Determinants and Aspectsof Dividend Policy

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Determinants and AspectsDeterminants and Aspects

of Dividend Policyof Dividend Policy




DETERMINANTS OF DIVIDENDPOLICY

Factors

Bonus Shares (Stock Dividend) and

Stock (Share) Splits

Legal, Procedural and Tax Aspects

Solved Problems




FACTORS1) Dividend payout (D/P) ratio

2) Stability of dividends

3) Legal, contractual and internal constraintsand restrictions

4) Owner¶s considerations

5) Capital market considerations

6) Inflation




(1) Dividend Payout (D/P) Ratio(1) Dividend Payout (D/P) Ratio

The D /P ratio indicates the percentage share of the

net earnings distributed to the shareholders as

dividends. Given the objective of wealthmaximisation, the D /P ratio should be such as can

maximise the wealth of its owners in the µlong-run¶.

In practice, investors, in general, have a clear cut

preference for dividends because of uncertainty and

imperfect capital markets. Therefore, a low D /P ratiomay cause a decline in share prices, while a high

ratio may lead to a rise in the market price of the

shares.




(2) Stability of Dividends(2) Stability of Dividends

Stable dividend policy refers to the consistency or lack of variability in the

stream of dividends, that is, a certain minimum amount of dividend is paid

out regularly. Of the three forms of stability of dividend, namely, constant

dividend per share, constant D /P ratio and constant dividend per share plus

extra dividend, the first one is the most appropriate. The investors prefer a

stable dividend policy for a number of reasons, such as, desire for current

income their, informational contents, institutional requirement, and so on.

Constant dividend per share policy is a policy of paying a certain fixed

amount per share as dividend.

Constant/target payout ratio is a policy to pay a constant percentage of net

earnings as dividend to shareholders in each dividend period.

Stable rupee plus extra dividend is a policy based on paying a fixed dividend

to shareholders supplemented by an additional dividend when earnings

warrant it.




Figure 1: Stable Dividend Policy

DPS

EPS

Times (Years)

E S P

a n d D P S

( R s )

It can, thus, be seen that while the earnings may fluctuate from year to year,

the dividend per share is constant. To be able to pursue such a policy, afirm whose earnings are not stable would have to make provisions in years

when earnings are higher for payment of dividends in lean years. Such

firms usually create a µreserve for dividends equalisation¶. The balance

standing in this fund is normally invested in such assets as can be readily

converted into cash.




There are many empirical studies, (e.g. Lintrer) to support the contention that

companies pursue a stable dividend policy.

According to John Lintrer¶s study, dividends are µsticky¶ in the sense that theyare slow to change and lag behind shifts in earnings by one or more periods.

This leads to the pattern of stable dividend per share during the periods of

fluctuating earnings per share and a rising step-function pattern of dividends

per share during increasing earnings per share periods.

Dt± D

t±1= a

0+ c (D

t

* ± Dt ± 1

) (1)

where Dt = Dividend amount under consideration

Dt±1= Dividend paid in the previous year

a0 = A constant which may have value of zero, but never negative

and generally has a positive value to reflect the greater

reluctance to reduce than to raise dividendsc = Speed of adjustment

Dt* = Target payout ratio = dividend payout ratio (r) multiplied by profit

after taxes (p) = rp

Dt ± Dt±1= Change in dividend payout (D)




The right hand side of Equation 1 can be rewritten as:

a0 + c (rPt ± Dt±1) = a0 + crPt ± cDt±1

Adding Dt±1 on both sides of Eq. 1

Dt = a0 + crPt ± cDt±1 + Dt±1 = a0 + crPt + Dt±1(1 ± c)

Let cr be represented by b1 (short-run propensity to pay dividends) and (1 ± c) be

represented by b2 (long-run propensity to pay dividends), we have:

Dt = a0 + b1Pt + b2Dt±1 (2)

Thus, dividends paid by an individual company are a function of a0 (constant), short-run

propensity to pay (b1) and long-run propensity to pay dividends (b2).

Bolten has also formulated a formula based on key variables suggested by Lintner:

where Dt + 1

= dividend amount under consideration,

Dt = prevailing dividend,

Dt /Et = prevailing payout ratio,

P * = target payout ratio,

Et = latest earnings per share, and

a = adjustment cushion.

)3(t

E

tEt

D*Pa

tD

1tD

¼¼¼¼

½

»

¬¬¬¬

-

«

!




Equation 3 suggests that the increase in dividends would be less than the

increase in earnings owing to the speed of adjustment.

Suppose the target payout ratio of a company is 50 per cent and the present

dividend is Rs 2 per share. The firm would not immediately pay a dividendof Rs 3 share if the earnings per share rose from Rs 5 per share to Rs 6,

since that would expose the firm to the necessity of reducing the dividend

in the following year, if the earnings per share fell below Rs 6. Rather, the

firm might decide to gradually move toward the 50 per cent target payout by

declaring a Rs 2.50 per share dividend. With Rs 2.50 dividend, the firm¶s

earnings per share could drop to Rs 5 in the following year and still be at

the 50 per cent target ratio, avoiding the necessity of reducing the dividend.

Thus,

In summing up, it can be commended that a firm should seek a stable

dividend policy which avoids occasional reductions in dividends. Investors

favourably react to the price of shares of such companies and there is a

price enhancing effect of such a policy.

50.2Rs6Rs6Rs

2Rs50.050.02Rs

1tD !!

¼¼½

»

¬¬-

«




(3) Legal, Contractual, and Internal(3) Legal, Contractual, and Internal

Constraints and RestrictionsConstraints and Restrictions

Legal Requirements Legal stipulations do not

require a dividend declaration but they specifythe conditions under which dividends must be

paid. Such conditions pertain to

a) Capital impairmentb) Net profits

c) Insolvency




(a) Capital Impairment Rules

Legal enactments limit the amount of cash dividends that a firm may pay. A firm

cannot pay dividends out of its paid-up capital, otherwise there would be a

reduction in the capital adversely affecting the security of its lenders. Therationale of this rule lies in protecting the claims of preference shareholders and

creditors on the firm¶s assets by providing a sufficient equity base since the

creditors have originally relied upon such an equity base while extending credit.

(b) Net Profits

The net profits requirement is essentially a corollary of the capital impairmentrequirement, in that it restricts the dividend to be paid out of the firm¶s current

profits plus past accumulated retained earnings. Alternatively, a firm cannot pay

cash dividends greater than the amount of current profits plus the accumulated

balance of retained earnings.

(c) InsolvencyA firm is said to be insolvent in two situations: first, when its liabilities exceed the

assets; and second, when it is unable to pay its bills. The rationale of the rule is to

protect the creditors by prohibiting the liquidation of near-bankrupt firms through

cash dividend payments to the equity owners.




Contractual RequirementsContractual Requirements

Important restrictions on the payment of dividend may be accepted by a

company when obtaining external capital either by a loan agreement, a

debenture indenture, a preference share agreement, or a lease contract.

Such restrictions may cause the firm to restrict the payment of cash

dividends until a certain level of earnings has been achieved or limit the

amount of dividends paid to a certain amount or percentage of earnings.

Since the payment of dividend involves a cash outflow, firms are forced

to reinvest the retained earnings within the firm.

Therefore, contractual constraints on dividend payments are quite

common. The payment of cash dividend in violation of a restriction would

amount to default in the case of a loan and the entire principal would

become due and payable. Keeping in view the severity of penalty, the

financial manager must ensure that the amount of dividend is within the

covenants already committed to lenders.




