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Transcript
Chapter 12:
Dividend and Share
Repurchase Decisions
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–1
Learning Objectives
•
Define ‘dividend policy’ and understand some
institutional features of dividends and share
repurchases.
•
Explain why dividend policy is irrelevant to
shareholders’ wealth in a perfect capital market
with no taxes.
•
Outline the imputation and capital gains tax
systems and explain their effects on returns
to investors.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–2
Learning Objectives (cont.)
•
Identify the factors that may cause dividend policy
to be important.
•
Be familiar with the nature of share buybacks,
dividend reinvestment plans and dividend election
schemes.
•
Outline the main factors that influence companies’
dividend policies.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–3
Dividend Policy
•
Business Decisions
–
–
–
•
Investment
Financing
Dividend
Dividend Policy
–
Determining how much of a company’s profit is to be
paid to shareholders as dividends and how much is to
be retained.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–4
Is there an Optimal Dividend Policy?
•
In a perfect capital market, dividend policy has no
impact on shareholders’ wealth and is, therefore,
irrelevant.
•
Introducing capital market imperfections, the
following views exist:
–
–
–
Dividend policy does not matter.
A high dividend policy is best.
A low dividend policy is best.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–5
Institutional Features of Dividends
•
Dividend Declaration Procedures
–
Interim and final

In Australia, if dividends are paid, we typically find two sorts,
a final dividend is paid after the end of the accounting or
reporting year.
 An interim dividend can be paid any time before the final
report is released, usually after the half-yearly accounts
are released.
–
Cum-dividend period

–
Period during which the share purchaser is qualified
to receive a previously announced dividend.
Ex-dividend date

Shares purchased on or after the ex-dividend date do not
include a right to the forthcoming dividend payment.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–6
Institutional Features of Dividends (cont.)
•
Declaration Date
–
•
Record (Books Closing) Date
–
–
–
•
Date board of directors pass a resolution to pay a dividend.
The date on which holders of record are designated
to receive a dividend.
This is 4 days after the ex-dividend date.
The idea is that if shares are traded cum-dividend, brokers
have time to notify the share register to ensure the new
shareholder receives the dividend.
Date of Payment
–
Date dividend cheques are mailed or dividends are paid
electronically.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–7
Institutional Features of Dividends (cont.)
•
Legal Considerations
–
–
–
–
–
–
Dividends can only be paid out of profit and are not
to be paid out of capital.
A dividend cannot be paid if it would make the company
insolvent.
Dividend restrictions may exist in covenants in trust
deeds and loan agreements.
Franked dividend carries credits for tax paid by the
company.
Under imputation, if a company has the capacity to pay
a franked dividend then, as a general rule, it must do so.
New Zealand also operates an imputation system
for dividends.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–8
Institutional Features of Dividends (cont.)
•
Dividend Imputation
–
Franked dividend

–
Franking credit

–
Credit for Australian company tax paid which, when distributed
to shareholders, can be offset against their tax liability.
Withholding tax

–
Carries a credit for income tax paid by the company.
Tax deducted by a company from the dividend payable to
a non-resident shareholder.
franking account

Account that records Australian tax paid on company profits,
this identifies the total amount of franking credits that can be
distributed to shareholders in the form of franked dividends.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–9
Repurchasing Shares
•
•
Over the past decade, popularity of Australian
companies buying back their own shares has
grown as a means of returning excess capital
to shareholders.
Types of share buyback
–
–
–
–
–
Equal access buyback — pro-rata to all shareholders.
Selective buyback — repurchase from specific, limited
number of shareholders.
On-market buyback — repurchase through normal stock
exchange trading.
Employee share scheme buyback.
Minimum loading buyback — buy back small parcels of
shares (transaction costs).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–10
Dividend Policies
•
Residual dividend policy
–
•
Pay out as dividends any profit that management does
not believe can be invested profitably.
Smoothed dividend policy
–
–
Target proportion of annual profits to be paid out as
dividend. Aim for dividends to equal the long-run
difference between expected profits and expected
investment needs.
Constant payout policy.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–11
Managers and Dividend Decisions
•
Dividends are an ‘active decision variable’
(Lintner).
•
Lintner found:
–
–
–
–
Companies have a long-term target payout ratio.
Managers focus on change in payout.
Dividends are smoothed relative to profits.
