Download Chapter 18

Chapter Eighteen
Dividends and Dividend Policy
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-1
Chapter Organisation
18.1
18.2
18.3
18.4
18.5
18.6
18.7
Cash Dividends and Dividend Payment
Does Dividend Policy Matter?
Real-world Factors Favouring a Low Payout
Real-world Factors Favouring a High Payout
A Resolution of Real-world Factors?
Establishing a Dividend Policy
Share Repurchase: An Alternative to Cash
Dividends
18.8 Share Dividends and Share Splits
18.9 Employee Share Ownership Plans
Summary and Conclusions
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-2
Chapter Objectives
• Know the different forms of dividends and the
appropriate dividend payment terminology.
• Outline the arguments supporting the case for
dividend irrelevance.
• Discuss factors favouring a low or a high payout.
• Explain the residual dividend policy.
• Illustrate the situation of share repurchases vs
paying a cash dividend.
• Understand both bonus issues and share splits.
• Outline the various employee share ownership
plans.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-3
Types of Dividends
• A dividend is a payment made out of a firm’s
earnings to its owners (shareholders).
• Dividends are usually paid in the form of cash.
• Types of cash dividends include:
–
–
–
–
regular cash dividends
extra dividends
special dividends
liquidating dividends.
• Share dividends are also paid, and share
repurchases are a dividend alternative.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-4
Cash Dividends
• Public companies commonly pay regular cash
dividends twice a year – an interim dividend and a
final dividend.
• After a dividend is declared, it is distributed to all
shareholders as of some specific date.
• The amount of the cash dividend is expressed in
terms of the dollars per share (dividends per share).
• Dividends are also expressed as a percentage of the
market price (dividend yield) or as a percentage of
earnings per share (dividend payout).
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-5
Procedure for Dividend Payment
Days
Thursday,
January
15
Wednesday,
January
28
Friday,
January
30
Monday,
February
16
Declaration
date
Ex-dividend
date
Record
date
Payment
date
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-6
Procedure for Dividend Payment
• Declaration date: the board of directors declares a
payment of dividends.
• Ex-dividend date: if you buy the share on or after this
date the seller is entitled to keep the dividend. Under
ASX rules, shares are traded ex-dividend on and
after the seventh business day before the record
date.
• Record date: declared dividends are distributable to
shareholders of record on a specific date.
• Payment date: the dividend cheques are mailed to
shareholders of record.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-7
The Ex-date Price Drop
Ex date
-t
. . .
–2
–1
0
+1
+2 . . . t
Price =$10
Price =$9
The share price will fall by the amount of the dividend on the ex
date (Time 0). If the dividend is $1 per share, the price will be
equal to $10 – 1 = $9 on the ex date.
Before ex date (Time –1)
Dividend = $0
Price = $10
On ex date (Time 0)
Dividend = $1
Price = $9
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-8
Do Dividends Matter?
• Yes
– The value of a share is based on the present value of
expected future dividends.
– Dividends are paid in cash, and everybody likes cash.
• No
– The value of a share is not affected by a switch in dividend
policy.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-9
Dividend Policy
• Should the firm pay out cash now or invest the cash
and pay it out later?
• Dividend policy is the time pattern of dividend payout.
In particular, should the firm pay out a large
percentage of its earnings now or a small (or even
zero) percentage?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-10
Example― Does Dividend Policy
Matter?
Dividend policy versus cash dividends
n
An illustration of dividend irrelevance
u
Original dividends
0
1
2
$1000
$1000
If RE = 20%: P0 = $1000/1.2 + $1000/1.22 = $1527.78
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-11
Example― Does Dividend Policy
Matter? (continued)
Assume an additional $200 of dividends is offered,
financed by an issue of debt or shares. New dividend
plan:
0
1
2
$1000
$1000
+200
–240
$1200
$760
P0 = $1200/1.2 + $760/1.22 = $1 527.78
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-12
Dividend Policy Irrelevance
• Any increase in dividends at one point is offset
exactly by a decrease somewhere else.
• An alternative explanation is home-made dividends.
Individual investors can undo corporate dividend
policy by reinvesting dividends or selling shares.
• Companies may help with creating home-made
dividends by offering shareholders automatic
dividend reinvestment plans (ADPs or DRIPs).
