Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Week 11: FNCE10002 Principles of Finance
Capital Structure and Payout Policy II
Mrinal Mishra, Ph.D.
Senior Lecturer, Department of Finance
Room 12.044, Faculty of Business and Economics
03 903 53420
mrinal.mishra@unimelb.edu.au
11.1
1
11. Capital Structure and Payout Policy II
1.
2.
3.
4.
Examine various payout policies of firms
Examine bonus shares and share splits
Examine the factors affecting dividend and share repurchase decisions
Does payout policy affect firm value?: An overview of theory and practice
These notes have been prepared by Asjeet S. Lamba, Department of Finance, University of Melbourne for
use by students enrolled in FNCE10002 Principles of Finance. Please let me know if you find any typos or
errors. This material is copyrighted by Asjeet S. Lamba and reproduced under license by the University of
Melbourne (© 2017-23)
11.2
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Required Readings: Weeks 11 – 12
 Week 11
 GRAH, Ch. 13 (Review Sec 13.1 – 13.3) Ch. 15
 Week 12
 GRAH, Ch. 8 (Sec 8.1 – 8.3)
11.3
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11.1 Payout Policies of Firms

The net after-tax cash flows (or free cash flows) of a firm can be put to several
uses, including paying dividends and repurchasing shares
11.4
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Summary of Payout Policies
 Regular dividend
 Dividends paid out to the shareholders every period (usually quarter, half-year or full
year)
 Special dividend
 A one-time dividend payment made by a firm, which is usually much larger than its
regular dividend
 Share split and bonus shares
 A dividend paid in ordinary shares rather than as cash to shareholders
 Share repurchase (or share buyback)
 A return of cash to shareholders via either an on-market or off-market repurchase of
shares
 Liquidating dividend (not covered)
 A return of capital to shareholders from a business operation that is being terminated
11.5
5
Institutional Features of Dividends
Dividend declaration (or announcement) date
 Record date
 The date on which the names all persons appearing as shareholders are entitled to receive
the dividend
 Ex-dividend date
 Typically, 1 – 2 business days before the record date so there is enough time for
company records to be updated
 If you purchase the shares before this date, you receive the announced dividend
 On, or after, this date you do not receive the announced dividend
 Payment date
 Date dividend is paid electronically (or mailed)
 Link to dividend information on ASX-listed firms:
https://www.asx.com.au/asx/markets/dividends.do

6
11.6
Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Case Study 1: CBA’s Dividend Announcement

Feb 15, 2023: Commonwealth Bank of Australia (ASX code: CBA) announced a fully
franked interim dividend of $2.10 per share. The 2023 interim dividend will be paid on 30
March 2023. The ex-dividend date is 22 February 2023 and the record date is 23 February
2023 (5 pm AEDT). The Group’s dividend reinvestment plan (DRP) will continue to
operate. No discount will be applied to shares issued under the DRP for this dividend
Source: www.commbank.com.au/about-us/shareholders/shareholder-information/dividend.html

Summary of CBA’s interim dividend of $2.10 per share
Declaration date
15 February 2023 (Wednesday)
Ex-dividend date
22 February 2023 (Wednesday)
Record date
23 February 2023 (Thursday)
Final dividend payment date
30 March 2023 (Thursday)
11.7
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Case Study 1: CBA’s Dividend Announcement
Declaration Date
February 15
Record Date
February 23
Payment Date
March 30
Ex-Dividend Date
February 22
The dividend of $2.10 declared by CBA on February 15 is payable on March 30 to
shareholders of record on February 23
 The ex-dividend date is 1 business day before the record date
 Shares trade without the dividend (“ex dividend”) from February 22 onwards
 Shares trade with the dividend (“cum dividend”) before February 22
 If no new information comes to the market, what will likely happen to the price of
shares on the ex-dividend date and why?