Internal ConstraintsInternal ConstraintsLiquid Assets Once the payment of dividend is permissible on legal and

contractual grounds, the next step is to ascertain whether the firm has sufficientcash funds to pay cash dividends.

Growth Prospects Another set of factors that can influence dividend policyrelates to the firm¶s growth prospects. The firm is required to make plans for financing its expansion programmes.

Financial Requirements Financial requirements of a firm are directly related to

its investment needs. The firm should formulate its dividends policy on the basisof its foreseeable investment needs

Availability of Funds The dividend policy is also constrained by the availabilityof funds and the need for additional investment. In evaluating its financialposition, the firm should consider not only its ability to raise funds but also thecost involved in it and the promptness with which financing can be obtained.

Earnings Stability The stability of earnings also has a significant bearing on the

dividend decision of a firm. Generally, the more stable the income stream, thehigher is the dividend payout ratio.

Control Dividend policy may also be strongly influenced by the shareholders¶ or the management¶s control objectives. That is to say, sometimes managementemploys dividend policy as an effective instrument to maintain its position of command and control.




Owner¶s ConsiderationsOwner¶s ConsiderationsTaxes The dividend policy of a firm may be dictated by the income taxstatus of its shareholders. If a firm has a large percentage of owners who

are in high tax brackets, its dividend policy should seek to have higher

retentions. Such a policy will provide its owners with income in the form

of capital gains as against dividends. Since capital gains are taxed at a

lower rate than dividends, they are worth more, after taxes, to the

individuals in a high tax bracket.Opportunities The firm should not retain funds if the rate of return earned

by it would be less than one which could have been earned by the

investors themselves from external investments of funds.

Dilution of Ownership The financial manager should recognise that a

high D/P ratio may result in the dilution of both control and earnings for

the existing equity holders. Dilution in earnings results because lowretentions may necessitate the issue of new equity shares in the future,

causing an increase in the number of equity shares outstanidng and

ultimately lowering earnings per share and their price in the market. By

retaining a high percentage of its earnings, the firm can minimise the

possibility of dilution of earnings.




Capital Market Considerations

Yet another set of factors that can strongly affect dividend policy is the

extent to which the firm has access to the capital markets. In case the firmhas easy access to the capital market, either because it is financially strong

or large in size, it can follow a liberal dividend policy. However, if the firm

has only limited access to capital markets, it is likely to adopt low dividend

payout ratios. Such firms are likely to rely more heavily on retained earnings

as a source of financing their investments.Inflation

Finally, inflation is another factor which affects the firm¶s dividend decision.

With rising prices, funds generated from depreciation may be inadequate to

replace obsolete equipments. These firms have to rely upon retained

earnings as a source of funds to make up the shortfall. This aspect becomesall the more important if the assets are to be replaced in the near future.

Consequently, their dividend payout tends to be low during periods of

inflation.




DIVIDEND POLICY IN INDIA

The main features of the corporate dividend policy in India are summarised

below

Most of the corporates have a policy of long-run dividend pay-out ratio.

Dividend changes follow shift in the long-term sustainable earnings.

Dividend policy as a residual decision after meeting the desired investment

needs is endorsed by about 50 per cent of the sample corporates. The

corporates which are creating shareholders value (EVA) significantly rescind

dividend increase in the event of growth opportunities available to them.Large firms are significantly less willing to rescind dividend increases.

Dividend policy provides a signalling mechanism of the future prospects of

the corporate and, to that exact, affects its market value.

Investors have different relative risk perceptions of dividend income and

capital gains and are not indifferent between receiving dividend income and

capital gains. Management should be responsive to the shareholderspreferences regarding dividend and the share buy back programme should

not replace the dividend payments of the corporates.

Dividend payments provide a bonding mechanism so as to encourage

manager to act in the best interest of the shareholders.




The corporate enterprises in India seem to have a tendency to pay relatively

less dividends. In fact, a fairly large number of them hardly pay any

dividend. The foreign controlled companies seem to follow a policy of larger distribution of profits relative to the domestic companies. Retained earnings

are a significant source of corporate finance.

The vast majority of the Indian corporates follows a stable dividend policy in

the sense that they pay either constant dividend per share in the following

year with fluctuating EPS or increased dividend with increase in EPS.

An overwhelming majority of corporates have a long-run target DIP ratio.The dividend changes follow shift in long-run sustainable earnings. Their

dividend policy is in agreement with the findings of Lintner¶s study on

dividend policy.

Firms which are creating shareholder value are significantly more willing to

rescind dividend increase in the event of growth opportunities available to

them. The larger firms are significantly less willing to rescind dividend

increase than the small firms.

Dividend policy provides a signalling mechanism of the future prospects of

the firm and thus affects its market value. The investors are not indifferent

between receiving dividend income and capital gains.

CONT D.




BONUS SHARES (STOCK DIVIDEND) ANDBONUS SHARES (STOCK DIVIDEND) AND

STOCK (SHARE) SPLITSSTOCK (SHARE) SPLITS

Apart from cash dividend, a firm can also reward its investors by

paying bonus shares. The bonus shares/share splits do not have

any economic impact on the firm in that its assets, earnings andinvestors¶ proportionate ownership remain unchanged. As a

result, the number of shares outstanding increases. The increased

number of shares outstanding tends to bring the market price of

shares within more popular range and promote more active

trading in shares. Moreover, bonus/split announcements haveinformational content to the investors. It will also enable the

conservation of corporate cash and further enable a firm to raise

additional funds particularly through the issue of convertible

securities.




TABLE 1 Effect of Bonus Shares and Share Splits

(I) Equity portion before the bonus issue:

Equity share capital (30,000 share of Rs 100 each) Rs 30,00,000

Share premium (@ Rs 25 per share) 7,50,000

Retained earnings 62,50,000

Total equity 1,00,00,000

(II) Equity portion after the bonus issue (1 : 2 ratio):

Equity share capital (45,000 shares of Rs 100 each) 45,00,000Share premium (45,000 shares × Rs 25) 11,25,000

Retained earnings (Rs 62,50,000 ± 15,000 shares × Rs 125) 43,75,000


(III) Equity portion after the share splits (10 : 1 ratio):

Equity share capital (3,00,000 shares of Rs 10 each) 30,00,000

Share premium 7,50,000

Retained earnings 62,50,000





LEGAL, PROCEDURAL AND TAX ASPECTSLEGAL, PROCEDURAL AND TAX ASPECTS

Legal Aspects

The amount of dividend that can be legally distributed is governed by companylaw, judicial pronouncements in leading cases, and contractual restrictions. Theimportant provisions of company law pertaining to dividends are described below.

1) Companies can pay only cash dividends (with the exception of bonusshares). Apart from cash, dividend may also be remitted by cheque or bywarrant.

2) Dividends can be paid only out of the profits earned during the financial year after providing for depreciation and after transferring to reserves suchpercentage of profits as prescribed by law.

3) Due to inadequacy or absence of profits in any year, dividend may be paidout of the accumulated profits of previous years.

4) Dividends cannot be declared for past years for which accounts have beenadopted by the shareholders in the annual general meeting.

5) Dividend declared, interim or final, should be deposited in a separate bankaccount within 5 days from the date of declaration and dividend will be paidwithin 30 days from such a date.

6) Dividend including interim dividend once declared becomes a debt. While thepayment of interim dividend cannot be revoked, the payment of final dividendcan be revoked with the consent of the shareholders.




Procedural Aspects

The important events and dates in the dividend payment procedure are:

1) Board Resoultion: The dividend decision is the prerogative of the board of

directors. Hence, the board of directors should in a formal meeting resolve

to pay the dividend.2) Shareholder Approval: The resolution of the board of directors to pay the

dividend has to be approved by the shareholders in the annual general

meeting.

