Dividend policy
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Dividend policy

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The policy a company uses to decide how much it will pay out to shareholders in dividends.

The policy a company uses to decide how much it will pay out to shareholders in dividends.

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    Dividend policy Dividend policy Presentation Transcript

    • INTRODUCTION TOINTRODUCTION TOCORPORATE FINANCECORPORATE FINANCEChapter 22 – Dividend PolicyChapter 22 – Dividend Policy
    • CHAPTER 22CHAPTER 22Dividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 3Lecture AgendaLecture Agenda• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Mechanics of Dividend PaymentsMechanics of Dividend Payments• Cash Dividend PaymentsCash Dividend Payments• M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance Theorem• The “Bird in the Hand” ArgumentThe “Bird in the Hand” Argument• Dividend Policy in PracticeDividend Policy in Practice• Relaxing the M&M AssumptionsRelaxing the M&M Assumptions• Stock Dividends and Stock SplitsStock Dividends and Stock Splits• Share RepurchasesShare Repurchases• Summary and ConclusionsSummary and Conclusions– Concept Review QuestionsConcept Review Questions
    • CHAPTER 22 – Dividend Policy 22 - 4Learning ObjectivesLearning ObjectivesYou should understand the following:You should understand the following:• The mechanics of dividend payments and why they areThe mechanics of dividend payments and why they aredifferent from interest paymentsdifferent from interest payments• The difference between a stock split and a stock dividendThe difference between a stock split and a stock dividend• Under what assumptions a dividend payment is irrelevantUnder what assumptions a dividend payment is irrelevantand what a homemade dividend isand what a homemade dividend is• Why dividend payments generally reflect the business risk ofWhy dividend payments generally reflect the business risk ofthe firmthe firm• How transactions costs, taxes and information problems giveHow transactions costs, taxes and information problems givevalue to corporate dividend policiesvalue to corporate dividend policies• How stock dividends and stock splits differHow stock dividends and stock splits differ• How a share repurchase program can substitute for aHow a share repurchase program can substitute for adividend payout policy.dividend payout policy.
    • CHAPTER 22 – Dividend Policy 22 - 5Important Chapter TermsImportant Chapter Terms• Agency theoryAgency theory• Bird in the hand argumentBird in the hand argument• Cash cowCash cow• Declaration dateDeclaration date• Dividend reinvestment plansDividend reinvestment plans• Dividend yieldDividend yield• Equity market capitalizationEquity market capitalization• Ex-dividend dateEx-dividend date• Free cash flowFree cash flow• Holder of recordHolder of record• Homemade dividendsHomemade dividends• Income strippingIncome stripping• Odd lotsOdd lots• Residual theory of dividendsResidual theory of dividends• Special dividendSpecial dividend• Split sharesSplit shares• Stock dividendStock dividend• Stock splitStock split• Tax clientelesTax clienteles
    • What is Dividend Policy?What is Dividend Policy?Dividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 7Dividend PolicyDividend PolicyWhat is It?What is It?• Dividend Policy refers to the explicit or implicitDividend Policy refers to the explicit or implicitdecision of the Board of Directors regarding thedecision of the Board of Directors regarding theamount of residual earnings (past or present)amount of residual earnings (past or present)that should be distributed to the shareholdersthat should be distributed to the shareholdersof the corporation.of the corporation.– This decision is considered aThis decision is considered a financing decisionfinancing decisionbecause the profits of the corporation are anbecause the profits of the corporation are animportant source of financing available to the firm.important source of financing available to the firm.
    • Types of DividendsTypes of DividendsDividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 9Types of DividendsTypes of Dividends• Dividends are a permanent distribution of residualDividends are a permanent distribution of residualearnings/property of the corporation to its owners.earnings/property of the corporation to its owners.• Dividends can be in the form of:Dividends can be in the form of:– CashCash– Additional Shares of Stock (stock dividend)Additional Shares of Stock (stock dividend)– PropertyProperty• If a firm is dissolved, at the end of the process, a finalIf a firm is dissolved, at the end of the process, a finaldividend of any residual amount is made to thedividend of any residual amount is made to theshareholders – this is known as ashareholders – this is known as a liquidating dividendliquidating dividend..
    • Dividends and Corporate FinancingDividends and Corporate FinancingDividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 11– In the absence of dividends, corporate earnings accrue to the benefit ofIn the absence of dividends, corporate earnings accrue to the benefit ofshareholders as retained earnings and are automatically reinvested inshareholders as retained earnings and are automatically reinvested inthe firm.the firm.– When a cash dividend is declared, those funds leave the firmWhen a cash dividend is declared, those funds leave the firmpermanently and irreversibly.permanently and irreversibly.– Distribution of earnings as dividends may starve the company of fundsDistribution of earnings as dividends may starve the company of fundsrequired for growth and expansion, and this may cause the firm to seekrequired for growth and expansion, and this may cause the firm to seekadditional external capital.additional external capital.Corporate Profits After TaxRetained EarningsDividendsDividends a Financing DecisionDividends a Financing Decision
    • CHAPTER 22 – Dividend Policy 22 - 12Dividends versus Interest ObligationsDividends versus Interest ObligationsInterestInterest• Interest is a payment to lenders for the use of their funds for a givenInterest is a payment to lenders for the use of their funds for a givenperiod of timeperiod of time• Timely payment of the required amount of interest is a legal obligationTimely payment of the required amount of interest is a legal obligation• Failure to pay interest (and fulfill other contractual commitments underFailure to pay interest (and fulfill other contractual commitments underthe bond indenture or loan contract) is an act of bankruptcy and thethe bond indenture or loan contract) is an act of bankruptcy and thelender has recourse through the courts to seek remedieslender has recourse through the courts to seek remedies• Secured lenders (bondholders) have the first claim on the firm’s assets inSecured lenders (bondholders) have the first claim on the firm’s assets inthe case of dissolution or in the case of bankruptcythe case of dissolution or in the case of bankruptcyDividendsDividends• A dividend is a discretionary payment made to shareholdersA dividend is a discretionary payment made to shareholders• The decision to distribute dividends is solely the responsibility of theThe decision to distribute dividends is solely the responsibility of theboard of directorsboard of directors• Shareholders are residual claimants of the firm (they have the last, andShareholders are residual claimants of the firm (they have the last, andresidual claim on assets on dissolution and on profits after all otherresidual claim on assets on dissolution and on profits after all otherclaims have been fully satisfied)claims have been fully satisfied)
    • The Mechanics of Dividend PaymentsThe Mechanics of Dividend PaymentsDividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 14Dividend PaymentsDividend PaymentsMechanics of Cash Dividend PaymentsMechanics of Cash Dividend Payments• Declaration DateDeclaration Date• Holder of Record DateHolder of Record Date• Ex-dividend DateEx-dividend Date• Payment DatePayment Date
    • CHAPTER 22 – Dividend Policy 22 - 15Dividend PaymentsDividend PaymentsMechanics of Cash Dividend PaymentsMechanics of Cash Dividend PaymentsDeclaration DateDeclaration Date– this is the date on which the Board of Directors meet and declare the dividend. In theirthis is the date on which the Board of Directors meet and declare the dividend. In theirresolution the Board will set theresolution the Board will set the date of recorddate of record, the, the date of paymentdate of payment and theand the amount of theamount of thedividenddividend for each share class.for each share class.– when CARRIED, this resolution makes the dividend a current liability for the firm.when CARRIED, this resolution makes the dividend a current liability for the firm.Date of RecordDate of Record– is the date on which the shareholders register is closed after the trading day and all thoseis the date on which the shareholders register is closed after the trading day and all thosewho are listed will receive the dividend.who are listed will receive the dividend.Ex dividend DateEx dividend Date– is the date that the value of the firm’s common shares will reflect the dividend payment (ie.is the date that the value of the firm’s common shares will reflect the dividend payment (ie.fall in value)fall in value)– ‘‘ex’ means without.ex’ means without.– At the start of trading on the ex-dividend date, the share price will normally open for tradingAt the start of trading on the ex-dividend date, the share price will normally open for tradingat the previous days close, less the value of the dividend per share. This reflects the factat the previous days close, less the value of the dividend per share. This reflects the factthat purchasers of the stock on the ex-dividend date and beyond WILL NOT receive thethat purchasers of the stock on the ex-dividend date and beyond WILL NOT receive thedeclared dividend.declared dividend.Date of PaymentDate of Payment– is the date the cheques for the dividend are mailed out to the shareholders.is the date the cheques for the dividend are mailed out to the shareholders.
