Capital Markets and Corporate Finance (Stream 1): FINC5001 Dr. Reuben Segara Finance Discipline School of Business University of Sydney 1 Dividend Policy 2 This Lecture PART I – Dividend Fundamentals • • • • What is Dividend Policy? Institutional Features of Dividends Types of Dividend Policies Trends in Dividend Policies PART 2 – Is There An Optimal Dividend Policy? • Dividend Policy is Irrelevant • Dividend Policy is Relevant PART 3 – Alternatives to Dividends • Share Buy-Backs • Dividend Reinvestment Plans (DRPs) 3 What is Dividend Policy? Definition Dividend policy refers to the decision corporations make to pay out profits as dividends or retain them within the firm • Corporations typically pay dividends twice a year: ? An Interim dividend ? A Final dividend ? A “Special” dividend • The dividend payout ratio quantifies the dividend policy decision 4 What is Dividend Policy? The Dividend Payout Ratio – An Ilustration EPS, DPS and Dividend Payout Ratio for CBA Ltd. 2001 Dividend per share (cents) Interim (cents) Final (cents) Total (cents) Earnings per share (cents) Dividend payout ratio 61 75 136 189. 6 71. 7% 68 82 150 209. 3 71. 7% 69 85 154 157. 3 97. 9% 79 104 183 196. 8 93. % 85 112 197 303 65. 0% 94 130 224 297 75. 7% 107 149 256 340 75. 4% 113 153 266 344 77. 2% 113 115 228 293 77. 8% 2002 2003 2004 2005 2006 2007 2008 2009 Earnings and Dividend Forecasts (cents per share) 2010 Dividend per share (cents) Earnings per share (cents) Dividend payout ratio 260 385. 6 67. 4% 2011 293. 9 441. 5 66. 6% 2012 338. 6 494. 1 68. 5% 5 Institutional Features of Dividends Legal Considerations 1. Can dividends be paid out of profits and/or paid out of capital? 2. Can dividends be paid out if it would make the company insolvent? 3. Can there be dividend restrictions in covenants in trust deeds and loan agreements? . Do investors prefer franked dividends? 5. Do companies have to pay out franked dividends? 6 Institutional Features of Dividends Dividend Declaration Procedure Where are the interim and final dividend amounts declared for any company? CUM-DIVIDEND PERIOD EX-DIVIDEND DATE 7 Institutional Features of Dividends Dividend Declaration Procedure TAXATION CONSIDERATIONS Franked dividend Imputation Tax Credit Withholding Tax 8 Institutional Features of Dividends Relevant Dates for Dividend Payments Code CBA Div Amount 113c Ex Div Date 16/02/2009 Record Date 20/02/2009 Date Payable 23/03/2009 % Franked 100% Type Interim 1 Feb ‘09 15 Feb ‘09 16 Feb ‘09. 20 Feb. ’09 23 Mar’09 … Declaration Date Cumdividend Date Exdividend Date Record Date Payment Date 9 Institutional Features of Dividends Price Behaviour around the Ex-Dividend Date Share price around the ex-dividend date of AMP Ltd on 10/03/00 Ex-dividend date 16. 60 16. 40 16. 20 16. 00 15. 80 15. 60 15. 40 Open 8 March Close 8 March/ Open 9 March Close 9 March/ Open 10 March Close 10 March Grossed up dividend of 33 cents AMP shares fell by 35 cents (approximately the value of the dividend to shareholders) when the shares opened on the ex-dividend date. Why? 10
Types of Dividend Policies Constant Payout Policy There are two common forms of dividend policies which firms use in practice 1. Constant (Smoothed) Payout Policy 2. Stable Dividend Policy Constant Payout Policy This is the policy of paying out a constant percentage of the firm’s earnings as dividends. What are the implications of the constant payout policy? 11 Types of Dividend Policies Stable Dividend Policy Stable Dividend Policy This involves the firm paying a stable amount of dollar dividends each year, with adjustments only when the level of expected net income exhibits a permanent change
What are the implications of a stable dividend policy? 12 Trends in Dividend Policies Managers and Dividend Decisions Dividends are an ‘active decision variable’ • Lintner (1956) found the following: ? Companies set 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 13 Trends in Dividend Policies Incorporating Lintner’s Findings Into Algebraic Notation Finding 1: The management of a company adopts long-run target payout ratios (defined as ? ) Dt = ? EPSt here: Dt = the dividend paid in period t EPSt = the earnings generated in period t 14 Trends in Dividend Policies Incorporating Lintner’s Findings Into Algebraic Notation Finding 2: Managers focus on change in the dividend payout ratio The variable that management focuses on:: Dt ? Dt ? 1 = ? EPSt ? Dt ? 