22 21 1 Explain what a cash dividend payment is how dividend payments are made and why dividend payments are different from interest payments 21 2 Describe typical dividend payouts and explain the importance of dividends ID: 536976
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Dividend Policy
22
21
.1
Explain what a cash dividend payment is, how dividend payments are made, and why dividend payments are different from interest payments.
21
.2
Describe typical dividend payouts and explain the importance of dividends.
21
.3
Explain how Modigliani and Miller proved that dividend payments are irrelevant, due to the existence of homemade dividends, and therefore have no impact on market value.
21
.4
Explain why dividend payments generally reflect the business risk of the firm and explain what the “bird in the hand” argument is.
21.5
Explain why firms are reluctant to cut their dividends and why they smooth their dividends.
21.6
Explain why dividends are not a residual, as implied by M&M.
21.7
Describe what a share repurchase program is and explain how it can substitute for dividend payments.Slide3
22.1
DIVIDEND PAYMENTSDividend policy is the explicit or implicit decision of the Board of Directors on the amount of residual earnings that should be distributed to shareholders
Dividend policy is considered to be a financing decision because the profits of the corporation are an important source of financing available to the firm
Dividends are a permanent distribution of residual earnings of the corporation to its owners and can be in the form of: cash, shares of stock, or property
If a firm is dissolved, a final dividend of any residual amount made to shareholders at the end of the process is called a liquidating dividend
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Corporate after-tax earnings accrue to the benefit of shareholders and can either be retained for reinvestment in the firm, or paid to shareholders
When a cash dividend is declared, those funds leave the firm permanently and irreversiblyThe proportion of earnings to be paid as a dividend is an important financing decision because the payment of dividends may starve the company of funds required for growth and expansion causing the firm to seek additional external capital
Firms sometimes issue special dividends which are paid in addition to the regular dividend
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DIVIDEND PAYMENTSSlide5
Interest is a payment to lenders for the use of their funds for a specified period of time
Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcyFirms are legally obligated to make interest payments on schedule, and the failure to pay interest and fulfill other contractual commitments under the bond indenture or loan contract is an act of bankruptcy for which the lender can take the borrower to court
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DIVIDEND PAYMENTSSlide6
Dividends are discretionary payments, made to shareholders, who are residual claimants of the firm
There is no legal obligation for firms to pay dividends to common shareholders.Furthermore, by law, board members cannot pay dividends out of capital, when it could cause insolvency, or if it causes a breach of debt covenantsUnlike interest, the decision to distribute dividends is taken solely at the discretion of the board of directors
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DIVIDEND PAYMENTSSlide7
Example:
May 1 – Declaration dateMay 13 – Ex-dividend dateMay 15 – Record date
May 31 – Dividend payment date
On the
declaration date (May 1), the board of directors decides it will pay a dividend on May 31.The dividend announcement will specify that
holders of record on the date of record (May 15) will be entitled to receive the declared dividend on the payment date (May 31)
On most exchanges common share transactions are settled three business days after the trade, so the
ex-dividend date
(the date after which the shares trade without the right to receive the declared dividend) will be two days prior to the record date (e.g., May 13, if May 15 is the record date)
A shareholder who sells on May 14 will therefore receive the dividend
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DIVIDEND PAYMENTSSlide8
Dividend Reinvestment Plans (DRIPs)
DRIPs allow shareholders to use the cash dividend proceeds to buy more shares of the firm, effectively reinvesting their dividends in the firmThis allows shareholders to buy as many shares as the cash dividend allows and the residual amount will be deposited as cash
Firms are therefore able to raise additional common stock capital each time a dividend is paid at no cost
Stock Dividends
Stock dividends result when firms distribute additional shares to existing shareholders instead of cashStock dividends represent nothing more than the recapitalization of the company’s earnings, since the amount of the stock dividend is transferred from the retained earnings account to the common share account
Because of the capital impairment rule, stock dividends reduce the firm’s ability to pay dividends in the future
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DIVIDEND PAYMENTSSlide9
Stock Dividend Example
Example: ABC declares a 10% stock dividend, has 215,000 shares outstanding, and its shares are currently $40 each.Since there are 215,000 shares outstanding, a 10% stock dividend requires 21,500 new shares be issued. At $40 each, this has a value of $860,000 which will be transferred from the retained earnings account to the common stock account.
