Topic 12 - Dividends And Dividend Policy

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This article is a topic within the subject Business Finance.

Contents

Required Reading

Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 430-452.

Kinds Of Distributions

Dividends are payments (shares or cash) made from earnings, whilst distributions are payments made from other sources.

  • Regular Cash Dividends – periodic payments to shareholders in the normal course of business
  • Extra Cash Dividends – non periodic cash payments
  • Special Dividends – onetime cash payment (doesn’t repeat)
  • Liquidating Dividends (Distribution) – cash payments after the sale of an asset
  • Stock Dividends – issuance of stocks to existing shareholders
  • Share Repurchases – cash payments made to shareholders by means of purchasing a portion of shares outstanding

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Cash Dividends

  1. Declaration Date - the payment of cash by the firm to shareholders is declared by the board of directors
    • Stock trades cum dividend (attached with a declared dividend)
  2. Ex Dividend Date – whoever bought the shares before this date (& holds) is entitled to the dividend
    • Stock trades ex dividend & falls by the dividend amount
  3. Record Date – the date by which holders must be on record to receive a dividend (4 days after the ex div date)
  4. Payment Date – the dividend is paid to shareholders who were on the record as of the record date (2-3 weeks prior)

Does Dividend Policy Matter – M&M Proposition

[1] Dividend Policy refers to the time pattern of dividend payouts. Should the firm pay cash now or reinvest and payout later?

M&M Assumptions

  1. No Taxes
  2. No Transaction Costs
  3. No Bankruptcy Costs

Proposition

Dividend Policy is irrelevant in the M&M world. Value of the dividend paying firm = Value of the non dividend paying firm.

Intuition

If investors can raise cash themselves by selling shares (homemade dividends) they do not need firms to pay them with cash.

Example – XYZ is an all equity firm with 1000 shares outstanding & will be dissolved in 1 year, cash flows will be $10,000 this year & next year. The firms cost of capital is 10%. Value = 10+10/1.1=19.09

Alternative policy - pay $11,000 now, (issue $1000 stock – new shareholders require 10%, pay $1100 later) & pay $8,900 year 2 Value = 11+8.9/1.1=19.09 - If an investor wants the old policy - he/she is able to reinvest $1 out of $11 (keep $10) at 10% & receive $8.9 + $1.1 in year 2 = $10.

XYZ is an all equity firm with 100,000 shares & market value of $10 million. It wants to pay a $10 dividend by issuing stocks.

  1. Need to raise $1,000,000
  2. Ex div price = $90, needs to issue 11,111 shares
  3. Value before $10,000,000 = Value after $90 * 111,111.11 = $10,000,000
  4. No Change in shareholder wealth

Real World Factors for Low Payouts

[2]

  • Taxes – when the investors marginal tax rate exceeds the firm’s tax rate, retention may be preferred
    • Capital Gains Taxes < Dividend Taxes
      • Classical System - Low Payout
  • Flotation Costs – firms that pay high dividends funded by stock issues will incur higher floatation costs (transaction costs) :*Dividend Restrictions – most bond covenants or laws (e.g. only pay out of retained profit) limit the dividends a firm can pay :*Financing Positive NPV Projects

Example – An all equity firm has 500,000 shares trading at $36/share. Dividends of $3.60 have been paid for several years. The firm has an opportunity that will pay $450,000 every year from the 3rd year onwards. To take it, it must cut dividends for the next 2 years, should the firm undertake the project? What is the effect in the share price? NPV = 595,095.32, increases price by $1.19

Real World Factors for High Payouts

[3]

  • Desire for Current Income – suited to different people e.g. widows & seniors clientele
  • Uncertainty Resolution – distant dividends are more uncertain than near term dividends
  • Taxes & Legal Benefits – dividends to firm, pension & trust funds are tax exempt
  • Dividend Imputation System – if MRT < corporate tax rate

Establishing a Dividend Policy: Time Pattern of Dividends Not Size

[4] Dividends can often carry information that signals the market. A decrease in dividends can signal an overload of positive NPV projects or bad future prospects.

Residual Dividend Approach

The firm pays dividends only after meeting its investment needs, maintenance of D/E ratio each period (selling stock is too expensive). The major negative is that dividends can be unstable but more flexible.

Dividend Stability Approach

Payout ratio is established based on the averages of projected future earnings, optimal capital structure range & capital budgeting requirements over a longer period. This reduces uncertainty, but the residual dividend approach is more flexible. A Cyclical Dividend Policy is where the manager selects a fixed fraction of that half’s earnings, whilst a Stable Dividend Policy is where dividends are a constant proportion of earnings over an earnings cycle (averaging).

A Compromise Dividend Policy

Avoid cutting + NPV projects to pay dividends, avoid dividend cuts, avoid selling equity, maintain a target D/E ratio & payout ratio, set regular dividends conservatively, rely on special dividends from time to time, budget over a long time horizon.

Stock Dividends & Stock Splits

[5]

  • Stock Dividendsdistribution of additional shares to existing shareholders, diluting the value of each share outstanding
    • A 10% stock dividend would issue 1 share per 10 shares outstanding
    • A 2% stock dividend, $1,000,000 MV & 20,000 shares @ $50 - $1,000,000 MV & 20,400 shares @ $49.01
  • Stock Splitsplitting shares proportionally e.g. 2 for 1 (each share is now worth half) – nothing in the firm changes
    • A stock dividend is like a mini stock split – no cash changes hands & equity is unchanged. Increases liquidity

Share Repurchases – An Alternative to Cash Dividends

[6] A Share Repurchase occurs when a firm buys back its own shares. Assuming the EMH, it has the same effect as a cash dividend – it reduces cash & equity.

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This is exactly the same as a cash dividend. If there are no imperfections, & taxes are ignored, then a cash dividend & a share purchase are the same thing.

Conclusion

  • All else equal, higher dividends are better than lower dividends because it means the firm is more profitable
  • Dividend policy irrelevant in perfect capital market without taxes
  • Managers should not forego + NPV projects to pay dividends
  • Investors have different objectives – creating a clientele for high/low payout firms
  • Stock Repurchases similar to Cash Dividends
  • Stock Dividends similar to Stock Splits

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End

This is the end of this topic. Click Business Finance to go back to the main subject page for Business Finance

References

Textbook refers to Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010.

  1. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 434-440
  2. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 436-438
  3. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 436-438
  4. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 441-442
  5. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 446-447
  6. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 443-445
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