1 15 Trends in Dividend Policies Incorporating Lintner’s Findings Into Algebraic Notation Finding 3: Managers are reluctant to change dividends because they are based on long-run forecasted profits. Thus, managers will only change the dividend in the next period by a certain portion (i. e. , adjustment rate (? ). Dt ? Dt ? 1 = ? ( ? EPSt ? Dt ? 1 ) 16 Trends in Dividend Policies Incorporating Lintner’s Findings Into Algebraic Notation Dt ? Dt ? 1 = ?? EPSt ? ? Dt ? 1 Re-expressing the above equation into “empirical form” Dt ? Dt ? 1 = a + b EPSt + c Dt ? 1 + ? where: a = constant; b = is ?? ; c = is –? ; and ? = is the error term that accounts for randomness not explained by the model 17 Trends in Dividend Policies Australian Evidence The coefficients a, b, and c in the Lintner model can be estimated using historical data • One Australian study, based on data for 23 firms from 1950 – 1978, found that: 1.
The average target payout ratio was 55% 2. The adjustment rate (the amount by which dividends were adjusted towards the target dividend in any one year) was 51% 1980 Dividend Policy Survey for Firms on the ASX • • • Objective: Data: Results: 18 Is there an Optimal Dividend Policy? Two Schools of Thought One School of Thought: Under Perfect Capital Markets Second School of Thought: Introducing Market Imperfections 19 Dividend Policy is Irrelevant Modigiliani and Miller (1961) • In a perfect capital market, MM (1961) states that the dividend payout ratio is a mere detail. The value of the firm is determined solely by the earning power of the firm’s assets • The manner in which earnings (net income) is divided into dividends and retained earnings does not affect shareholder’s wealth. 20 Dividend Policy is Irrelevant Conditions under which dividend policy is irrelevant The main assumptions underlying the M&M irrelevance proof are: 1. 2. 3. 4. There are no costs of issuing shares There are no costs of trading shares All market participants (e. g. , management and shareholders) have the same information There are no personal or corporate taxes 21 Dividend Policy is Irrelevant An Example
An example…. Adams Construction and Feldon Home Builders Two identical companies, except their dividend policy. Both have 4 millions shares outstanding. Both companies have assets worth $40 million. Expected net cash inflow is $6 million next year. Adams Construction Return on investment Price per share 15% $10 Feldon Home Builders 15% $10 Both firms anticipate an investment opportunity next year that will require $6 million. How will the two firms finance this opportunity? 22 Dividend Policy is Irrelevant An Example: Adams Construction Pays out 100% of next year’s cash inflows as dividends. Earns and distributes $1. 0/share Will raise $6 million in a new equity offering to finance the new investment opportunity 600,000 shares at $10 each Today Tomorrow Assets worth $40 million 4 million shares $10 per share Assets worth $46million 4. 6 million shares $10 per share Adams Construction original shareholders earn 15% return in the form of dividend. 23 Dividend Policy is Irrelevant An Example: Feldon Home Builders Retains next year’s $6 million cash inflows; invest $6 million in the new investment opportunity Today Tomorrow Assets worth $40 million 4 million shares $10 per share Assets worth $46million 4 million shares $11. per share Shareholders earn required return of 15% in the form of stock price increase. Firm value for both firms is the same, regardless of the dividend payout policy! 24 Dividend Policy is Irrelevant What have we learnt? From the perspective of individual investors: ? What shareholder receive in dividends they lose in future capital gains (e. g. , Adams Construction) ? What shareholders miss in current dividends, they receive as a future capital gain (e. g. , Feldon Home Builders) Individual investors are indifferent to receiving dividends or capital gains 25 Dividend Policy is Irrelevant
What have we learnt? From the perspective of the company ? Whatever is paid out in dividends can be costlessly recovered by issuing new shares (e. g. , Adams Construction) The dividend policy is irrelevant as equity capital can be costlessly raised. 26 Dividend Policy is Relevant Real-World Influences on Dividends What happens when we relax each of the four assumptions used for the Modigiliani and Miller (1961) irrelevance proof? Relaxing these four assumptions, we introduce capital market imperfections ? There are costs of issuing shares ? There are costs of trading shares ? Information asymmetry exists ?
