Dividend Policy

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The policy a company uses to decide how much it will pay out to shareholders in dividends.

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INTRODUCTION TO CORPORATE FINANCE Chapter 22 – Dividend Policy

PowerPoint Presentation:

CHAPTER 22 Dividend Policy

Lecture Agenda:

CHAPTER 22 – Dividend Policy 22 - 3 Lecture Agenda Learning Objectives Important Terms Mechanics of Dividend Payments Cash Dividend Payments M&M’s Dividend Irrelevance Theorem The “Bird in the Hand” Argument Dividend Policy in Practice Relaxing the M&M Assumptions Stock Dividends and Stock Splits Share Repurchases Summary and Conclusions Concept Review Questions

Learning Objectives:

CHAPTER 22 – Dividend Policy 22 - 4 Learning Objectives You should understand the following: The mechanics of dividend payments and why they are different from interest payments The difference between a stock split and a stock dividend Under what assumptions a dividend payment is irrelevant and what a homemade dividend is Why dividend payments generally reflect the business risk of the firm How transactions costs, taxes and information problems give value to corporate dividend policies How stock dividends and stock splits differ How a share repurchase program can substitute for a dividend payout policy.

Important Chapter Terms:

CHAPTER 22 – Dividend Policy 22 - 5 Important Chapter Terms Agency theory Bird in the hand argument Cash cow Declaration date Dividend reinvestment plans Dividend yield Equity market capitalization Ex-dividend date Free cash flow Holder of record Homemade dividends Income stripping Odd lots Residual theory of dividends Special dividend Split shares Stock dividend Stock split Tax clienteles

What is Dividend Policy?:

What is Dividend Policy? Dividend Policy

Dividend Policy What is It?:

CHAPTER 22 – Dividend Policy 22 - 7 Dividend Policy What is It? Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation. This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.

Types of Dividends:

Types of Dividends Dividend Policy

Types of Dividends:

CHAPTER 22 – Dividend Policy 22 - 9 Types of Dividends Dividends are a permanent distribution of residual earnings/property of the corporation to its owners. Dividends can be in the form of: Cash Additional Shares of Stock (stock dividend) Property If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders – this is known as a liquidating dividend .

Dividends and Corporate Financing:

Dividends and Corporate Financing Dividend Policy

Dividends a Financing Decision:

CHAPTER 22 – Dividend Policy 22 - 11 In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm. When a cash dividend is declared, those funds leave the firm permanently and irreversibly. Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital. Corporate Profits After Tax Retained Earnings Dividends Dividends a Financing Decision

Dividends versus Interest Obligations:

CHAPTER 22 – Dividend Policy 22 - 12 Dividends versus Interest Obligations Interest Interest is a payment to lenders for the use of their funds for a given period of time Timely payment of the required amount of interest is a legal obligation Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcy Dividends A dividend is a discretionary payment made to shareholders The decision to distribute dividends is solely the responsibility of the board of directors Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)

The Mechanics of Dividend Payments:

The Mechanics of Dividend Payments Dividend Policy

Dividend Payments Mechanics of Cash Dividend Payments:

CHAPTER 22 – Dividend Policy 22 - 14 Dividend Payments Mechanics of Cash Dividend Payments Declaration Date Holder of Record Date Ex-dividend Date Payment Date

Dividend Payments Mechanics of Cash Dividend Payments:

CHAPTER 22 – Dividend Policy 22 - 15 Dividend Payments Mechanics of Cash Dividend Payments Declaration Date this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record , the date of payment and the amount of the dividend for each share class. when CARRIED, this resolution makes the dividend a current liability for the firm. Date of Record is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend. Ex dividend Date is the date that the value of the firm’s common shares will reflect the dividend payment (ie. fall in value) ‘ex’ means without. At the start of trading on the ex-dividend date, the share price will normally open for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend. Date of Payment is the date the cheques for the dividend are mailed out to the shareholders.

