Dividend Policy

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INTRODUCTION TO CORPORATE FINANC – Dividend Policy

CHAPTER 22 Dividend Policy

Dividend PolicyWhat is It?

Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation. This decision is considered a financing

decision because the profits of the corporation are an important source of financing available to the firm.

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Definition:

Dividend Policy means that decision of the management through which it is determined how much of net profits are to be distributed as dividend among the shareholders and how much to be retained in the business.

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Significance :

Determination of dividend policy of the firm is one of the important financial decisions of the management. Three main decisions are taken in the financial management. These are:

i) Investment Decisions ii) Financing Decision iii) Dividend Decisions

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Factors Determining Dividend Policy

1. Financial Needs of the Company2. Stability of Dividends3. Legal Requirements4. Liquidity5. Growth Prospects6. Availability of Funds7. Earnings Stability

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8. Control9. Taxes10. Investment Opportuni9ties11. Effects on Earnings Per Share12. Age of Company13. Inflation

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Kinds of Dividend: Cash Dividend Stock Dividend or Bonus Shares Interim Dividend Extra Dividend Property Dividend Scrip Dividend Bond Dividend Composite Dividend

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Types of Dividend Policy:

Steady Dividends at the Present Level Policy Steady Dividends at a Lower Level Policy Steady Dividends at Higher Level Policy Dividends Fluctuating with Earnings Policy Low Regular Dividends Plus Extra Dividend Policy of Eliminating the Dividend Entirely

Types of Dividends

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

Dividends can be in the form of: Cash Additional Shares of Stock (stock dividend) Property

If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders – this is known as a liquidating dividend.

Dividends a Financing Decision

In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm.

When a cash dividend is declared, those funds leave the firm permanently and irreversibly.

Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.

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Corporate Profits After Tax Retained Earnings

Dividends

Dividends versus Interest Obligations

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

period of time Timely payment of the required amount of interest is a legal

obligation Failure to pay interest (and fulfill other contractual commitments

under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies

Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcy

Dividends A dividend is a discretionary payment made to shareholders The decision to distribute dividends is solely the responsibility of the

board of directors Shareholders are residual claimants of the firm (they have the last,

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

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THE MECHANICS OF DIVIDEND PAYMENTS

Dividend Policy

Trade Settlement and the Ex Dividend Date

Changes in the Settlement Cycle In June 1995 the settlement cycle for all non-money-market Canadian and

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

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 failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S. broker, increased the need to minimize the risks involved in the clearing and settlement of securities.

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

Ex Dividend Date The 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 record.

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DIVIDEND DECISION AND THE BOARD OF DIRECTORS

Dividend Policy

Dividend PolicyDividends, Shareholders and the Board of Directors

There is no legal obligation for firms to pay dividends to common shareholders

Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because: Board members are jointly and severally liable for any

damages they may cause Board members are constrained by legal rules affecting

dividends including: Not paying dividends out of capital Not paying dividends when that decision could cause the

firm to become insolvent Not paying dividends in contravention of contractual

commitments (such as debt covenant agreements)

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Dividend PaymentsDividend Reinvestment Plans (DRIPs)

Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm DRIPs will buy as many shares as the cash dividend

allows with the residual deposited as cash Leads to shareholders owning odd lots (less than 100

shares)

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

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Dividend PaymentsStock Dividends

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

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

Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future.

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Dividend PaymentsStock Dividends

Implications reduction in the R/E account reduced capacity to pay future dividends proportionate share ownership remains unchanged shareholder’s wealth (theoretically) is unaffected

Effect on the Company conserves cash serves to lower the market value of firm’s stock modestly promotes wider distribution of shares to the extent that current owners divest

themselves of shares...because they have more adjusts the capital accounts dilutes EPS

Effect on Shareholders proportion of ownership remains unchanged total value of holdings remains unchanged if former DPS is maintained, this really represents an increased dividend payout

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Dividend PaymentsStock Splits

Although there is no theoretical proof, there is some who believe that an optimal price range exists for a company’s common shares.

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

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

The result is: increase in the number of share outstanding theoretically, no change in shareholder wealth

Reasons for use: better share price trading range psychological appeal (signalling affect)

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Cash Dividend PaymentsThe Macro Perspective

: Aggregate after-tax profits run at approximately 6% of

GDP but are highly variable Aggregate dividends are relatively stable when

compared to after-tax profits. They are sustained in the face of drops in profit during

recessions They are held reasonably constant in the face of peaks in

aggregate profits.

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Cash Dividend PaymentsThe Macro Perspective

Aggregate Dividend payouts further illustrates the effects of relatively stable dividend payouts in the face of profit volatility: The normal aggregate dividend payout rate is

about 40% of after-tax profit When profits drop and dividends are held

constant, payout rates rise to 100%

()

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MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCE

THEOREMM&M, Dividends and Firm Value

Modigliani and Miller’s Dividend Irrelevance Theorem

The value of M&M’s Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.

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M&M’s Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

Start with the single-period DDM:

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1

110 )K(

PDP

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

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1

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PDmVmP

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[ 22-]

M&M’s Dividend Irrelevance TheoremAssumptions

No Taxes Perfect capital markets

large number of individual buyers and sellers costless information no transaction costs

All firms maximize value There is no debt

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

Where: X represents cash flow from operations I represents investment X – I is free cash flow mD1 is dividend to current shareholders at time

1

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1111 mDInPX


Residual Theory of Dividends

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

Identify free cash flow generated in the previous period

Identify investment projects that have positive NPVs

Invest in all positive NPV projects If free cash flow is insufficient, then raise external

capital – in this case no dividend is paid If free cash flow exceeds investment requirements,

the residual amount is distributed in the form of cash dividends.

