Chapter 14

Dividends and Dividend Policy

Cash dividends and dividend payment

Ø Dividend: payment made out of a firm’s earnings to its owners, in the form of
either cash or shares
• Regular cash dividends
o cash payment made by a firm to its owners in the ordinary course
of business, usually made twice a year
o Interim dividend: mid-financial year dividend
o Final dividend: paid at the end of the year
• Extra dividends
o Indicating the extra part may or may not be repeated in the
future
• Special dividends
o Indicates that this dividend is viewed as a truly unusual or one-
time event and it will not be repeated
• Liquidating dividends
o Some or all of the business has been liquidated, or sold off
• A cash dividend reduces a company’s cash holdings and also its retained
earnings, except in the case of a liquidating dividend
• Stock dividends
o Issuance of stocks to existing shareholders
Ø Distribution: payment made by a firm to its owners from sources other than
current or accumulated retained earnings
• Share repurchase
o Cash payment to shareholders by means of purchasing a portion
of shares outstanding
Ø Dividend payment: a chronology
• Declaration date: the payment of cash by the firm to shareholders is
declared by the board of directors
• Ex-dividend date: to make sure that dividend cheques go to the right
people, if stocks are bought before this date, the shareholder on record
will receive the dividend
• Date of record: date by which holders must be on record to receive a
dividend
• Date of payment: date that the dividend cheques are mailed or
deposited directly to shareholders’ bank accounts
Ø The stock price drops by the amount of after-tax value of the dividend on the
ex-dividend date, the stock is then trading cum dividend
Does dividend policy matter?

Ø Dividend policy: the time pattern of dividend payouts, whether cash should be
paid out now or invest that money and pay out later
Ø M&M dividend policy irrelevancy proposition: dividend policy is irrelevant in
the M&M world
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• If investors can raise cash themselves by selling shares, they do not need
firms to provide them with cash through dividend payments
• Assumption is that no taxes, transactions and bankruptcy costs
• Shareholders can replicate his cash flows to match his desired cash flows
in different years
Ø Real world factors favouring a low payout:
• Taxes
o Classical tax system
§ tax rate applied to capital gains is less than that which
applies to dividends
§ tax on capital gains is not paid until the shares are sold, so
time value of money reduces the effective rate on capital
gains
§ the investor can generate dividends when they want by
selling some of their shares, paying lower taxes on the
returns they recover from the investment
o Imputation system
§ The effective tax rate applying to the cash dividend can be
much lower than that applying to capital gains
§ When the marginal rate tax rate for individuals exceeds
that for firms, investors may prefer that earnings be
retained rather than paid out as dividends
§ Overseas shareholders would prefer dividends to be kept
to a minimum as they are effectively operating under a
classical tax system
• Flotation costs
o Firms that pay high dividends and simultaneously sell stock to
fund growth will incur high floatation costs than comparable low
payout firms
• Dividend restrictions
o Most bond indentures and some federal and state laws limit the
dividends a firm can pay
Ø Real world factors favouring a high payout:
• Desire for current income
o The group of retired people and others living on their capital,
“widows and orphans”
 o Sale of low dividend shares to generate funds involve brokage
fees, other transaction costs and capital gains taxes
o Time required to sell securities to meet their cash needs
• Tax and legal benefits
o Under an imputation tax system, dividends that come with
franking credits attached, valuable to people such as retirees who
are unlikely to have significant other sources of income
o Corporate investors
§ When a company owns shares in another company,
dividends paid are tax-free income
§ Tax free exclusion does not apply to capital gains
§ No tax exclusions for interest payments as well, hence
holding high dividend shares are preferred to long term
bonds
o Tax-exempt investors
§ Institutions such as superannuation funds are set up to
manage money for the benefits of others, they are
considered imprudent to buy shares with no established
dividend record
§ University endowment funds are prohibited from spending
any of the principal, dividends paid give them some ability
to spend
Ø Reasons for a firm finding it difficult to change its dividend policy
• Dividend clienteles
o Argument that shares attract particular groups based on dividend
yield and the resulting tax effects
o Wealthy individuals in high marginal tax brackets have an
incentive to pursue low payout shares
o Other groups have an incentive to pursue high payout shares
o Therefore companies with high payouts attract one group, and
low payout companies attract another
o By changing dividend payout, it will not necessarily immediately
attract those investors from other group, but risk losing some of
its current shareholders
• Signalling
o Investors recognise that management has better information on
the future prospects of a company than they do
o Investors seek to interpret the signals provided by management
through corporate announcements in terms of what they imply
about the firm’s future prospects
o Investors interpret an increase in dividend as being indicative of
management’s confidence of higher earnings in the future, vice
versa
 o Management is also aware that investors will only become
confused if they continually change the firm’s dividend payout,
uncertainty will translate into a lower share price
o Therefore managers will only change the firm’s dividend payout
when they are confident that future earnings will support the
dividend payout
o Hence dividend payouts change with the level of earnings, but
with a lag