8
11.8
Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Case Study 1: CBA’s Dividend Announcement
$112
Declaration date: Feb 15 (Price = $103.00,
Price drop = $6.25! – What happened here?)
$110
$108
Feb 21 (Price = $101.52)
Feb 14 (Price = $109.25)
Share Price
$106
Record date: Feb 23 (Price = $99.90)
$104
$102
Payment date: Mar 30 (Price = $97.75)
$100
$98
$96
Ex dividend date: Feb 22 (Price = $99.20,
Price drop = $2.32)
$94
01-Feb-23
09-Feb-23
17-Feb-23
25-Feb-23
05-Mar-23
13-Mar-23
21-Mar-23
29-Mar-23
Source: https://finance.yahoo.com/quote/CBA.AX?p=CBA.AX. Daily share price data for CBA from
Feb 1 – Mar 31, 2023
11.9
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Dividend Payout Policies
 Pure residual dividend policy
 Pay out any earnings that the firm does not need to reinvest
 Dividends and dividend payout ratios tend to be unstable
 Smoothed (or fixed) dividend policy
 Target a proportion of earnings to be paid out as dividends
 Objective here is for the dividends to equal the (long run) difference between expected
earnings and expected capital expenditures – Stable dividends over time
 Constant payout dividend policy
 Pay a constant amount as dividends
 Stable dividend payout ratio but unstable dividend amounts
 Low regular dividend and special (or extra) dividend policy
11.10
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividend Payout Policies
 Illustration: ABL Ltd has projected the following total net income and capital
expenditures
Net Income
Capital Expenditures
Year 1
$3,000,000
$2,000,000
Year 2
$4,000,000
$5,000,000
Year 3
$5,000,000
$3,000,000
 ABL has 2,000,000 shares outstanding and currently pays an annual dividend of
$0.50 per share. For each scenario below, calculate the dividends per share paid and
external financing needed over the next three years.
 Case 1: The company adopts a pure residual dividend policy
 Case 2: The company maintains its current dividend per share of $0.50
 Case 3: The company maintains a fixed dividend payout ratio of 40 percent.
 Comment on the degree of variability in dividends for each scenario above
11.11
11
Dividend Payout Policies
 Case 1: The company adopts a pure residual dividend policy
1. Net income
2. Capital expenditures
3. Net cash flows = (1) − (2)
4. Total dividends*
5. Total shares outstanding
6. External financing required
7. Dividend per share**
Year 1
$3,000,000
$2,000,000
$1,000,000
$1,000,000
2,000,000
$0
$0.50
Year 2
$4,000,000
$5,000,000
−$1,000,000
$0
2,000,000
$1,000,000
$0.00
Year 3
$5,000,000
$3,000,000
$2,000,000
$2,000,000
2,000,000
$0
$1.00
* Total dividend = Net income – Capital expenditure (if positive)
** Dividend per share = Total dividend/2000000
11.12
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividend Payout Policies
 Case 2: The company maintains its current dividend per share of $0.50
1. Net income
2. Capital expenditures
3. Net cash flows = (1) − (2)
4. Total dividends*
5. Total shares outstanding
6. External financing required
7. Dividend per share**
Year 1
$3,000,000
$2,000,000
$1,000,000
$1,000,000
2,000,000
$0
$0.50
Year 2
$4,000,000
$5,000,000
−$1,000,000
$1,000,000
2,000,000
$2,000,000
$0.50
Year 3
$5,000,000
$3,000,000
$2,000,000
$1,000,000
2,000,000
$0
$0.50
* Total dividend = 0.50 × 2000000 shares
** Dividend per share = Total dividend/2000000
11.13
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Dividend Payout Policies
 Case 3: The company maintains a fixed dividend payout ratio of 40 percent
1. Net income
2. Capital expenditures
3. Net cash flows = (1) − (2)
4. Total dividends*
5. Total shares outstanding
6. External financing required
7. Dividend per share**
Year 1
$3,000,000
$2,000,000
$1,000,000
$1,200,000
2,000,000
$200,000
$0.60
Year 2
$4,000,000
$5,000,000
−$1,000,000
$1,600,000
2,000,000
$2,600,000
$0.80
Year 3
$5,000,000
$3,000,000
$2,000,000
$2,000,000
2,000,000
$0
$1.00
* Total dividend = 0.40 × Net income
** Dividend per share = Total dividend/2000000
 What trends do we observe? www.pollev.com/Mrinal
11.14
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Low Regular Dividend and Extra Dividend Policy
 This policy involves paying a low regular dividend, supplemented by special (or
extra) cash dividends as warranted by earnings
 The graph on the next slide shows the dividend history of Costco Wholesale Corp
(Nasdaq: COST) from 2011 – 2020 when it has paid a relatively low quarterly
dividend supplemented with large special dividends every 2 to 3 years
Payable
Amount
Type
11-Dec-20
$10.00
Special Cash
13-Nov-20
$0.70
Regular Cash
14-Aug-20
$0.70
Regular Cash
15-May-20
$0.70
Regular Cash
21-Feb-20
$0.65
Regular Cash
Dividend yield for regular dividend paid
in Nov 2020: 0.70/380.20 = 0.18%
 Dividend yield for special dividend paid
in Dec 2020: 10.00/365.60 = 2.74%
 What are the incentives or reasons for
doing so? Any thoughts?

