M argue t hat dividends and capita l gains are per f ect

substitutessubstitutes


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The BirdThe Bird--inin--thethe--H and Argu m entH and Argu m entM&M versus G ordons Bird in t he H and T heoryM&M versus G ordons Bird in t he H and T heory

0

1

P D

- 5 F GURE

Gordon

OP TIMAL INVEST MENT

M&M

0

01

P P P


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The BirdThe Bird--inin--thethe--H and Argu m entH and Argu m entM&M versus G ordons Bird in t he H and T heoryM&M versus G ordons Bird in t he H and T heory

Conclusions:Conclusions: Fir m s cann o t change under lying operati ona l Fir m s cann o t change under lying operati ona l

characteristics by c hanging t he dividendcharacteristics by c hanging t he dividend The dividend s ho uld re flect t he f ir ms operati onsThe dividend s ho uld re flect t he f ir ms operati ons

thr ough the residua l va lue of dividendsthr ough the residua l va lue of dividends


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Dividend P olicy in PracticeDividend P olicy in Practice



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Dividend P olicy in PracticeDividend P olicy in Practice

Firms smooth their dividendsFirms smooth their dividends Fir m s tend t o hol d dividends c onstant, even in t heFir m s tend t o hol d dividends c onstant, even in t he

f ace of increasing a f ter f ace of increasing a f ter--tax pr of ittax pr of it Fir m s are very re luctant t o cut dividendsFir m s are very re luctant t o cut dividends


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Dividend P olicy in PracticeDividend P olicy in PracticeLintner s W ork on Dividend Adjust m entLintner s W ork on Dividend Adjust m ent

John Lintner suggested a partial adjustment John Lintner suggested a partial adjustment model to explain the smoothing of dividendmodel to explain the smoothing of dividendbehaviour illustrating that firms slowly changebehaviour illustrating that firms slowly change

dividends as they move toward a new target dividends as they move toward a new target level:level:

1 )- ( t -*t t

![ -7]


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The target dividendThe target dividend D Dt t * * Lintner suggested is a functionLintner suggested is a functionof the firms optimal payout rate of the firms underlyingof the firms optimal payout rate of the firms underlyingearnings (earnings (E Et t ) leading to the following equation:) leading to the following equation:

The coefficient on lagged dividends was estimated at The coefficient on lagged dividends was estimated at 0.70 indicating an adjustment speed (0.70 indicating an adjustment speed (b b) coefficent of ) coefficent of 0.30.0.30.

The coefficient on current earnings (The coefficient on current earnings (c c) was estimated at ) was estimated at 0.150.15

)1( 11 cE Dba D t -t ![ -8]


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ImplicationsImplications The speed of dividend adjust m ent is only ab out 30The speed of dividend adjust m ent is only ab out 30

percentpercent

Fir m s are very re luctant t o f ully adjustFir m s are very re luctant t o f ully adjust Fir m s d o no t follow a p olicy of paying a c onstantFir m s d o no t follow a p olicy of paying a c onstant

pr oportion of earnings out as dividendspr oportion of earnings out as dividends

Dividend p olicy in practice d oes n o t follow M&MsDividend p olicy in practice d oes n o t follow M&Msirrelevance argu m ents because t he rea l wor ld d oesirrelevance argu m ents because t he rea l wor ld d oesno t m atc h the assu m ptions used .no t m atc h the assu m ptions used .


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Re laxing t he M&M Assu m ptionsRe laxing t he M&M Assu m ptionsW e lcom e t o the Rea l W or ld!W e lcom e t o the Rea l W or ld!

