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