    • CHAPTER 22 – Dividend Policy 22 - 16Declaration DateDate ofRecordDate ofPaymentEx Dividend Date is determinedby the Date of Record.The market value of the sharesdrops by the value of the dividendper share on market opening…comparedto the previous day’s close.The Board Meetsand passes themotion to createthe dividend2 business days prior to the Date of RecordDividend Declaration Time LineDividend Declaration Time Line
    • CHAPTER 22 – Dividend Policy 22 - 17Changes in the Settlement CycleChanges in the Settlement Cycle• In June 1995 the settlement cycle for all non-money-market Canadian andIn June 1995 the settlement cycle for all non-money-market Canadian andU.S. securities was reduced from five business days (T + 5) toU.S. securities was reduced from five business days (T + 5) to three businessthree businessdaysdays (T + 3).(T + 3).• The rationale for the change stems from the 1987 stock market crash when itThe rationale for the change stems from the 1987 stock market crash when itwas realized that a securities market failure could result in a credit marketwas realized that a securities market failure could result in a credit marketfailure. The gridlock created in 1990 by the bankruptcy of Drexel Burnhamfailure. The gridlock created in 1990 by the bankruptcy of Drexel BurnhamLambert, a large U.S. broker, increased the need to minimize the risksLambert, a large U.S. broker, increased the need to minimize the risksinvolved in the clearing and settlement of securities.involved in the clearing and settlement of securities.• The shortened settlement cycle requires that the payment of funds and theThe shortened settlement cycle requires that the payment of funds and thedelivery of securities take place on thedelivery of securities take place on the third business daythird business day after the tradeafter the tradedate. This will reduce credit, market and liquidity risks by decreasing post-date. This will reduce credit, market and liquidity risks by decreasing post-trade settlement exposure.trade settlement exposure.Ex Dividend DateEx Dividend Date• The date is not chosen by the board of directors, rather it is determined as aThe date is not chosen by the board of directors, rather it is determined as aresult of the exchanges settlement practices and is a function of the date ofresult of the exchanges settlement practices and is a function of the date ofrecord.record.Trade Settlement and the Ex DividendTrade Settlement and the Ex DividendDateDate
    • Dividend Decision and the Board ofDividend Decision and the Board ofDirectorsDirectorsDividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 19Dividend PolicyDividend PolicyDividends, Shareholders and the Board of DirectorsDividends, Shareholders and the Board of Directors• There is no legal obligation for firms to pay dividends toThere is no legal obligation for firms to pay dividends tocommon shareholderscommon shareholders• Shareholders cannot force a Board of Directors toShareholders cannot force a Board of Directors todeclare a dividend, and courts will not interfere with thedeclare a dividend, and courts will not interfere with theBOD’s right to make the dividend decision because:BOD’s right to make the dividend decision because:– Board members are jointly and severally liable for any damagesBoard members are jointly and severally liable for any damagesthey may causethey may cause– Board members are constrained by legal rules affectingBoard members are constrained by legal rules affectingdividends including:dividends including:• Not paying dividends out of capitalNot paying dividends out of capital• Not paying dividends when that decision could cause the firm toNot paying dividends when that decision could cause the firm tobecome insolventbecome insolvent• Not paying dividends in contravention of contractual commitmentsNot paying dividends in contravention of contractual commitments(such as debt covenant agreements)(such as debt covenant agreements)
    • Dividend PaymentsDividend PaymentsDividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 21Dividend PaymentsDividend PaymentsDividend Reinvestment Plans (DRIPs)Dividend Reinvestment Plans (DRIPs)• Involve shareholders deciding to use the cashInvolve shareholders deciding to use the cashdividend proceeds to buy more shares of the firmdividend proceeds to buy more shares of the firm– DRIPs will buy as many shares as the cash dividend allows withDRIPs will buy as many shares as the cash dividend allows withthe residual deposited as cashthe residual deposited as cash– Leads to shareholders owning odd lots (less than 100 shares)Leads to shareholders owning odd lots (less than 100 shares)• Firms are able to raise additional common stockFirms are able to raise additional common stockcapital continuously at no cost and fosters an on-capital continuously at no cost and fosters an on-going relationship with shareholders.going relationship with shareholders.
    • CHAPTER 22 – Dividend Policy 22 - 22Dividend PaymentsDividend PaymentsStock DividendsStock Dividends• Stock dividends simply amount to distribution ofStock dividends simply amount to distribution ofadditional shares to existing shareholdersadditional shares to existing shareholders• They represent nothing more than recapitalizationThey represent nothing more than recapitalizationof earnings of the company. (that is, the amount ofof earnings of the company. (that is, the amount ofthe stock dividend is transferred from the R/Ethe stock dividend is transferred from the R/Eaccount to the common share account.account to the common share account.• Because of theBecause of the capital impairment rulecapital impairment rule stockstockdividends reduce the firm’s ability to pay dividendsdividends reduce the firm’s ability to pay dividendsin the future.in the future.
