INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
CHAPTER 22
Dividend Policy
Lecture Agenda
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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
CHAPTER 22 – Dividend Policy
22 - 3
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.
CHAPTER 22 – Dividend Policy
22 - 4
Important Chapter Terms
•
•
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•
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•
•
•
Agency theory
Bird in the hand argument
Cash cow
Declaration date
Dividend reinvestment plans
Dividend yield
Equity market capitalization
Ex-dividend date
•
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•
•
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
CHAPTER 22 – Dividend Policy
22 - 5
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
CHAPTER 22 – Dividend Policy
22 - 6
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.
CHAPTER 22 – Dividend Policy
22 - 7
Dividends a Financing Decision
– 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
Retained Earnings
Corporate Profits After Tax
Dividends
CHAPTER 22 – Dividend Policy
22 - 8
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)
CHAPTER 22 – Dividend Policy
22 - 9
Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date
– 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
– The date on which the shareholders register is closed
after the trading day and all those who are listed will
receive the dividend.
CHAPTER 22 – Dividend Policy
22 - 10
Dividend Payments
Mechanics of Cash Dividend Payments
Ex dividend Date
– The date that the value of the firm’s common shares will
reflect the dividend payment (i.e.. 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 exdividend date and beyond WILL NOT receive the declared
dividend.
Date of Payment
– The date the cheques for the dividend are mailed out to
the shareholders.
CHAPTER 22 – Dividend Policy
22 - 11
Dividend Declaration Time Line
2 business days prior to the Date of Record
Declaration Date
The Board Meets
and passes the
motion to create
the dividend
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.
CHAPTER 22 – Dividend Policy
22 - 12
Trade Settlement and the Ex Dividend
Date
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.
CHAPTER 22 – Dividend Policy
22 - 13
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)
CHAPTER 22 – Dividend Policy
22 - 14
Dividend Payments
Dividend Reinvestment Plans (DRIPs)
• 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 ongoing relationship with shareholders
CHAPTER 22 – Dividend Policy
22 - 15
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.
CHAPTER 22 – Dividend Policy
22 - 16
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
CHAPTER 22 – Dividend Policy
22 - 17
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:
CHAPTER 22 – Dividend Policy
22 - 18
Dividend Payments
Stock Dividend Example
After the stock dividend:
ABC Company
Equity Accounts
as at March 1, 20x9
Common stock (236,500)
Retained earnings
Net worth
$5,860,000
19,140,000
$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.
CHAPTER 22 – Dividend Policy
22 - 19
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)
CHAPTER 22 – Dividend Policy
22 - 20
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 = P0[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
CHAPTER 22 – Dividend Policy
22 - 21
Dividend Payments
Further Stock Split Examples
A 4 for 3 Stock Split:
New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50
The firm’s equity accounts:
Commons shares (133,333 outstanding)
Retained earnings
Net Worth
$1,500,000
15,000,000
$16,500,000
A 3 for 4 Reverse Stock Split:
New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00
The firm’s equity accounts:
Commons shares (75,000 outstanding)
Retained earnings
Net Worth
$1,500,000
15,000,000
$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.
CHAPTER 22 – Dividend Policy
22 - 22
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.
CHAPTER 22 – Dividend Policy
22 - 23
Stock Dividends versus Stock Splits
Stock Dividends
Stock Splits
•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
the investor
•same
CHAPTER 22 – Dividend Policy
22 - 24
Cash Dividend Payments
The Macro Perspective
• Figure 22-2 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.
CHAPTER 22 – Dividend Policy
22 - 25
Cash Dividend Payments
Aggregate Dividends and Profits
FIGURE 22-2
CHAPTER 22 – Dividend Policy
22 - 26
Cash Dividend Payments
The Macro Perspective
• Figure 22-3 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)
CHAPTER 22 – Dividend Policy
22 - 27
Cash Dividend Payments
Aggregate Dividend Payouts
FIGURE 22-3
CHAPTER 22 – Dividend Policy
22 - 28
Cash Dividend Payments
The Macro Perspective - Question
• Why are dividends smoothed and not matched
to profits?
CHAPTER 22 – Dividend Policy
22 - 29
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
CHAPTER 22 – Dividend Policy
22 - 30
Cash Dividend Payments
Dividend Yields
Table 22-1 S&P/TSX 60 Index Dividend Yields
BCE
Celestica Inc.
CIBC
Cott Corporation
Kinross Gold Corporation
TransAlta Corporation
Yellow Pages Income Fund
1996
%
1997
%
1998
%
1999
%
2000
%
2001
%
2002
%
2003
%
2004
%
2005
%
Average
4.69
0
3.67
0.23
0
6.22
3.42
0
3.07
0.53
0
5.16
2.52
0
2.85
0.54
0
4.52
1.41
0
3.37
0
0
5.35
1.07
0
3.17
0
0
5.59
3.15
0
2.9
0
0
4.06
3.99
0
3.48
0
0
4.92
4.08
0
3.28
0
0
5.73
4.29
0
3.31
0
0
5.88
7.34
4.44
0
3.57
0
0
4.51
7.09
3.31
0.00
3.27
0.13
0.00
5.19
7.22
CHAPTER 22 – Dividend Policy
22 - 31
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.
CHAPTER 22 – Dividend Policy
22 - 32
M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value
Start with the single-period DDM:
[ 22-1]
D1  P1
P0 
(1  Ke )
CHAPTER 22 – Dividend Policy
22 - 33
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( D1  P1 )
mP0  V0 
(1  Ke )
CHAPTER 22 – Dividend Policy
22 - 34
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
CHAPTER 22 – Dividend Policy
22 - 35
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:
[ 22-3]
X 1  nP1  I1  mD1
• Where:




X
I
X–I
mD1
represents cash flow from operations
represents investment
is free cash flow
is dividend to current shareholders at time 1
CHAPTER 22 – Dividend Policy
22 - 36
M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value
• Solving for dividends paid out (mD1 ):
mD1  X 1  nP1  I1
CHAPTER 22 – Dividend Policy
22 - 37
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:
[ 22-4]
X1  I1  [( m  n) P1  V1 ]
V0 
(1  K )
• The value of the firm is the value of the next period’s free
cash flow (X1 –I1) plus the next period’s equity market
value…
CHAPTER 22 – Dividend Policy
22 - 38
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:
X t  It
V0  
t
(
1

K
)
t 1

[ 22-5]
Value has
nothing
to do with
dividends
• 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
CHAPTER 22 – Dividend Policy
22 - 39
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.
CHAPTER 22 – Dividend Policy
22 - 40
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:
CHAPTER 22 – Dividend Policy
22 - 41
M&M’s Dividend Irrelevance Theorem
Internal Funds, Investment, and Dividends
22 - 4 FIGURE
OPTIMAL INVESTMENT
Rate of
Return
MC=MR
IOS
WACC
Internal Funds Available
$11,976
Million
$177,607
Million
CHAPTER 22 – Dividend Policy
22 - 42
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.
CHAPTER 22 – Dividend Policy
22 - 43
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?
CHAPTER 22 – Dividend Policy
22 - 44
The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed
• Remember the two-stage DDM?
[ 22-6]
ROE 2  K e
ROE1  BVPS
Inv
P

(
)
Ke
(1  K e )
Ke
– 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.
CHAPTER 22 – Dividend Policy
22 - 45
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
CHAPTER 22 – Dividend Policy
22 - 46
The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory
22 - 5 FIGURE
OPTIMAL INVESTMENT
D1
P0
Gordon
P1  P0
P0
M&M
CHAPTER 22 – Dividend Policy
22 - 47
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
CHAPTER 22 – Dividend Policy
22 - 48
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
CHAPTER 22 – Dividend Policy
22 - 49
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]
ΔDt  β(Dt* -Dt-1 )
CHAPTER 22 – Dividend Policy
22 - 50
Dividend Policy in Practice
Lintner’s Work on Dividend Adjustment
• The target dividend Dt* Lintner suggested is a function
of the firm’s optimal payout rate of the firm’s underlying
earnings (Et) leading to the following equation:
[ 22-8]
Dt  a  (1  b) Dt-1  cE1
• 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
CHAPTER 22 – Dividend Policy
22 - 51
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.
CHAPTER 22 – Dividend Policy
22 - 52
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
CHAPTER 22 – Dividend Policy
22 - 53
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.)
CHAPTER 22 – Dividend Policy
22 - 54
Relaxing the M&M Assumptions
The Signalling Model
22 - 6 FIGURE
et
$
et*
dt*
dt
1
2
CHAPTER 22 – Dividend Policy
3
Time
22 - 55
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.
CHAPTER 22 – Dividend Policy
22 - 56
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.
CHAPTER 22 – Dividend Policy
22 - 57
Relaxing the M&M Assumptions
Taxes
Table 22-3 Individual Tax Rates (% ) on Dividends and Capital Gains
Income Level
British Columbia
Alberta
Ontario
Quebec
Nova Scotia
Dividends
Capital gains
Dividends
Capital gains
Dividends
Capital gains
Dividends
Capital gains
Dividends
Capital gains
$25,000
$50,000
$75,000
$100,000
2.52
12.45
3.63
12.63
0.00
10.65
5.95
14.37
0.00
12.02
6.19
15.58
8.03
16.00
8.24
15.58
15.42
19.19
8.75
18.48
15.69
18.85
13.83
18.00
20.74
21.71
26.06
22.86
17.05
21.34
20.04
20.35
13.83
18.00
20.74
21.71
26.06
22.86
19.06
22.63
CHAPTER 22 – Dividend Policy
22 - 58
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.
CHAPTER 22 – Dividend Policy
22 - 59
Relaxing the M&M Assumptions
MYW’s B Corporation Shares
22 - 7 FIGURE
6
P0  
t 1
dt
P0