Managers avoid changes in dividends that may have
to be subsequently reversed.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–12
Irrelevance Theory
•
Value of firm is determined solely by the earning
power of the firm’s assets, and the manner in
which the earnings stream is split between
dividends and retained earnings does not affect
shareholders’ wealth.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–13
Modigliani and Miller (1961)
•
Given the investment decision of the firm, the
dividend payout ratio is a mere detail. It does not
affect the wealth of shareholders.
•
Assumptions
–
–
–
No taxes, transaction costs, or other market
imperfections.
A fixed investment or capital budgeting program.
No personal taxes — investors are indifferent between
receiving dividends or capital gains.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–14
MM’s Conclusion
•
Dividend policy is a trade-off between retaining
profit, paying dividends and making new share
issues to replace cash paid out.
•
Paying a dividend and issuing new shares to
replace the cash:
–
–
Does not change the value of the company; and
Does not change the wealth of the old shareholders,
because the value of their shares falls by an amount
equal to the cash paid to them.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–15
MM’s Conclusion (cont.)
•
If a company increases its dividends, it must
replace the cash by making a share issue.
•
Old shareholders receive a higher current
dividend, but a proportion of future dividends must
be diverted to the new shareholders.
•
The present value of these forgone future
payments is equal to the increase in current
dividends.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–16
MM’s Conclusion (cont.)
•
The MM dividend irrelevance proposition is valid
in a perfect capital market with no taxes.
•
Therefore, if dividend policy is important in
practice, the reasons for its importance must relate
to factors that MM excluded from their analysis.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–17
Dividends and Taxes
•
Differential tax treatment of dividend income
versus capital gains arising from retained
profits can either favour or penalise payment
of dividends.
•
This difference in tax treatment is understood
by comparing a classical tax system with an
imputation tax system.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–18
Classical Tax System
•
In a classical tax system:
–
–
–
–
•
Company profits are taxed at the corporate tax rate, tc,
leaving (1– tc) to be distributed as a dividend.
Dividends received by shareholders are then taxed at
the shareholder’s personal marginal tax rate, tp.
The consequence is that, from a dollar of company profit,
the shareholder ends up with (1– tc)x (1– tp) dollars of
after-tax dividend in a classical tax system.
The result is that profit paid as a dividend is effectively
taxed twice.
In Australia, a classical tax system operated
until 1 July 1987, when an imputation system
was introduced.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–19
Imputation Tax System
•
A system under which Australian resident equity
investors can use tax credits associated with
franked dividends to offset their personal tax.
•
The system eliminates the double taxation inherent
in the classical tax system.
•
Company tax is assessed on the corporate profits
in the normal way, at the corporate tax rate (tc).
•
As of 2002, tc is 30%.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–20
Imputation Tax System (cont.)
•
For each dollar of franked dividends paid by the
company, resident shareholders will be taxed at
their marginal rate (tp) on an imputed dividend of
$D / (1 – tc).
• This is referred to as the ‘grossed-up dividend’.
• The grossed-up dividend is equal to the dividend
plus the franking credit.
• Franking credit is given by:
Imputation

dividend  tc 
credit 
1  tc 
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–21
Imputation Tax System (cont.)
•
The shareholder receives a tax credit equal
to the franking credit.
•
The credit can be used to offset tax liabilities
associated with any other form of income.
•
The tax credit cannot be carried forward but
excess or unused tax credits are refunded as
of July 2000.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–22
Imputation Tax System (cont.)
•
The result is that franked dividends are effectively
tax-free to Australian residents, if the investor’s
marginal tax rate is equal to the corporate tax rate.
•
If the investor’s marginal tax rate is less than the
corporate rate, then the investor will have excess
tax credits which can be used to reduce tax on
other income, or refunded if they cannot be used.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–23
Imputation Tax System (cont.)
•
If the investor’s marginal tax rate is greater than
the corporate rate, some tax will be payable by the
investor on the dividend.
•
Investors pay tax, at their marginal rate, on any
unfranked dividends received.
•
Since 1 October 2003, Australian and New Zealand
companies have been able to distribute all franking
credits to Australian and NZ resident shareholders.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–24
Imputation and Capital Gains Tax
•
If companies retain profits, their share price is likely
to rise relative to companies that distribute profits,
giving rise to capital gains tax liabilities for
shareholders if and when the shares are sold.
•
Capital gains receive preferential tax treatment
compared to ‘ordinary’ income.
•
Capital gains tax (CGT) applies only to short-term
gains and to long-term real capital gains on assets
acquired on or after 20 September 1985, and is
payable only when gains have been realised.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–25
Imputation and Capital Gains Tax (cont.)