11.15
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Low Regular Dividend and Extra Dividend Policy
Special dividend: $10.00
$10.00
$9.00
$8.00
Special dividend: $7.00
Special dividend: $7.00
$7.00
$6.00
Special dividend: $5.00
$5.00
$4.00
$3.00
$2.00
Regular dividends
$1.00
Jun-20
Oct-20
Feb-20
Jun-19
Oct-19
Feb-19
Jun-18
Oct-18
Feb-18
Jun-17
Oct-17
Feb-17
Jun-16
Oct-16
Feb-16
Jun-15
Oct-15
Feb-15
Jun-14
Oct-14
Feb-14
Jun-13
Oct-13
Feb-13
Jun-12
Oct-12
Feb-12
Jun-11
Oct-11
Feb-11
$0.00
11.16
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Examples of Dividend Payout Policies in Australia
11.17
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Examples of Dividend Payout Policies in Australia
www.pollev.com/Mrinal
Source: Bergmann (2016) “The Rise in Dividend Payments”, RBA Bulletin, Table 2. Public statements of dividend
policies of selected ASX 20 companies.
18
11.18
Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividend Payouts in Practice: The US Experience
Evidence suggests
that firms smoothen
dividends over time
rather than adjusting
them in response to
earnings changes
 Repurchase are
typically used to
return temporary
earnings to
shareholders

11.19
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Dividend Payout Ratios in the US and Australia
What accounts
for the significant
divergence in
payout ratios
between the US
and Australia
since the 1990s?
11.20
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
The Classical Versus Imputation Tax Systems
 The significant divergence in payout ratios between the US and Australia since the
1990s can be attributed to differences in how dividend income is taxed in Australia
versus the US
 US: The “classical” tax system
 Australia: The imputation tax system which was introduced in 1987
 Illustration: A company has taxable earnings of $1,000,000, 1 million shares
outstanding, and a 100% dividend payout policy. Its corporate tax rate is 30%.
Shareholder A has a marginal tax rate of 40% and she owns 1,000 shares of the
company, or 0.1% of the shares outstanding. Shareholder B has a marginal tax rate
is 15% and he also owns 1,000 shares of the company 0.1% of the shares
outstanding
11.21
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The Classical Versus Imputation Tax Systems
 At the company level…
Taxable earnings
$1,000,000
Corporate tax (at 30%)
$300,000
Net income (= Dividend paid)
$700,000
Number of shares
1,000,000
Dividend per share
$0.70
 At the shareholder level, before personal taxes…
Share of earnings (0.1%)
$1,000
Dividends received (0.1%)
$700
11.22
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
The Classical Versus Imputation Tax Systems

At the shareholder level, after personal taxes…
23
Shareholder A (tp = 40%)
Shareholder B (tp = 15%)
Dividends received (0.1%)
$700
$700
Personal tax (at tp)
$280
$105
After-tax dividend
$420
$595

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 × 1 − 𝑡
× 1−𝑡
= 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

$1,000 × 1 − 0.30 × 1 − 𝑡
= 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
$1,000 × 1 − 0.30 × 1 − 0.40 = $420 𝑓𝑜𝑟 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝐴
 $1,000 × 1 − 0.30 × 1 − 0.15 = $595 𝑓𝑜𝑟 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝐵
 The net effect of a classical tax system is that earnings are double-taxed, first at the
corporate level and then at the personal level

11.23
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The Classical Versus Imputation Tax Systems
 The imputation tax system in Australia seeks to eliminate the double-taxation of
dividends at the investor level
 It’s called the imputation system because it attributes (or imputes) taxes owed
by the company to its shareholders
 Two important features of the imputation tax system…
 Resident taxpayers pay tax on the pre-corporate tax income that gave rise to the
dividend, rather than the dividend itself. This is known as the “grossed-up”
dividend and is calculated as…


𝐷𝑖𝑣
=
Resident taxpayers then receive a tax credit for the corporate taxes already paid
 This is known as a franking credit or imputation credit
24
24
11.24
Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
The Classical Versus Imputation Tax Systems