Taxation effects Dividend policy can impact on shareholder wealth under real-world circumstances 27 Dividend Policy is Relevant Cost of Issuing Shares • Are the costs associated with issuing new shares significant? Yes! KPMG Survey of the Costs of IPOs for 58 ASX listed firms between 2001 and 2002 ? Over 2. 5% of the amount raised is above $500m ? Over 5. 0% of the amount raised was between $100m and $500m ? Over 11. 0% of the amount raised was below $10m 28 Dividend Policy is Relevant Cost of Issuing Shares • Are the costs associated with issuing new shares significant? Yes! 29 Dividend Policy is Relevant
Cost of Issuing Shares • Are the costs associated with issuing new shares significant? Yes! 30 Dividend Policy is Relevant Cost of Issuing Shares • What is the implication of high issuance costs? ? A high dividend payout policy can have a negative impact on shareholder wealth 31 Dividend Policy is Relevant Cost of Trading Shares • Are trading costs significant? Three main costs associated with trading shares Brokerage Fees GST Bid-ask spread • • Institutional investor: On average, 0. 3% or 0. 6% for a “round trip” transaction. Retail investor: On average, $20 per trade (considerably higher) 10% of the brokerage fee • Ranges from 0. 06% to 0. 2% for a round-trip transaction for the most heavily traded stocks 32 Dividend Policy is Relevant Cost of Trading Shares • What is the implication of high trading costs? ? Dividend policies can affect a corporation’s value as investors may place a higher value on stocks with dividend policies they prefer. 33 Dividend Policy is Relevant Information Asymmetry It is typically assumed that managers have access to more information than do shareholders What does this suggest? • Dividend policy may act as an information “signal” to investors 1. 2. A dividend increase A cut in dividends 4 Dividend Policy is Relevant The Effect of Taxation • An individual will be tax neutral (indifferent) to firm dividend policy if after-all-tax income from dividends is equal to after-all-tax income from capital gains: (1 ? ? ps ) = (1 ? ? pg ) where: ? ps = the personal tax rate on dividend income ? pg = the personal tax rate on capital gains 35 Dividend Policy is Relevant The Effect of Taxation GENERALISATIONS When ? pg > ? ps Investors will prefer the payment of dividends to capital gains Investors will prefer the receive capital gains than payment of dividends When ? pg < ? ps
Differential tax treatments across investors can result in the formation of tax induced clienteles, which can influence firm value 36 Alternatives to Dividends Introduction • There are a number of alternatives to dividends available to corporations • All of these alternatives can be considered part of dividend policy SOME ALTERNATIVES TO DIVIDENDS 1. 2. Share buy-backs Dividend Reinvestment Plans (DRPs) 37 Alternatives to Dividends Share Buy-Backs In a share buyback, the corporation goes into the market and buys back its own shares in return for cash What is the similarity between a dividend and share buy-back? Both return cash to the shareholder. What are the differences between a dividend and share buy-back? 1. 2. of the cash In the case of a dividend, all shareholders receive their share for sale receive cash In a share buyback, only shareholders offering their shares 38 Alternatives to Dividends Share Buy-Backs Types of Share Buy-Backs Equal Access Buy Back Selective Buy Back On-market Buy Back Employee Share Scheme Buy Back Odd-lot Buy Back • • Pro-rata to all shareholders Repurchase from specific, number of shareholders. limited • •
Repurchase through normal stock exchange trading Buy back shares from employees who participated in employee share schemes earlier Buy back small unmarketable parcels of shares (transaction costs) 39 • Alternatives to Dividends Share Buy-Backs • s. 295A of the Corporations Act 2001 generally precludes a company from purchasing its own shares • Exemptions to this general prohibition introduced in 1989 allowed public companies to repurchase their shares • 10/12 limit rule 40 Alternatives to Dividends Share Buy-Backs Pre-1995 – procedure for repurchases was complicated and costly! Result?