    • CHAPTER 22 – Dividend Policy 22 - 23Dividend PaymentsDividend PaymentsStock DividendsStock DividendsImplicationsImplications– reduction in the R/E accountreduction in the R/E account– reduced capacity to pay future dividendsreduced capacity to pay future dividends– proportionate share ownership remains unchangedproportionate share ownership remains unchanged– shareholder’s wealth (theoretically) is unaffectedshareholder’s wealth (theoretically) is unaffectedEffect on the CompanyEffect on the Company– conserves cashconserves cash– serves to lower the market value of firm’s stock modestlyserves to lower the market value of firm’s stock modestly– promotes wider distribution of shares to the extent that current owners divest themselves ofpromotes wider distribution of shares to the extent that current owners divest themselves ofshares...because they have moreshares...because they have more– adjusts the capital accountsadjusts the capital accounts– dilutes EPSdilutes EPSEffect on ShareholdersEffect on Shareholders– proportion of ownership remains unchangedproportion of ownership remains unchanged– total value of holdings remains unchangedtotal value of holdings remains unchanged– if former DPS is maintained, this really represents an increased dividend payoutif former DPS is maintained, this really represents an increased dividend payout
    • CHAPTER 22 – Dividend Policy 22 - 24Dividend PaymentsDividend PaymentsStock Dividend ExampleStock Dividend ExampleABC CompanyABC CompanyEquity AccountsEquity Accountsas at February xx, 20x9as at February xx, 20x9Common stock (215,000)Common stock (215,000) $5,000,000$5,000,000Retained earningsRetained earnings 20,000,00020,000,000Net WorthNet Worth $25,000,000$25,000,000The company, on March 1, 20x9 declares a 10 percent stock dividend when the currentThe company, on March 1, 20x9 declares a 10 percent stock dividend when the currentmarket price for the stock is $40.00 per share.market price for the stock is $40.00 per share.This stock dividend will increase the number of shares outstanding by 10 percent. ThisThis stock dividend will increase the number of shares outstanding by 10 percent. Thiswill mean issuing 21,500 shares. The value of the shares is:will mean issuing 21,500 shares. The value of the shares is:$40.00 (21,500) = $860,000$40.00 (21,500) = $860,000This stock dividend will result in $860,000 being transferred from the retained earningsThis stock dividend will result in $860,000 being transferred from the retained earningsaccount to the common stock account:account to the common stock account:next page...next page...
    • CHAPTER 22 – Dividend Policy 22 - 25Dividend PaymentsDividend PaymentsStock Dividend ExampleStock Dividend ExampleAfter the stock dividend:After the stock dividend:ABC CompanyABC CompanyEquity AccountsEquity Accountsas at March 1, 20x9as at March 1, 20x9Common stock (236,500)Common stock (236,500) $5,860,000$5,860,000Retained earningsRetained earnings 19,140,00019,140,000Net worthNet worth $25,000,000$25,000,000The market price of the stock will be affected by the stock dividend:The market price of the stock will be affected by the stock dividend:New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36The individual shareholder’s wealth will remain unchanged.The individual shareholder’s wealth will remain unchanged.
    • CHAPTER 22 – Dividend Policy 22 - 26Dividend PaymentsDividend PaymentsStock SplitsStock Splits• Although there is no theoretical proof, there is some whoAlthough there is no theoretical proof, there is some whobelieve that an optimal price range exists for abelieve that an optimal price range exists for acompany’s common shares.company’s common shares.• It is generally felt that there is greater demand forIt is generally felt that there is greater demand forshares of companies that are traded in the $40 - $80shares of companies that are traded in the $40 - $80dollar range.dollar range.• The purpose of a stock split is to decrease share price.The purpose of a stock split is to decrease share price.• The result is:The result is:– increase in the number of share outstandingincrease in the number of share outstanding– theoretically, no change in shareholder wealththeoretically, no change in shareholder wealth• Reasons for use:Reasons for use:– better share price trading rangebetter share price trading range– psychological appeal (signalling affect)psychological appeal (signalling affect)
    • CHAPTER 22 – Dividend Policy 22 - 27Dividend PaymentsDividend PaymentsStock Split ExampleStock Split ExampleThe Board of Directors of XYZ Company is considering using a stock splitThe Board of Directors of XYZ Company is considering using a stock splitto put its shares into a better trading range. They are confident that theto put its shares into a better trading range. They are confident that thefirm’s stock price will continue to rise given the firm’s outstandingfirm’s stock price will continue to rise given the firm’s outstandingfinancial performance. Currently, the company’s shares are trading forfinancial performance. Currently, the company’s shares are trading for$150 and the company’s shareholders equity accounts are as follows:$150 and the company’s shareholders equity accounts are as follows:Commons shares (100,000 outstanding)Commons shares (100,000 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000A 2 for 1 Stock Split:A 2 for 1 Stock Split:New Share Price = PNew Share Price = P00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00The firm’s equity accounts:The firm’s equity accounts:Commons shares (200,000 outstanding)Commons shares (200,000 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000
    • CHAPTER 22 – Dividend Policy 22 - 28Dividend PaymentsDividend PaymentsFurther Stock Split ExamplesFurther Stock Split ExamplesA 4 for 3 Stock Split:A 4 for 3 Stock Split:New Share Price = PNew Share Price = P00[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50The firm’s equity accounts:The firm’s equity accounts:Commons shares (133,333 outstanding)Commons shares (133,333 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000A 3 for 4 Reverse Stock Split:A 3 for 4 Reverse Stock Split:New Share Price = PNew Share Price = P00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00The firm’s equity accounts:The firm’s equity accounts:Commons shares (75,000 outstanding)Commons shares (75,000 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000Clearly the Board can use stock splits and reverse stock splits to place the firm’s stockClearly the Board can use stock splits and reverse stock splits to place the firm’s stockin a particular trading range.in a particular trading range.
    • CHAPTER 22 – Dividend Policy 22 - 29Dividend PaymentsDividend PaymentsStock Split EffectsStock Split Effects• shareholders wealth should remain unaffected:shareholders wealth should remain unaffected:Original Holdings: (100 shares @ $150/share) = $15,000Original Holdings: (100 shares @ $150/share) = $15,000After a 4 for 1 split: (400 shares @ $37.50/share) =After a 4 for 1 split: (400 shares @ $37.50/share) =$15,000$15,000• the above will hold true if there is no psychologicalthe above will hold true if there is no psychologicalappeal to the stock split.appeal to the stock split.• There is some evidence that the share price ofThere is some evidence that the share price ofcompanies which split stock is more bouyantcompanies which split stock is more bouyantbecause of a positive signal being transferred to thebecause of a positive signal being transferred to themarket by this action.market by this action.
