Unformatted text preview: FINC 202 2009 Lecture 09 Dividend Policy Note: What is not covered will be rolled over into Lecture 10
1 Dividend Signalling Theory • Share prices change in response to the announcement by firms of: • Therefore dividend announcements signal information to investors Initiation of Dividends • P0⇑ Increase in size of Dividends • _________________________________ Reduction in size of Dividends • P0⇓ Omission of Dividends • __________________________________ About the firm’s future prospects • ___________________________________ 2 Signalling Theory: • The important variable is called “Abnormal Return” (AR) Constructed from returns • Daily …or • Weekly …or • Monthly Measuring Dividend Signals Measuring Pt − Pt −1 R jt = Pt −1 Indext − Indext −1 RMt = Indext −1 or... Pt R jt = ln Pt −1 Indext RMt = ln Indext −1 or... 3 • An estimation period of (say!) 100 days is used to get an estimate of E(R) Statistical Method = Simple regression of 100 observations of Rjt on RMt The values of the parameters______________________. • Use Rjt and RMt from the Test Period in conjunction with _________________________________________ R jt = α j + β j RMt + ε jt
E(R) for any given day t is the righthand side without the error term 4 Regression estimation period Forecast into this Period t110 t10 t0 t10 AR jt = R jt − E ( R jt ) Where : E ( R jt ) = α + β RMt This is called the Test Period 5 NZ data 19901999 ARs associated with announcement of Increased Dividends AND Increased Earnings Increased
0.0200 0.0150 0.0100 0.0050 0.0000 0.0050 0.0100 0.0150 0.0200 ARt10 ARt9 ARt8 ARt7 ARt6 ARt5 ARt4 ARt3 ARt2 ARt1 ARt0 ARt1 ARt2 ARt3 ARt4 ARt5 ARt6 ARt7 ARt8 ARt9 ARt10 6 ARs statistically significant at the 5% level of error are circled NZ data 19901999 ARs associated with announcement of Decreased Dividends AND Decreased Earnings Decreased
0.0200 BAD NEWS CASE 0.0150 0.0100 0.0050 0.0000 0.0050 0.0100 0.0150 0.0200 ARt10 ARt9 ARt8 ARt7 ARt6 ARt5 ARt4 ARt3 ARt2 ARt1 ARt0 ARt1 ARt2 ARt3 ARt4 ARt5 ARt6 ARt7 ARt8 ARt9 ARt10 Day zero (t0) ARs statistically significant at the 5% level of error are circled 7 What these diagrams say in terms of What share prices: GOOD NEWS CASE share Pt in $ t0 Good news case Time 8 What these diagrams say in terms of What share prices: BAD NEWS CASE share Pt in $ t0 Bad news case Time 9 Dividend Behaviour of Firms
• •
Lintner (1956) studied dividend behaviour of US firms
John Lintner, “Distribution of Incomes of corporations among Dividends, Retained Earnings, and Taxes” American Economic Review Vol 46, May 1956 Four major findings: Firms have longrun _______________________________________________ This ties in with Capital Structure and WACC See Problem 3 on next slide These interlock with each other Managers focus more on dividend changes than on ____________________________________________ Firms reluctant to make dividend changes that might have to be reversed Dividend changes follow shifts in longrun sustainable earnings
10 10 Problem 3 Yolanda Skateboards forecasts the following information for next year: • • • • • • • • • • NPAT = $4 m Dividend payout ratio d = 40% Weighting of equity wS = 25% D1 = $1 P0 =$20 g =5% rRF = 6% = 1 β rM =10% Flotation costs are super expensive at 10% of the share price Required: (a) What is the BPEQUITY with when d = 40% ? (b) What is the cost of equity, rS when d = 40% (c) What is the new BPEQUITY if d = 60% ? (d) What is the cost of new equity rE if d = 60% 11 11 ∆RE NPAT × ( 1 − d ) BP = = ws ws = Solution 3 rS = rRF + β ( rM − rRF ) = = =
OR... D1 rS = +g P0 =
12 12 . BP = ∆RE ws .