•
As of 21 September 1999, capital gains earned
over 12 months or longer are subject to CGT
discounting.
•
For individuals, only 50% of the gain is taxed
at their personal marginal tax rate.
•
For superannuation funds, the discount is 33.33%,
so 66.66% of the capital gain is subject to CGT.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–26
Imputation and Capital Gains Tax (cont.)
•
Consequently, effective rates of CGT are likely
to be relatively low for many investors.
•
However, where a capital gain arises from
retention of profits which have been taxed, any
CGT that is payable will be in addition to the tax
already paid by the company.
•
In other words, retention of profits can involve
double taxation as franking credits cannot be
transferred to shareholders through capital gains.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–27
Imputation and Dividend Policy
•
If all company shares were held by resident
investors with marginal tax rates less than
company tax rates, then the optimal dividend
policy for an Australian company is one that at
least pays dividends to the limit of its franking
account balance.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–28
Imputation and Dividend Policy (cont.)
•
This policy will benefit resident investors in two ways:
–
–
•
The franking credits attached to franked dividends can be
used to reduce investors’ personal tax liabilities.
Since the alternative to dividends is capital gains, which are
subject to company tax and CGT, higher dividends will mean
that less CGT is payable by investors.
If all franking credits are not paid out, the credits that
are retained are potentially wasted as they have no
value except when accompanying dividend
payments. (At best, their value is discounted if they
are used to offer franking credits on future dividends.)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–29
Imputation and Dividend Policy (cont.)
•
Complicating factors for optimal dividend policy:
–
–
–
•
Shares are held by both resident and non-resident
individuals.
Many individuals have personal marginal tax rates that are
greater than the company tax rate and may have a taxbased preference for retention of profits.
Since July 2000, resident investors that are tax-exempt
have excess franking credits refunded.
Overall, the interaction of CGT and the imputation
system means that shareholders with low (high)
marginal tax rates prefer profits to be paid out as
dividends (retained, leading to capital gains).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–30
Imputation Clienteles
•
Clientele effect
–
–
–
–
Investors choosing to invest in companies that have
policies meeting their particular requirements.
For example: Investors who require high current income
may choose to invest in companies that have high
dividend payouts.
Also, companies paying fully-franked dividends would
attract shareholders who receive the greatest value
from tax credits (i.e. Australian residents, possibly with
low personal tax rates who can receive a refund of
franking credits).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–31
Value of Franking Credits
•
The argument that investors will prefer tax credits
to be distributed rather than retained assumes that
tax credits are valuable to investors.
•
Supporting evidence from the dividend drop-off
ratio:
–
‘Drop-off ratio’: ratio of the decline in the share price
on the ex-dividend day to the dividend per share.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–32
Value of Franking Credits (cont.)
•
Walker and Partington (1999) study drop-off ratios:
–
–
–
1 January 1995 – 1 March 1997, when ASX allowed
trading in cum-dividend shares after the ex-dividend date.
Find a drop-off ratio of 1.23, implying that $1 of
fully-franked dividends is worth more than $1.
Some variability because of different individual marginal
tax rates.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–33
Value of Franking Credits (cont.)
•
Cannavan, Finn and Gray (2004) also study
drop-off ratios:
–
–
–
Use futures contracts on dividend paying shares
to compare with actual shares.
Futures contract does not entitle holder to dividends so
difference should reflect market value of dividend and
associated franking credit.
Tax rules change requiring shares to be held 45 days in
order to claim franking credits.

Prior to introduction of this rule, franking credits had some
value — franking credits were easily transferable from those
that could not use them to those that could.
 After this rule, franking credits appear to be worthless.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–34
Non-Tax Reasons for the Relevance of
Dividend Policy
•
Information effects and signalling to investors:
–
–
Evidence suggests share price changes around the time
of the announcement of dividend changes are positively
related to the change in the dividend.
MM claim that this does not invalidate irrelevance theory.
The price change is the result of the information content
associated with the dividend announcement.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–35
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Three implications of dividend information and
signalling hypothesis:
–
–
–
–
Unanticipated dividend changes should be followed by
share price changes in the same direction.
Empirical support for this implication found in US studies
by Grullon, Michaely and Swaminathan (2002), Michaely,
Thaler and Womack (1995), and Healy and Palepu (1988).
Australian evidence supports this implication as well:
Balachandaran and Faff (2004).