3) Record Date: The dividend is payable to shareholders whose names appear

in the register of members as on the record date.

4) Dividend Payment: Once a dividend declaration has been made, dividendwarrant must be posted within 30 days.

5) Unpaid Dividend: if the money transferred to the µunpaid dividend account¶

in the scheduled bank remains unpaid/unclaimed for a period of 7 years

from the date of such transfer, the company is required to transfer the same

to the µInvestor.

Tax Aspects

With effect from financial year 2003-4, dividend income from domestic

companies and mutual funds is exempt from tax in the hands of the

shareholders/investors/unit-holders. However, the domestic companies will be

liable to pay dividend distribution tax at the effective rate of 16.995 per cent on

dividends paid after April 1, 2007.




SOLVED PROBLEMSSOLVED PROBLEMS




SOLVED PROBLEM 1

X Cement Ltd requires you, as their financial consultant, to advise them withrespect to the dividend policy they have to follow for the current year. The

cement industry has been through a very trying period in the last five years and

the constraints on operations have been removed in the early part of the year.

The company hopes to improve its position in the years to come and has plans

to put up an additional plant in the neighbourhood of the present factory. The

increased profits, due to expansion in capacity, are expected to be 25 per cent

of the additional capital investment after meeting interest charges but before

depreciation on the additional plant installed. The shares of X Cement Ltd are

widely held and there is a large majority of holdings in the hands of middle

class invesotrs whose average holdings do not exceed 500 shares. The

following further data is also made available to you:




Particulars Last 5 years Current

year

1 2 3 4 5 6

Earnings per share (Rs) 6.00 5.0 4.5 4.5 4.0 17.5

Cash availability per share (Rs) 7.50 6.0 5.0 4.0 4.0 20.0

Dividend/share (Rs) 3.00 3.0 3.0 2.0 Nil ?

Pay out ratio 50 60 67 45 ² ?

Average market price (face

value of Rs 100)

80 70 70 70 60 140

P/E ratio 13.33:1 14:1 15.6:1 15.6:1 15:1 8:1

What recommendations would you make? Give reasons for your answers.




Solution

The company appears to be following a stable dividend policy, that is, a

policy of maintaining a stable rupee dividend, decreasing it only when it

appears that earnings have reached a new, permanently low level or vice-

versa in that although the EPS has declined from Rs 6 in Year 1 to Rs 4.50 in

Year 3, no corresponding decrease was effected in the DPS. However, when

the declining trend of earnings continued in subsequent years too, the

dividends had been lowered inasmuch as no dividends were paid in year 5.

Consequently, its share prices fell from Rs 80 in Year 1 to Rs 60 in Year 5.

The decline in market prices is less pronounced in the context of much

distressing profitability and dividend record of the company during the

period as a whole. The rate of return of 6 per cent on equity capital in Year 1

was the maximum. Even this modest amount consistently declined to

eventually a very low figure of 4 per cent by current year; the dividend yield

was still smaller. The only off-setting factor was the stable dividend policy.




Given the improved record of earnings in the current year and the trend which is

likely to continue in future years, coupled with favourable liquidity position, a rise in

dividend is commended for the undermentioned reasons.

(a) The investors would receive dividend income free of tax, especially if this

category of investors includes retired persons who need the current income for living expenses and do not wish to sell even a small portion of their shares

either because of transaction costs involved or because they are reluctant to

µeating their own capital¶.

(b) The investors must be expecting a substantial rise in dividend in the light of the

current market price of Rs 140 compared to Rs 60 last year. Failure to pay

dividend commensurate to the shareholder¶s expectation will have an adverseeffect on share prices.

(c) Cement industry with stable sales and earnings can afford high leverage ratios.

The company is not likely to encounter any major difficulty in raising funds to

finance an additional plant due to bright future prospects.

(d) The payment of dividend resolves uncertainty; investors in general are risk

averters; they prefer current dividends to larger deferred dividends.The payment was 50 per cent in Year 1; the payment of 60 per cent is recommeded

this year, assuming that target dividend payout ratio is 75 per cent. Moreover, the

company through advertisements should make the investors aware of the growth

prospects and the investment opportunities ahead which would have a positive

effect on share prices.




SOLVED PROBLEM 2

From the following financial statistics of Infosys Ltd for the period 1993-94 to 2001-02 (along

with Sensex), comment on its dividend policy. Are its shares overvalued?

Year MPS Networth

(Rs lakh)

Equity

Divide

nd (Rs

lakh)

EAT

(Rs

Lakh)

EPS NWPS D/P

(%)

DPS Sense

x

1993-94 Rs 343 2,870 117 809 Rs 24.15 Rs 85.67 14.46 Rs 3.49 4,485

1994-95 607 6,247 231 1,332 19.88 93.24 17.34 3.45 4,385

1995-96 458 7,984 363 2,101 28.94 109.97 17.28 5.00 3,259

1996-97 731 11,284 399 3,698 50.94 155.43 10.79 5.50 3,440

1997-98 1,493 17,296 703 6,036 39.53 113.28 11.65 4.60 3,770

1998-99 2,597 57,443 1,211 13,526 84.43 358.57 8.95 7.56 3,286

1999-00* 6,891 83,330 2,976 29,352 91.64 260.16 10.14 9.29 4,543

2000-01 7,173 1,38,964 6,615 62,881 196.32 433.86 10.52 20.65 4,355

2001-02 3,606 2,08,031 13,236 80,796 244.32 629.06 16.38 40.02 3,336

* Company issued bonus shares in the ratio of 1:1.




Solution The Infosys Ltd appears to be following a stable dividend policy. The

dividend per share (DPS) have consistently increased from Rs 3.5 in 1993-94 to Rs

7.56 in 1998-99 and, further, to Rs 40.02 in 2001-02. Though the DPS has shown a

significant increase over the years, the dividends paid are low in relation to the

market price of its share (MPS). The dividend yield (DPS/MPS) is less than one per cent in most of the years. In 2001-02, when dividends paid were maximum, the

dividend yield was 1.1 per cent only. The dividend payout (D/P) ratios is also a

pointer towards the same, varying in the range of 8.95 per cent (1993-94) and 17.34

per cent (2001-02). The D/P ratios of less than 20 per cent, for a

software/information technology company is below the mark.

The DPS are also not commensurate with the pronounced increase in the EAT as

well as the EPS over the years particularly since 1998-99. For instance, while EPS

was Rs 196.32 and Rs 244.32 in 2001 and 2002 respectively, the corresponding DPS

in these years were Rs 20.65 and Rs 40.02 only. However, Infosys has virtually

doubled the payment of DPS in 2002 over 2001. Given the improved record of

earnings, particularly since 1998-99 and the trend which is likely to continue infuture years in view of increased level of projects from the US, Infosys would be

well advised to pay higher dividend.

All along the period under reference, the market price of its shares seem to be over-

valued as reflected in the market price/book value (net worth) ratio (P/B ratio) as

shown below:




Year MPS NWPS P/B

1993-94 Rs 343 Rs 85.67 4.00

1994-95 607 93.24 6.51

1995-96 458 109.97 4.16

1996-97 731 155.43 4.70

1997-98 1,493 113.28 13.18

1998-99 2,597 358.57 7.24

1999-00 6,891 260.16 26.49

2000-01 7,173 433.86 16.53

2001-02 3,606 629.06 5.73

The P/B ratio indicates that the MPS of Infosys' shares is substantially

overvalued. It was maximum (26.49 times) in 1999-2000. The reason may behigher expected of growth of software industry by the investors in view of large

number of project and service outsourcing done from India by the USA.