Transactions CostsTransactions Costs Underwriting c osts are very h igh , pr oviding a str ongUnderwriting c osts are very h igh , pr oviding a str ong

incentive for f ir m s t o f inance gr owth out of f ree cas h incentive for f ir m s t o f inance gr owth out of f ree cas h flowflow

Facing t hese h igh underwriting c osts f ir m s:Facing t hese h igh underwriting c osts f ir m s:W ith h igh gr owth rates have little incentive t o pay dividendsW ith h igh gr owth rates have little incentive t o pay dividendsW ith volatile earnings c onserve cas h f r om year t o year t o W ith volatile earnings c onserve cas h f r om year t o year t o f inance pr o jects and t here fore pay very c onservativef inance pr o jects and t here fore pay very c onservative

dividendsdividends


59/81



Dividends andDividends and SignallingSignalling Under c onditions of infor m ation asy mm etry, s hare hol ders andUnder c onditions of infor m ation asy mm etry, s hare hol ders and

the investing pub lic watc h for m anage m ent signa ls (acti ons)the investing pub lic watc h for m anage m ent signa ls (acti ons)ab out what m anage m ent kn ows .ab out what m anage m ent kn ows .

Manage m ent is t here fore very cauti ous ab out dividendManage m ent is t here fore very cauti ous ab out dividendchangest hey d ont want t o create h igh expectati ons (t h is is t hechangest hey d ont want t o create h igh expectati ons (t h is is t hereas on for extra or specia l dividends) t hat wi ll lead t o reas on for extra or specia l dividends) t hat wi ll lead t o disapp ointm ent, and t hey d ont want t o have invest ors over reactdisapp ointm ent, and t hey d ont want t o have invest ors over reactto negative earnings surprises (t he sticky dividend p hen om en on)to negative earnings surprises (t he sticky dividend p hen om en on)

(T he(T he S ignalling S ignalling Model is e xp lained in FigureModel is e xp lained in Figure 6 found on the ne x t slide.)6 found on the ne x t slide.)


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Re laxing t he M&M Assu m ptionsRe laxing t he M&M Assu m ptionsThe Signa lling Mode lThe Signa lling Mode l

- 6 F IGURE

e t$

1 2 3 Ti m e

e t*

dt*

dt


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Agency TheoryAgency Theory Invest ors are wary of seni or m anage m ent s o they seek t o putInvest ors are wary of seni or m anage m ent s o they seek t o put

contr ols in p lace .contr ols in p lace . There is a f ear t hat m anagers m ay waste c orporate res ources byThere is a f ear t hat m anagers m ay waste c orporate res ources by

over over--investing in low or poo r NPV pr o jects .investing in low or poo r NPV pr o jects . Gordon Dona lds on argued t h is is t he reas on for the peckingGordon Dona lds on argued t h is is t he reas on for the pecking

order m anage m ents tend t o use w hen raising capita lorder m anage m ents tend t o use w hen raising capita lS hare hol ders w ould pre f er t o receive a dividend and t hen haveShare hol ders w ould pre f er t o receive a dividend and t hen havem anage m ent f ile a pr ospectus, justi f ying invest m ent in pr o jects andm anage m ent f ile a pr ospectus, justi f ying invest m ent in pr o jects andthe need t o raise t he capita l that was just distributed as a dividend .the need t o raise t he capita l that was just distributed as a dividend .

S hare hol ders are prepared t o pay t ho se additi ona l underwritingShare hol ders are prepared t o pay t ho se additi ona l underwritingcosts as an agency c ost incurred t o m onitor and assesscosts as an agency c ost incurred t o m onitor and assessm anage m ent .m anage m ent .


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Taxes and the Clientele Effect Taxes and the Clientele Effect Tab leTab le --3 (on the following s lide) i llustrates t hat di ff erent c lasses3 (on the following s lide) i llustrates t hat di ff erent c lasses

of invest ors f ace di ff erent tax bracketsof invest ors f ace di ff erent tax brackets Pre f erence for dividends versus capita l gains inc om e dependsPre f erence for dividends versus capita l gains inc om e depends

on the pr ovince of residence and taxab le inc om e leve l leading t o on the pr ovince of residence and taxab le inc om e leve l leading t o tax c liente les .tax c liente les .

