Copyright 2004 McGraw-Hill AustraliaPty Ltd19-219.1 Cash Dividends and Dividend Payment19.2 Does Dividend Policy Matter?19.3 Real-world Factors Favouring a Low Payout19.4 Real-world Factors Favouring a High Payout19.5 A Resolution of Real-world Factors?19.6 Establishing a Dividend Policy19.7 Share Repurchase: An Alternative to CashDividends19.8 Share Dividends and Share Splits19.9 Employee Share Ownership Plans19.10 Summary and ConclusionsChapter Organisation
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-3Chapter Objectives• Know the different forms of dividends and the appropriatedividend payment terminology.• Outline the arguments supporting the case for dividendirrelevance.• Discuss factors favouring a low or a high payout.• Explain the residual dividend policy.• Illustrate the situation of share repurchases vs paying a cashdividend.• Understand both bonus issues and share splits.• Outline the various employee share ownership plans.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-4Types of Dividends• A dividend is a payment made out of a firm’searnings to its owners (shareholders).• Dividends are usually paid in the form of cash.• Types of cash dividends include:– regular cash dividends– extra dividends– special dividends– liquidating dividends.• Share dividends are also paid, and sharerepurchases are a dividend alternative.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-5Procedure for Dividend PaymentDaysThursday, Wednesday, Friday, Monday,January January January February15 28 30 16Declaration Ex-dividend Record Paymentdate date date date
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-6Procedure for Dividend Payment• Declaration date: the board of directors declares a paymentof dividends.• Ex-dividend date: if you buy the share on or after this datethe seller is entitled to keep the dividend. Under ASX rules,shares are traded ex-dividend on and after the seventhbusiness day before the record date.• Record date: declared dividends are distributable toshareholders of record on a specific date.• Payment date: the dividend cheques are mailed toshareholders of record.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-7The Ex-date Price DropEx datePrice =$10Price =$9-t . . . –2 –1 0 +1 +2 . . . tThe share price will fall by the amount of the dividend on the exdate (Time 0). If the dividend is $1 per share, the price will beequal to $10 – 1 = $9 on the ex date.Before ex date (Time –1) Dividend = $0 Price = $10On ex date (Time 0) Dividend = $1 Price = $9
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-8Do Dividends Matter?• Yes: the value of a share is based on the presentvalue of expected future dividends.• No: the value of a share is not affected by a switchin dividend policy.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-9Does Dividend Policy Matter?Dividend policy versus cash dividendsAn illustration of dividend irrelevance Original dividends0 1 2$1000 $1000If RE = 20%: P0 = $1000/1.2 + $1000/1.22= $1527.78
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-10Does Dividend Policy Matter?0 1 2$1000 $1000+200 –240$1200 $760Assume an additional $200 of dividends is offered,financed by an issue of debt or shares. New dividendplan:P0 = $1200/1.2 + $760/1.22= $1 527.78
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-11Dividend Policy Irrelevance• Any increase in dividends at one point is offset exactly by adecrease somewhere else.• An alternative explanation is home-made dividends.Individual investors can undo corporate dividend policy byreinvesting dividends or selling shares.• Companies may help with creating home-made dividends byoffering shareholders automatic dividend reinvestment plans(DRIPs).