Dividend Declaration Time Line:

CHAPTER 22 – Dividend Policy 22 - 16 Declaration Date Date of Record Date of Payment Ex Dividend Date is determined by the Date of Record. The market value of the shares drops by the value of the dividend per share on market opening…compared to the previous day’s close. The Board Meets and passes the motion to create the dividend 2 business days prior to the Date of Record Dividend Declaration Time Line

Trade Settlement and the Ex Dividend Date:

CHAPTER 22 – Dividend Policy 22 - 17 Changes in the Settlement Cycle In June 1995 the settlement cycle for all non-money-market Canadian and U.S. securities was reduced from five business days (T + 5) to three business days (T + 3). The rationale for the change stems from the 1987 stock market crash when it was realized that a securities market failure could result in a credit market failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S. broker, increased the need to minimize the risks involved in the clearing and settlement of securities. The shortened settlement cycle requires that the payment of funds and the delivery of securities take place on the third business day after the trade date. This will reduce credit, market and liquidity risks by decreasing post-trade settlement exposure. Ex Dividend Date The date is not chosen by the board of directors, rather it is determined as a result of the exchanges settlement practices and is a function of the date of record. Trade Settlement and the Ex Dividend Date

Dividend Decision and the Board of Directors:

Dividend Decision and the Board of Directors Dividend Policy

Dividend Policy Dividends, Shareholders and the Board of Directors:

CHAPTER 22 – Dividend Policy 22 - 19 Dividend Policy Dividends, Shareholders and the Board of Directors There is no legal obligation for firms to pay dividends to common shareholders Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because: Board members are jointly and severally liable for any damages they may cause Board members are constrained by legal rules affecting dividends including: Not paying dividends out of capital Not paying dividends when that decision could cause the firm to become insolvent Not paying dividends in contravention of contractual commitments (such as debt covenant agreements)

Dividend Payments:

Dividend Payments Dividend Policy

Dividend Payments Dividend Reinvestment Plans (DRIPs):

CHAPTER 22 – Dividend Policy 22 - 21 Dividend Payments Dividend Reinvestment Plans (DRIPs) Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm DRIPs will buy as many shares as the cash dividend allows with the residual deposited as cash Leads to shareholders owning odd lots (less than 100 shares) Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders.

Dividend Payments Stock Dividends:

CHAPTER 22 – Dividend Policy 22 - 22 Dividend Payments Stock Dividends Stock dividends simply amount to distribution of additional shares to existing shareholders They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E 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.

Dividend Payments Stock Dividends:

CHAPTER 22 – Dividend Policy 22 - 23 Dividend Payments Stock Dividends Implications reduction in the R/E account reduced capacity to pay future dividends proportionate share ownership remains unchanged shareholder’s wealth (theoretically) is unaffected Effect on the Company conserves cash serves to lower the market value of firm’s stock modestly promotes wider distribution of shares to the extent that current owners divest themselves of shares...because they have more adjusts the capital accounts dilutes EPS Effect on Shareholders proportion of ownership remains unchanged total value of holdings remains unchanged if former DPS is maintained, this really represents an increased dividend payout

Dividend Payments Stock Dividend Example:

CHAPTER 22 – Dividend Policy 22 - 24 Dividend Payments Stock Dividend Example ABC Company Equity Accounts as at February xx, 20x9 Common stock (215,000) $5,000,000 Retained earnings 20,000,000 Net Worth $25,000,000 The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share. This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is: $40.00 (21,500) = $860,000 This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account: next page...

Dividend Payments Stock Dividend Example:

CHAPTER 22 – Dividend Policy 22 - 25 Dividend Payments Stock Dividend Example After the stock dividend: ABC Company Equity Accounts as at March 1, 20x9 Common stock (236,500) $5,860,000 Retained earnings 19,140,000 Net worth $25,000,000 The market price of the stock will be affected by the stock dividend: New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36 The individual shareholder’s wealth will remain unchanged.