However, the MPS is not warranted by the fundamental factors such as EPS,

DPS, NWPS, P/B ratio and so on.



Dividend and ShareDividend and ShareRepurchase DecisionsRepurchase Decisions



Dividend PolicyDividend Policy

nn Business DecisionsBusiness Decisions

nn InvestmentInvestment

nn FinancingFinancing

nn DividendDividend

nn Dividend PolicyDividend Policynn Determining how much of a company¶s profitDetermining how much of a company¶s profit

is to beis to be paid to shareholders aspaid to shareholders asdividends and how much is todividends and how much is to beberetained.retained.



Is there an Optimal DividendIs there an Optimal Dividend

Policy?Policy?nn In a perfect capital market, dividend policyIn a perfect capital market, dividend policy

has no impact on shareholders¶ wealthhas no impact on shareholders¶ wealth

and is, therefore, irrelevant.and is, therefore, irrelevant.

nn Introducing capital market imperfections,Introducing capital market imperfections,

the following views exist:the following views exist:nn Dividend policy does not matter.Dividend policy does not matter.

nn A high dividend policy is best. A high dividend policy is best.

nn A low dividend policy is best. A low dividend policy is best.



Institutional Features of Institutional Features of

DividendsDividends

nn Dividend Declaration ProceduresDividend Declaration Proceduresnn Interim and finalInterim and final

nn In Australia, if dividends are paid, we typically findIn Australia, if dividends are paid, we typically findtwo sorts, a final dividend is paid after the end of two sorts, a final dividend is paid after the end of the accounting or reporting year.the accounting or reporting year.

nn An interim dividend can be paid any time before An interim dividend can be paid any time beforethe final report is released, usually after the half the final report is released, usually after the half--

yearly accountsyearly accountsare released.are released.

nn CumCum--dividend perioddividend periodnn Period during which the share purchaser isPeriod during which the share purchaser is

qualifiedqualifiedto receive a reviousl announced dividend.to receive a reviousl announced dividend.



nn Declaration DateDeclaration Date

nn Date board of directors pass a resolutionDate board of directors pass a resolutionto pay a dividend.to pay a dividend.

nn Record (Books Closing) DateRecord (Books Closing) Datenn The date on which holders of record areThe date on which holders of record are

designateddesignatedto receive a dividend.to receive a dividend.

nn This is 4 days after the exThis is 4 days after the ex--dividend date.dividend date.

nn The idea is that if shares are traded cumThe idea is that if shares are traded cum--dividend, brokers have time to notify thedividend, brokers have time to notify the

share register to ensure the newshare register to ensure the new

Institutional Features of Dividends (cont.)Institutional Features of Dividends (cont.)




nn Legal ConsiderationsLegal Considerations

nn Dividends can only be paid out of profitDividends can only be paid out of profitand are notand are not

to be paid out of capital.to be paid out of capital.nn A dividend cannot be paid if it would make A dividend cannot be paid if it would make

the company insolvent.the company insolvent.

nn Dividend restrictions may exist inDividend restrictions may exist in

covenants in trustcovenants in trustdeeds and loan agreements.deeds and loan agreements.

nn Franked dividend carries credits for taxFranked dividend carries credits for taxpaid by the company.paid by the company.




nn Dividend ImputationDividend Imputation

nn Franked dividendFranked dividend

nn Carries a credit for income tax paid by theCarries a credit for income tax paid by the

company.company.nn Franking creditFranking credit

nn Credit for Australian company tax paid which,Credit for Australian company tax paid which,when distributed to shareholders, can be offsetwhen distributed to shareholders, can be offset

against their tax liability.against their tax liability.nn Withholding taxWithholding tax

nn Tax deducted by a company from the dividendTax deducted by a company from the dividendpayable topayable to

a nona non--resident shareholder.resident shareholder.



Repurchasing SharesRepurchasing Shares

nn Over the past decade, popularity of Over the past decade, popularity of Australian companies buying back their Australian companies buying back their

own shares has grown as a means of own shares has grown as a means of returning excess capitalreturning excess capitalto shareholders.to shareholders.

nn Types of share buybackTypes of share buybacknn Equal access buybackEqual access buyback ²² propro--rata to allrata to all

shareholders.shareholders.

nn Selective buybackSelective buyback ²² repurchase fromrepurchase fromspecific, limited number of shareholders.specific, limited number of shareholders.

nn OnOn--market bu backmarket bu back ²² re urchase throu hre urchase throu h



Dividend PoliciesDividend Policies

nn Residual dividend policyResidual dividend policy

nn Pay out as dividends any profit thatPay out as dividends any profit that

management does not believe can bemanagement does not believe can beinvested profitably.invested profitably.

nn Smoothed dividend policySmoothed dividend policynn Target proportion of annual profits to be paidTarget proportion of annual profits to be paid

out as dividend. Aim for dividends to equal theout as dividend. Aim for dividends to equal thelonglong--run difference between expected profitsrun difference between expected profits

and expected investment needs.and expected investment needs.



Managers and DividendManagers and Dividend

DecisionsDecisionsnn Dividends are an µactive decision variable¶Dividends are an µactive decision variable¶

(Lintner).(Lintner).

nn Lintner found:Lintner found:

nn Companies have a longCompanies have a long--term target payoutterm target payout

ratio.ratio.nn Managers focus on change in payout.Managers focus on change in payout.

nn Dividends are smoothed relative to profits.Dividends are smoothed relative to profits.

nn Managers avoid changes in dividends thatManagers avoid changes in dividends that



Irrelevance TheoryIrrelevance Theory

nn Value of firm is determined solely by theValue of firm is determined solely by theearning power of the firm¶s assets, and theearning power of the firm¶s assets, and the

manner in which the earnings stream ismanner in which the earnings stream issplit between dividends and retainedsplit between dividends and retainedearnings does not affect shareholders¶earnings does not affect shareholders¶

wealth.wealth.



Modigliani and Miller (1961)Modigliani and Miller (1961)

nn Given the investment decision of the firm,Given the investment decision of the firm,the dividend payout ratio is a mere detail.the dividend payout ratio is a mere detail.

It does not affect the wealth of It does not affect the wealth of shareholders.shareholders.

nn Assumptions Assumptionsnn No taxes, transaction costs, or other marketNo taxes, transaction costs, or other market

imperfections.imperfections.

nn A fixed investment or capital budgeting A fixed investment or capital budgeting



MM¶s ConclusionMM¶s Conclusion

nn Dividend policy is a tradeDividend policy is a trade--off betweenoff betweenretaining profit, paying dividends andretaining profit, paying dividends and

making new share issues to replace cashmaking new share issues to replace cashpaid out.paid out.

nn Paying a dividend and issuing new sharesPaying a dividend and issuing new sharesto replace the cash:to replace the cash:

nn Does not change the value of the company;Does not change the value of the company;

andand



MM¶s Conclusion (cont.)MM¶s Conclusion (cont.)

nn If a company increases its dividends, itIf a company increases its dividends, itmust replace the cash by making a sharemust replace the cash by making a share

issue.issue.

nn Old shareholders receive a higher currentOld shareholders receive a higher current

dividend, but a proportion of futuredividend, but a proportion of futuredividends must be diverted to the newdividends must be diverted to the newshareholders.shareholders.