New share price = Old price / 1.1 = $40 / 1.1 = $36.36
But
, a new shareholder will have 10% more shares so her wealth will remain
unchanged.
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Common stock
$5,000,000
Retained earnings
$20,000,000
Net worth
$25,000,000
Common stock
$5,860,000
Retained earnings
$19,140,000
Net worth
$25,000,000
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DIVIDEND PAYMENTSSlide10
Although there is no theoretical explanation, some believe that an optimal price range exists for a company’s common shares because there is greater demand for shares that are traded in the $40 to $80 range
Stock splits decrease the per unit share price to keep a share trading in the preferred price range, which has psychological appealThe result of a stock split is both an increase in the number of shares outstanding but no net change in shareholder wealth
There is some evidence that the share price of companies that use stock splits to keep the price their shares in a preferred range is more buoyant because of a positive signal being transferred to the market by the act of initiating the stock split
Reverse splits allow a company whose shares have fallen in price below the preferred range to restore its shares to the preferred range
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DIVIDEND PAYMENTSSlide11
Stock Split Example
Example: XYZ has 100,000 shares
outstanding which are trading for $150 each.
A 2 for 1 stock split will double the number of shares outstanding to 200,000 and halve the share price to $75
A 4 for 3 stock split will increase the number of shares outstanding to 133,333 and drop the share price to ¾ of $150, or $112.50
A 3 for 4 reverse stock split will decrease the number of shares outstanding to 75,000 and increase the share price to 4/3 of $150 or $200
The equity accounts will not be changed by any of the above split or reverse split examples
A firm can therefore use splits and reverse splits to place the firm’s stock in a particular trading range
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Common stock
$1,500,000
Retained earnings
$15,000,000
Net worth
$16,500,000
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DIVIDEND PAYMENTSSlide12
22.2
CASH DIVIDEND PAYMENTSFigure 22-3 indicates that:
Aggregate after-tax profits run at approximately 6% of GDP but are highly variable from year to year
Aggregate dividends are relatively more stable from year to year, with firms sustaining them when profits fall and holding them relatively constant when profits surge
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Figure 22-4 indicates that the normal aggregate dividend payout rate is about 40% of after-tax profit, with payouts rising when profits drop and payouts are unreduced
Why are dividends smoothed over time instead of varying with profits?Booth • Cleary – 3rd Edition
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CASH DIVIDEND PAYMENTSSlide14
Table 22-1 (see the following slides) shows
dividend yields for selected companiesWhy is there such a substantial difference in dividend yields across major Canadian companies?Generally, income trusts and large, stable financial and utility common shares pay the highest dividend yields, while smaller companies pay no dividends at all
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22.2
CASH DIVIDEND PAYMENTSSlide15
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22.2
CASH DIVIDEND PAYMENTSSlide16
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CASH DIVIDEND PAYMENTSSlide17
22.3
MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCE THEOREMThe Dividend Irrelevance Theorem proposed by Modigliani and Miller (M&M) shows how dividend policy can create value
Firms should pay out the residual cash if free cash flow exceeds investment requirements, otherwise no dividend should be paid; this is called the residual theory of dividends
The important assumptions of the theory are:
No taxesCapital markets are perfect in that there are a large number of individual buyers and sellers, information is costless and there are no transaction costs
All firms act to maximize valueThere is no debt (so the sources of funds equals the uses of funds)
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M&M, Dividends, and Firm Value
Start with the single-period DDM, as in Equation 22-1:
Multiply by the number of shares outstanding (m) to obtain the value of the whole firm (V
0
) assuming no debt, as in Equation 22-2:
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MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCE THEOREMSlide19
Without debt, sources and uses of funds are equal, as in Equation 22-3:
where:
X = cash flow from operations
I = investment
X – I = free cash flow
mD
= total dollar amount of dividend
And:
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MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCE THEOREMSlide20
If a firm pays out dividends that exceed its free cash flow (X – I), then it must issue new common shares to pay for these dividends.