    • CHAPTER 22 – Dividend Policy 22 - 30-- lowers stock price slightlylowers stock price slightly -- large drop in stock pricelarge drop in stock price-- little psychological appeallittle psychological appeal -- much stronger potentialmuch stronger potentialsignalling effectsignalling effect-- recapitalization of earningsrecapitalization of earnings -- no recapitalizationno recapitalization-- no change in proportionalno change in proportional -- samesameownershipownership-- odd lots createdodd lots created -- odd lots rareodd lots rare-- theoretically, no value totheoretically, no value to -- samesamethe investorthe investorStock Dividends versus Stock SplitsStock Dividends versus Stock SplitsStock Dividends Stock Splits
    • CHAPTER 22 – Dividend Policy 22 - 31Cash Dividend PaymentsCash Dividend PaymentsThe Macro PerspectiveThe Macro Perspective• Figure 22 -1 illustrates:Figure 22 -1 illustrates:– Aggregate after-tax profits run at approximately 6% of GDP butAggregate after-tax profits run at approximately 6% of GDP butare highly variableare highly variable– Aggregate dividends are relatively stable when compared toAggregate dividends are relatively stable when compared toafter-tax profits.after-tax profits.• They are sustained in the face of drops in profit during recessionsThey are sustained in the face of drops in profit during recessions• They are held reasonably constant in the face of peaks in aggregateThey are held reasonably constant in the face of peaks in aggregateprofits.profits.(See Figure 22 - 1 on the following slide)(See Figure 22 - 1 on the following slide)
    • CHAPTER 22 – Dividend Policy 22 - 32Cash Dividend PaymentsCash Dividend PaymentsAggregate Dividends and ProfitsAggregate Dividends and ProfitsFIGURE 22-2
    • CHAPTER 22 – Dividend Policy 22 - 33Cash Dividend PaymentsCash Dividend PaymentsThe Macro PerspectiveThe Macro Perspective• Figure 22 -2 illustrates:Figure 22 -2 illustrates:– Aggregate Dividend payouts further illustrates theAggregate Dividend payouts further illustrates theeffects of relatively stable dividend payouts in the faceeffects of relatively stable dividend payouts in the faceof profit volatility:of profit volatility:• The normal aggregate dividend payout rate is about 40% ofThe normal aggregate dividend payout rate is about 40% ofafter-tax profitafter-tax profit• When profits drop and dividends are held constant, payoutWhen profits drop and dividends are held constant, payoutrates rise to 100%rates rise to 100%(See Figure 22 - 2 on the following slide)(See Figure 22 - 2 on the following slide)
    • CHAPTER 22 – Dividend Policy 22 - 34Cash Dividend PaymentsCash Dividend PaymentsAggregate Dividend PayoutsAggregate Dividend PayoutsFIGURE 22-3
    • CHAPTER 22 – Dividend Policy 22 - 35Cash Dividend PaymentsCash Dividend PaymentsThe Macro Perspective - QuestionThe Macro Perspective - Question• Why are dividends smoothed and not matchedWhy are dividends smoothed and not matchedto profits?to profits?
    • CHAPTER 22 – Dividend Policy 22 - 36Cash Dividend PaymentsCash Dividend PaymentsThe Micro PerspectiveThe Micro Perspective• Table 22 -1 contains dividend yields forTable 22 -1 contains dividend yields forselected companies.selected companies.– The companies chosen here illustrate the dramaticThe companies chosen here illustrate the dramaticdifferences between companies:differences between companies:• Some pay no dividendsSome pay no dividends• Some pay consistent cash dividends representing substantialSome pay consistent cash dividends representing substantialyields on current shares pricesyields on current shares prices– The highest yields are found in the case of Income Trusts andThe highest yields are found in the case of Income Trusts andlarge stable ‘blue-chip’ financials and utilitieslarge stable ‘blue-chip’ financials and utilities
    • CHAPTER 22 – Dividend Policy 22 - 37Cash Dividend PaymentsCash Dividend PaymentsDividend YieldsDividend Yields1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average% % % % % % % % % %BCE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31Celestica Inc. 0 0 0 0 0 0 0 0 0 0 0.00CIBC 3.67 3.07 2.85 3.37 3.17 2.9 3.48 3.28 3.31 3.57 3.27Cott Corporation 0.23 0.53 0.54 0 0 0 0 0 0 0 0.13Kinross Gold Corporation 0 0 0 0 0 0 0 0 0 0 0.00TransAlta Corporation 6.22 5.16 4.52 5.35 5.59 4.06 4.92 5.73 5.88 4.51 5.19Yellow Pages Income Fund 7.34 7.09 7.22Table 22-1 S&P/TSX 60 Index Dividend Yields
    • Modigliani and Miller’s DividendModigliani and Miller’s DividendIrrelevance TheoremIrrelevance TheoremM&M, Dividends and Firm ValueM&M, Dividends and Firm Value
    • CHAPTER 22 – Dividend Policy 22 - 39Modigliani and Miller’s Dividend IrrelevanceModigliani and Miller’s Dividend IrrelevanceTheoremTheoremThe value of M&M’s Dividend IrrelevanceThe value of M&M’s Dividend Irrelevanceargument is that in the end, it shows whereargument is that in the end, it shows wherevalue can be created with dividend policy andvalue can be created with dividend policy andwhy.why.