Under the imputation system, at the shareholder level, after personal
taxes…
25
Shareholder A (tp = 40%)
Shareholder B (tp = 15%)
$700
$700
700/(1 – 0.3) = $1,000
700/(1 – 0.3) = $1,000
Personal tax liability (at tp)1
$400
$150
Franking credit (0.1%)2
$300
$300
After-tax dividend3
$600
$850
Dividends received (0.1%)
Grossed-up dividends

Notes:
1. Personal tax liability = (Grossed-up dividend) × tp
2. Franking credit = Earnings × tc
3. After-tax dividend = Dividends received – Personal tax liability + Franking credit
11.25
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The Classical Versus Imputation Tax Systems
26paid out as dividends are
 The net effect of an imputation tax system is that earnings
taxed only once at the shareholder’s marginal tax rate
 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 ×
1−𝑡
= 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
 $1,000 ×
1 − 0.40 = $600 𝑓𝑜𝑟 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝐴
 $1,000 × 1 − 0.15 = $850 𝑓𝑜𝑟 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝐵
 Compare this with the situation under the classical tax system…
 $1,000 ×
 $1,000 ×
1 − 0.30 × 1 − 0.40 = $420 𝑓𝑜𝑟 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝐴
1 − 0.30 × 1 − 0.15 = $595 𝑓𝑜𝑟 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝐵
 How has the imputation tax system influenced firms’ dividend payout policies?
11.26
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividend Payouts in Practice: The Australian Experience
Average
dividend yields
of Australia
firms are over
3.5% and
second to
dividend yields
in the UK
Source: https://www.adviservoice.com.au/2020/12/cpd-the-australian-dividend-landscape-versus-global-dividends,
Chart 5 which shows average dividend yields for selected markets and regions at the end of 2020.
11.27
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Dividend Payouts in Practice: The Australian Experience
Average
dividend
payout ratios of
Australia firms
are almost 80%
and second to
dividend
payout ratios in
the UK
Source: https://www.adviservoice.com.au/2020/12/cpd-the-australian-dividend-landscape-versus-global-dividends,
Chart 6 which shows average dividend payout ratios for selected markets and regions at the end of 2020.
28
11.28
Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividend Payouts in Practice: The Australian Experience
Dividend payout ratios
and dividend yields for
selected Australia firms
show that 75% of all
companies pay out 50%
or more of their
earnings, only 18% of
companies have a
higher retention rate,
and very few (7%) have
the highest reinvestment
Source: https://www.adviservoice.com.au/2020/12/cpd-the-australian-dividend-landscape-versus-global-dividends,
Chart 7 which shows dividend payout ratios and dividend yields for selected ASX-listed firms at the end of 2020.
11.29
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Dividend Payouts in Practice: The Australian Experience
Dividend payout
ratios and dividend
yields for selected
industrial sectors
show that there is a
tendency for these to
be high across most
sectors with only the
healthcare and IT
sectors reinvesting for
the future
Source: https://www.adviservoice.com.au/2020/12/cpd-the-australian-dividend-landscape-versus-global-dividends,
Chart 8 which shows dividend payout ratios and dividend yields for selected sectors on the ASX at the end of 2020.
30
11.30
Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
11.2 Bonus Shares and Share Splits
 Bonus shares (or share dividends) are payments made to existing shareholders where
the dividend takes the form of new shares issued
 Example 1: A company has 10 million shares outstanding trading at $10 per share. If
it pays a 20% share dividend what will happen to the number of shares outstanding,
the share price and the market value of its shares?
 The number of shares outstanding increases by 20%: 10 × 1.20 = 12 million
 The price per share changes by a factor of 1/1.20 = 0.833 (Not a 20% fall!)
 Price after share dividend = 10.00 × 0.833 = $8.33
 The market value of shares does not change…
 Before payment: 10 × 10.00 = $100 million
 After payment: 12 × 8.33 = $100 million
11.31
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Bonus Shares and Share Splits
 Share splits affect a company’s shares in a similar way to share dividends. When a
company conducts a share split, its share price declines because the number of
outstanding shares increases
 Example 2: A company has 10 million shares outstanding trading at $10 per share. If
it conducts a 2-for-1 share split what will happen to the number of shares
outstanding, the share price and the market value of its shares? What would happen
if this was a 5-for-1 share split?
 A 2-for-1 share split means that for every 1 share owned you receive 2 shares after
the split
 A 5-for-1 share split means that for every 1 share owned you receive 5 shares after
the split
11.32
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Bonus Shares and Share Splits
 In the case of a 2-for-1 share split…
 The number of shares outstanding double: 10 × 2 = 20 million
 The price per share changes by a factor of 1/2 = 0.5
 Price after share split = 10.00 × 0.5 = $5.00
 The market value of shares does not change…
 Before share split: 10 × 10.00 = $100 million
 After share split: 20 × 5.00 = $100 million
11.33
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Bonus Shares and Share Splits
 In the case of a 5-for-1 share split…
 The number of shares outstanding increases five-fold: 10 × 5 = 50 million
 The price per share changes by a factor of 1/5 = 0.2
 Price after share split = 10.00 × 0.2 = $2.00
 The market value of shares does not change…
 Before share split: 10 × 10.00 = $100 million
 After share split: 50 × 2.00 = $100 million
11.34
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Bonus Shares and Share Splits
Reverse share splits are the opposite of share splits where the number of shares outstanding decreases,
and the share price rises as a result of a consolidation of shares
 Example 3: A company has 1 billion shares outstanding trading at $0.10 per share. If it conducts a 1for-100 reverse share split what will happen to the number of shares outstanding, the share price and
the market value of its shares?
 The number of shares outstanding falls by a factor of 100: 1000/100 = 10 million
 The price per share rises by a factor of 100: 0.10 × 100 = $10.00
 The market value of shares does not change…
 Before reverse share split: 1000 × 0.10 = $100 million
 After reverse share split: 10 × 10.00 = $100 million
 If nothing changes, why do firms bother with share splits or reverse share splits?