MM¶s Conclusion (cont.)MM¶s Conclusion (cont.)

nn The MM dividend irrelevance propositionThe MM dividend irrelevance propositionis validis valid

in a perfect capital market with no taxes.in a perfect capital market with no taxes.

nn Therefore, if dividend policy is important inTherefore, if dividend policy is important in

practice, the reasons for its importancepractice, the reasons for its importancemust relate to factors that MM excludedmust relate to factors that MM excludedfrom their analysis.from their analysis.



Dividends and TaxesDividends and Taxes

nn Differential tax treatment of dividendDifferential tax treatment of dividendincome versus capital gains arising fromincome versus capital gains arising from

retainedretainedprofits can either favour or penaliseprofits can either favour or penalisepaymentpayment

of dividends.of dividends.

nn This difference in tax treatment isThis difference in tax treatment is

understoodunderstood



Classical Tax SystemClassical Tax Systemnn In a classical tax system:In a classical tax system:

nn Company profits are taxed at theCompany profits are taxed at thecorporate tax rate,corporate tax rate, t t cc, leaving (1, leaving (1± ± t t c c ) to be) to bedistributed as a dividend.distributed as a dividend.

nn Dividends received by shareholders areDividends received by shareholders arethen taxed atthen taxed atthe shareholder¶s personal marginal taxthe shareholder¶s personal marginal taxrate,rate, t t p p..

nn The consequence is that, from a dollar of The consequence is that, from a dollar of company profit, the shareholder ends upcompany profit, the shareholder ends upwith (1with (1± ± t t cc)x (1)x (1± ± t t pp) dollars of ) dollars of after after--tax dividend in a classical taxtax dividend in a classical tax

system.system.



Imputation Tax SystemImputation Tax System

nn A system under which Australian resident A system under which Australian residentequity investors can use tax creditsequity investors can use tax credits

associated with franked dividends to offsetassociated with franked dividends to offsettheir personal tax.their personal tax.

nn The system eliminates the double taxationThe system eliminates the double taxationinherent in the classical tax system.inherent in the classical tax system.

nn Company tax is assessed on the corporateCompany tax is assessed on the corporate

profits in the normal way, at the corporateprofits in the normal way, at the corporate



Imputation Tax System (cont.)Imputation Tax System (cont.)

nn For each dollar of franked dividends paidFor each dollar of franked dividends paidby the company, resident shareholders willby the company, resident shareholders will

be taxed at their marginal rate (be taxed at their marginal rate (t t pp) on an) on animputed dividend of $imputed dividend of $DD / (1/ (1 ± ± t t cc).).

nn This is referred to as the µgrossedThis is referred to as the µgrossed--upup

dividend¶.dividend¶.nn The grossedThe grossed--up dividend is equal to theup dividend is equal to the

dividend plus the franking credit.dividend plus the franking credit.

nn Franking credit is given by:Franking credit is given by:

c

c

t

t

v!

1dividendcreditImputation




nn The shareholder receives a tax creditThe shareholder receives a tax creditequalequal

to the franking credit.to the franking credit.

nn The credit can be used to offset taxThe credit can be used to offset tax

liabilities associated with any other form of liabilities associated with any other form of income.income.

nn The tax credit cannot be carried forwardThe tax credit cannot be carried forward




nn The result is that franked dividends areThe result is that franked dividends areeffectively taxeffectively tax--free to Australian residents,free to Australian residents,

if the investor¶s marginal tax rate is equalif the investor¶s marginal tax rate is equalto the corporate tax rate.to the corporate tax rate.

nn If the investor¶s marginal tax rate is lessIf the investor¶s marginal tax rate is lessthan the corporate rate, then the investor than the corporate rate, then the investor will have excess tax credits which can bewill have excess tax credits which can be

used to reduce tax on other income, or used to reduce tax on other income, or

I t ti T S tI t ti T S t



Imputation Tax SystemImputation Tax System

(cont.)(cont.) If the investor¶s marginal tax rate isIf the investor¶s marginal tax rate is

greater thangreater thanthe corporate rate, some tax will bethe corporate rate, some tax will bepayable by the investor on thepayable by the investor on thedividend.dividend.

Investors pay tax, at their marginalInvestors pay tax, at their marginal

rate, on any unfranked dividendsrate, on any unfranked dividendsreceived.received.

Since 1 October 2003, Australian andSince 1 October 2003, Australian and



Imputation and Capital GainsImputation and Capital Gains

TaxTaxnn If companies retain profits, their shareIf companies retain profits, their shareprice is likely to rise relative toprice is likely to rise relative tocompanies that distribute profits, givingcompanies that distribute profits, givingrise to capital gains tax liabilities for rise to capital gains tax liabilities for shareholders if and when the sharesshareholders if and when the sharesare sold.are sold.

nn Capital gains receive preferential taxCapital gains receive preferential taxtreatment compared to µordinary¶treatment compared to µordinary¶income.income.



Imputation and Capital Gains Tax (cont.)Imputation and Capital Gains Tax (cont.)

nn As of 21 September 1999, capital gains As of 21 September 1999, capital gainsearned over 12 months or longer areearned over 12 months or longer are

subject to CGT discounting.subject to CGT discounting.

nn For individuals, only 50% of the gain isFor individuals, only 50% of the gain is

taxedtaxedat their personal marginal tax rate.at their personal marginal tax rate.

nn For superannuation funds, the discount isFor superannuation funds, the discount is



Imputation and Capital Gains Tax (cont.)Imputation and Capital Gains Tax (cont.)

nn Consequently, effective rates of CGT areConsequently, effective rates of CGT arelikelylikely

to be relatively low for many investors.to be relatively low for many investors.

nn However, where a capital gain arises fromHowever, where a capital gain arises fromretention of profits which have been taxed,retention of profits which have been taxed,any CGT that is payable will be in additionany CGT that is payable will be in additionto the tax already paid by the company.to the tax already paid by the company.

nn In other words, retention of profits canIn other words, retention of profits can



Imputation and DividendImputation and Dividend

PolicyPolicynn If all company shares were held byIf all company shares were held by

resident investors with marginal tax ratesresident investors with marginal tax rates

less than company tax rates, then theless than company tax rates, then theoptimal dividend policy for an Australianoptimal dividend policy for an Australiancompany is one that at least payscompany is one that at least pays

dividends to the limit of its frankingdividends to the limit of its frankingaccount balance.account balance.



Imputation and Dividend Policy (cont.)Imputation and Dividend Policy (cont.)

nn This policy will benefit resident investorsThis policy will benefit resident investorsin two ways:in two ways:

nn The franking credits attached to frankedThe franking credits attached to franked

dividends can be used to reduce investors¶dividends can be used to reduce investors¶personal tax liabilities.personal tax liabilities.

nn Since the alternative to dividends is capitalSince the alternative to dividends is capitalgains, which are subject to company taxgains, which are subject to company tax

and CGT, higher dividends will mean thatand CGT, higher dividends will mean thatless CGT is payable by investors.less CGT is payable by investors.

nn If all franking credits are not paid out,If all franking credits are not paid out,



Imputation and Dividend Policy (cont.)Imputation and Dividend Policy (cont.)

nn Complicating factors for optimalComplicating factors for optimaldividend policy:dividend policy:

nn Shares are held by both resident and nonShares are held by both resident and non--resident individuals.resident individuals.

nn Many individuals have personal marginalMany individuals have personal marginaltax rates that are greater than thetax rates that are greater than thecompany tax rate and may have a taxcompany tax rate and may have a tax--based preference for retention of profits.based preference for retention of profits.

nn Since July 2000, resident investors thatSince July 2000, resident investors thatare taxare tax--exempt have excess frankingexempt have excess frankingcredits refunded.credits refunded.