Substituting into Equation 22-2, we obtain equations 22-4 and 22-5:
The value of the firm is the value of the next period’s free cash flow (X
1
– I 1) plus the next period’s equity market value (
V1)
The dividend is the free cash flow each period, which is a residual amount after the firm has taken care of all of its positive NPV investment opportunities
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MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCE THEOREMSlide21
The
residual theory of dividends suggests that management should:Identify free cash flow generated last year
Identify and invest in all positive NPV projects
If free cash flow is insufficient to fund all positive NPV opportunities, the firm should raise external capital after exhausting its retained earnings (no dividend paid)
If free cash flow exceeds the requirement to fund all positive NPV opportunities, then the residual amount should be distributed in the form of a cash dividend
Investment decisions are therefore independent of the firm’s dividend policy. No firm would pass on a positive NPV project due to a lack of funds because the cost of those funds is less than the IRR of the project. The value of the firm will be maximized only if the project is undertaken.
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22.3
MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCE THEOREMSlide22
As in Figure
22-5, Tim Horton’s has 2011 cash flow from operations of $391 million and investment of $152.7 millionFree cash flow is X – I = $238.3 millionMarginal cost = marginal revenue where the WACC intersects with the IOS (at $152.7 million)
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MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCE THEOREMSlide23
M&M’s Homemade Dividend Argument
M&M’s dividend irrelevance argument is often illustrated using the concept of
homemade dividends
, where shareholders can create or eliminate dividends by their own behaviour and so are indifferent to a firm’s dividend policy
We must assume no taxes, transaction costs, or other market imperfectionsIf these assumptions do not hold, the irrelevance argument may not be
valid
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MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCE THEOREMSlide24
22.4
THE “BIRD IN THE HAND” ARGUMENTThe “bird in the hand
” argument relaxes M&M’s assumptions
Firms that reinvest free cash flow put that money at risk because there is no certainty of the reinvestment’s outcome; the forfeited dividends could pay off, or they could be lost
The PVGO in Equation 22-6 may not materialize.Therefore, a cash dividend could be worth more than an equivalent capital
gain
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Myron Gordon suggested that dividends are more stable than capital gains and are therefore more highly valued by investors; therefore, investors perceive non-dividend paying firms to be riskier and apply higher discount rates to them causing them to have lower share prices
Contrast Gordon’s argument with M&M’s assertion that dividends and capital gains are perfect substitutes; Figure 22-6
shows a difference in optimal
investment
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THE “BIRD IN THE HAND” ARGUMENTSlide26
22.5
DIVIDEND POLICY IN PRACTICEFirms smooth their dividends so that dividend payments are often less volatile than actual earnings
Some firms hold their dividends constant, even in the face of increasing after-tax profit, or raise them very slowly to avoid having to cut dividends
John
Lintner suggested a partial adjustment model (equations 22-7 and 22-8) to explain the smoothing of dividend behaviour by illustrating that firms slowly change their dividends to a new target level
The target dividend Dt
* relates to the optimal payout rate
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Lintner’s
ResultsThe coefficient on lagged dividends was estimated at 0.70, indicating an adjustment speed coefficient (b) of 0.30; therefore, the speed of adjustment is about 30%The coefficient on current earnings (c) was estimated at 0.15
Conclusions:
Firms are very reluctant to fully adjust quickly
Firms do not follow a policy of paying a constant proportion of earnings out as dividendsTherefore, dividend policy in practice does not follow M&M’s irrelevance argument because M&M’s assumptions do not hold in the real
world
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DIVIDEND POLICY IN PRACTICESlide28
22.6
RELAXING THE M&M ASSUMPTIONS:Welcome to the Real World!
Transaction Costs
Transaction costs are high in the real world; specifically, underwriting costs are very high and provide a strong incentive for firms to finance growth out of free cash flow
Therefore, firms with high growth rates have little incentive to pay dividends and if earnings are volatile over
time, cash will be conserved from year to year to maintain project
financing
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Dividends and Signalling
If information asymmetries (a market imperfection) exist, shareholders and the public don’t know as much about the firm as management does; so, they watch management’s actions for signals about the true condition of the firmUnder such scrutiny, management has an incentive to be cautious about dividend changes to avoid creating impossibly high expectations or future disappointment; special dividends, which avoid an increase in the regular dividend, are an example of
this
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22.6
RELAXING THE M&M ASSUMPTIONS:
Welcome to the Real World!Slide30
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22.6
RELAXING THE M&M ASSUMPTIONS:
Welcome to the Real World!