Solution 3 page 2 = D1 rE = +g P0 ( 1 − F % ) = =
13 13 . Two Effects of a rise in Dividend Payout Two Ratio “d” on WACC Schedule Ratio
WACC WACC0 BPEQUITY 0 $$
14 14 Alternative Dividend Policies (1)
Putting Linter’s findings aside for a while, what are the possible dividend policies • Constant dollar dividend No ∆ from _________________________________________ • Steadily increasing dividend Choose rate of increase • Maybe equivalent to “g” • Is this sustainable? Constant dividend payout ratio Requires stable or steadily growing NPAT If not, then the dividends • ___________________________________________
15 15 Alternative Dividend Policies (2)
•
Longrun target dividend payout ratio Can be readjusted as firm’s prospects change Smooth trends in dividend increases But what about downward adjustments? • • • Small regular dividend ________________ Residual dividend policy No dividend at all in any period
form, eventually Until sometime in the distant future • But all firms return cash to shareholders in some 16 16 A pure Residual Dividend Policy Residual • • Investment, financing & dividend decisions are related Total sources of funds = ______________________________ ∆Debt + ( NPAT + Shares NEW ) = Investment + Dividend
or ∆Debt + ( NPAT + Shares NEW − Dividend ) = Investment
17 17 • If firm can raise external funds at will, then all 3 decision areas can be set at optimal levels: All positive NPV projects can be undertaken, • financed by RE and external funding Any debt/equity securities issued are sold in optimal proportions funding dividend payout ratio will be maintained by external • ____________________________
18 18 • But if sale of new shares is not feasible, one of the 3 policy areas must be residual. a. Investment policy as the residual ? Which one ? Investment = ∆Debt + NPAT + Shares NEW − Dividend • But firm should not: Forgo positive NPV projects _________________________________ invest in negative NPV projects because surplus funds available
19 19 b. Financing policy as the residual? ( Investment + Dividend ) − NPAT = ∆Debt + Shares NEW
But firm should not operate with debt ratio: • below the optimal level • _________________________ 20 20 c. Dividend policy as the residual ? Dividend = ∆Debt + NPAT + Shares NEW − Investment
Steps in setting dividend: • • • • determine optimal capital budget determine amount of debt & equity required use RE to supply equity component (supplement by share issue if required) pay dividends if ________________________ 21 21 This amounts to: Target Dividends = Net Income  equity ratio Total E = NPAT − × capital TA budget Total × capital budget 22 22 Example of residual dividend policy
Assumptions: • Firm is funded by debt and ordinary equity only • • • Target debt ratio = wd = 40% (infer equity ratio from this) Forecasted NPAT = $60m • We are ALWAYS looking into the future and NOT the past Three possible levels of investment: low: $40m medium: $70m high: $150m
23 23 (i) Investment Budget = $40m
∆ Debt required = 0.4 x $40m = $16m Debt required = 0.4 x $40m = $16m ∆ Equity required = 0.6 x $40m = $24m Equity required = 0.6 x $40m = $24m NPAT1 > ∆ Equity so New Shares = 0 Equity so New Shares = 0 D1 = ∆ Debt +NPAT1 + SharesNEW Inv Total E Dividends = NPAT  × capital TA budget = 60m − 0.6 × ( 40m ) = 36m
24 24 = $16m + $60m + $0m $40m = $36m d = _____________________ (ii) Investment Budget = $70m ∆ Debt required = 0.4 x $70m = $28m Debt required = 0.4 x $70m = $28m ∆ Equity required = 0.6 x $70m = $42m Equity required = 0.6 x $70m = $42m NPAT1 > ∆ Equity so New Shares = 0 Equity so New Shares = 0 D1 = ∆ Debt +NPAT1 + SharesNEW – Inv = $28m + $60m + $0m $70m = $18m d = ______________________________ Total E Dividends = NPAT  × capital TA budget = 60m − 0.6 × ( 70m ) = 18m
25 25 (iii) Investment Budget = $150m
∆ Debt required = 0.4 x $150m = $60m Debt required = 0.4 x $150m = $60m ∆ Equity required = 0.6 x $150m = 90m Equity required = 0.6 x $150m = 90m NPAT1 < ∆ Equity so New Shares = $30m D1 = ∆ Debt +NPAT1 + SharesNEW – Inv =$60m + $60m + $30m $150m =$0m d = ________________________ Total E Dividends = NPAT  × capital TA budget = 60m − 0.6 × ( 150m ) 26 = −30m
26 • • • A firm’s next NPAT expected to be $50m Target capital structure: wd = 30% and wS = 70% Optimum capital budget = $60m Problem 2 With respect to the residual dividend policy: 1. 2. 1. What is the total amount of dividends to be paid and the value of “d” ? If the optimum capital budget = $100m, what is “d” and what must be raised in new shares?
27 27 If the optimum capital budget = $100m and NPAT = $80m, what is paid out in dividends and what is “d”? Solution 2 Total E Dividends = NPAT  × capital TA budget = (parts 1 and 2) d= Div = NPAT Total E Dividends = NPAT  × capital TA budget = = d= Div = NPAT 28 28 Solution 2 (part 3) Total E Dividends = NPAT  × capital TA budget = = d= Div = NPAT 29 29 Conclusions on Residual Dividend Policy • Payout ratio fluctuates with NPAT and Investment budget. Fluctuations are considered bad… • …if investors believe dividends perform a signalling function • Therefore dividend smoothed around longrun target payout ratio (eg. 50%) over medium term shortrun deviations from optimal ______________________________________
30 30 • Lintner (1956) Example: low NPAT1 and high Investment Example: low NPAT • The firm does a compromise: Payout ratio allowed to fall below target level • But not to the full extent possible • Tolerated temporarily Debt ratio is allowed to rise above target level • But not to the full extent possible • Tolerated temporarily Some projects _____________________
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 Spring '09
 WarwickAnderson
 Dividend, TA, dividend payout ratio, residual dividend policy, Jt

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