H igh incom e earners tend t o pre f er capita l gains (t here is anH igh incom e earners tend t o pre f er capita l gains (t here is anadditiona l tax incentive for suc h individua ls in t hat t hey can c hoo seadditiona l tax incentive for suc h individua ls in t hat t hey can c hoo sethe tim ing of the sa le of their invest m entre m e m ber only rea lized the tim ing of the sa le of their invest m entre m e m ber only rea lized capita l gains are subject t o taxcapita l gains are subject t o tax

L ow incom e earners tend t o pre f er dividendsLow incom e earners tend t o pre f er dividends

Co nc lusi onCo nc lusi on f ir ms s ho uld n o t change dividend p olicy drastica llyf ir ms s ho uld n o t change dividend p olicy drastica llysince it upsets t he existing owners h ip base .since it upsets t he existing owners h ip base .


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Re laxing t he M&M Assu m ptionsRe laxing t he M&M Assu m ptionsTaxesTaxes

Income evel , , , ,

itish Columb ia i i en s .52 6.19 15.69 20.04

Capita l gains12.45 15.58 18.85 20.35

Alb e ta i i en s 3.63 8.03 13.83 13.83Capita l gains 12.63 16.00 18.00 18.00

O nta io Di i en s 0.00 8.24 20.74 20.74Capita l gains 10.65 15.58 21.71 21.71

Q ue b e Di i en s 5.95 15.42 26.06 26.06Capita l gains 14.37 19.19 22.86 22.86

Nova

otia

Divi en s

0.00 8.75 17.05 19.06

Capita l gains 12.02 18.48 21.34 22.63

le -3 Individ l te ( ) on Dividend nd C pit l in


64/81


Re laxing t he M&M Assu m ptionsRe laxing t he M&M Assu m ptionsRepackaging DividendRepackaging Dividend- -Paying SecuritiesPaying Securities

Tax clienteles help to explain the financialTax clienteles help to explain the financialengineering whereby different parts of theengineering whereby different parts of the

return by the firm are stripped, repackaged andreturn by the firm are stripped, repackaged andsold to different investors as illustrated insold to different investors as illustrated inFigureFigure 7. (See the following slide)7. (See the following slide)

Split shares are shares sold as the dividendsSplit shares are shares sold as the dividendsand capital gains parts.and capital gains parts.


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Re laxing t he M&M Assu m ptionsRe laxing t he M&M Assu m ptionsMYW s B Co rporation S haresMYW s B Co rporation S hares

MYW

- 7 F IGURE

$143 m illion$330 m illion

$454 m illion


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Share Repurc hasesShare Repurc hases

Simply another form of payout policy.Simply another form of payout policy. An alternative to cash dividend where theAn alternative to cash dividend where the

objective is to increase the price per shareobjective is to increase the price per sharerather than paying a dividend.rather than paying a dividend.

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


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allowed under the OBCA and CBCAallowed under the OBCA and CBCA reasons for use:reasons for use:

Off setting t he exercise of executive st ock optionsOff setting t he exercise of executive st ock options Leveraged recapita lizationsLeveraged recapita lizations Infor m ation or signa lling e ff ectsInfor m ation or signa lling e ff ects Repurc hase dissident s haresRepurc hase dissident s hares Re m oving cas h witho ut generating expectati ons for f utureRe m oving cas h witho ut generating expectati ons for f uture

distributi onsdistributi ons Take t he f ir m private .Take t he f ir m private .



69/81


they are usually done on an irregular basis, so a shareholderthey are usually done on an irregular basis, so a shareholdercannot depend on income from this source.cannot depend on income from this source.

if regular repurchases are made, there is a good chance that if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were simply aRevenue Canada will rule that the repurchases were simply atax avoidance scheme (to avoid tax on dividends) and willtax avoidance scheme (to avoid tax on dividends) and willassess taxassess tax

there may be some agency problemsthere may be some agency problems - - if managers haveif managers haveinside information, they are purchasing from shareholders at inside information, they are purchasing from shareholders at

a price less than the intrinsic value of the shares.a price less than the intrinsic value of the shares.