Special dividend announcements provide mean abnormal
returns of 5.44% over a 3-day period.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–36
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Three implications of dividend information and
signalling hypothesis (cont.):
–
–
–
–
Unanticipated dividend changes should be followed by
market revision of expectations of future earnings in the
same direction.
Empirical evidence also supports this implication, for
example Ofer and Seigel (1987).
Analysts revisions of earnings forecasts are positively
related to dividend changes.
Grullon and Michaely (2004) find that analysts revise
profit forecasts downwards during the month of a share
repurchase announcement.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–37
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Three implications of dividend information and
signalling hypothesis (cont.):
–
–
–
–
–
Changes in dividends should be followed by changes
in earnings in the same direction.
Evidence on this implication is mixed and does not
strongly support it.
Watts (1973) and Penman (1983) find little support for
implication.
Healy and Palepu (1988) find support when focusing
on companies that initiate and omit dividends.
Benartzi, Michaely and Thaler (1997), and Grullon,
Michaely and Swaminathan (2002) find link between
increased dividends and recent earnings but no link
between increased dividends and future increases
in earnings.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–38
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Three implications of dividend information and signalling
hypothesis (cont.):
–
–
–
Changes in dividends should be followed by changes in
earnings in the same direction.
De Angelo, De Angelo and Skinner (1996) also find no link
between dividend increases and future positive profit surprises.
Signalling argument, the third implication, is not supported
by empirical evidence.
•
Signal is not of continued dividend growth but rather of
permanence of current increase in dividend.
•
Alternatively, increased dividend may signal reduced risk
associated with profits and cash flows, thereby reducing
discount rate and raising share price.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–39
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Three implications of dividend information and
signalling hypothesis (cont.):
–
–
–
Alternative interpretations of information conveyed.
Benartzi, Michaely and Thaler (1997) argue that the
signal is not of continued dividend growth but of
permanence of current increase in dividend.
Alternatively, Grullon, Michaely and Swaminathan (2002)
argue that an increased dividend may signal reduced
risk associated with profits and cash flows, thereby
reducing discount rate and raising share price.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–40
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Agency costs and corporate governance
–
–
Agency costs can be reduced by paying higher dividends.
Increased capital-raising required:
 Accountability to market.
 Increases provision of information.
 Increases monitoring of managers.
 Managers more likely to act in interests of shareholders.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–41
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Agency costs and corporate governance (cont.)
–
–
–
Lie (2000) and Grullon, Michaely and Swaminathan (2002)
provide empirical evidence that increased payouts either
as special dividends, increased ordinary dividends or a
share repurchase program signal reduced opportunity to
over invest, free cash flow hypothesis.
Firms with limited investment opportunities exhibit a
bigger abnormal return to the announcement of such
initiatives.
In Australia, Telstra’s announcement in June 2004 that
they intend to focus on a higher dividend payout rate of
80% and to initiate $1.5b worth of capital management
programs (special dividends and / or repurchases) was
greeted with a 4.6% increase in share price.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–42
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Agency costs and corporate governance (cont.)
–
–
–
La Porta, Lopez-De-Silanes, Shleifer and Vishny (2000)
provide empirical evidence that in countries where
investors’ interests are relatively well protected, dividends
are less likely to be a mechanism to reduce agency costs.
Well-protected investors are willing to forgo dividends
now in return for growth.
High-growth companies pay lower dividends
in economies where investors are relatively
well-protected legally.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–43
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Agency costs and corporate governance (cont.)
–
–
–
–
Correia Da Silva, Goeregen and Renneboog (2004)
argue that dividend policy may be influenced by corporate
governance regimes.
Market based and block-holder based regimes of
corporate governance.
The presence of large (block) shareholders reduces
the impetus to pay out dividends (consider News Corp.
in Australia, large block holder, low dividends).
Controlling interest is a substitute for dividends as a
monitoring mechanism, while agency costs are less
of an issue as shareholder is potentially insider or
even a manager.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–44
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Investment opportunities
–
Differences in the nature of investment opportunities
will influence corporate financial decisions,
including dividends.
–
Lots of investment opportunities — low dividends.
–
Jones and Sharma (2001) rank Australian companies
on basis of growth opportunities between 1991
and 1998.
–
Find low-growth companies have lower dividend
yields than high-growth companies.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–45
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
•
Shareholders’ preference for current income
–
Need for shares to yield current income.
–
MM support irrelevance stance, given shareholders can
create ‘homemade dividends’.
Issue and transaction costs
–
Company can avoid incurring costs associated with share
issue by reducing dividends.