Establishing a dividend policy

Ø Residual dividend approach

• Policy under which a firm pays dividends only after meeting its
investment needs while maintaining a desired debt-equity ratio
• The firm’s objective is to meet its investment needs and maintain its
desired debt-equity ratio before paying dividends
• Firms with many investment opportunities pay a small percentage of
their earnings as dividends
• Slower growing firms in more mature industries use a higher payout
ratio
Ø Dividend stability
• Residual approach might lead to a very unstable dividend payout
• If investment opportunities in one period are quite high, dividends will
be low, vice versa
• Cyclical dividend policy
o Fixed fraction of that half’s earnings
o Dividends vary throughout the year and time
• Stable dividend policy
o Each dividend can be a fixed fraction of yearly earnings
• Stable dividend policy is in better interests of the firm and its
shareholders because dividend cuts are viewed as highly undesirable, a
signal of financial distress
Ø A compromise dividend policy
• Avoid cutting back n positive NPV projects to pay a dividend
• Avoid dividend cuts
• Avoid need to sell equity
• Maintain a target debt-equity ratio
• Maintain a target dividend payout ratio

Share repurchase

Ø A firm’s purchase of its own shares, also known as share buyback

Ø In a world without taxes and transaction costs
 • A share repurchase has the same effect as a cash dividend as the cash
amount in the firm is reduced and the shareholders as a group have
more cash
• The book value of the equity is reduced in both cases, in dividends case
the equity is reduced because of a drop in share price
• EPS will be higher for share repurchase (accounting adjustment) but PE
ratio would be the same for both
• If there are no imperfections, and taxes are ignored, then a cash
dividend and a share repurchase are essentially the same thing
Ø Real world considerations in a repurchase
• Repurchase has a significant tax effect
• Dividend in a dividend imputation system can be tax free, depending on
the shareholder’s marginal tax rate, but they have no choice whether to
receive the dividend or not
• In a repurchase, the shareholder pays taxes only if the shareholder
actually chooses to sell
• It is common today that part of the buyback will be treated as dividends
with franking credits attached and part will be treated as capital gain on
the sale

Bonus issues and share splits

Ø Bonus issue: payment made by a firm to its owners in the form of shares,
diluting the value of each share outstanding
Ø Share split: an increase in a firm’s shares outstanding without any change in
owner’s equity
Ø Popular trading range
• When the security is priced above the trading range, many investors do
not have the funds to buy the common trading unit of 100 shares, called
a round lot
• Commissions are higher for trades in odd-lot form
Ø It is often observed that after a share split, liquidity of the shares decrease
Ø Reverse split: share split under which a firm’s number of shares outstanding is
reduced
• Transaction costs to shareholders may be less after the reverse share
splits
• Liquidity and marketability might be improved when its price is raised to
the popular trading range
• Reverse split can achieve instant respectability