Chapter 12 dividend policy

 Enable shareholders to use dividend entitlements to acquire additional shares without transaction costs and generally below market price.. The number of shares the shareholder will r

to accompany

Chapter 12

Dividend Policy

Dividend Fundamentals

 Dividends are the key return variable from which owners and investors determine share value.

 The decision whether to pay dividends will have

a significant affect on the firm’s external financing requirements.

 The larger the dividends paid, the greater the

amount of financing that may need to be raised externally through borrowing or the sale of

shares.

Cash Dividend Payment

Procedures

 Whether, and in what amount to pay a dividend is decided at the semi annual meeting of a

company’s board of directors.

 Amount Of Dividends: Generally in accordance

with the company’s policy, but may be altered

depending on the financial circumstances at the time.

 Timing: based upon the following relevant dates:

Cash Dividend Payment

Dividend Reinvestment Plans

 Introduced into Australia in the early 1980’s, and greatly enhanced the appeal of shares to some

shareholders.

 Enable shareholders to use dividend entitlements

to acquire additional shares without transaction

costs and generally below market price.

 Under the scheme shareholders may elect to

receive issued shares in lieu of their cash dividend entitlement The number of shares the shareholder will receive is based on the cash dividend

otherwise payable and the current market value of the shares.

The Residual Theory Of

Dividends

 Does dividend policy matter, and what effect

does it have on share price?

 The Residual Theory Of Dividends: suggests that

the dividend paid by a firm should be viewed as the residual amount left over after all acceptable investment opportunities have been undertaken.

 If the firm’s equity financing need was greater

than the balance of retained earnings no cash

The Residual Theory Of

Dividends

The Residual Theory Of

Dividends

Table 12.1, Page 525

Arguments For Dividend

Irrelevance

 Miller & Modigliani and other advocates for dividend

irrelevance argue that, all else being equal, an

investor’s required return and therefore the value of the firm is unaffected by dividend policy, for three reasons:

1 The firm’s value is solely determined by the earning

power and risk of its assets.

2 If dividends do affect value, they do so solely

because of their informational content, which signals management’s earnings expectations.

3 A clientele effect exists that causes a firm’s

shareholders to receive the dividends that they expect.

Arguments For Dividend

Relevance

 Gordon & Lintner, key advocates for dividend

relevance believe that there is a direct

relationship between the firm’s dividend policy and its market value.

 This belief is based upon the bird in the hand

argument, that suggests that investors are

generally risk averse and view current dividends

as less risky than future dividends or capital

gains

Factors Affecting Dividend

Policy

 Dividend Policy: The firm’s plan of action to be

followed whenever a decision concerning dividends

4 Growth prospects of the firm

5 Owner considerations

 Tax status of a firm’s owners

 Investment opportunities available to

Types Of Dividend Policy

Constant Payout Ratio Dividend Policy:

 Based on the payment of a certain percentage

of earnings to owners in each dividend period.

 Consequently, if the firm’s earnings drop, or the

firm incurs a loss, dividends may be low to non existent which may adversely affect the firm’s share price.

 Sporadic dividend payments as a result of this

policy may make owners uncertain about the returns they can expect and consequently

impact on share price

Regular Dividend Policy:

 Based on the payment of a fixed dollar dividend

in each period

 Reduces investor uncertainty, generally

stabilising share price.

 Generally formed around a target dividend

Low Regular & Extra Dividend Policy:

 Based on the payment of a low regular dividend, supplemented by an additional dividend when earnings are higher than normal in a given

period.

 Common in companies that experience cyclical shifts in earnings.

 Allows the company to provide stability and

flexibility in the payment of dividends.

Types Of Dividend Policy

Other Forms Of Dividends

Share Dividends/Bonus Issue:

 Payment to the existing shareholders of a

dividend in the form of shares.

 Don’t have any “real” value, but can be sold by

shareholders to recognise their value.

 Can be paid as a replacement or supplement to cash dividends.