Figure 22-7
The
Signalling ModelSlide31
Taxes
Different investors face different tax brackets and some have a preference for dividend income over capital gains incomeHigh
income investors tend to prefer capital gains while low income investors tend to prefer dividends
Firms that make rapid, major changes to their dividend policies may therefore upset major shareholder constituencies who are expecting the firm’s existing policies to persist and have invested in the firm because of those
policies
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RELAXING THE M&M ASSUMPTIONS:
Welcome to the Real World!Slide32
Repackaging
Dividend-Paying SecuritiesIncome stripping
is the process of repackaging securities to provide different types of income based on different parts of the return, and is usually motivated by the preferences of different tax clienteles
Figure
22-8 shows how MYW converted BCE common shares into special preferred shares (paying dividends) and installment receipts (
IR)
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22.6
RELAXING THE M&M ASSUMPTIONS:
Welcome to the Real World!Slide33
22.7
SHARE REPURCHASESShare repurchases are another form of payout policy and an alternative to cash dividends where the objective is to increase the price per share rather than paying a cash distribution to shareholders
Since there are rules against the improper accumulation of funds, firms adopt a policy of large, infrequent share repurchase programs, which are allowed under the OCBA and CBCA
Reasons for share repurchases:
Offsetting dilution caused by exercised executive stock optionsLeveraged recapitalizations
Information, or signaling effectsRepurchasing shares from dissident shareholdersRemoving cash from the balance sheet without generating expectations for future cash distributions
Taking the firm private
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Advantages of Share Repurchases
:Signal positive information about the firm’s future cash flowsCan be used to implement a large-scale capital structure changes
Increase investors’ returns without creating an expectation of higher, future cash flows
Reduce future cash dividend requirements or increase cash dividends per share on the remaining shares without creating a continuing incremental cash drain
Benefit shareholders because capital gains are taxed more favourably than dividends
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SHARE REPURCHASESSlide35
Disadvantages of Share Repurchases
:Can signal negative information about the firm’s future growth and investment opportunities (i.e., if the firm had good opportunities, it should invest in them instead of using the cash to repurchase shares)Shareholders cannot depend on income from share repurchases because they are usually done on an irregular basis
If regular repurchases are made, Canada Revenue Agency may rule that the repurchases were a tax-avoidance scheme (to avoid tax on dividends) and may assess tax
There may be some agency problems, particularly if managers have inside information that suggests the intrinsic value of the shares actually exceeds the price they are paying shareholders to repurchase the shares of the
company
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SHARE REPURCHASESSlide36
Methods
Tender offers are formal offers to purchase a specified number of shares at a specified premium over the current market priceOpen market purchases are done through an investment dealerIn any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus
Repurchased Shares
In the United States repurchased shares are called treasury stock, are non-voting, may not receive dividends and can be resold if not retired
But, in Canada, repurchased shares are simply cancelled and cannot be classified as treasury
stock
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SHARE REPURCHASESSlide37
Example: Suppose a firm has total earnings of $4.4 million, its current share price is $20, and 1,100,000 shares are outstanding. What impact will repurchasing 100,000 shares have?
Current EPS = earnings/# of shares = $4,400,000/1,100,000
= $4.00
Current P/E ratio = $
20/$4 = 5 timesPost-repurchase EPS = $4,400,000/1,000,000 = $4.40Post-repurchase expected share price = 5 × $4.40 = $22 per share
Effects of a Share RepurchaseA repurchase increases EPS if after-tax earnings are unchanged
A higher price per share should result (assuming the P/E multiple stays the same)Shareholders who do not sell their shares back to the firm will enjoy a capital gain if the repurchase causes a persistent increase in the stock
price
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SHARE REPURCHASESSlide38
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