Dividend Payments Stock Splits:

CHAPTER 22 – Dividend Policy 22 - 26 Dividend Payments Stock Splits Although there is no theoretical proof, there is some who believe that an optimal price range exists for a company’s common shares. It is generally felt that there is greater demand for shares of companies that are traded in the $40 - $80 dollar range. The purpose of a stock split is to decrease share price. The result is: increase in the number of share outstanding theoretically, no change in shareholder wealth Reasons for use: better share price trading range psychological appeal (signalling affect)

Dividend Payments Stock Split Example:

CHAPTER 22 – Dividend Policy 22 - 27 Dividend Payments Stock Split Example The Board of Directors of XYZ Company is considering using a stock split to put its shares into a better trading range. They are confident that the firm’s stock price will continue to rise given the firm’s outstanding financial performance. Currently, the company’s shares are trading for $150 and the company’s shareholders equity accounts are as follows: Commons shares (100,000 outstanding) $1,500,000 Retained earnings 15,000,000 Net Worth $16,500,000 A 2 for 1 Stock Split: New Share Price = P 0 [1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00 The firm’s equity accounts: Commons shares (200,000 outstanding) $1,500,000 Retained earnings 15,000,000 Net Worth $16,500,000

Dividend Payments Further Stock Split Examples:

CHAPTER 22 – Dividend Policy 22 - 28 Dividend Payments Further Stock Split Examples A 4 for 3 Stock Split: New Share Price = P 0 [1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50 The firm’s equity accounts: Commons shares (133,333 outstanding) $1,500,000 Retained earnings 15,000,000 Net Worth $16,500,000 A 3 for 4 Reverse Stock Split: New Share Price = P 0 [1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00 The firm’s equity accounts: Commons shares (75,000 outstanding) $1,500,000 Retained earnings 15,000,000 Net Worth $16,500,000 Clearly the Board can use stock splits and reverse stock splits to place the firm’s stock in a particular trading range.

Dividend Payments Stock Split Effects:

CHAPTER 22 – Dividend Policy 22 - 29 Dividend Payments Stock Split Effects shareholders wealth should remain unaffected: Original Holdings: (100 shares @ $150/share) = $15,000 After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000 the above will hold true if there is no psychological appeal to the stock split. There is some evidence that the share price of companies which split stock is more bouyant because of a positive signal being transferred to the market by this action.

Stock Dividends versus Stock Splits:

CHAPTER 22 – Dividend Policy 22 - 30 - lowers stock price slightly - large drop in stock price - little psychological appeal - much stronger potential signalling effect - recapitalization of earnings - no recapitalization - no change in proportional - same ownership - odd lots created - odd lots rare - theoretically, no value to - same the investor Stock Dividends versus Stock Splits Stock Dividends Stock Splits

Cash Dividend Payments The Macro Perspective:

CHAPTER 22 – Dividend Policy 22 - 31 Cash Dividend Payments The Macro Perspective Figure 22 -1 illustrates: Aggregate after-tax profits run at approximately 6% of GDP but are highly variable Aggregate dividends are relatively stable when compared to after-tax profits. They are sustained in the face of drops in profit during recessions They are held reasonably constant in the face of peaks in aggregate profits. (See Figure 22 - 1 on the following slide)

Cash Dividend Payments Aggregate Dividends and Profits:

CHAPTER 22 – Dividend Policy 22 - 32 Cash Dividend Payments Aggregate Dividends and Profits FIGURE 22-2

Cash Dividend Payments The Macro Perspective:

CHAPTER 22 – Dividend Policy 22 - 33 Cash Dividend Payments The Macro Perspective Figure 22 -2 illustrates: Aggregate Dividend payouts further illustrates the effects of relatively stable dividend payouts in the face of profit volatility: The normal aggregate dividend payout rate is about 40% of after-tax profit When profits drop and dividends are held constant, payout rates rise to 100% (See Figure 22 - 2 on the following slide)

Cash Dividend Payments Aggregate Dividend Payouts:

CHAPTER 22 – Dividend Policy 22 - 34 Cash Dividend Payments Aggregate Dividend Payouts FIGURE 22-3

Cash Dividend Payments The Macro Perspective - Question:

CHAPTER 22 – Dividend Policy 22 - 35 Cash Dividend Payments The Macro Perspective - Question Why are dividends smoothed and not matched to profits?

Cash Dividend Payments The Micro Perspective:

CHAPTER 22 – Dividend Policy 22 - 36 Cash Dividend Payments The Micro Perspective Table 22 -1 contains dividend yields for selected companies. The companies chosen here illustrate the dramatic differences between companies: Some pay no dividends Some pay consistent cash dividends representing substantial yields on current shares prices The highest yields are found in the case of Income Trusts and large stable ‘blue-chip’ financials and utilities

Cash Dividend Payments Dividend Yields:

CHAPTER 22 – Dividend Policy 22 - 37 Cash Dividend Payments Dividend Yields

Modigliani and Miller’s Dividend Irrelevance Theorem:

Modigliani and Miller’s Dividend Irrelevance Theorem M&M, Dividends and Firm Value

Modigliani and Miller’s Dividend Irrelevance Theorem:

CHAPTER 22 – Dividend Policy 22 - 39 Modigliani and Miller’s Dividend Irrelevance Theorem The value of M&M’s Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.