    • CHAPTER 22 – Dividend Policy 22 - 40M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm ValueStart with the single-period DDM:Start with the single-period DDM:1110)K(PDPe++=[ 22-1]
    • CHAPTER 22 – Dividend Policy 22 - 41M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value• Multiply by the number of shares outstandingMultiply by the number of shares outstanding((mm) to convert the single stock price model to a) to convert the single stock price model to amodel to value the whole firm:model to value the whole firm:1)( 1100)K(PDmVmPe++==[ 22-2]
    • CHAPTER 22 – Dividend Policy 22 - 42M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremAssumptionsAssumptions• No TaxesNo Taxes• Perfect capital marketsPerfect capital markets– large number of individual buyers and sellerslarge number of individual buyers and sellers– costless informationcostless information– no transaction costsno transaction costs• All firms maximize valueAll firms maximize value• There is no debtThere is no debt
    • CHAPTER 22 – Dividend Policy 22 - 43M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value• Without debt, sources and uses of funds identityWithout debt, sources and uses of funds identity(sources = uses) can be expressed as:(sources = uses) can be expressed as:• Where:Where: XX represents cash flow from operationsrepresents cash flow from operations II represents investmentrepresents investment X – IX – I is free cash flowis free cash flow mDmD11 is dividend to current shareholders at time 1is dividend to current shareholders at time 11111 mDInPX +=+[ 22-3]
    • CHAPTER 22 – Dividend Policy 22 - 44M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value• Solving for dividends paid out (Solving for dividends paid out (mDmD11 ):):1111 InPXmD −+=
    • CHAPTER 22 – Dividend Policy 22 - 45M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value• If a firm pays out dividends that exceeds its free cashIf a firm pays out dividends that exceeds its free cashflow (X –I), then it must issue new common shares to payflow (X –I), then it must issue new common shares to payfor these dividends.for these dividends.• Substituting into Equation 22 – 2 we get:Substituting into Equation 22 – 2 we get:• The value of the firm is the value of the next period’s freeThe value of the firm is the value of the next period’s freecash flow (cash flow (XX11 –I–I11) plus the next period’s equity market) plus the next period’s equity marketvalue…value…)1(])[(X 11110KVPnmIV+=++−=[ 22-4]
    • CHAPTER 22 – Dividend Policy 22 - 46M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value• The firm value is determined as the present value of theThe firm value is determined as the present value of thefree cash flows to the equity holders:free cash flows to the equity holders:• The dividend is equal to the free cash flow each period,The dividend is equal to the free cash flow each period,and dividends are therefore a residual after the firm hasand dividends are therefore a residual after the firm hastaken care of all of its investment requirements – this istaken care of all of its investment requirements – this isthethe Residual Theory of DividendsResidual Theory of Dividends)1(10 ∑= +−=αttttKIXV[ 22-5]Value hasnothingto do withdividends
    • CHAPTER 22 – Dividend Policy 22 - 47M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremResidual Theory of DividendsResidual Theory of DividendsTheThe Residual Theory of DividendsResidual Theory of Dividends suggests thatsuggests thatlogically, each year, management should:logically, each year, management should:– Identify free cash flow generated in the previousIdentify free cash flow generated in the previousperiodperiod– Identify investment projects that have positive NPVsIdentify investment projects that have positive NPVs– Invest in all positive NPV projectsInvest in all positive NPV projects• If free cash flow is insufficient, then raise external capital – inIf free cash flow is insufficient, then raise external capital – inthis case no dividend is paidthis case no dividend is paid• If free cash flow exceeds investment requirements, theIf free cash flow exceeds investment requirements, theresidual amount is distributed in the form of cash dividends.residual amount is distributed in the form of cash dividends.
    • CHAPTER 22 – Dividend Policy 22 - 48M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremResidual Theory of Dividends - ImplicationResidual Theory of Dividends - ImplicationThe implication of theThe implication of the Residual Theory of DividendsResidual Theory of Dividends are:are:Investment decisions are independent of the firm’s dividendInvestment decisions are independent of the firm’s dividendpolicypolicy• No firm would pass on a positive NPV project because of the lackNo firm would pass on a positive NPV project because of the lackof funds, because, by definition the incremental cost of those fundsof funds, because, by definition the incremental cost of those fundsis less than the IRR of the project, so the value of the firm isis less than the IRR of the project, so the value of the firm ismaximized only if the project is undertaken.maximized only if the project is undertaken.• If the firm can’t make good use of free cash flow (ie. It has noIf the firm can’t make good use of free cash flow (ie. It has noprojects with IRRs > cost of capital) then those funds should beprojects with IRRs > cost of capital) then those funds should bedistributed back to shareholders in the form of dividends for themdistributed back to shareholders in the form of dividends for themto invest on their own.to invest on their own.• The firm should operate where Marginal Cost equals MarginalThe firm should operate where Marginal Cost equals MarginalRevenue as seen in Figure 22 – 4 on the following slide:Revenue as seen in Figure 22 – 4 on the following slide:
    • CHAPTER 22 – Dividend Policy 22 - 49M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremInternal Funds, Investment, and DividendsInternal Funds, Investment, and Dividends22 - 4 FIGURE$11,976MillionRate ofReturnWACCInternal Funds AvailableOPTIMAL INVESTMENTIOS$177,607MillionMC=MR
    • CHAPTER 22 – Dividend Policy 22 - 50M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremHomemade DividendsHomemade Dividends• Shareholders can buy or sell shares in anShareholders can buy or sell shares in anunderlying company to create their own cashunderlying company to create their own cashflow pattern.flow pattern.– They don’t need management declare a cashThey don’t need management declare a cashdividend, they can create their own.dividend, they can create their own.Conclusion: under the assumptions of M&M’s model,Conclusion: under the assumptions of M&M’s model,the investor is indifferent to the firm’s dividend policy.the investor is indifferent to the firm’s dividend policy.
    • The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentDividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 52The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M’s Assumptions RelaxedM&M’s Assumptions Relaxed• Risk is a real world factor.Risk is a real world factor.• Firm’s that reinvest free cash flow, put thatFirm’s that reinvest free cash flow, put thatmoney at risk – there is no certainty ofmoney at risk – there is no certainty ofinvestment outcome – those forfeit dividendsinvestment outcome – those forfeit dividendsthat are reinvested…could be lost!that are reinvested…could be lost!• Remember the two-stage DDM?Remember the two-stage DDM?