Disadvantages of Share Repurc hasesDisadvantages of Share Repurc hases


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tender offer:tender offer: th is is a for m a l off er to purc hase a given nu m ber of shares at ath is is a for m a l off er to purc hase a given nu m ber of shares at a

given price over current m arket price .given price over current m arket price .

open market purchase:open market purchase: the purc hase of shares t hr ough an invest m ent dea ler like anythe purc hase of shares t hr ough an invest m ent dea ler like any

o ther invest or o ther invest or th is is n o t designed for large b lock purc hases .th is is n o t designed for large b lock purc hases .

private negotiation with major shareholdersprivate negotiation with major shareholders

In any repurchase program, the securities commissionIn any repurchase program, the securities commissionrequires disclosure of the event as well as all otherrequires disclosure of the event as well as all othermaterial information through a prospectus.material information through a prospectus.

Metho ds of Share Repurc hasesMetho ds of Share Repurc hases


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- 71

called treasury stock (U.S.)called treasury stock (U.S.) nonnon--voting (U.S.)voting (U.S.) may not receive dividends (U.S.)may not receive dividends (U.S.) if not retired, can be resold (U.S.)if not retired, can be resold (U.S.) unlike the U.S., repurchases in Canada do not unlike the U.S., repurchases in Canada do not

involve shares that can be placed into treasuryinvolve shares that can be placed into treasury

stockstock - - they are canceledthey are canceled

Repurc hased S haresRepurc hased S hares


72/81


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

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

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

Expected market price after repurchase:Expected market price after repurchase:

= [p/e][= [p/e][EPSEPS newnew ] = [5][$4.40] = $.00 per share] = [5][$4.40] = $.00 per share

Repurc hase Exa m pleRepurc hase Exa m ple


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

a higher market price per outstanding share of a higher market price per outstanding share of common stock should result common stock should result stockholders not selling their shares back tostockholders not selling their shares back to

the firm will enjoy a capital gain if thethe firm will enjoy a capital gain if the

repurchase increases the stock price.repurchase increases the stock price.

Eff ects of A Share Repurc haseEff ects of A Share Repurc hase


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signal positive information about the firms future cashsignal positive information about the firms future cash flows flows

used to effect a largeused to effect a large- -scale change in the firms capitalscale change in the firms capitalstructurestructure

increase investors return without creating anincrease investors return without creating anexpectation of higher future cash dividendsexpectation of higher future cash dividends

reduce future cash dividend requirements or increasereduce future cash dividend requirements or increasecash dividends per share on the remaining shares,cash dividends per share on the remaining shares,without creating a continuing incremental cash drainwithout creating a continuing incremental cash drain

capital gains treated more favourably than cash dividendscapital gains treated more favourably than cash dividends for tax purposes. for tax purposes.

Advantages of Share Repurc hases Advantages of Share Repurc hases


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signal negative information about the firmssignal negative information about the firms future growth and investment opportunities future growth and investment opportunities

the provincial securities commission may raisethe provincial securities commission may raisequestions about the intentionquestions about the intention share repurchase may not qualify the investorshare repurchase may not qualify the investor

for a capital gain for a capital gain

Disadvantages of Share Repurc hasesDisadvantages of Share Repurc hases


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Borr owing to Pay DividendsBorr owing to Pay Dividends

SignallingSignalling


77/81


Is this legal? is it possible to do?Is this legal? is it possible to do?YesYes the f ir m m ust have t he abi lity and capacity t o borr owthe f ir m m ust have t he abi lity and capacity t o borr ow the f ir m m ust have su ff icient retained earnings t o a llow itthe f ir m m ust have su ff icient retained earnings t o a llow it

to pay t he dividendto pay t he dividend the f ir m m ust have su ff icient cas h on hand t o pay t hethe f ir m m ust have su ff icient cas h on hand t o pay t he

cas h dividendcas h dividend the f ir m m ust NOT have agreed t o any lim itations on thethe f ir m m ust NOT have agreed t o any lim itations on the

pay m ent of dividends under t he b ond indenture .pay m ent of dividends under t he b ond indenture .

