Lecture11 - FIN2101 FIN2101 Business Finance II Module 10...

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Unformatted text preview: FIN2101 FIN2101 Business Finance II Module 10 Module Dividend Policy Student Activities Student Reading Text, Chapter 12 Text Study Guide, Chapter 12 Text Study Study Book, Module 10 Appendix 10.1, 10.2 and 10.3 Tutorial Activities Tutorial Workbook, Self Assessment Activity Self 10.1 10.1 Text Study Guide, Chapter 11, All Text Study Cash Dividends Cash Typically semi-annual in Australia. Interim dividend paid after the end of Interim the first half of the year, and a final dividend usually paid after the AGM. dividend Can only be paid out of current or Can accumulated profits. accumulated Cannot be paid out of capital or if it Cannot would make the company insolvent. would Payment Procedures Payment Announcement date Declaration date Date of record Ex-dividend date Payment date Payment Procedures Payment 1 2 3 4 Ex-dividend period 1 Announcement date 2 Declaration date 3 Ex-dividend date 4 Date of record 5 Payment date 5 Three Approaches Three Dividend policy cannot affect Dividend shareholders’ wealth in a perfect capital market and is therefore irrelevant. irrelevant. High dividends are best - relevant. Low dividends are best - relevant. Relevance Argument Relevance Resolution of uncertainty - the ‘bird-inthe-hand’ argument/fallacy. Information content of Information announcements – signalling. announcements dividend Relevance Argument Relevance Clientele effect – tax – investors’ preferences Relevance Argument Relevance Agency costs can be reduced by Agency paying higher dividends. paying Issue costs will be minimised if the firm Issue pays lower dividends. pays Shareholders’ transaction costs will be Shareholders’ higher, the lower the dividend. higher, Dividends As An Active Decision Variable Decision Management must pay a dividend Management before investing in new projects. before A shortfall may arise and could be shortfall overcome in 1 of 3 possible ways: overcome – reduce investment opportunities; – issue additional debt finance; – issue additional equity. Dividends As An Active Decision Variable Decision If management decides to pay a dividend If and then make up the shortfall to fund the new investments, it obviously considers dividend policy to be important. Dividends are, therefore, an active decision variable. active Irrelevance Argument Irrelevance Modigliani and Miller. Earnings are what affect the value of Earnings the firm and not decisions on when earnings are distributed to investors. earnings As long as the return is constant, As investors don’t care about how that return is made up, ie dividend or capital gain. gain. Irrelevance Argument Irrelevance D 0 (1 + g ) P0 = ks - g D1 P0 = ks - g e1 (1 - b ) P0 = ks - g e1 (1 - b ) = k s - b.r e1 (1 - b ) P0 = k s - b.k s e1 (1 - b ) = k s (1 - b ) e1 P0 = ks Value is a function of future earnings, not future dividends Passive Residual Approach Passive Dividends to be paid should be a Dividends residual variable or a passive variable. residual Management does not manipulate Management dividends to achieve its objective. dividends Residual Theory of Dividends Residual First determine the optimal capital budget. Determine the amount of ordinary equity Determine needed to finance new investments according to target capital structure. according If possible, use internal funds (retained If earnings) to meet needs. earnings) Pay cash dividends with left over or residual Pay internal funds. internal Passive Residual Approach Passive Based on several points. It is imperative that management takes It advantage of all investment opportunities. advantage Pay dividends only if there is a surplus. Maximisation of earnings potential is of Maximisation paramount importance. paramount Investors prefer a capital gain and larger Investors future dividends to short-term, smaller payments. payments. Passive Residual Approach Passive Key assumptions: a given investment plan which is not given affected by changes in dividend policy; affected a perfectly competitive market (no perfectly transaction, flotation or information costs); transaction, no taxes, therefore investors are indifferent no between receiving dividends or capital gains. gains. MM on Dividends MM MM put forward the passive residual approach. Dividend policy is irrelevant and investment policy Dividend is all that matters. is “Homemade dividend” notion. Under the “Active Decision Variable” approach, the Under firm is not doing anything for investors that they can’t already do for themselves. can’t Investment policy is of paramount importance. MM on Dividends MM A decision on whether or not to pay a decision dividend and the level of dividend will ultimately be affected by the investment opportunities available. investment The choice is simple - dividend or no The dividend. dividend. Dividend Policy - MM Position Dividend Company Z 1 million shares, no debt Value: $5m Assets: $4m + $1m cash Investment Opportunity: Invest $1m cash to return $2m Options: Choice 1 Pay no dividend Invest $1m cash Choice 2(A) Pay dividend of $1m cash Don’t invest Choice 2(B) Pay dividend Fund investment by share issue Value to Shareholder - Choice 1 Value VS = = V+ (R - O) N 5+ 6 = 1 = $6 (2 1 - 1) Value to Shareholder - Choice 2(A) Value VS = (V - D) + Dividend Received N 5-1 = +1 1 =4+1 = $5 Value to Shareholder - Choice 2(B) Value VS = = ( V - D) ( 5 - 1) + S + ( R - O) + Dividend N + NS + 1 + ( 2 - 1) +1 1 + 0.2 4+1+1 VS = +1 1.2 6 = +1 1.2 = $6 Homemade Dividend Example Homemade 2 firms, A & B, identical risk and income firms, streams. streams. k = 10%. Net income = $5 000 on 5 000 shares. An investor has 100 shares in each. Each has an identical investment Each opportunity generating 30% on a $5 000 outlay (ie $1 500 p.a.). outlay Homemade Dividend Homemade Dividend Policy A: No dividend payout Use retained earnings to fund the Use investment investment Dividend Policy B: 100% dividend payout Fund investment with new share issue Firms A and B Now Firms Firm A Value NI/k $5 000/0.1 Dividend NI/n $5 000/5 000 Price V/n Firm B $50 000 $50 000 $1 $1 $50 000/5 000 $10 $10 Firms A and B Later Firms NI V Firm A $5 000 + $1 500 = $6 500 Firm B $5 000 + $1 500 = $6 500 $6 500/0.1 = $65 000 $6 500/0.1 = $65 000 Firms A and B Later Firms P * Firm A $65 000/5 000 = $13 Firm B $65 000/5 500* = $12 The firm issues 500 shares @ $10 to finance the investment. Firms A and B Later Firms Investor now has 100 shares in Firm A @ $13 = $1 300 total value. Investor now has 100 shares in Firm B @ $12 plus $100 dividend income (@$1 per share), giving a total value of $1 300. Homemade Dividend Homemade If the investor requires dividend income from Firm A, he/she could sell 7.7 shares ($100/$13) to raise approximately $100. This is what is referred to as a “homemade dividend”. Shareholder’s Wealth - Firm A Shareholder’s The investor’s position would then be: 92.3 shares @ $13 Plus: $100 cash Shareholder’s Wealth $1 200 100 $1 300 Conclusion Conclusion The shareholder’s wealth position is the The same under either plan. same An individual investor would be indifferent An between Company A and Company B which are identical in every respect except for dividend policy. dividend The dividend policy is therefore irrelevant. The Evidence The Most companies have a long-term target Most dividend payout ratio. dividend Managers are concerned more about the Managers change in dividends than the absolute level of dividends. of Dividends are ‘smoothed’ relative to profits. Reluctance to change dividends to a level Reluctance that cannot be sustained in the future. that Dividend Policy and the Classical Tax System Classical Companies should adopt a stable or Companies ‘smoothed’ policy to minimise changes in payouts which can cause major variations in share price. share The target payout ratio should be low The enough to minimise the need for share issues. issues. Dividend Policy and the Imputation System Imputation When the company tax rate = the top When personal marginal tax rate, the optimal policy for Australian companies owned by resident shareholders would be to pay the maximum possible franked dividends and adopt a dividend reinvestment plan to limit the outflow of cash. the Dividend Policy and the Imputation System Imputation More complex for 3 reasons: Tax-exempt and non-resident shareholders cannot Tax-exempt use imputation tax credits. use Company tax rate ≠ top personal tax rate, meaning Company that some resident shareholders may prefer the retention of profits. retention Non-tax factors such as the information effects of Non-tax changes in dividends are still important. changes Dividend Policy In Practice Dividend Most companies appear to try to pay some Most dividend and to maintain a stable dividend policy over time. policy Management obviously therefore thinks that Management dividend policy is important. dividend If they didn’t think that dividends affect the If value of the firm, they wouldn’t pay a dividend to shareholders. dividend Factors Affecting Dividend Policy Factors Legal constraints. Firm’s capacity to pay – available excess Firm’s cash. cash. Contractual constraints – loan covenants. Growth prospects. Owner considerations: – tax status of the firm’s owners; – owners’ investment opportunities; – potential dilution of ownership. Types of Dividend Policies Types Constant-payout-ratio – A certain % of earnings is paid each period. Regular dividend policy – Payment of a fixed-dollar dividend each period. Low-regular-and-extra dividend policy – Payment of a low regular dividend, Payment supplemented by an ‘extra’ dividend when earnings warrant it. earnings Pages 439-40 of text. Other Dividends Other Dividend reinvestment plans (DRPs) Dividend election schemes (DESs) Bonus share plans (BSPs) Share splits Share buy-backs Dividend Reinvestment Plans Dividend Shareholders have the option of reinvesting all or Shareholders part of their dividends in additional shares. part Price is at a discount (2.5%-10%) to the market Price price. price. Dividends remain taxable to the investor as if paid Dividends in cash, and franking credits attaching to the dividends are received. dividends Cost-effective way of raising new capital – no Cost-effective prospectus or other disclosures required. prospectus Dividend Election Schemes Dividend Offer shareholders the option of receiving their Offer dividends in one or more of a number of forms. dividends Options include: – fully franked dividends; – unfranked dividends; – bonus shares. Enabled firms to “stream” imputation credits to Enabled particular classes of investors. particular Now restricted to bonus share plans and overseas Now dividend plans. dividend Bonus Share Plans Bonus Shareholders receive dividends in the form of Shareholders shares. shares. The number issued is proportional to cash The dividends foregone. dividends Advantages: – – To shareholder, information content. To company, conserves cash. A drawback is that shareholders do not receive drawback franking credits, and this reduces the popularity of BSPs. BSPs. Share Splits Share Involve issuing new free shares on a pro-rata Involve free basis to current shareholders. basis It is argued that shareholders will benefit because It the share price will not fall precisely in proportion to the increase in the number of shares (information content). (information Conserve cash. Often used to lower the share price and thus Often enhance trading. enhance Share Buy-Backs Share The company The shareholders. shareholders. Motives: – – – repurchases shares from its provide a tax-effective dividend for shareholders; remove small shareholdings from the share register; enhance shareholders value (decrease the number of enhance shares and therefore increase EPS; positive information content); content); – help discourage an unfriendly takeover. Share Buy-Backs Share In 1995, total repurchases by listed In companies in Australia was $770m. companies In 1999, the corresponding figure was In $8.8b. $8.8b. Legal restrictions in Australia to protect Legal creditors and shareholders. creditors In any 12-month period, a company may In only buy up to 10% of its paid-up capital. only ...
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