Post-1995 – procedure for repurchases was simplified Result? 100 Number of companies with buy-backs 90 80 70 60 50 40 30 20 10 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 41 Year Alternatives to Dividends Share Buy-Backs Do Share Buy-Backs Affect Firm Value? Corporation A (before buy back) Assets worth $20bn Shares outstanding: 20 bn Value per share: $1 Intended buy Back 1 billion shares Corporation A (after buy back) Assets worth $19bn Shares outstanding: 19 bn Value per share: $1 THEORETICALLY A share buy back should have no effect on the share price IF shares are bought back at their fair value. 2 Alternatives to Dividends Share Buy-Backs Do Share Buy-Backs Affect Firm Value? PRACTICALLY Do share buy-backs affect firm value? • It has been found that the majority of companies announcing buy-backs outperform the market following the announcement WHY? 43 Alternatives to Dividends Dividend Reinvestment Plans Dividend Reinvestment Plans (DRPs) offer shareholders the option to apply all or part of their cash dividends to the purchase of additional shares in the company. • DRPs have become increasingly popular over the last few years. (e. g. DRPs increased from 5% of all listed companies in 1982 to 14% of all listed companies by 1999) • What has been the reason for this increased popularity in DRPs? 44 Alternatives to Dividends Dividend Reinvestment Plans Potential Problems resulting from the Popularity of DRPs • Increase in popularity in DRPs can lead to a surplus cash position for the firm. This can either be good or bad! How to make DRPs less attractive? 45 Alternatives to Dividends Dividend Reinvestment Plans Pros and Cons for Investors Pros ? ? ? Avoid brokerage and stamp duty associated with acquiring shares Additional shares may be issued at a small discount (2. to 5%) to market price Receive the franking credits that can be used to offset their personal tax liability Cons ? ? ? No control over the reinvestment price Discount disadvantages those shareholders who do not participate in the DRP Familiarisation with plan and its tax consequences 46 Alternatives to Dividends Dividend Reinvestment Plans Pros and Cons to the Company Pros ? ? Cheap and effective means of raising capital and conserving cash Promotes good shareholder relations and stability of ownership Cons ? ? ? ? Administration costs Promotion of the plan Excessive capital raising Dilution of EPS 47
Alternatives to Dividends Dividend Reinvestment Plans How many shares does an investor receive from participating in a DRP? • The price of shares issued under a DRP is usually a weighted average price based on transactions over a specified period “ CBA Shares will be allotted or transferred at a price which is to the arithmetic average of the daily volume weighted average market price (rounded to the nearest cent) of all Commonwealth Bank shares sold on the Australian Stock Exchange during the ten trading days immediately following the record date for payment of the relevant dividend. 48 Alternatives to Dividends Dividend Reinvestment Plans How many shares does an investor receive from participating in a DRP? An Example (CBA Shares) ? ? The interim CBA 2005 dividend was 69 cents The weighted average share price over a specified 10-day period (10 days after the Record Date) was $24. 75 If an investor owns 1,000 CBA shares, how many additional shares will he/she receive under the DRP? 49