M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value:

CHAPTER 22 – Dividend Policy 22 - 40 M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value Start with the single-period DDM: [ 22-1]

M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value:

CHAPTER 22 – Dividend Policy 22 - 41 M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value Multiply by the number of shares outstanding ( m ) to convert the single stock price model to a model to value the whole firm: [ 22-2]

M&M’s Dividend Irrelevance Theorem Assumptions:

CHAPTER 22 – Dividend Policy 22 - 42 M&M’s Dividend Irrelevance Theorem Assumptions No Taxes Perfect capital markets large number of individual buyers and sellers costless information no transaction costs All firms maximize value There is no debt

M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value:

CHAPTER 22 – Dividend Policy 22 - 43 M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value Without debt, sources and uses of funds identity (sources = uses) can be expressed as: Where: X represents cash flow from operations I represents investment X – I is free cash flow mD 1 is dividend to current shareholders at time 1 [ 22-3]

M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value:

CHAPTER 22 – Dividend Policy 22 - 44 M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value Solving for dividends paid out ( mD 1 ):

M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value:

CHAPTER 22 – Dividend Policy 22 - 45 M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value If a firm pays out dividends that exceeds its free cash flow (X –I), then it must issue new common shares to pay for these dividends. Substituting into Equation 22 – 2 we get: 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… [ 22-4]

M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value:

CHAPTER 22 – Dividend Policy 22 - 46 M&M’s Dividend Irrelevance Theorem M&M, Dividends, and Firm Value The firm value is determined as the present value of the free cash flows to the equity holders: The dividend is equal to the free cash flow each period, and dividends are therefore a residual after the firm has taken care of all of its investment requirements – this is the Residual Theory of Dividends [ 22-5] Value has nothing to do with dividends

M&M’s Dividend Irrelevance Theorem Residual Theory of Dividends:

CHAPTER 22 – Dividend Policy 22 - 47 M&M’s Dividend Irrelevance Theorem Residual Theory of Dividends The Residual Theory of Dividends suggests that logically, each year, management should: Identify free cash flow generated in the previous period Identify investment projects that have positive NPVs Invest in all positive NPV projects If free cash flow is insufficient, then raise external capital – in this case no dividend is paid If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.

M&M’s Dividend Irrelevance Theorem Residual Theory of Dividends - Implication:

CHAPTER 22 – Dividend Policy 22 - 48 M&M’s Dividend Irrelevance Theorem Residual Theory of Dividends - Implication The implication of the Residual Theory of Dividends are: Investment decisions are independent of the firm’s dividend policy No firm would pass on a positive NPV project because of the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken. If the firm can’t make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own. The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure 22 – 4 on the following slide:

M&M’s Dividend Irrelevance Theorem Internal Funds, Investment, and Dividends:

CHAPTER 22 – Dividend Policy 22 - 49 M&M’s Dividend Irrelevance Theorem Internal Funds, Investment, and Dividends 22 - 4 FIGURE $11,976 Million Rate of Return WACC Internal Funds Available OPTIMAL INVESTMENT IOS $177,607 Million MC=MR

M&M’s Dividend Irrelevance Theorem Homemade Dividends:

CHAPTER 22 – Dividend Policy 22 - 50 M&M’s Dividend Irrelevance Theorem Homemade Dividends Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern. They don’t need management declare a cash dividend, they can create their own. Conclusion: under the assumptions of M&M’s model, the investor is indifferent to the firm’s dividend policy.

The “Bird-in-the-Hand” Argument :

The “Bird-in-the-Hand” Argument Dividend Policy

The “Bird-in-the-Hand” Argument M&M’s Assumptions Relaxed:

CHAPTER 22 – Dividend Policy 22 - 52 The “Bird-in-the-Hand” Argument M&M’s Assumptions Relaxed Risk is a real world factor. Firm’s that reinvest free cash flow, put that money at risk – there is no certainty of investment outcome – those forfeit dividends that are reinvested…could be lost! Remember the two-stage DDM?