–
This means that more financing requirements can be met
internally, out of retained profits.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–46
Non-Tax Reasons for the Relevance of
Dividend Policy (cont.)
•
Dividend clienteles
–
Groups of investors who choose to invest in companies
that have dividend policies which meet their particular
requirements.
–
If equilibrium exists in terms of the supply and demand
for particular dividend policies, the price of a company’s
shares will be independent of its dividend policy.
–
This is because there are always other companies
with the same (or a similar) dividend policy that can
act as substitutes.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–47
Share Repurchases
•
A share buyback is when a company purchases its own shares
on the stock market and then proceeds to either cancel them
(Aust.) or retain them as treasury stock (US).
•
There are legal requirements associated with buybacks,
but generally companies can repurchase up to 10%
of their ordinary shares in a 12-month period.
•
Rapid growth in repurchases in Australia, $770m in the 1995
financial year, up to $7.7b in the 12 months to June 2004.
•
In 1999 and 2000, US industrial companies distributed
more cash to shareholders through share repurchases
than dividends.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–48
Why Repurchase Shares?
•
Dividend substitution
–
–
•
If capital gains are taxed more favourably than dividends.
Some supporting evidence from the US, where dividend
payout ratios have been falling in the 1980s and 1990s.
Improved performance measures
–
–
EPS may rise, but if cash is returned rather than used to
retire debt, financial risk is increased and PE ratio along
with share price may fall.
Return of funds that cannot be profitably used will
raise share price.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–49
Why Repurchase Shares? (cont.)
•
Signalling and undervaluation
–
–
•
Managers buying back company stock indicates that
they believe the stock is undervalued by the market.
Alternatively, a buyback announcement could be
accompanied by some new information, e.g. sale of
unprofitable asset/division.
Resource allocation and agency costs
–
–
Share repurchase returns capital to shareholders, who can
reallocate funds into profitable activities through the capital
market.
Reduces the potential for managers to inefficiently use free
cash (i.e. reduces agency costs).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–50
Why Repurchase Shares? (cont.)
•
Financial flexibility
–
–
•
Payment of dividends is a long-term commitment and
sudden major changes (especially decreases) in dividend
policy are unappreciated by market.
buybacks offer an alternative way to make distributions
that may not be permanent.
Employee share options
–
–
Unlike paying dividends, share repurchases do not lead
to the ex-dividend price drop-off.
Option holders (typically management) prefer a share
repurchase to a dividend payout as a means of
distributing profits to shareholders.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–51
Share Repurchases in Australia
•
Five categories of share buyback:
–
–
–
–
–
Equal access buyback — pro-rata to all shareholders.
Selective buyback — repurchase from specific, limited
number of shareholders.
On-market buyback — repurchase through normal stock
exchange trading.
Employee share scheme buyback.
Minimum holding buyback — buy back small parcels of
shares (transaction costs).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–52
Share Repurchases in Australia
•
Off-market buybacks can be structured to provide significant
tax advantages with a large dividend and franking component.
(see for example Finance in Action: CBA’s 2004 off-market
share buyback.)
•
Key point is that receipt of such a dividend is at the discretion
of the shareholder who sells the shares back to the company.
•
ASX requires companies to justify buyback — many on-market
buybacks are justified on the basis that the market undervalues
the company’s shares.
•
Otchere and Ross (2002) find positive abnormal returns for
companies, citing undervaluation as justification of a buyback.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–53
Dividend Reinvestment Plans (DRPs)
•
Definition
–
DRPs offer shareholders the option to apply all or part
of their cash dividends to the purchase of additional shares
in the company (in some cases at a discount price).
–
The number of listed companies which operate dividend
reinvestment plans increased from just 5 in late 1982
to 14% of all listed companies by 1999.
–
In 2003/04, $5.2b of total $29.8b of dividends declared
by listed companies were reinvested through DRPs.
–
The imputation system has played a large part in
this increased popularity, providing an incentive
to increase payouts.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–54
DRPs (cont.)
•
Benefits to the company:
–
–
•
Cheap and effective means of raising capital and
conserving cash
Promotes good shareholder relations and stability of
ownership
Disadvantages to the company:
–
–
–
–
Administration costs
Promotion of the plan
Excessive capital raising
Dilution of EPS
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–55
DRPs (cont.)
•
Benefits to investors:
–
Taxation benefits.
– Flexibility.
– Savings program.
– Shares are generally issued at a discount to market
price and are free from brokerage and stamp duty.