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Residual Theory of Dividends - Implication

The implication of the Residual Theory of Dividends are:

Investment decisions are independent of the firm’s dividend policy No firm would pass on a positive NPV project because of the

lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken.

If the firm can’t make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own.

The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure 22 – 4 on the following slide:

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Homemade Dividends

Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern. They don’t need management declare a cash

dividend, they can create their own.

Conclusion: under the assumptions of M&M’s model, the investor is indifferent to the firm’s dividend policy.

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The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed

Risk is a real world factor. Firm’s that reinvest free cash flow, put

that money at risk – there is no certainty of investment outcome – those forfeit dividends that are reinvested…could be lost!

Remember the two-stage DDM?

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Remember the two-stage DDM?

The first term is the present value of existing opportunities (PVEO)

The second term is the present value of growth opportunities (PVGO)

These forecast returns face risks of new market entrants to compete for the excess profits forecast in emerging opportunities making PVGO extremely vulnerable.

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Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by investors.

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

The difference between the M&M and Gordon arguments are illustrated in Figure 22 - 5 on the following slide: M&M argue that dividends and capital gains are perfect

substitutes

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DIVIDEND POLICY IN PRACTICE

Dividend Policy

Dividend Policy in Practice

Firms smooth their dividends Firms tend to hold dividends constant, even in

the face of increasing after-tax profit Firms are very reluctant to cut dividends

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Dividend Policy in Practice Lintner’s Work on Dividend Adjustment

Implications The speed of dividend adjustment is only

about 30 percent Firms are very reluctant to fully adjust Firms do not follow a policy of paying a

constant proportion of earnings out as dividends

Dividend policy in practice does not follow M&M’s irrelevance arguments because the real world does not match the assumptions

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Relaxing the M&M AssumptionsWelcome to the Real World!

Transactions Costs Underwriting costs are very high, providing a

strong incentive for firms to finance growth out of free cash flow

Facing these high underwriting costs firms: With high growth rates have little incentive to

pay dividends With volatile earnings conserve cash from year

to year to finance projects and therefore pay very conservative dividends

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Dividends and Signalling Under conditions of information asymmetry,

shareholders and the investing public watch for management signals (actions) about what management knows.

Management is therefore very cautious about dividend changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)

(The Signalling Model is explained in Figure 22 – 6 found on the next slide.)

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Agency Theory Investors are wary of senior management so they seek

to put controls in place. There is a fear that managers may waste corporate

resources by over-investing in low or poor NPV projects. Gordon Donaldson argued this is the reason for the

pecking order managements tend to use when raising capital Shareholders would prefer to receive a dividend and then

have management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend.

Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess management.

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Repurchased Shares

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

not involve shares that can be placed into treasury stock - they are canceled

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Effects of A Share Repurchase

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

a higher market price per outstanding share of common stock should result

stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price.

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Advantages of Share Repurchases

signal positive information about the firm’s future cash flows

used to effect a large-scale change in the firm’s capital structure

increase investor’s return without creating an expectation of higher future cash dividends

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

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

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Borrowing to Pay DividendsAn Example

The foregoing example illustrates: it is possible for a firm with ‘borrowing capacity’ to borrow

funds to pay cash dividends. this is not possible if the lenders insist on restrictive

covenants that limit or prevent this from occurring. the cash for the dividend must be present in the cash

account. payment of dividends reduces both the cash account on

the asset side of the balance sheet as well as the retained earnings account on the ‘claims’ side of the balance sheet.

in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. (Bondholders in this example may have thought their firm would have only a 25% debt ratio….after the dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.)

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Factors that affect Dividend Policy

Company projects low growth, has excess funds, may = large dividends (PG & E)

Management expects high growth, high need for cash; may = high retained earnings and low or no dividends (high tech firms)

Stockholders’ preferencesCapital gains vs ordinary income

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Factors that affect dividend policy

Restrictions on dividend paymentsBond indenture agreementsLack of retained earnings

Availability of cash

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Dividend determination methods

Dividend Rate. Most companies use a fixed dollar amount per share. This amount is determined by the Board of Directors

Dividends tend to stay the same or increase slightly each year; shows stability, positive future

Decreases in dividends can severely impact the stock price

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Leading Dividend Theories

Clientele Dividend Theory Some investors, such as elderly people on

fixed incomes, tend to prefer to receive dividend income.

Others, such as young investors often prefer growth, and tend to like their income in the form of capital gains rather than as dividend income.

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Alternatives to Cash Dividends

Stock Dividends Existing shareholders receive additional shares

of stock instead of cash dividends Stock dividends represent a distribution of stock

of less than 25% of total shares outstanding Done usually if the firm wants to conserve cash The number of shares is expressed as a

percentage of current stock holdings.

e.g. if there is a 10% stock dividend, you would receive one additional share for every 10 that you currently own.

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Alternatives to Cash Dividends

Stock Splits If total shares will increase by more than

25%, the company will usually declare a stock split.

Expressed as a ratio to original shares.

Link to Reuters

e.g. a 2-1 split means that each investor will end up with twice as many shares as they had prior to the split.

http://www.reuters.com/

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Stock Repurchases

A firm buys back its own stock on the open market

A very common occurrence recently By reducing the number of shares

outstanding, earnings per share are increased

Rather than payout a dividend, which would have immediate tax consequences for the investor, a stock repurchase increases the share price

Stock repurchase reverses the impact of dilution

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Stock Repurchase Effect

Serves as a perfect replacement for a dividend payment to shareholders

Example: stock worth $60 per share pays $4 dividend. Shareholder has a Stock worth $60 and must pay tax on the $4 dividend

If dividend money used to repurchase stock instead, shareholder ends up with stock worth $64 with no immediate recognition of income

Dividend Policy

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