Fundamentals of corproate finance 3e chapter 19

Chapter Nineteen
Dividends and Dividend Policy

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19-1


Chapter Organisation
19.1
19.2
19.3
19.4
19.5
19.6
19.7

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
19.8 Share Dividends and Share Splits
19.9 Employee Share Ownership Plans
19.10 Summary and Conclusions

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19-2


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.

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19-3

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.
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19-4


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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19-5


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
shareholders of record on a specific date.

distributable

•

Payment date: the dividend cheques
shareholders of record.

are mailed to

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to

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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)
On ex date (Time 0)

Dividend = $0

Price = $10

Dividend = $1

Price = $9

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19-7


Do Dividends Matter?
• Yes: the value of a share is based on the present

value of expected future dividends.
• No: the value of a share is not affected by a switch
in dividend policy.

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19-8

Does Dividend Policy Matter?
Dividend policy versus cash dividends
 An

illustration of dividend irrelevance

 Original

0

dividends
1

2

$1000

$1000

If RE = 20%: P0 = $1000/1.2 + $1000/1.22 = $1527.78

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19-9


Does Dividend Policy Matter?
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

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19-10


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
(DRIPs).

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19-11


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.

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19-12


Dividends and the Real World
A high payout is better if one considers:
•

Desire for current income instead of capital gain.

•

Uncertainty resolution: ‘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.

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19-13


Examples of Imputed Tax Credits

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To Date …
•

Based on the home-made dividend argument, dividend policy
is irrelevant.

•

Because of high taxation of some individual investors, a highdividend policy may be best.

•

Because of new issue costs, a low-dividend policy is best.

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19-15


Dividends and Signals
• 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.

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19-16


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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19-17


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.

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19-18


Residual Dividend Policy

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19-19


Relationship Between Dividends and
Investment
Dividends

New investment

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19-20

Key Concepts in Dividend Policy
•

Dividend stability—dividends are only increased if the
increase is sustainable.

•

Dividend streaming—shareholders can choose different
dividend schemes to suit their tax position (franked vs
unfranked dividends)

•

Special dividends—‘one-off’’ extra dividends.

•

Dividend reinvestment schemes—company reinvests
individuals’ dividends into fully paid shares of the company.
Avoids transactions costs and need for prospectus, and
shares are usually offered at a discount.

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19-21

Australian Equity Raisings 2001

Source: Australian Stock Exchange

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19-22


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.

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19-23


Share Repurchases
•

•

•

•
•

Equal access purchase
Offer made by company to all shareholders to purchase
shares in the same proportion as their holdings.
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.

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19-24


Cash Dividend versus Share
Repurchase
Assume no taxes, commissions or other market
imperfections.

Consider a firm with 50 000 shares outstanding, net
profit of $100 000 and the following balance sheet.

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19-25