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-12Dividends and the Real WorldA low payout is better if one considers:• Taxes: Optimal dividend policy is determined by variousshareholder situations. Some shareholders prefer highfranked dividends, others prefer the company to pay nodividend and retain the funds for reinvestment (tax ondividend income vs capital gains tax).• Flotation costs: Higher dividend payouts may require a newshare issue, which could be expensive and decrease thevalue of the firm.• Dividend restrictions: Debt contracts might limit thepercentage of income that can be paid out as dividends.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-13Dividends and the Real WorldA high payout is better if one considers:• Desire for current income instead of capital gain.• Uncertainty resolution: ‘bird-in-hand’ story.• Tax benefits: There are some investors who do receivefavourable tax treatment from holding high dividends (e.g.corporate investors).• Legal benefits.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-14Examples of Imputed Tax CreditsShareholders’ levelof taxable income6 001to20 00020 001to50 00050 001to60 00060 000+Marginal tax rate(1 July 2000)17% 30% 42% 47%Corporate taxDividend paid$3070$3070$3070$3070Taxpayer’s additionalassessable income $100 $100 $100 $100Tax on assessable incomeCredit for company tax$1730$3030$4230$4730Net credit (payment) $13 nil ($12) ($17)Tax to be paidon dividends ($13) nil $12 $17
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-15To Date …• Based on the home-made dividend argument, dividend policyis irrelevant.• Because of high taxation of some individual investors, a high-dividend policy may be best.• Because of new issue costs, a low-dividend policy is best.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-16Dividends and Signals• Changes in dividends convey information– Dividend increases:Management believes it can be sustained.Expectation of higher future dividends, increasingpresent value.Signal of a healthy, growing firm.– Dividend decreases:Management believes it can no longer sustain thecurrent level of dividends.Expectation of lower dividends indefinitely; decreasingpresent value.Signal of a firm that is having financial difficulties.– The information content makes it difficult to interpret theeffect of the dividend policy of the firm.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-17Clientele Effect• Shares attract particular groups based on dividendyield and the resulting tax effects.• Some investors prefer low dividend payouts andwill buy shares in those companies that offer lowdividend payouts.• Some investors prefer high dividend payouts andwill buy shares in those companies that offer highdividend payouts.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-18Residual Dividend Policy• Issue costs eliminate any indifference betweenfinancing by internal capital and new shares.• Dividends are paid only if profits are not completelyused for investment purposes.• Desired debt-to-equity ratio is maintained.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-21Key Concepts in Dividend Policy• Dividend stability—dividends are only increased if theincrease is sustainable.• Dividend streaming—shareholders can choose differentdividend schemes to suit their tax position (franked vsunfranked dividends)• Special dividends—‘one-off’’ extra dividends.• Dividend reinvestment schemes—company reinvestsindividuals’ dividends into fully paid shares of the company.Avoids transactions costs and need for prospectus, andshares are usually offered at a discount.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-23Share Repurchases• Company buys back its own shares.• Similar to a cash dividend in that it returns cashfrom the firm to the shareholders.• This is another argument for dividend policyirrelevance in the absence of taxes or otherimperfections.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-24Share Repurchases• Equal access purchaseOffer made by company to all shareholders to purchaseshares in the same proportion as their holdings.• On-market purchasePurchase by a company of its own shares on the openmarket.• Employee share purchaseRepurchase shares from employees that were issued underemployee incentive scheme.• Selective purchaseRepurchase of shares from specific shareholders.• Odd-lot purchaseRepurchase of small parcels of shares.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-25Cash Dividend versus ShareRepurchaseAssume no taxes, commissions or other marketimperfections.Consider a firm with 50 000 shares outstanding, netprofit of $100 000 and the following balance sheet.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-26Cash Dividend versus ShareRepurchase (continued)• Price per share is $20 ($1 000 000/50 000).• EPS = $2.00 ($100 000/50 000).• PE ratio = 10.• The firm is considering either:– Paying a $1 per share cash dividend.OR– Repurchasing 2500 shares at $20 a share.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-27Cash Dividend versus ShareRepurchase (continued)Price per share is $19.00 ($950 000/50 000).EPS = $2.00 ($100 000/50 000).PE ratio = 10.Cash Dividend OptionCash $ 50 000 $ 0 DebtOther Assets 900 000 950 000 EquityTotal $ 950 000 $ 950 000 Total
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-28Cash Dividend versus ShareRepurchase (continued)Price per share is $20.00 ($950 000/47 500).EPS = $2.10 ($100 000/47 500).PE ratio = 9.5.Share Repurchase OptionCash $ 50 000 $ 0 DebtOther Assets 900 000 950 000 EquityTotal $ 950 000 $ 950 000 Total
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-29Share Dividends and Share SplitsBonus shares and share splits:• involve issuing new shares on a pro-rata basis to the currentshareholders• do not change the firm’s assets, earnings, risk assumed andinvestors’ percentage of ownership in the company• increase the number of shares outstanding• reduce the value per shareA common explanation is to adjust the share price to a ‘moredesirable trading range’.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-30Reverse Splits• The firm reduces the number of shares outstanding.• Reasoning:– reduction in transaction costs– increase in share marketability (trading range)– regain respectability.
Copyright 2004 McGraw-Hill AustraliaPty Ltd19-31Share Ownership Plans• Encourage the financial participation of employees in thecompany, including:– fully paid shares– partly paid shares– special classes of shares– options– phantom or shadow shares– employee share trusts.