Imputation ClientelesImputation Clienteles

nn Clientele effectClientele effect

nn Investors choosing to invest in companies thatInvestors choosing to invest in companies that

have policies meeting their particular have policies meeting their particular requirements.requirements.

nn For example: Investors who require highFor example: Investors who require highcurrent income may choose to invest incurrent income may choose to invest incompanies that have high dividend payouts.companies that have high dividend payouts.

nn Also, companies paying fully Also, companies paying fully--frankedfrankeddividends would attract shareholders whodividends would attract shareholders who

receive the greatest valuereceive the greatest value



Value of Franking CreditsValue of Franking Credits

nn The argument that investors will prefer taxThe argument that investors will prefer taxcredits to be distributed rather thancredits to be distributed rather than

retained assumes that tax credits areretained assumes that tax credits arevaluable to investors.valuable to investors.

nn Supporting evidence from the dividendSupporting evidence from the dividenddropdrop--off ratio:off ratio:

nn µDropµDrop--off ratio¶: ratio of the decline in theoff ratio¶: ratio of the decline in theshare priceshare price

--




(cont.)(cont.)nn Walker and Partington (1999) study dropWalker and Partington (1999) study drop--

off ratios:off ratios:

nn 1 January 19951 January 1995 ± ± 1 March 1997, when ASX1 March 1997, when ASXallowed trading in cumallowed trading in cum--dividend shares after dividend shares after the exthe ex--dividend date.dividend date.

nn Find a dropFind a drop--off ratio of 1.23, implying that $1off ratio of 1.23, implying that $1of of fullyfully--franked dividends is worth more than $1.franked dividends is worth more than $1.

nn Some variability because of differentSome variability because of different

individual marginal tax rates.individual marginal tax rates.




(cont.)(cont.)nn Cannavan, Finn and Gray (2004) alsoCannavan, Finn and Gray (2004) also

studystudy

dropdrop--off ratios:off ratios:nn Use futures contracts on dividend payingUse futures contracts on dividend paying

sharessharesto compare with actual shares.to compare with actual shares.

nn Futures contract does not entitle holder toFutures contract does not entitle holder todividends so difference should reflect marketdividends so difference should reflect marketvalue of dividend and associated frankingvalue of dividend and associated franking

credit.credit.



NonNon--Tax Reasons for the Relevance of Tax Reasons for the Relevance of

Dividend PolicyDividend Policy

nn Information effects and signalling toInformation effects and signalling toinvestors:investors:

nn Evidence suggests share price changesEvidence suggests share price changesaround the time of the announcement of around the time of the announcement of dividend changes are positively related to thedividend changes are positively related to thechange in the dividend.change in the dividend.

nn MM claim that this does not invalidateMM claim that this does not invalidateirrelevance theory. The price change is theirrelevance theory. The price change is theresult of the information content associatedresult of the information content associatedwith the dividend announcement.with the dividend announcement.




Dividend Policy (cont.)Dividend Policy (cont.)nn Three implications of dividendThree implications of dividend

information and signalling hypothesis:information and signalling hypothesis:

nn Unanticipated dividend changes should beUnanticipated dividend changes should be

followed by share price changes in thefollowed by share price changes in thesame direction.same direction.

nn Empirical support for this implication foundEmpirical support for this implication foundin US studiesin US studies

by Grullon, Michaely and Swaminathanby Grullon, Michaely and Swaminathan(2002), Michaely, Thaler and Womack(2002), Michaely, Thaler and Womack(1995), and Healy and Palepu (1988).(1995), and Healy and Palepu (1988).

nn Australian evidence supports this Australian evidence supports this

im lication as well: Balachandaran andim lication as well: Balachandaran and




Dividend Policy (cont.)Dividend Policy (cont.)

nn Three implications of dividend informationThree implications of dividend informationand signalling hypothesis (cont.):and signalling hypothesis (cont.):

nn Unanticipated dividend changes should beUnanticipated dividend changes should befollowed by market revision of expectations of followed by market revision of expectations of future earnings in the same direction.future earnings in the same direction.

nn Empirical evidence also supports thisEmpirical evidence also supports thisimplication, for example Ofer and Seigelimplication, for example Ofer and Seigel(1987).(1987).

nn Analysts revisions of earnings forecasts are Analysts revisions of earnings forecasts are

positively related to dividend changes.positively related to dividend changes.





information and signalling hypothesisinformation and signalling hypothesis(cont.):(cont.):nn Changes in dividends should be followedChanges in dividends should be followed

by changesby changesin earnings in the same direction.in earnings in the same direction.

nn Evidence on this implication is mixed andEvidence on this implication is mixed anddoes notdoes not

strongly support it.strongly support it.nn Watts (1973) and Penman (1983) find littleWatts (1973) and Penman (1983) find little

support for implication.support for implication.

nn Healy and Palepu (1988) find supportHealy and Palepu (1988) find support

when focusinwhen focusin




Dividend Policy (cont.)Dividend Policy (cont.)nn Three implications of dividend information and signallingThree implications of dividend information and signalling

hypothesis (cont.):hypothesis (cont.):nn Changes in dividends should be followed by changes inChanges in dividends should be followed by changes in

earnings in the same direction.earnings in the same direction.

nn De Angelo, De Angelo and Skinner (1996) also find no linkDe Angelo, De Angelo and Skinner (1996) also find no linkbetween dividend increases and future positive profit surprises.between dividend increases and future positive profit surprises.

nn Signalling argument, the third implication, is not supportedSignalling argument, the third implication, is not supportedby empirical evidence.by empirical evidence.

nn Signal is not of continued dividend growth but rather of Signal is not of continued dividend growth but rather of permanence of current increase in dividend.permanence of current increase in dividend.

nn Alternatively, increased dividend may signal reduced risk Alternatively, increased dividend may signal reduced riskassociated with profits and cash flows, thereby reducingassociated with profits and cash flows, thereby reducingdiscount rate and raising share price.discount rate and raising share price.





information and signalling hypothesisinformation and signalling hypothesis(cont.):(cont.):

nn Alternative interpretations of information Alternative interpretations of informationconveyed.conveyed.

nn Benartzi, Michaely and Thaler (1997)Benartzi, Michaely and Thaler (1997)argue that theargue that the

signal is not of continued dividend growthsignal is not of continued dividend growthbut of permanence of current increase inbut of permanence of current increase individend.dividend.

nn Alternatively, Grullon, Michaely and Alternatively, Grullon, Michaely andSwaminathan 2002 ar ue that anSwaminathan 2002 ar ue that an




Dividend Policy (cont.)Dividend Policy (cont.)nn Agency costs and corporate Agency costs and corporate

governancegovernance

nn Agency costs can be reduced by paying Agency costs can be reduced by paying

higher dividends.higher dividends.nn Increased capitalIncreased capital--raising required:raising required:

nn Accountability to market. Accountability to market.

nn Increases provision of information.Increases provision of information.

nn Increases monitoring of managers.Increases monitoring of managers.

nn Managers more likely to act in interests of shareholders.Managers more likely to act in interests of shareholders.




