Lecture Essentials of corporate finance (2/e) – Chapter 14: Dividends and dividend policy

In this chapter, you will: Understand dividend types and how they are paid, understand the issues surrounding dividend policy decisions, understand the difference between cash and share dividends, understand why share repurchases are an alternative to dividends.

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Dividends and dividend

policy

Chapter 14

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Key concepts and skills

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Chapter outline

• Cash dividends and dividend payment

• Does dividend policy matter?

• Establishing a dividend policy

• Share repurchase: An alternative to

cash dividends

• Bonus issues and share splits

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Cash dividends

• Regular cash dividend—cash

payments made directly to

shareholders, usually each quarter

• Extra cash dividend—indication that the

‘extra’ amount may not be repeated in

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– Occurs four business days before date of record

– If you buy a share on or after this date, you will

not receive the dividend

– Share price generally drops by about the amount

of the dividend

• Date of record—holders of record are

determined and they will receive the dividend payment

• Date of payment—cheques are mailed

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Example of the procedure for dividend payment—Figure 14.1

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The ex-date price drop—Figure

14.2

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Does dividend policy

matter?

• Dividends matter

– The value of the share is based on the

present value of expected future

dividends.

• Dividend policy may not matter

– Dividend policy is the decision to pay

dividends versus retaining funds to

reinvest in the firm.

– In theory, if the firm reinvests capital now,

it will grow and can pay higher dividends in the future.

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Illustration of dividend policy

irrelevance Wharton Corporation

• All-equity firm with 100 shares outstanding

• Investors require a 10% return

• Expected cash flow = $10 000 each year

• Plans to dissolve firm in 2 years

• Firm can either:

A.pay out dividends of $10 000 per year for each of

the next two years ($100 per share); or

B.pay $11 000 this year, raising the other $1000 by

issuing stock (or bonds), then pay an amount in year 2 sufficient to provide new shareholders with a 10%

return.

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Illustration of dividend policy

irrelevance Wharton Corporation (cont.)

Year 1 Year 2 Year 1 Year 2 Cash Flow $10,000 $10,000 $10,000 $10,000

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Factors favouring a low

payout

• Why might a low payout be desirable?

• Taxes

– Individuals in upper income tax brackets

might prefer lower dividend payouts, with the immediate tax consequences, to higher

capital gains.

• Flotation costs

– Low payouts can decrease the amount of

capital that needs to be raised, thereby

lowering flotation costs.

• Dividend restrictions

– Debt contracts might limit the percentage of

income that can be paid out as dividends.

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Factors favouring a high

payout

• Why might a high payout be desirable?

• Desire for current income

– Individuals in low tax brackets

– Groups that are prohibited from spending principal

(trusts and endowments)

• Uncertainty resolution

– No guarantee that higher future dividends will

materialise

• Taxes

– Dividend exclusion for corporations

– Tax-exempt investors don’t have to worry about

differential treatment between dividends and capital

gains

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Clientele 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.

• Clientele effect—argument goes that

shares attract particular groups, based on

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Implications of the clientele

effect

• What do you think will happen if a firm

changes its policy from one of high

payout to one of low payout?

• What do you think will happen if a firm

changes its policy from one of low

payout to one of high payout?

• If this is the case, does dividend

POLICY matter?

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Signalling—Information content of dividends

• Share prices generally rise with

unexpected increases in dividends and

fall with unexpected decreases in

dividends.

• Does this mean that the average

investor prefers a high dividend payout ratio?

• No—changes in the dividend send a

signal about management’s view

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Dividend policy in practice

• Residual dividend policy

• Alternative dividend policy

– Cyclical dividend policy

• Each dividend is a fixed fraction of that half's earnings Here, dividends will vary throughout the year and over time.

– Stable dividend policy

• Each dividend is a fixed fraction of yearly earnings Here, all dividend payments will be equal

throughout the year.

• Compromise dividend policy

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Residual dividend policy

• Determine capital budget

• Determine target capital structure

• Finance investments with a

combination of debt and equity in line

with the target capital structure

– Remember that retained earnings are

equity

– If additional equity is needed, issue new

shares

• If there are excess earnings, pay the

remainder out in dividends

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Alternative dividend policies—

Figure 14.4

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Compromise dividend

policy

• Goals, ranked in order of importance

– Avoid cutting back on positive NPV

projects to pay a dividend

– Avoid dividend cuts

– Avoid the need to sell equity

– Maintain a target debt–equity ratio

– Maintain a target dividend payout ratio

• Companies want to accept positive

NPV projects, while avoiding negative

signals.

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Share repurchase

• Company buys back its own shares

– Tender offer—company states a purchase

price and a desired number of shares

– Open market—company buys shares in the

• This is another argument for dividend

policy irrelevance in the absence of taxes

or other imperfections

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Real-world considerations

• Share repurchase allows investors to

decide if they want the current cash flow

and associated tax consequences.

• Investors face capital gains taxes instead

of ordinary income taxes (lower rate).

• In our current tax structure, repurchases

may be more desirable owing to the

options and structuring provided to

shareholders.

• The ATO recognises this and will not allow

a share repurchase for the sole purpose of allowing investors to avoid taxes.

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Information content of share

repurchases

• Share repurchases send a positive

signal that management believes that

the current price is low.

• Tender offers send a more positive

signal than open-market repurchases

because the company is stating a

specific price.

• The share price often increases when

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Share dividends

• Pay additional shares instead of cash

• Increases the number of outstanding

shares

• Small share dividend

– Less than 20–25%

– If you own 100 shares and the company

declared a 10% share dividend, you would receive an additional 10 shares

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Share splits

• Share splits—essentially the same as a stock dividend, except expressed as a ratio.

– For example, a 2-for-1 stock split is the

same as a 100% stock dividend.

• Share price is reduced when the share splits.

• Common explanation for split is to

return price to a ‘more desirable trading

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Reverse share splits

• Reverse split reduces number of shares

outstanding.

– For example, a 1-for-5 stock split replaces

every five shares of stock with one share.

• Reasons:

1 Transaction costs may be less for investors.

2 Liquidity might be improved.

3 Too low a price not considered ‘respectable’.

4 Exchange minimum price per share

requirements.

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Quick quiz

• What are the different types of dividends and

how is a dividend paid?

• What is the clientele effect and how does it

affect dividend policy relevance?

• What is the information content of dividend

changes?

• What is the difference between a residual

dividend policy and a compromise dividend

policy?

• What are share dividends and how do they

differ from cash dividends?

• How are share repurchases an alternative to

dividends and why might investors prefer

them?

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Chapter 14

END

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