Affordability
Liquidity
 Signaling


11.35
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Case Study 2: Would you Like a Split With Your Latte?
 Starbucks Corp. (Nasdaq: SBUX) issued 2.1 million shares at $17.00 and listed on
the Nasdaq market on 26 June 1992. Since then, Starbucks’ shares have split 6 times
where each split was a 2-for-1 share split (see next slide). Calculate the split adjusted
IPO price of the company. The share price of Starbucks in mid-May 2024 was
$74.93. What would this share price have been if the company had never split its
shares? Calculate Starbucks’ total rate of return since the IPO (ignoring dividends).
Calculate Starbucks’ compounded annual rate of return since its IPO (ignoring
dividends). (To simplify the analysis, assume that year 0 is the end of 1992)
11.36
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Case Study 2: Would you Like a Split With Your Latte?
 The table shows the share split history of Starbucks since its IPO
Starbucks Corp’s Split History
Date
Split ratio
30-Sep-93
2-for-1
04-Dec-95
2-for-1
22-Mar-99
2-for-1
30-Apr-01
2-for-1
24-Oct-05
2-for-1
09-Apr-15
2-for-1
Source: https://investor.starbucks.com/stock-information/dividend-and-stock-split-history/default.aspx

For example, if you had purchased 1,000 shares after Starbucks went public in June 1992,
on 30 Sep 1993 he would have received 2,000 shares for these 1,000 shares and the share
price would have halved. By end-April 2015 he would have owned 64,000 shares!
11.37
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Case Study 2: Would you Like a Split With Your Latte?
Source: finance.yahoo.com. Share price and split history of Starbucks Corp (Nasdaq: SBUX) since its IPO in
June 1992 adjusted for the six share splits. The S letter indicates the 2-for-1 stock splits over this period.
38
11.38
Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Case Study 2: Would you Like a Split With Your Latte?
 The IPO price, adjusted for the six splits = 17/(2 × 2 × 2 × 2 × 2 × 2) = $0.265625
 What would this share price have been if the company had never split its shares?
 The share price on May 6, 2024 was $74.93
 The unadjusted share price would have been…
 74.93 × (2 × 2 × 2 × 2 × 2 × 2) = $4,795
 What is Starbucks’ total return since the IPO (ignoring dividends)?
 Using the prices adjusted for share splits…
 Total RSBUX = (74.93 – 0.265625)/0.265625 = approx. 28,100%!
 Alternatively, using the prices unadjusted for share splits…
 Total RSBUX = (4795 – 17.00)/17.00 = approx. 28,100%
11.39
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Case Study 2: Would you Like a Split With Your Latte?
 What is Starbucks’ compounded annual return since its IPO (ignoring dividends)?
 Assuming that year 0 is the end of 1992 and we’re at the end of 2023, we have…
 Total number of years, n = 2023 – 1992 = 31 years
 Using the prices adjusted for share splits…
 74.93 = 0.265625(1 + RSBUX)31
 RSBUX = (74.93/0.265625)1/31 – 1 = 19.96%
 Using the prices unadjusted for share splits…
 4795 = 17(1 + RSBUX)31
 RSBUX = (4795/17)1/31 – 1 = 19.96%
11.40
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
11.3 Factors Affecting Dividends and Share Repurchases
 Share repurchases (or share buybacks in Australia) have become a significant
mechanism for returning cash to shareholders since the early 2000s (see next graph)
 They enhance shareholder value, perhaps because they have traditionally been a tax-
advantaged method of distributing cash
 Two methods of repurchasing shares in Australia…
 Off-market buybacks
 On-market buybacks (our focus)
 Note that in Australia shares repurchased are cancelled, reducing the shares outstanding
 Share repurchases can also potentially send a positive signal to investors in the
market that management believes the shares are undervalued
 A commonly cited advantage of share buybacks is that they increase the company’s
