Chapter 22 dividend policy

Dividend PolicyDividend Policy

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.

CHAPTER 22 – Dividend Policy 22 - 3

Dividend Policy

Types of DividendsDividends are a permanent distribution of residual

earnings/property of the corporation to its owners.Dividends can be in the form of:

CashAdditional 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.


Dividend Policy

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.


Corporate Profits After Tax Retained Earnings

Dividends

Dividends versus Interest ObligationsInterest 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)


Dividend Policy

Dividend PaymentsMechanics of Cash Dividend Payments

Declaration DateHolder of Record DateEx-dividend DatePayment Date


Dividend PaymentsMechanics of Cash Dividend PaymentsDeclaration Date

this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class.

when CARRIED, this resolution makes the dividend a current liability for the firm.

Date of Record is the date on which the shareholders register is closed after the trading day and

all those who are listed will receive the dividend.

Ex dividend Date is the date that the value of the firm’s common shares will reflect the dividend

payment (ie. fall in value) ‘ex’ means without. At the start of trading on the ex-dividend date, the share price will normally open

for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend.

Date of Payment is the date the cheques for the dividend are mailed out to the shareholders.



Declaration Date

Date ofRecord

Date ofPayment

Ex Dividend Date is determined by the Date of Record.The market value of the sharesdrops by the value of the dividendper share on market opening…comparedto the previous day’s close.

The Board Meetsand passes themotion to createthe dividend

2 business days prior to the Date of Record

Trade Settlement and the Ex Dividend DateChanges 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.


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 causeBoard 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)


Dividend Policy

Dividend PaymentsDividend Reinvestment Plans (DRIPs)Involve shareholders deciding to use the cash

dividend proceeds to buy more shares of the firmDRIPs will buy as many shares as the cash dividend

allows with the residual deposited as cashLeads 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.


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.


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


Dividend PaymentsStock SplitsAlthough 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 outstandingtheoretically, no change in shareholder wealth

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


Dividend PaymentsStock Split Effectsshareholders wealth should remain unaffected:

Original Holdings: (100 shares @ $150/share) = $15,000

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

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

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


Stock Dividends versus Stock Splits

- lowers stock price slightly - large drop in stock price- little psychological appeal - much stronger potential

signalling effect- recapitalization of earnings - no recapitalization- no change in proportional - same

ownership- odd lots created - odd lots rare- theoretically, no value to - same

the investor


Stock Dividends Stock Splits

Cash Dividend PaymentsThe Macro Perspective - Question

Why are dividends smoothed and not matched to profits?


M&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.


M&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm Value

Start with the single-period DDM:


1

110 )K(

PDP

e

[ 22-1]


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


1

)( 1100 )K(

PDmVmP

e

[ 22-2]

M&M’s Dividend Irrelevance TheoremAssumptions

No TaxesPerfect capital markets

large number of individual buyers and sellerscostless informationno transaction costs

All firms maximize valueThere is no debt



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


1111 mDInPX [ 22-3]


Solving for dividends paid out (mD1 ):


1111 InPXmD

M&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueIf a firm pays out dividends that exceeds its free cash

flow (X –I), then it must issue new common shares to pay for these dividends.

Substituting into Equation 22 – 2 we get:

The value of the firm is the value of the next period’s free cash flow (X1 –I1) plus the next period’s equity market value…


)1(

])[(X 11110 K

VPnmIV

[ 22-4]

M&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueThe firm value is determined as the present value of

the free cash flows to the equity holders:

The dividend is equal to the free cash flow each period, and dividends are therefore a residual after the firm has taken care of all of its investment requirements – this is the Residual Theory of Dividends


)1(1

0

tt

tt

K

IXV[ 22-5]

Value has nothing

to do with dividends

M&M’s Dividend Irrelevance TheoremResidual 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 NPVsInvest 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.


M&M’s Dividend Irrelevance TheoremResidual Theory of Dividends - ImplicationThe 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:


M&M’s Dividend Irrelevance TheoremHomemade 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.


Dividend Policy

Dividend Policy in PracticeFirms 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


Dividend Policy in PracticeLintner’s Work on Dividend Adjustment

John Lintner suggested a partial adjustment model to explain the smoothing of dividend behaviour illustrating that firms slowly change dividends as they move toward a new target level:


1 ) -Dβ(DΔD t-*tt [ 22-7]

Dividend Policy in Practice Lintner’s Work on Dividend Adjustment

The target dividend Dt* Lintner suggested is a function of

the firm’s optimal payout rate of the firm’s underlying earnings (Et) leading to the following equation:

The coefficient on lagged dividends was estimated at 0.70 indicating an adjustment speed (b) coefficent of 0.30.

The coefficient on current earnings (c) was estimated at 0.15


)1( 11 cEDbaD t-t [ 22-8]

Dividend Policy in Practice Lintner’s Work on Dividend Adjustment

ImplicationsThe speed of dividend adjustment is only about 30

percentFirms are very reluctant to fully adjustFirms 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 used.


Relaxing the M&M AssumptionsWelcome to the Real World!

Transactions CostsUnderwriting 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


Share RepurchasesSimply another form of payout policy.An alternative to cash dividend where the

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

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


Dividend Policy

Share Repurchases allowed under the OBCA and CBCA reasons for use:

Offsetting the exercise of executive stock options Leveraged recapitalizations Information or signalling effects Repurchase dissident shares Removing cash without generating expectations for

future distributions Take the firm private.


Disadvantages of Share Repurchases they are usually done on an irregular basis, so a

shareholder cannot depend on income from this source. if regular repurchases are made, there is a good chance

that Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax

there may be some agency problems - if managers have inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.


Methods of Share Repurchases tender offer:

this is a formal offer to purchase a given number of shares at a given price over current market price.

open market purchase: the purchase of shares through an investment dealer like

any other investor this is not designed for large block purchases.

private negotiation with major shareholders

In any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus.


Repurchased Sharescalled 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


Repurchase ExampleCurrent EPS

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

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

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

Expected market price after repurchase:= [p/e][EPSnew] = [5][$4.40] = $22.00 per share


Effects of A Share RepurchaseEPS should increase following the repurchase

if earnings after-tax remains the samea higher market price per outstanding share

of common stock should resultstockholders not selling their shares back to

the firm will enjoy a capital gain if the repurchase increases the stock price.


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.


Disadvantages of Share Repurchasessignal negative information about the firm’s

future growth and investment opportunitiesthe provincial securities commission may

raise questions about the intentionshare repurchase may not qualify the

investor for a capital gain


Signalling

Borrowing to Pay Dividends Is this legal? is it possible to do? Yes

the firm must have the ability and capacity to borrow the firm must have sufficient retained earnings to

allow it to pay the dividend the firm must have sufficient cash on hand to pay the

cash dividend the firm must NOT have agreed to any limitations on

the payment of dividends under the bond indenture. Why?

A possible answer is to signal to the market that the board is confident about the firm’s ability to sustain cash dividends into the future.


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%.)


Summary and ConclusionsIn this chapter you have learned:

About the different types of dividends including, regular and special cash dividends, stock dividends, stock splits as well as share repurchases.

M&M’s dividend irrelevance argument and the real world factors such as transactions costs, taxes, clientele effects and signalling tend to favour real-world dividend relevance

Tax motives and other reasons explain why firms might want to repurchase their shares.


Chapter 22 dividend policy

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Transcript of Chapter 22 dividend policy