The “Bird-in-the-Hand” Argument M&M’s Assumptions Relaxed:

CHAPTER 22 – Dividend Policy 22 - 53 The “Bird-in-the-Hand” Argument M&M’s Assumptions Relaxed Remember the two-stage DDM? The first term is the present value of existing opportunities (PVEO) The second term is the present value of growth opportunities (PVGO) These forecast returns face risks of new market entrants to compete for the excess profits forecast in emerging opportunities making PVGO extremely vulnerable. [ 22-6]

The “Bird-in-the-Hand” Argument M&M’s Assumptions Relaxed:

CHAPTER 22 – Dividend Policy 22 - 54 The “Bird-in-the-Hand” Argument M&M’s Assumptions Relaxed Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by investors. This implies that investors perceive non-dividend paying firms to be riskier and apply a higher discount rate to value them causing the share price to fall. The difference between the M&M and Gordon arguments are illustrated in Figure 22 - 5 on the following slide: M&M argue that dividends and capital gains are perfect substitutes

The “Bird-in-the-Hand” Argument M&M versus Gordon’s Bird in the Hand Theory:

CHAPTER 22 – Dividend Policy 22 - 55 The “Bird-in-the-Hand” Argument M&M versus Gordon’s Bird in the Hand Theory 22 - 5 FIGURE Gordon OPTIMAL INVESTMENT M&M

The “Bird-in-the-Hand” Argument M&M versus Gordon’s Bird in the Hand Theory:

CHAPTER 22 – Dividend Policy 22 - 56 The “Bird-in-the-Hand” Argument M&M versus Gordon’s Bird in the Hand Theory Conclusions: Firms cannot change underlying operational characteristics by changing the dividend The dividend should reflect the firm’s operations through the residual value of dividends

Dividend Policy in Practice:

Dividend Policy in Practice Dividend Policy

Dividend Policy in Practice:

CHAPTER 22 – Dividend Policy 22 - 58 Dividend Policy in Practice Firms smooth their dividends Firms tend to hold dividends constant, even in the face of increasing after-tax profit Firms are very reluctant to cut dividends

Dividend Policy in Practice Lintner’s Work on Dividend Adjustment:

CHAPTER 22 – Dividend Policy 22 - 59 Dividend Policy in Practice Lintner’s Work on Dividend Adjustment John Lintner suggested a partial adjustment model to explain the smoothing of dividend behaviour illustrating that firms slowly change dividends as they move toward a new target level: [ 22-7]

Dividend Policy in Practice Lintner’s Work on Dividend Adjustment:

CHAPTER 22 – Dividend Policy 22 - 60 Dividend Policy in Practice Lintner’s Work on Dividend Adjustment The target dividend D t * Lintner suggested is a function of the firm’s optimal payout rate of the firm’s underlying earnings ( E t ) leading to the following equation: The coefficient on lagged dividends was estimated at 0.70 indicating an adjustment speed ( b ) coefficent of 0.30. The coefficient on current earnings ( c ) was estimated at 0.15 [ 22-8]

Dividend Policy in Practice Lintner’s Work on Dividend Adjustment:

CHAPTER 22 – Dividend Policy 22 - 61 Dividend Policy in Practice Lintner’s Work on Dividend Adjustment Implications The speed of dividend adjustment is only about 30 percent Firms are very reluctant to fully adjust Firms do not follow a policy of paying a constant proportion of earnings out as dividends Dividend policy in practice does not follow M&M’s irrelevance arguments because the real world does not match the assumptions used.

Relaxing the M&M Assumptions Welcome to the Real World!:

CHAPTER 22 – Dividend Policy 22 - 62 Relaxing the M&M Assumptions Welcome to the Real World! Transactions Costs Underwriting costs are very high, providing a strong incentive for firms to finance growth out of free cash flow Facing these high underwriting costs firms: With high growth rates have little incentive to pay dividends With volatile earnings conserve cash from year to year to finance projects and therefore pay very conservative dividends

Relaxing the M&M Assumptions Welcome to the Real World!:

CHAPTER 22 – Dividend Policy 22 - 63 Relaxing the M&M Assumptions Welcome to the Real World! Dividends and Signalling Under conditions of information asymmetry, shareholders and the investing public watch for management signals (actions) about what management knows. Management is therefore very cautious about dividend changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon) (The Signalling Model is explained in Figure 22 – 6 found on the next slide.)