Dividend Policy (cont.)Dividend Policy (cont.)nn Agency costs and corporate Agency costs and corporate

governance (cont.)governance (cont.)

nn Lie (2000) and Grullon, Michaely andLie (2000) and Grullon, Michaely and

Swaminathan (2002) provide empiricalSwaminathan (2002) provide empiricalevidence that increased payouts either evidence that increased payouts either as special dividends, increased ordinaryas special dividends, increased ordinarydividends or a share repurchase programdividends or a share repurchase program

signal reduced opportunity to over invest,signal reduced opportunity to over invest,free cash flow hypothesis.free cash flow hypothesis.

nn Firms with limited investment opportunitiesFirms with limited investment opportunitiesexhibit aexhibit a

bigger abnormal return to thebigger abnormal return to the





nn Agency costs and corporate governance Agency costs and corporate governance(cont.)(cont.)

nn La Porta, LopezLa Porta, Lopez--DeDe--Silanes, Shleifer andSilanes, Shleifer andVishny (2000) provide empirical evidence thatVishny (2000) provide empirical evidence thatin countries where investors¶ interests arein countries where investors¶ interests arerelatively well protected, dividends are lessrelatively well protected, dividends are less

likely to be a mechanism to reduce agencylikely to be a mechanism to reduce agencycosts.costs.

nn WellWell--protected investors are willing to forgoprotected investors are willing to forgodividends now in return for growth.dividends now in return for growth.





nn Agency costs and corporate governance Agency costs and corporate governance(cont.)(cont.)

nn Correia Da Silva, Goeregen and RenneboogCorreia Da Silva, Goeregen and Renneboog(2004) argue that dividend policy may be(2004) argue that dividend policy may beinfluenced by corporate governance regimes.influenced by corporate governance regimes.

nn Market based and blockMarket based and block--holder basedholder basedregimes of corporate governance.regimes of corporate governance.

nn The presence of large (block) shareholdersThe presence of large (block) shareholdersreducesreduces

the impetus to pay out dividends (consider the impetus to pay out dividends (consider




Dividend Policy (cont.)Dividend Policy (cont.)nn Investment opportunitiesInvestment opportunities

nn Differences in the nature of investmentDifferences in the nature of investmentopportunitiesopportunitieswill influence corporate financial decisions,will influence corporate financial decisions,including dividends.including dividends.

nn Lots of investment opportunitiesLots of investment opportunities ²² lowlow

dividends.dividends.

nn Jones and Sharma (2001) rank AustralianJones and Sharma (2001) rank Australiancompaniescompanies





nn Shareholders¶ preference for currentShareholders¶ preference for currentincomeincome

nn Need for shares to yield current income.Need for shares to yield current income.

nn MM support irrelevance stance, givenMM support irrelevance stance, givenshareholders can create µhomemadeshareholders can create µhomemade

dividends¶.dividends¶.

nn Issue and transaction costsIssue and transaction costsnn

Company can avoid incurring costsCompany can avoid incurring costs





nn Dividend clientelesDividend clienteles

nn Groups of investors who choose to invest inGroups of investors who choose to invest in

companies that have dividend policies whichcompanies that have dividend policies whichmeet their particular requirements.meet their particular requirements.

nn If equilibrium exists in terms of the supply andIf equilibrium exists in terms of the supply anddemanddemandfor particular dividend policies, the price of afor particular dividend policies, the price of acompany¶s shares will be independent of itscompany¶s shares will be independent of itsdividend policy.dividend policy.



Share RepurchasesShare Repurchasesnn A share buyback is when a company purchases its own shares A share buyback is when a company purchases its own shares

on the stock market and then proceeds to either cancel themon the stock market and then proceeds to either cancel them(Aust.) or retain them as treasury stock (US).(Aust.) or retain them as treasury stock (US).

nn There are legal requirements associated with buybacks,There are legal requirements associated with buybacks,but generally companies can repurchase up to 10%but generally companies can repurchase up to 10%

of their ordinary shares in a 12of their ordinary shares in a 12--month period.month period.

nn Rapid growth in repurchases in Australia, $770m in the 1995Rapid growth in repurchases in Australia, $770m in the 1995financial year, up to $7.7b in the 12 months to June 2004.financial year, up to $7.7b in the 12 months to June 2004.

nn In 1999 and 2000, US industrial companies distributedIn 1999 and 2000, US industrial companies distributedmore cash to shareholders through share repurchasesmore cash to shareholders through share repurchasesthan dividends.than dividends.



Why Repurchase Shares?Why Repurchase Shares?

nn Dividend substitutionDividend substitution

nn If capital gains are taxed more favourablyIf capital gains are taxed more favourably

than dividends.than dividends.nn Some supporting evidence from the US,Some supporting evidence from the US,

where dividend payout ratios have beenwhere dividend payout ratios have beenfalling in the 1980s and 1990s.falling in the 1980s and 1990s.

nn Improved performance measuresImproved performance measures

nn EPS may rise, but if cash is returned rather EPS may rise, but if cash is returned rather

than used to retire debt financial risk isthan used to retire debt financial risk is




(cont.)(cont.)nn Signalling and undervaluationSignalling and undervaluationnn Managers buying back company stockManagers buying back company stock

indicates thatindicates thatthey believe the stock is undervalued bythey believe the stock is undervalued bythe market.the market.

nn Alternatively, a buyback announcement Alternatively, a buyback announcementcould be accompanied by some newcould be accompanied by some new

information, e.g. sale of unprofitableinformation, e.g. sale of unprofitableasset/division.asset/division.

nn

Resource allocation and agency costsResource allocation and agency costs




(cont.)(cont.)nn Financial flexibilityFinancial flexibility

nn Payment of dividends is a longPayment of dividends is a long--termterm

commitment and sudden major changescommitment and sudden major changes(especially decreases) in dividend policy are(especially decreases) in dividend policy areunappreciated by market.unappreciated by market.

nn buybacks offer an alternative way to makebuybacks offer an alternative way to makedistributions that may not be permanent.distributions that may not be permanent.

nn Employee share optionsEmployee share optionsnn Unlike paying dividends, share repurchasesUnlike paying dividends, share repurchases

do not lead to the exdo not lead to the ex--dividend price dropdividend price drop--off.off.



Share Repurchases inShare Repurchases in

AustraliaAustraliann Five categories of share buyback:Five categories of share buyback:nn Equal access buybackEqual access buyback ²² propro--rata to allrata to all

shareholders.shareholders.

nn Selective buybackSelective buyback ²² repurchase fromrepurchase fromspecific, limited number of shareholders.specific, limited number of shareholders.

nn OnOn--market buybackmarket buyback ²² repurchaserepurchasethrough normal stock exchange trading.through normal stock exchange trading.

nn Employee share scheme buyback.Employee share scheme buyback.nn Minimum holding buybackMinimum holding buyback ²² buy backbuy back

small parcels of shares (transactionsmall parcels of shares (transactioncosts).costs).



Share Repurchases inShare Repurchases in

AustraliaAustraliann Off Off--market buybacks can be structured to provide significantmarket buybacks can be structured to provide significanttax advantages with a large dividend and franking component.tax advantages with a large dividend and franking component.

(see for example Finance in Action: CBA¶s 2004 off (see for example Finance in Action: CBA¶s 2004 off--marketmarketshare buyback.)share buyback.)

nn Key point is that receipt of such a dividend is at the discretionKey point is that receipt of such a dividend is at the discretion

of the shareholder who sells the shares back to the company.of the shareholder who sells the shares back to the company.

nn ASX requires companies to justify buyback ASX requires companies to justify buyback ²² many onmany on--marketmarketbuybacks are justified on the basis that the market undervaluesbuybacks are justified on the basis that the market undervaluesthe company¶s shares.the company¶s shares.

nn Otchere and Ross (2002) find positive abnormal returns for Otchere and Ross (2002) find positive abnormal returns for companies, citing undervaluation as justification of a buyback.companies, citing undervaluation as justification of a buyback.