Why?Why? A possib le answer is t o signa l to the m arket t hat t he A possib le answer is t o signa l to the m arket t hat t he

board is c onf ident ab out the f ir ms abi lity to sustain cas h board is c onf ident ab out the f ir ms abi lity to sustain cas h dividends int o the f uture .dividends int o the f uture .

Borr owing to Pay DividendsBorr owing to Pay Dividends


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Assets: Liabi lities:

Cas h 10 Long-ter m Debt 0Fixed Assets 140 Co mm on St ock 50

Retained Earnings 100To ta l Assets $150 T o ta l Claim s $150

After Borrowingbefore cash dividend : Assets: Liabi lities:


Retained Earnings 100

To ta l Assets $200 T o ta l Claim s $200

Before Borrowing:0% Debt

25% Debt

Borr owing to Pay DividendsBorr owing to Pay Dividends An Exa m ple An Exa m ple


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Assets: Liabi lities:

Cas h 60 Current liabi lities 50Fixed Assets 140 L ong-ter m Debt 50

Co mm on S hares 50Retained earnings 50


After Cash Dividend payment of $50 Assets: Liabi lities:


Retained earnings 50


After Dividend Declarationbefore date of payment.

50% Debt

33% Debt



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The foregoing example illustrates:The foregoing example illustrates: it is possib le for a f ir m with borr owing capacity to borr ow f unds t o it is possib le for a f ir m with borr owing capacity to borr ow f unds t o

pay cas h dividends .pay cas h dividends . th is is n o t possib le if the lenders insist on restrictive c ovenants t hatth is is n o t possib le if the lenders insist on restrictive c ovenants t hat

lim it or prevent t h is f r om occurring .lim it or prevent t h is f r om occurring . the cas h for the dividend m ust be present in t he cas h acc ount .the cas h for the dividend m ust be present in t he cas h acc ount . pay m ent of dividends reduces b o th the cas h acc ount on the assetpay m ent of dividends reduces b o th the cas h acc ount on the asset

side of the ba lance s heet as we ll as t he retained earnings acc ountside of the ba lance s heet as we ll as t he retained earnings acc ounton the claim s side of the ba lance s heet .on the claim s side of the ba lance s heet .

in the absence of restricti ons, it is p ossib le t o trans f er wea lth f r om in the absence of restricti ons, it is p ossib le t o trans f er wea lth f r om

the b ondhol ders t o the st ockhol ders . the b ondhol ders t o the st ockhol ders . (Bondhol ders in t h is exa m ple(Bondhol ders in t h is exa m plem ay have t ho ug h t their f ir m would have only a 25% debt rati o .a f ter t hem ay have t ho ug h t their f ir m would have only a 25% debt rati o .a f ter t hedividend t he debt rati o r ose t o 33% and t he equity cusi on dr opped f r om dividend t he debt rati o r ose t o 33% and t he equity cusi on dr opped f r om 75% t o 66% .)75% t o 66% .)



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Su mm ary and Co nc lusionsSu mm ary and Co nc lusions

In this chapter you have learned:In this chapter you have learned:

About the di ff erent types of dividends inc luding, regu lar and About the di ff erent types of dividends inc luding, regu lar andspecia l cas h dividends, st ock dividends, st ock sp lits as we ll asspecia l cas h dividends, st ock dividends, st ock sp lits as we ll asshare repurc hases .share repurc hases .

M&Ms dividend irre levance argu m ent and t he rea l wor ld f act orsM&Ms dividend irre levance argu m ent and t he rea l wor ld f act orssuc h as transacti ons c osts, taxes, c liente le e ff ects andsuc h as transacti ons c osts, taxes, c liente le e ff ects andsigna lling tend t o f avour rea lsigna lling tend t o f avour rea l--wor ld dividend re levancewor ld dividend re levance

Tax m o tives and o ther reas ons exp lain w hy f ir m s m igh t want t o Tax m o tives and o ther reas ons exp lain w hy f ir m s m igh t want t o repurc hase t heir s hares .repurc hase t heir s hares .

Chapter 22 - Dividend Policy (1)

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Transcript of Chapter 22 - Dividend Policy (1)