Relaxing the M&M Assumptions The Signalling Model:

CHAPTER 22 – Dividend Policy 22 - 64 Relaxing the M&M Assumptions The Signalling Model 22 - 6 FIGURE e t $ 1 2 3 Time e t * d t * d t

Relaxing the M&M Assumptions Welcome to the Real World!:

CHAPTER 22 – Dividend Policy 22 - 65 Relaxing the M&M Assumptions Welcome to the Real World! Agency Theory Investors are wary of senior management so they seek to put controls in place. There is a fear that managers may waste corporate resources by over-investing in low or poor NPV projects. Gordon Donaldson argued this is the reason for the pecking order managements tend to use when raising capital Shareholders would prefer to receive a dividend and then have management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend. Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess management.

Relaxing the M&M Assumptions Welcome to the Real World!:

CHAPTER 22 – Dividend Policy 22 - 66 Relaxing the M&M Assumptions Welcome to the Real World! Taxes and the Clientele Effect Table 22 -3 (on the following slide) illustrates that different classes of investors face different tax brackets Preference for dividends versus capital gains income depends on the province of residence and taxable income level leading to tax clienteles. High income earners tend to prefer capital gains (there is an additional tax incentive for such individuals in that they can choose the timing of the sale of their investment…remember only ‘realized’ capital gains are subject to tax Low income earners tend to prefer dividends Conclusion – firm’s should not change dividend policy drastically since it upsets the existing ownership base.

Relaxing the M&M Assumptions Taxes:

CHAPTER 22 – Dividend Policy 22 - 67 Relaxing the M&M Assumptions Taxes

Relaxing the M&M Assumptions Repackaging Dividend-Paying Securities:

CHAPTER 22 – Dividend Policy 22 - 68 Relaxing the M&M Assumptions Repackaging Dividend-Paying Securities Tax clienteles help to explain the financial engineering whereby different parts of the return by the firm are stripped, repackaged and sold to different investors as illustrated in Figure 22 – 7. (See the following slide) Split shares are shares sold as the dividends and capital gains parts.

Relaxing the M&M Assumptions MYW’s B Corporation Shares:

CHAPTER 22 – Dividend Policy 22 - 69 Relaxing the M&M Assumptions MYW’s B Corporation Shares 22 - 7 FIGURE $143 million $330 million $454 million

Share Repurchases:

CHAPTER 22 – Dividend Policy 22 - 70 Share Repurchases Simply another form of payout policy. An alternative to cash dividend where the objective is to increase the price per share rather than paying a dividend. Since there are rules against improper accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.

Share Repurchases:

Share Repurchases Dividend Policy

Share Repurchases:

CHAPTER 22 – Dividend Policy 22 - 72 allowed under the OBCA and CBCA reasons for use: Offsetting the exercise of executive stock options Leveraged recapitalizations Information or signalling effects Repurchase dissident shares Removing cash without generating expectations for future distributions Take the firm private. Share Repurchases

Disadvantages of Share Repurchases:

CHAPTER 22 – Dividend Policy 22 - 73 they are usually done on an irregular basis, so a shareholder cannot depend on income from this source. if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax there may be some agency problems - if managers have inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares. Disadvantages of Share Repurchases

Methods of Share Repurchases:

CHAPTER 22 – Dividend Policy 22 - 74 tender offer: this is a formal offer to purchase a given number of shares at a given price over current market price. open market purchase: the purchase of shares through an investment dealer like any other investor this is not designed for large block purchases. private negotiation with major shareholders In any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus. Methods of Share Repurchases

Repurchased Shares:

CHAPTER 22 – Dividend Policy 22 - 75 called treasury stock (U.S.) non-voting (U.S.) may not receive dividends (U.S.) if not retired, can be resold (U.S.) unlike the U.S., repurchases in Canada do not involve shares that can be placed into treasury stock - they are canceled Repurchased Shares