• However, we have so far ignored several real-world
factors (e.g. taxes) that might influence our
conclusions about dividend policy irrelevance.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-13
Dividend Imputation
• The imputation system results in shareholders
receiving a tax credit with their dividend for the tax
actually paid by the company.
• Imputation credits can be offset against income tax
on the income of shareholders.
• Franked dividends are dividends that are paid out of
company profits on which tax has been levied.
• Dividends are declared as ‘fully franked’, ‘partially
franked’, or ‘unfranked’.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-14
Examples of Imputed Tax Credits
Shareholders’ level
of taxable income
Marginal tax rate
(1 July 2006)
Corporate tax
Dividend paid
Taxpayer’s additional
assessable income
Tax on assessable income
Credit for company tax
Net credit (payment)
Tax to be paid
on dividends
6 001
to
25 000
15%
25 001 75 001 150000
to
to
+
75 000 150 000
30%
40%
45%
$30
70
$30
70
$30
70
$30
70
$100
$15
30
$15
$100
$30
30
nil
$100
$40
30
($10)
$100
$45
30
($15)
($15)
nil
$10
$15
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-15
Dividends and the Real World
A low payout is better if one considers:
• Taxes: Optimal dividend policy is determined by
various shareholder situations. Some shareholders
prefer high franked dividends, others prefer the
company to pay no dividend and retain the funds
for reinvestment (tax on dividend income vs capital
gains tax).
• Flotation costs: Higher dividend payouts may
require a new share issue, which could be
expensive and decrease the value of the firm.
• Dividend restrictions: Debt contracts might limit the
percentage of income that can be paid out as
dividends.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-16
Dividends and the Real World
A high payout is better if one considers:
• Desire for current income: Receiving large regular
income payments instead of capital gains.
• Uncertainty resolution: The ‘bird-in-hand’ story.
• Tax benefits: There are some investors who do
receive favourable tax treatment from holding high
dividends (e.g. corporate investors).
• Legal benefits: Superannuation and trust funds.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-17
Resolution of Real-world Factors
• Recall:
– Based on the home-made dividend argument, dividend
policy is irrelevant.
– Because of high taxation of some individual investors, a
high-dividend policy may be best.
– Because of new issue costs, a low-dividend policy is best.
• Two important concepts related to dividends and
dividend policy relevant at this point are the:
– Information content of dividends
– Clientele effect.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-18
Information Content of Dividends
• Changes in dividends convey information
– Dividend increases:
 Management believes it can be sustained
 Expectation of higher future dividends, increasing present value
 Signal of a healthy, growing firm
– Dividend decreases:
 Management believes it can no longer sustain the current level
of dividends
 Expectation of lower dividends indefinitely; decreasing present
value
 Signal of a firm that is having financial difficulties
• The information content makes it difficult to interpret
the effect of the dividend policy of the firm
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-19
Clientele Effect
• Shares attract particular groups based on dividend
yield and the resulting tax effects.
• Some investors prefer low dividend payouts and will
buy shares in those companies that offer low
dividend payouts.
• Some investors prefer high dividend payouts and will
buy shares in those companies that offer high
dividend payouts.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-20
Residual Dividend Policy
• Issue costs eliminate any indifference between
financing by internal capital and new shares.
• Dividends are paid only if profits are not completely
used for investment purposes.
• Desired debt-to-equity ratio is maintained.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-21
Example―Residual Dividend
Policy
• Each row in the table below represents a different
level of investment. The firm’s desired debt-to-equity
ratio is 0.50 (i.e. 1/3 debt and 2/3 equity).
Row
1
2
3
4
5
6
(1)
After-tax
earnings
1 000
1 000
1 000
1 000
1 000
1 000
(2)
New
investment
3 000
2 000
1 500
1 000
500
0
(3)
(4)
(5)
(6)
Additional Retained Additional
debt
earnings
shares
Dividends
1 000
1 000
1 000
0
667
1 000
333
0
500
1 000
0
0
333
667
0
333
167
333
0
667
0
0
0
1 000
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-22
Relationship Between Dividends
and Investment
Dividends
($)
999
666
333
0
-333
0
500
1000
1500
2000
2500
3000
New investment ($)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-23
Key Concepts in Dividend Policy
• Dividend stability—dividends are only increased if
the increase is believed to be sustainable.