•
Disadvantages to investors:
–
Need to keep substantive and comprehensive records
throughout the period of ownership of assets affected
by capital gains tax.
– Familiarisation with plan and its tax consequences.
– No control over the reinvestment price.
– Discount disadvantages shareholders who do not
participate in the DRP.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–56
Dividend Election Schemes
•
Allow shareholders the option of receiving their
dividends in one or more of a number of forms.
•
For example, as bonus shares (deferring tax),
or as dividends from overseas subsidiaries
(foreign tax credits).
•
•
Tax effectiveness of ‘dividend streaming’ via
such schemes has been restricted.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–57
Establishing a Dividend Policy
•
Schools of thought:
–
Dividend policy does not matter (MM).
– A high dividend policy is best (agency costs, preference for
current income and imputation tax system).
– A low dividend policy is best (issue costs, transaction costs
and tax considerations).
•
Lease et al. (2000) conclude that shareholders’ wealth is
affected by dividend policy due to market imperfections such
as taxes, agency costs and asymmetric information.
•
Policy should be devised on a firm by firm case, depending
on imperfections that have the greatest impact on the firm.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–58
Dividend Policy Under Imputation
•
Strong incentives for tax-paying companies to pay
franked dividends.
–
The benefits of doing so are greatest for resident.
shareholders subject to marginal tax rates that are
lower than the company tax rate.
–
On the other hand, shareholders with marginal tax
rates that are higher than the company tax rate may
prefer that companies retain profits (subject to the
magnitude of the CGT).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–59
Dividend Policy Under Imputation (cont.)
•
If the company tax rate and top personal tax rate
were equal, then the optimal dividend policy for
Australian companies owned by resident
shareholders would be to pay the maximum
possible franked dividends and adopt a DRP
to limit the outflow of cash.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–60
Dividend Policy Under Imputation (cont.)
•
In practice, the situation is more complex for
three main reasons:
–
Many companies have both tax-paying resident
shareholders who can use franking credits, and
non-resident shareholders who cannot use them.
–
Equality between the company tax rate and the top
personal tax rate no longer exists.
–
Factors other than tax:

Information effects of dividends.
 DRPs may create free cash flows that cannot
be invested profitably.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–61
Agency Costs
•
Payment of dividends has a role in reducing
agency costs — pay out of excess cash reduces
opportunities for managers to destroy value
by over-investing.
•
High-growth companies require capital, and
dividend policy should account for positive
NPV investment opportunities, with a low
payout policy.
•
Conversely, mature companies with limited
growth opportunities should pay out surplus cash
with a higher payout policy.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–62
Asymmetric Information
•
Dividend and share repurchase announcements
have information content.
•
Market responds to changes in dividends,
special dividends, reductions in and suspensions
of dividends.
•
Increased ordinary dividends signal permanent
increase in earnings and ability to maintain
dividend level.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–63
Asymmetric Information (cont.)
•
Special dividend or buyback indicates release
of temporary free cash flow.
•
Managers are cautious and will not excessively raise
ordinary dividends for fear of having to reduce
dividend in future, a strong negative signal.
•
Instead, a special dividend may accompany an
ordinary dividend to indicate a temporary increase
in dividend.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–64
Dividend Policy and Firm Life Cycle
•
A company’s dividend payout policy may need
to change as it moves through it’s life cycle.
•
A new business with good growth prospects is likely
to require capital and unlikely to payout dividends.
•
As the firm matures and has limited growth
prospects and scarce positive NPV projects,
excess free cash flow should be paid out as
dividends to minimise agency costs.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–65
Summary
•
Dividend policy is about the trade-off between
retaining profit and paying out dividends.
•
Does not affect shareholders’ wealth in a
perfect capital market.
•
Dividend policy becomes important when we
• consider taxes and agency costs.
•
Imputation system does eliminate double taxing
of dividend income and encourages higher
dividend payout ratios.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–66
Summary (cont.)
•
Dividend policy environment has been changed
by recent alteration to capital gains tax laws,
favouring capital gains over dividends.
•
Share buybacks have become an increasingly
popular way to distribute cash to shareholders.
•
Profits earned overseas can be distributed
more tax-effectively to shareholders through
share buybacks.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–67
Summary (cont.)
•
Dividends and share repurchases have a role
in reducing agency costs.
•
Share repurchase and dividend announcements
have significant effects on share prices
•
Combined impact of agency costs, information
effects and other imperfections leads to a payout
policy that needs to change as the firm moves
through its life cycle.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
12–68