    • CHAPTER 22 – Dividend Policy 22 - 53The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M’s Assumptions RelaxedM&M’s Assumptions Relaxed• Remember the two-stage DDM?Remember the two-stage DDM?– The first term is the present value of existing opportunitiesThe first term is the present value of existing opportunities(PVEO)(PVEO)– The second term is the present value of growth opportunitiesThe second term is the present value of growth opportunities(PVGO)(PVGO)– These forecast returns face risks of new market entrants toThese forecast returns face risks of new market entrants tocompete for the excess profits forecast in emerging opportunitiescompete for the excess profits forecast in emerging opportunitiesmaking PVGO extremely vulnerable.making PVGO extremely vulnerable.)ROE()K(1Inv 2e1eee KKKBVPSROEP−++×=[ 22-6]
    • CHAPTER 22 – Dividend Policy 22 - 54The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M’s Assumptions RelaxedM&M’s Assumptions Relaxed• Myron Gordon suggests that dividends are more stableMyron Gordon suggests that dividends are more stablethan capital gains and are therefore more highly valuedthan capital gains and are therefore more highly valuedby investors.by investors.• This implies that investors perceive non-dividend payingThis implies that investors perceive non-dividend payingfirms to be riskier and apply a higher discount rate tofirms to be riskier and apply a higher discount rate tovalue them causing the share price to fall.value them causing the share price to fall.• The difference between the M&M and Gordon argumentsThe difference between the M&M and Gordon argumentsare illustrated in Figure 22 - 5 on the following slide:are illustrated in Figure 22 - 5 on the following slide:– M&M argue that dividends and capital gains are perfectM&M argue that dividends and capital gains are perfectsubstitutessubstitutes
    • CHAPTER 22 – Dividend Policy 22 - 55The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand TheoryM&M versus Gordon’s Bird in the Hand Theory01PD22 - 5 FIGUREGordonOPTIMAL INVESTMENTM&M001PPP −
    • CHAPTER 22 – Dividend Policy 22 - 56The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand TheoryM&M versus Gordon’s Bird in the Hand TheoryConclusions:Conclusions:– Firms cannot change underlying operationalFirms cannot change underlying operationalcharacteristics by changing the dividendcharacteristics by changing the dividend– The dividend should reflect the firm’s operationsThe dividend should reflect the firm’s operationsthrough the residual value of dividendsthrough the residual value of dividends
    • Dividend Policy in PracticeDividend Policy in PracticeDividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 58Dividend Policy in PracticeDividend Policy in Practice• Firms smooth their dividendsFirms smooth their dividends– Firms tend to hold dividends constant, even in theFirms tend to hold dividends constant, even in theface of increasing after-tax profitface of increasing after-tax profit– Firms are very reluctant to cut dividendsFirms are very reluctant to cut dividends
    • CHAPTER 22 – Dividend Policy 22 - 59Dividend Policy in PracticeDividend Policy in PracticeLintner’s Work on Dividend AdjustmentLintner’s Work on Dividend Adjustment• John Lintner suggested a partial adjustmentJohn Lintner suggested a partial adjustmentmodel to explain the smoothing of dividendmodel to explain the smoothing of dividendbehaviour illustrating that firms slowly changebehaviour illustrating that firms slowly changedividends as they move toward a new targetdividends as they move toward a new targetlevel:level:1 )-Dβ(DΔD t-*tt =[ 22-7]
    • CHAPTER 22 – Dividend Policy 22 - 60Dividend Policy in PracticeDividend Policy in PracticeLintner’s Work on Dividend AdjustmentLintner’s Work on Dividend Adjustment• The target dividendThe target dividend DDtt**Lintner suggested is a function ofLintner suggested is a function ofthe firm’s optimal payout rate of the firm’s underlyingthe firm’s optimal payout rate of the firm’s underlyingearnings (earnings (EEtt) leading to the following equation:) leading to the following equation:• The coefficient on lagged dividends was estimated atThe coefficient on lagged dividends was estimated at0.70 indicating an adjustment speed (0.70 indicating an adjustment speed (bb) coefficent of) coefficent of0.30.0.30.• The coefficient on current earnings (The coefficient on current earnings (cc) was estimated at) was estimated at0.150.15)1( 11 cEDbaD t-t +−+=[ 22-8]
    • CHAPTER 22 – Dividend Policy 22 - 61Dividend Policy in PracticeDividend Policy in PracticeLintner’s Work on Dividend AdjustmentLintner’s Work on Dividend AdjustmentImplicationsImplications– The speed of dividend adjustment is only about 30The speed of dividend adjustment is only about 30percentpercent– Firms are very reluctant to fully adjustFirms are very reluctant to fully adjust– Firms do not follow a policy of paying a constantFirms do not follow a policy of paying a constantproportion of earnings out as dividendsproportion of earnings out as dividendsDividend policy in practice does not follow M&M’sDividend policy in practice does not follow M&M’sirrelevance arguments because the real world doesirrelevance arguments because the real world doesnot match the assumptions used.not match the assumptions used.
    • CHAPTER 22 – Dividend Policy 22 - 62Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsWelcome to the Real World!Welcome to the Real World!Transactions CostsTransactions Costs– Underwriting costs are very high, providing a strongUnderwriting costs are very high, providing a strongincentive for firms to finance growth out of free cashincentive for firms to finance growth out of free cashflowflow– Facing these high underwriting costs firms:Facing these high underwriting costs firms:• With high growth rates have little incentive to pay dividendsWith high growth rates have little incentive to pay dividends• With volatile earnings conserve cash from year to year toWith volatile earnings conserve cash from year to year tofinance projects and therefore pay very conservativefinance projects and therefore pay very conservativedividendsdividends
    • CHAPTER 22 – Dividend Policy 22 - 63Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsWelcome to the Real World!Welcome to the Real World!Dividends and SignallingDividends and Signalling– Under conditions of information asymmetry, shareholders andUnder conditions of information asymmetry, shareholders andthe investing public watch for management signals (actions)the investing public watch for management signals (actions)about what management knows.about what management knows.– Management is therefore very cautious about dividendManagement is therefore very cautious about dividendchanges…they don’t want to create high expectations (this is thechanges…they don’t want to create high expectations (this is thereason for extra or special dividends) that will lead toreason for extra or special dividends) that will lead todisappointment, and they don’t want to have investors over reactdisappointment, and they don’t want to have investors over reactto negative earnings surprises (the sticky dividend phenomenon)to negative earnings surprises (the sticky dividend phenomenon)(The Signalling Model is explained in Figure 22 – 6 found on the next slide.)(The Signalling Model is explained in Figure 22 – 6 found on the next slide.)
    • CHAPTER 22 – Dividend Policy 22 - 64Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsThe Signalling ModelThe Signalling Model22 - 6 FIGUREet$1 2 3 Timeet*dt*dt
    • CHAPTER 22 – Dividend Policy 22 - 65Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsWelcome to the Real World!Welcome to the Real World!Agency TheoryAgency Theory– Investors are wary of senior management so they seek to putInvestors are wary of senior management so they seek to putcontrols in place.controls in place.– There is a fear that managers may waste corporate resources byThere is a fear that managers may waste corporate resources byover-investing in low or poor NPV projects.over-investing in low or poor NPV projects.– Gordon Donaldson argued this is the reason for the peckingGordon Donaldson argued this is the reason for the peckingorder managements tend to use when raising capitalorder managements tend to use when raising capital• Shareholders would prefer to receive a dividend and then haveShareholders would prefer to receive a dividend and then havemanagement file a prospectus, justifying investment in projects andmanagement file a prospectus, justifying investment in projects andthe need to raise the capital that was just distributed as a dividend.the need to raise the capital that was just distributed as a dividend.• Shareholders are prepared to pay those additional underwritingShareholders are prepared to pay those additional underwritingcosts as an agency cost incurred to monitor and assesscosts as an agency cost incurred to monitor and assessmanagement.management.