• Special dividends—‘one-off’’ extra dividends,
clearly indicated as such.
• Dividend reinvestment schemes—company
reinvests individuals’ dividends into fully paid
shares of the company. Avoids transactions costs
(e.g. brokerage, stamp duty) and need for
prospectus, and shares are usually offered at a
discount. For tax purposes, a cash dividend is
notionally paid with any franking credits.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-24
Australian Equity Raisings 2001
Source: Australian Stock Exchange
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-25
Share Repurchases
• Company buys back its own shares.
• Similar to a cash dividend in that it returns cash from
the firm to the shareholders.
• This is another argument for dividend policy
irrelevance in the absence of taxes or other
imperfections.
• Subject to Corporations Act 2001 and ASX rules.
• Generally companies are able to purchase 10 per
cent of their ordinary shares in a 12-month period.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-26
Types of Buy-Back
• Equal access purchase:
– All shareholders are invited to sell to the company directly.
• On-market purchase:
– Purchase by a company of its own shares on the open
market.
• Employee share purchase:
– Repurchase shares from employees that were issued under
employee incentive scheme.
• Selective purchase:
– Repurchase of shares from specific shareholders.
• Odd-lot purchase:
– Repurchase of small parcels of shares.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-27
Example―Cash Dividend versus
Share Repurchase
Assume no taxes or other market imperfections.
Consider a firm with 50,000 shares outstanding, net
profit of $100,000 and the following balance sheet.
Cash
Other Assets
Total
$ 100 000
900 000
$1 000 000
$
0
1 000 000
$1 000 000
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Debt
Equity
Total
18-28
Example―Cash Dividend versus
Share Repurchase (continued)
• Price per share is $20 ($1 000 000/50 000).
• EPS = $2.00 ($100 000/50 000).
• PE ratio = 10 ($20/2).
• The firm is considering either:
– Paying a $1 per share cash dividend
OR
– Repurchasing 2500 shares at $20 a share.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-29
Example―Cash Dividend versus
Share Repurchase (continued)
Cash Dividend Option
Cash
$
Other Assets
Total
50 000
900 000
$ 950 000
$
0 Debt
950 000 Equity
$ 950 000 Total
Price per share is $19.00 ($950 000/50 000).
EPS = $2.00 ($100 000/50 000).
PE ratio = 9.50 ($19/2).
Copyright  2007 McGraw-Hill Australia Pty Ltd
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18-30
Cash Dividend versus Share
Repurchase (continued)
Share Repurchase Option
Cash
Other Assets
Total
$
50 000
900 000
$ 950 000
$
0 Debt
950 000 Equity
$ 950 000 Total
Price per share is $20.00 ($950 000/47 500).
EPS = $2.105 ($100 000/47 500).
PE ratio = 9.5 ($20/2.105).
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-31
Share Dividends and Splits
• Bonus shares and share splits:
– involve issuing new shares on a pro-rata basis to the
current shareholders
– do not change the firm’s assets, earnings, risk assumed
and investors’ percentage of ownership in the company
– increase the number of shares outstanding
– reduce the value per share.
• A common explanation is to adjust the share price
to a ‘more desirable trading range’.
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18-32
Reverse Splits
• The firm reduces the number of shares outstanding.
• For example, in a one-for-three reverse split, each
shareholder exchanges three old shares for one new
share.
• Reasoning:
– reduction in transaction costs
– increase in share marketability (trading range)
– regain respectability.
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18-33
Employee Share Ownership Plans
• Encourage the financial participation of employees in
the company. Can involve:
–
–
–
–
–
–
–
fully paid shares
partly paid shares
special classes of shares
options
phantom or shadow shares
employee share trusts
tax exemptions.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-34
Summary and Conclusions
• Dividend policy is irrelevant when there are no taxes
and other imperfections because shareholders can
effectively undo the firm’s dividend strategy.
• New issue flotation costs and the demand of some
shareholders for a high-dividend payout has led
companies to develop dividend reinvestment plans.
• The clientele effect suggests that firms should be
reluctant to change dividend policy.
• Dividend stability is usually viewed as highly
desirable.
• A share buy-back acts much like a cash dividend.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
18-35