Repurchase Example:

CHAPTER 22 – Dividend Policy 22 - 76 Current EPS = [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00 Current P/E ratio = $20 / $4 = 5X EPS after repurchase of 100,000 shares = $4.4 m / 1.0 = $4.40 Expected market price after repurchase: = [p/e][EPS new ] = [5][$4.40] = $22.00 per share Repurchase Example

Effects of A Share Repurchase:

CHAPTER 22 – Dividend Policy 22 - 77 EPS should increase following the repurchase if earnings after-tax remains the same a higher market price per outstanding share of common stock should result stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price. Effects of A Share Repurchase

Advantages of Share Repurchases:

CHAPTER 22 – Dividend Policy 22 - 78 signal positive information about the firm’s future cash flows used to effect a large-scale change in the firm’s capital structure increase investor’s return without creating an expectation of higher future cash dividends reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, without creating a continuing incremental cash drain capital gains treated more favourably than cash dividends for tax purposes. Advantages of Share Repurchases

Disadvantages of Share Repurchases:

CHAPTER 22 – Dividend Policy 22 - 79 signal negative information about the firm’s future growth and investment opportunities the provincial securities commission may raise questions about the intention share repurchase may not qualify the investor for a capital gain Disadvantages of Share Repurchases

Borrowing to Pay Dividends:

Borrowing to Pay Dividends Signalling

Borrowing to Pay Dividends:

CHAPTER 22 – Dividend Policy 22 - 81 Is this legal? is it possible to do? Yes the firm must have the ability and capacity to borrow the firm must have sufficient retained earnings to allow it to pay the dividend the firm must have sufficient cash on hand to pay the cash dividend the firm must NOT have agreed to any limitations on the payment of dividends under the bond indenture. Why? A possible answer is to signal to the market that the board is confident about the firm’s ability to sustain cash dividends into the future. Borrowing to Pay Dividends

Borrowing to Pay Dividends An Example:

CHAPTER 22 – Dividend Policy 22 - 82 Assets : Liabilities : Cash 10 Long-term Debt 0 Fixed Assets 140 Common Stock 50 Retained Earnings 100 Total Assets $150 Total Claims $150 After Borrowing…before cash dividend : Assets : Liabilities : Cash 60 Long-term Debt 50 Fixed Assets 140 Common Stock 50 Retained Earnings 100 Total Assets $200 Total Claims $200 Before Borrowing: 0% Debt 25% Debt Borrowing to Pay Dividends An Example

PowerPoint Presentation:

CHAPTER 22 – Dividend Policy 22 - 83 Assets : Liabilities : Cash 60 Current liabilities 50 Fixed Assets 140 Long-term Debt 50 Common Shares 50 Retained earnings 50 Total Assets $200 Total Claims $200 After Cash Dividend payment of $50 Assets : Liabilities : Cash 10 Long-term Debt 50 Fixed Assets 140 Common Stock 50 Retained earnings 50 Total Assets $150 Total Claims $150 After Dividend Declaration…before date of payment. 50% Debt 33% Debt Borrowing to Pay Dividends An Example …

Borrowing to Pay Dividends An Example:

CHAPTER 22 – Dividend Policy 22 - 84 The foregoing example illustrates: it is possible for a firm with ‘borrowing capacity’ to borrow funds to pay cash dividends. this is not possible if the lenders insist on restrictive covenants that limit or prevent this from occurring. the cash for the dividend must be present in the cash account. payment of dividends reduces both the cash account on the asset side of the balance sheet as well as the retained earnings account on the ‘claims’ side of the balance sheet. in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. (Bondholders in this example may have thought their firm would have only a 25% debt ratio….after the dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.) Borrowing to Pay Dividends An Example

Summary and Conclusions:

CHAPTER 22 – Dividend Policy 22 - 85 Summary and Conclusions In this chapter you have learned: About the different types of dividends including, regular and special cash dividends, stock dividends, stock splits as well as share repurchases. M&M’s dividend irrelevance argument and the real world factors such as transactions costs, taxes, clientele effects and signalling tend to favour real-world dividend relevance Tax motives and other reasons explain why firms might want to repurchase their shares.

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