(1  k ) t (1  k ) 6
$454 million
MYW
$143 million
$330 million
dt
min($ 30, P6  1)
Pref  

(1  k )6
t 1 (1  k ) t
6
P6  min($ 30, P6  1)
IR 
(1  k ) 6
CHAPTER 22 – Dividend Policy
22 - 60
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.
CHAPTER 22 – Dividend Policy
22 - 61
Share Repurchases
• 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.
CHAPTER 22 – Dividend Policy
22 - 62
Disadvantages of Share Repurchases
•
•
•
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.
CHAPTER 22 – Dividend Policy
22 - 63
Methods of Share Repurchases
•
tender offer:
–
•
open market purchase:
–
–
•
this is a formal offer to purchase a given number of shares at a
given price over current market price.
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.
CHAPTER 22 – Dividend Policy
22 - 64
Repurchased Shares
•
•
•
•
•
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
CHAPTER 22 – Dividend Policy
22 - 65
Repurchase Example
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][EPSnew] = [5][$4.40] = $22.00 per share
CHAPTER 22 – Dividend Policy
22 - 66
Effects of A Share Repurchase
• 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.
CHAPTER 22 – Dividend Policy
22 - 67
Advantages of Share Repurchases
•
•
•
•
•
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.
CHAPTER 22 – Dividend Policy
22 - 68
Disadvantages of Share Repurchases
• 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
CHAPTER 22 – Dividend Policy
22 - 69
Borrowing to Pay Dividends
•
•
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.
CHAPTER 22 – Dividend Policy
22 - 70
Borrowing to Pay Dividends
An Example
Before Borrowing:
Assets:
Cash
Fixed Assets
Total Assets
0% Debt
Liabilities:
10
140
$150
Long-term Debt
0
Common Stock
50
Retained Earnings 100
Total Claims
$150
After Borrowing…before cash dividend:
Assets:
Cash
Fixed Assets
Total Assets
25% Debt
Liabilities:
60
140
$200
Long-term Debt
50
Common Stock
50
Retained Earnings 100
Total Claims
CHAPTER 22 – Dividend Policy
$200
22 - 71
Borrowing to Pay Dividends
An Example …
After Dividend Declaration…before date of payment.
Assets:
Cash
Fixed Assets
Total Assets
Liabilities:
60
140
$200
Current liabilities
Long-term Debt
Common Shares
Retained earnings
Total Claims
50
50
50
50
$200
After Cash Dividend payment of $50
Assets:
Cash
Fixed Assets
Total Assets
50% Debt
33% Debt
Liabilities:
10
140
$150
Long-term Debt
Common Stock
Retained earnings
Claims
CHAPTER 22 Total
– Dividend
Policy
50
50
50
$150
22 - 72
Borrowing to Pay Dividends
An Example
•
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%.)
CHAPTER 22 – Dividend Policy
22 - 73
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.
CHAPTER 22 – Dividend Policy
22 - 74
Copyright
Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (the Canadian copyright licensing
agency) is unlawful. Requests for further information should be
addressed to the Permissions Department, John Wiley & Sons
Canada, Ltd. The purchaser may make back-up copies for his or her
own use only and not for distribution or resale. The author and the
publisher assume no responsibility for errors, omissions, or
damages caused by the use of these files or programs or from the
use of the information contained herein.
CHAPTER 22 – Dividend Policy
22 - 75