    • CHAPTER 22 – Dividend Policy 22 - 66Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsWelcome to the Real World!Welcome to the Real World!Taxes and the Clientele EffectTaxes and the Clientele Effect– Table 22 -3 (on the following slide) illustrates that differentTable 22 -3 (on the following slide) illustrates that differentclasses of investors face different tax bracketsclasses of investors face different tax brackets– Preference for dividends versus capital gains income dependsPreference for dividends versus capital gains income dependson the province of residence and taxable income level leading toon the province of residence and taxable income level leading totax clienteles.tax clienteles.• High income earners tend to prefer capital gains (there is anHigh income earners tend to prefer capital gains (there is anadditional tax incentive for such individuals in that they can chooseadditional tax incentive for such individuals in that they can choosethe timing of the sale of their investment…remember only ‘realized’the timing of the sale of their investment…remember only ‘realized’capital gains are subject to taxcapital gains are subject to tax• Low income earners tend to prefer dividendsLow income earners tend to prefer dividendsConclusion – firm’s should not change dividend policy drasticallyConclusion – firm’s should not change dividend policy drasticallysince it upsets the existing ownership base.since it upsets the existing ownership base.
    • CHAPTER 22 – Dividend Policy 22 - 67Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsTaxesTaxesIncome Level $25,000 $50,000 $75,000 $100,000British Columbia Dividends 2.52 6.19 15.69 20.04Capital gains 12.45 15.58 18.85 20.35Alberta Dividends 3.63 8.03 13.83 13.83Capital gains 12.63 16.00 18.00 18.00Ontario Dividends 0.00 8.24 20.74 20.74Capital gains 10.65 15.58 21.71 21.71Quebec Dividends 5.95 15.42 26.06 26.06Capital gains 14.37 19.19 22.86 22.86Nova Scotia Dividends 0.00 8.75 17.05 19.06Capital gains 12.02 18.48 21.34 22.63Table 22-3 Individual Tax Rates (%) on Dividends and Capital Gains
    • CHAPTER 22 – Dividend Policy 22 - 68Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsRepackaging Dividend-Paying SecuritiesRepackaging Dividend-Paying Securities• Tax clienteles help to explain the financialTax clienteles help to explain the financialengineering whereby different parts of theengineering whereby different parts of thereturn by the firm are stripped, repackaged andreturn by the firm are stripped, repackaged andsold to different investors as illustrated insold to different investors as illustrated inFigure 22 – 7. (See the following slide)Figure 22 – 7. (See the following slide)• Split shares are shares sold as the dividendsSplit shares are shares sold as the dividendsand capital gains parts.and capital gains parts.
    • CHAPTER 22 – Dividend Policy 22 - 69Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsMYW’s B Corporation SharesMYW’s B Corporation Shares)1()1(61600 ∑= +++=tttkPkdPMYW)1()1,30min($)1(Pref6166∑= +−++=t ttkPkd22 - 7 FIGURE$143 million$330 million$454 million)1()1,30min($IR 666kPP+−−=
    • CHAPTER 22 – Dividend Policy 22 - 70Share RepurchasesShare Repurchases• Simply another form of payout policy.Simply another form of payout policy.• An alternative to cash dividend where theAn alternative to cash dividend where theobjective is to increase the price per shareobjective is to increase the price per sharerather than paying a dividend.rather than paying a dividend.• Since there are rules against improperSince there are rules against improperaccumulation of funds, firms adopt a policy ofaccumulation of funds, firms adopt a policy oflarge infrequent share repurchase programs.large infrequent share repurchase programs.
    • Share RepurchasesShare RepurchasesDividend PolicyDividend Policy
    • CHAPTER 22 – Dividend Policy 22 - 72• allowed under the OBCA and CBCAallowed under the OBCA and CBCA• reasons for use:reasons for use:– Offsetting the exercise of executive stock optionsOffsetting the exercise of executive stock options– Leveraged recapitalizationsLeveraged recapitalizations– Information or signalling effectsInformation or signalling effects– Repurchase dissident sharesRepurchase dissident shares– Removing cash without generating expectations for futureRemoving cash without generating expectations for futuredistributionsdistributions– Take the firm private.Take the firm private.Share RepurchasesShare Repurchases
    • CHAPTER 22 – Dividend Policy 22 - 73• they are usually done on an irregular basis, so a shareholderthey are usually done on an irregular basis, so a shareholdercannot depend on income from this source.cannot depend on income from this source.• if regular repurchases are made, there is a good chance thatif regular repurchases are made, there is a good chance thatRevenue Canada will rule that the repurchases were simply aRevenue Canada will rule that the repurchases were simply atax avoidance scheme (to avoid tax on dividends) and willtax avoidance scheme (to avoid tax on dividends) and willassess taxassess tax• there may be some agency problems - if managers havethere may be some agency problems - if managers haveinside information, they are purchasing from shareholders atinside information, they are purchasing from shareholders ata price less than the intrinsic value of the shares.a price less than the intrinsic value of the shares.Disadvantages of Share RepurchasesDisadvantages of Share Repurchases
    • CHAPTER 22 – Dividend Policy 22 - 74• tender offer:tender offer:– this is a formal offer to purchase a given number of shares at athis is a formal offer to purchase a given number of shares at agiven price over current market price.given price over current market price.• open market purchase:open market purchase:– the purchase of shares through an investment dealer like anythe purchase of shares through an investment dealer like anyother investorother investor– this is not designed for large block purchases.this is not designed for large block purchases.• private negotiation with major shareholdersprivate negotiation with major shareholdersIn any repurchase program, the securities commissionIn any repurchase program, the securities commissionrequires disclosure of the event as well as all otherrequires disclosure of the event as well as all othermaterial information through a prospectus.material information through a prospectus.Methods of Share RepurchasesMethods of Share Repurchases
    • CHAPTER 22 – Dividend Policy 22 - 75• called treasury stock (U.S.)called treasury stock (U.S.)• non-voting (U.S.)non-voting (U.S.)• may not receive dividends (U.S.)may not receive dividends (U.S.)• if not retired, can be resold (U.S.)if not retired, can be resold (U.S.)• unlike the U.S., repurchases in Canada do notunlike the U.S., repurchases in Canada do notinvolve shares that can be placed into treasuryinvolve shares that can be placed into treasurystock - they are canceledstock - they are canceledRepurchased SharesRepurchased Shares