Dividend Reinvestment PlansDividend Reinvestment Plans

(DRPs)(DRPs)nn

DefinitionDefinitionnn DRPs offer shareholders the option toDRPs offer shareholders the option toapply all or partapply all or partof their cash dividends to the purchase of of their cash dividends to the purchase of additional sharesadditional sharesin the company (in some cases at ain the company (in some cases at adiscount price).discount price).

nn The number of listed companies whichThe number of listed companies whichoperate dividend reinvestment plansoperate dividend reinvestment plansincreased from just 5 in late 1982increased from just 5 in late 1982to 14% of all listed companies by 1999.to 14% of all listed companies by 1999.



DRPs (cont.)DRPs (cont.)

nn Benefits to the company:Benefits to the company:

nn Cheap and effective means of raising capitalCheap and effective means of raising capital

and conserving cashand conserving cashnn Promotes good shareholder relations andPromotes good shareholder relations and

stability of ownershipstability of ownership

nn Disadvantages to the company:Disadvantages to the company:

nn Administration costs Administration costs

nn Promotion of the planPromotion of the plan



DRPs (cont.)DRPs (cont.)nn Benefits to investors:Benefits to investors:

nn Taxation benefits.Taxation benefits.

nn Flexibility.Flexibility.

nn Savings program.Savings program.

nn Shares are generally issued at a discount to marketShares are generally issued at a discount to marketprice and are free from brokerage and stamp duty.price and are free from brokerage and stamp duty.

nn Disadvantages to investors:Disadvantages to investors:

± ± Need to keep substantive and comprehensive recordsNeed to keep substantive and comprehensive recordsthroughout the period of ownership of assets affectedthroughout the period of ownership of assets affectedby capital gains tax.by capital gains tax.

± ± Familiarisation with plan and its tax consequences.Familiarisation with plan and its tax consequences. ± ± No control over the reinvestment price.No control over the reinvestment price.

± ± Discount disadvantages shareholders who do notDiscount disadvantages shareholders who do notparticipate in the DRP.participate in the DRP.



Dividend Election SchemesDividend Election Schemes

nn Allow shareholders the option of receiving Allow shareholders the option of receivingtheir dividends in one or more of a number their dividends in one or more of a number

of forms.of forms.

nn For example, as bonus shares (deferringFor example, as bonus shares (deferring

tax),tax),nn or as dividends from overseas subsidiariesor as dividends from overseas subsidiaries

(foreign tax credits).(foreign tax credits).



Establishing a DividendEstablishing a Dividend

PolicyPolicynn Schools of thought:Schools of thought:

nn Dividend policy does not matter (MM).Dividend policy does not matter (MM).

nn A high dividend policy is best (agency costs, preference for A high dividend policy is best (agency costs, preference for current income and imputation tax system).current income and imputation tax system).

nn A low dividend policy is best (issue costs, transaction costs A low dividend policy is best (issue costs, transaction costsand tax considerations).and tax considerations).

nn Lease et al. (2000) conclude that shareholders¶ wealth isLease et al. (2000) conclude that shareholders¶ wealth isaffected by dividend policy due to market imperfections suchaffected by dividend policy due to market imperfections suchas taxes, agency costs and asymmetric information.as taxes, agency costs and asymmetric information.

nn Policy should be devised on a firm by firm case, dependingPolicy should be devised on a firm by firm case, dependingon imperfections that have the greatest impact on the firm.on imperfections that have the greatest impact on the firm.



Dividend Policy Under Dividend Policy Under

ImputationImputationnn Strong incentives for taxStrong incentives for tax--payingpaying

companies to pay franked dividends.companies to pay franked dividends.

nn The benefits of doing so are greatest for The benefits of doing so are greatest for resident. shareholders subject to marginal taxresident. shareholders subject to marginal taxrates that arerates that arelower than the company tax rate.lower than the company tax rate.

nn On the other hand, shareholders withOn the other hand, shareholders withmarginal taxmarginal tax

rates that are higher than the company taxrates that are higher than the company tax



Dividend Policy Under Imputation (cont.)Dividend Policy Under Imputation (cont.)

nn If the company tax rate and top personalIf the company tax rate and top personaltax rate were equal, then the optimaltax rate were equal, then the optimal

dividend policy for Australian companiesdividend policy for Australian companiesowned by resident shareholders would beowned by resident shareholders would beto pay the maximum possible frankedto pay the maximum possible frankeddividends and adopt a DRPdividends and adopt a DRPto limit the outflow of cash.to limit the outflow of cash.



Dividend Policy Under Imputation (cont.)Dividend Policy Under Imputation (cont.)

nn In practice, the situation is more complexIn practice, the situation is more complexfor for

three main reasons:three main reasons:nn Many companies have both taxMany companies have both tax--payingpaying

resident shareholders who can use frankingresident shareholders who can use frankingcredits, andcredits, and

nonnon--resident shareholders who cannot useresident shareholders who cannot usethem.them.

nn Equality between the company tax rate andEquality between the company tax rate and

the top personal tax rate no longer exists.the top personal tax rate no longer exists.



Agency CostsAgency Costsnn Payment of dividends has a role inPayment of dividends has a role in

reducingreducingagency costsagency costs ²² pay out of excess cashpay out of excess cashreduces opportunities for managers toreduces opportunities for managers to

destroy valuedestroy valueby over by over--investing.investing.

nn HighHigh--growth companies require capital,growth companies require capital,andanddividend policy should account for dividend policy should account for positivepositive

NPV investment opportunities, with aNPV investment opportunities, with a



Asymmetric InformationAsymmetric Informationnn Dividend and share repurchaseDividend and share repurchase

announcementsannouncementshave information content.have information content.

nn Market responds to changes inMarket responds to changes individends,dividends,special dividends, reductions in andspecial dividends, reductions in and

suspensionssuspensionsof dividends.of dividends.

A t i I f tiA t i I f ti



Asymmetric InformationAsymmetric Information

(cont.)(cont.)nn Special dividend or buyback indicatesSpecial dividend or buyback indicatesreleasereleaseof temporary free cash flow.of temporary free cash flow.

nn Managers are cautious and will notManagers are cautious and will notexcessively raise ordinary dividends for excessively raise ordinary dividends for fear of having to reduce dividend infear of having to reduce dividend in

future, a strong negative signal.future, a strong negative signal.

nn Instead, a special dividend mayInstead, a special dividend may

Di id d P li d Fi LifDi id d P li d Fi Lif



Dividend Policy and Firm LifeDividend Policy and Firm Life

CycleCyclenn A company¶s dividend payout policy A company¶s dividend payout policymay needmay needto change as it moves through it¶s lifeto change as it moves through it¶s lifecycle.cycle.

nn A new business with good growth A new business with good growthprospects is likely to require capital andprospects is likely to require capital and

unlikely to payout dividends.unlikely to payout dividends.

nn As the firm matures and has limited As the firm matures and has limited



SummarySummarynn Dividend policy is about the tradeDividend policy is about the trade--off off

between retaining profit and paying outbetween retaining profit and paying outdividends.dividends.

nn Does not affect shareholders¶ wealth inDoes not affect shareholders¶ wealth inaaperfect capital market.perfect capital market.

nn Dividend policy becomes importantDividend policy becomes importantwhen wewhen we

nn consider taxes and agency costs.consider taxes and agency costs.



Summary (cont.)Summary (cont.)nn Dividend policy environment has beenDividend policy environment has been

changedchangedby recent alteration to capital gains taxby recent alteration to capital gains tax

laws, favouring capital gains over laws, favouring capital gains over dividends.dividends.

nn

Share buybacks have become anShare buybacks have become anincreasingly popular way to distributeincreasingly popular way to distributecash to shareholders.cash to shareholders.

Determinants and Aspectsof Dividend Policy

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