 From an accounting perspective involves simply a transfer of funds between capital accounts rather

Share Dividends/Bonus Issue Continued:

 From a shareholders’ perspective the per share value

of the shareholders’ holdings decreases, as will the market value of the shares

 The payment of share dividends can be seen as a

signal of the confidence of the company’s

management.

 From the firm’s perspective the payment of share

dividends allow them to utilise the cash for other

purposes such as expansion/growth How the cash is then used will have a significant affect on share price.

Other Forms Of Dividends

Other Forms Of Dividends

Share Splits:

 Are not a true dividend.

 Commonly used to lower the market price of a firm’s shares by increasing the number of shares belonging to each shareholder.

 Has no effect on the firm’s capital structure.

 May be used when the firm feels shares are over priced and by lowering them they will enhance trading activity.

 Often made prior to new issues of shares.

Share Splits Continued:

Other Forms Of Dividends

Other Forms Of Dividends

Share Buybacks:

 The repurchasing by the firms of outstanding ordinary shares in the market.

 Can be viewed as a tax effective cash dividend.

 Can help to discourage an unfriendly takeover.

 Desired effects include the enhancement of shareholder value by:

 Reducing the number of shares outstanding

 Increasing earnings per share

 Sending a positive signal within the marketplace

Share Buybacks Continued:

 Results in a reverse dilution of shares.

 Brought back shares are cancelled and cannot be reissued

 Three types of buyback:

1 Equal access buyback

2 Selective buyback through a tender process

3 On market trading

 Shareholder approval required for any buyback that

Other Forms Of Dividends

Dividend Imputation Tax

System

 Was introduced in Australian in 1987.

 Eliminated the double taxing of company profits

distributed as dividends.

 From the shareholder’s point of view the dividends

are effectively tax or part tax free (depending on

company and individual tax rates).

 Tax paid on the distributed profit by the company is imputed to the shareholder.

 Three key elements:

1 Applies to dividends paid from company profits

upon which tax has been paid in Australia.

2 The tax credits received by shareholders can be

offset against all forms of income.

3 Imputation credits are confined to resident

individuals for dividends paid by resident firms Dividend Imputation Tax

System

 Fully Franked Dividends:

Dividends paid only from profits on which

Australian income tax has been paid.

 Partly Franked Dividends:

Dividends paid from profits of which part of have borne Australian income tax.

 Franking Credits:

The tax credit attaching to a dividend.

Dividend Imputation Tax

System

Dividend Imputation Tax

System

 Effects On Shareholders:

Page 539

Effects Of Imputation On

Companies

 The franking account is a notional account

maintained for tax purposes and reflects the amount

of company profits that can be distributed as franked dividends.

 Franked dividends can only be paid whilst the

franking account balance is in credit.

 Franking credit available is calculated by:

or

Where:

T R = Corporate tax rate

NI = Adjusted amount – the amount of after tax

earnings that can be distributed as franked dividends.

BA = The basic amount of tax paid

Effects Of Imputation On

Companies

) 1

( T R EBT

NI  (  1 )

Page 541

Effects Of Imputation On

Companies

Effects Of Imputation On

Shareholders

 From a shareholders perspective the taxable

income from dividends can be calculated by:

Taxable = Dividend + Dividend x Franking

 Franking ratio is the proportion of dividend

distribution subject to imputation tax credit, and is calculated by:

Franking Ratio =

) 1

R

T

T NI

BA





Effects Of Imputation On

Shareholders

The Cost Of Capital &

Imputation Of Dividends

 Cost of capital relates to imputation because capital

budgeting is done in after-tax terms.

 We use the before tax cost of capital weighted by an

( 1

][

) 1

(

V

S T

r V

D r

Cash Flows & WACC With

Dividend Imputation

 The value of a firm after tax with imputation can be calculated by:

V = D + E = [Equation 12.3]

 γ Will range between 0 (no imputation) and 1

(full imputation), and can be difficult to

Cash Flows & WACC With

Dividend Imputation

Cash Flows & WACC With

Dividend Imputation

Cash Flows & WACC With

Dividend Imputation

Cash Flows & WACC With

Dividend Imputation