    • CHAPTER 22 – Dividend Policy 22 - 76Current EPSCurrent EPS= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00Current P/E ratioCurrent P/E ratio= $20 / $4 = 5X= $20 / $4 = 5XEPS after repurchase of 100,000 sharesEPS after repurchase of 100,000 shares== $4.4 m / 1.0 = $4.40$4.4 m / 1.0 = $4.40Expected market price after repurchase:Expected market price after repurchase:= [p/e][EPS= [p/e][EPSnewnew] = [5][$4.40] = $22.00 per share] = [5][$4.40] = $22.00 per shareRepurchase ExampleRepurchase Example
    • CHAPTER 22 – Dividend Policy 22 - 77• EPS should increase following the repurchase ifEPS should increase following the repurchase ifearnings after-tax remains the sameearnings after-tax remains the same• a higher market price per outstanding share ofa higher market price per outstanding share ofcommon stock should resultcommon stock should result• stockholders not selling their shares back tostockholders not selling their shares back tothe firm will enjoy a capital gain if thethe firm will enjoy a capital gain if therepurchase increases the stock price.repurchase increases the stock price.Effects of A Share RepurchaseEffects of A Share Repurchase
    • CHAPTER 22 – Dividend Policy 22 - 78• signal positive information about the firm’s future cashsignal positive information about the firm’s future cashflowsflows• used to effect a large-scale change in the firm’s capitalused to effect a large-scale change in the firm’s capitalstructurestructure• increase investor’s return without creating anincrease investor’s return without creating anexpectation of higher future cash dividendsexpectation of higher future cash dividends• reduce future cash dividend requirements or increasereduce future cash dividend requirements or increasecash dividends per share on the remaining shares,cash dividends per share on the remaining shares,without creating a continuing incremental cash drainwithout creating a continuing incremental cash drain• capital gains treated more favourably than cashcapital gains treated more favourably than cashdividends for tax purposes.dividends for tax purposes.Advantages of Share RepurchasesAdvantages of Share Repurchases
    • CHAPTER 22 – Dividend Policy 22 - 79• signal negative information about the firm’ssignal negative information about the firm’sfuture growth and investment opportunitiesfuture growth and investment opportunities• the provincial securities commission may raisethe provincial securities commission may raisequestions about the intentionquestions about the intention• share repurchase may not qualify the investorshare repurchase may not qualify the investorfor a capital gainfor a capital gainDisadvantages of Share RepurchasesDisadvantages of Share Repurchases
    • Borrowing to Pay DividendsBorrowing to Pay DividendsSignallingSignalling
    • CHAPTER 22 – Dividend Policy 22 - 81• Is this legal? is it possible to do?Is this legal? is it possible to do?• YesYes– the firm must have the ability and capacity to borrowthe firm must have the ability and capacity to borrow– the firm must have sufficient retained earnings to allow itthe firm must have sufficient retained earnings to allow itto pay the dividendto pay the dividend– the firm must have sufficient cash on hand to pay thethe firm must have sufficient cash on hand to pay thecash dividendcash dividend– the firm must NOT have agreed to any limitations on thethe firm must NOT have agreed to any limitations on thepayment of dividends under the bond indenture.payment of dividends under the bond indenture.• Why?Why?– A possible answer is to signal to the market that theA possible answer is to signal to the market that theboard is confident about the firm’s ability to sustain cashboard is confident about the firm’s ability to sustain cashdividends into the future.dividends into the future.Borrowing to Pay DividendsBorrowing to Pay Dividends
    • CHAPTER 22 – Dividend Policy 22 - 82Assets: Liabilities:Cash 10 Long-term Debt 0Fixed Assets 140 Common Stock 50Retained Earnings 100Total Assets $150 Total Claims $150After Borrowing…before cash dividend:Assets: Liabilities:Cash 60 Long-term Debt 50Fixed Assets 140 Common Stock 50Retained Earnings 100Total Assets $200 Total Claims $200Before Borrowing:0% Debt25% DebtBorrowing to Pay DividendsBorrowing to Pay DividendsAn ExampleAn Example
    • CHAPTER 22 – Dividend Policy 22 - 83Assets: Liabilities:Cash 60 Current liabilities 50Fixed Assets 140 Long-term Debt 50Common Shares 50Retained earnings 50Total Assets $200 Total Claims $200After Cash Dividend payment of $50Assets: Liabilities:Cash 10 Long-term Debt 50Fixed Assets 140 Common Stock 50Retained earnings 50Total Assets $150 Total Claims $150After Dividend Declaration…before date of payment.50% Debt33% DebtBorrowing to Pay DividendsBorrowing to Pay DividendsAn Example …An Example …
    • CHAPTER 22 – Dividend Policy 22 - 84• The foregoing example illustrates:The foregoing example illustrates:– it is possible for a firm with ‘borrowing capacity’ to borrow funds toit is possible for a firm with ‘borrowing capacity’ to borrow funds topay cash dividends.pay cash dividends.– this is not possible if the lenders insist on restrictive covenants thatthis is not possible if the lenders insist on restrictive covenants thatlimit or prevent this from occurring.limit or prevent this from occurring.– the cash for the dividend must be present in the cash account.the cash for the dividend must be present in the cash account.– payment of dividends reduces both the cash account on the assetpayment of dividends reduces both the cash account on the assetside of the balance sheet as well as the retained earnings accountside of the balance sheet as well as the retained earnings accounton the ‘claims’ side of the balance sheet.on the ‘claims’ side of the balance sheet.– in the absence of restrictions, it is possible to transfer wealth fromin the absence of restrictions, it is possible to transfer wealth fromthe bondholders to the stockholders.the bondholders to the stockholders. (Bondholders in this example(Bondholders in this examplemay have thought their firm would have only a 25% debt ratio….after themay have thought their firm would have only a 25% debt ratio….after thedividend the debt ratio rose to 33% and the equity cusion dropped fromdividend the debt ratio rose to 33% and the equity cusion dropped from75% to 66%.)75% to 66%.)Borrowing to Pay DividendsBorrowing to Pay DividendsAn ExampleAn Example
    • CHAPTER 22 – Dividend Policy 22 - 85Summary and ConclusionsSummary and ConclusionsIn this chapter you have learned:In this chapter you have learned:– About the different types of dividends including, regular andAbout the different types of dividends including, regular andspecial cash dividends, stock dividends, stock splits as well asspecial cash dividends, stock dividends, stock splits as well asshare repurchases.share repurchases.– M&M’s dividend irrelevance argument and the real world factorsM&M’s dividend irrelevance argument and the real world factorssuch as transactions costs, taxes, clientele effects andsuch as transactions costs, taxes, clientele effects andsignalling tend to favour real-world dividend relevancesignalling tend to favour real-world dividend relevance– Tax motives and other reasons explain why firms might want toTax motives and other reasons explain why firms might want torepurchase their shares.repurchase their shares.