earnings per share as the number of shares on issue declines (see next slide)
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Factors Affecting Dividends and Share Repurchases
Investors Rewarded with Bumper Dividends, Buybacks
 Aug 31, 2021: The latest corporate profit reporting season saw three-quarters of
companies reporting higher earnings than a year ago, with more than $34 billion
in dividends declared as well as $20-billion worth of share buybacks. The
resources sector was the standout, with profit growth of almost 100 per cent on the
back of soaring commodity prices… A feature of the reporting season, which runs
during August, is how keen companies are to reward shareholders – not only with
higher or special dividends but also with share buybacks. Buybacks benefit
shareholders as, with fewer shares in circulation, earnings per share improves as
do dividends per share.
Source: https://www.smh.com.au/business/companies/investors-rewarded-with-bumper-dividends-buybacks
11.42
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Factors Affecting Dividends and Share Repurchases
 However…
 Where does the cash to buyback shares come from? What are the three possible sources?
 If (say) a company sells 10% of its productive assets to raise cash to buyback 10% of its
shares, what would you expect to happen to its earnings?
 Any comprehensive payout policy involves examining dividend payments and
implementing share repurchase programs together
11.43
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Factors Affecting Dividends and Share Repurchases
In the US, share
repurchases have
become a
significant
mechanism for
returning cash to
shareholders since
the early 2000s
11.44
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividends Versus Share Repurchases
On average, share
repurchases are
viewed as being
discretionary
whereas dividends
are not
11.45
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Dividends Versus Share Repurchases
Undervaluation
Note!
Several factors
determine the
decision of
managers to
repurchase shares
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
11.4 Does Payout Policy Affect Firm Value?: Theory
 In addition to their capital structure theory, Modigliani and Miller (1961) also
proposed the dividend irrelevance theory
 The main assumptions of this theory are…
 Capital markets are perfect
 The firm can issue and sell new shares as and when needed
 There are no personal taxes
 The firm is all-equity financed (capital structure decisions are ignored)
 The firm has a given investment plan which is not affected by changes in its
dividends (capital investment decisions are ignored)
 Firm value is determined only by the earnings generated by the firm’s assets
 How the earnings stream is divided between dividends and retained earnings does
not affect shareholders’ wealth
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Does Payout Policy Affect Firm Value?: Theory
 Illustration: Genron Corp’s board is meeting to decide how to pay out $20 million in
excess cash to shareholders. Genron has no debt and its cost of equity equals its
(unlevered) cost of capital of 12%. It has 10 million shares outstanding so the firm
will be able to pay a $2 per share dividend immediately. The firm expects to
generate future net cash flows of $48 million per year and anticipates paying a
dividend of $4.80 per share every year thereafter. Which, if any, of the following
three payout policies would be preferred by shareholders?
 Policy 1: Pay dividends with excess cash
 Policy 2: Repurchase shares and pay no dividend
 Policy 3: Pay a higher dividend now and issue new equity
11.48
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Does Payout Policy Affect Firm Value?: Theory
 The firm’s total market value today is…
 V0 = Cash on hand + PV(Expected cash flows)
 V0 = 20.0 + 48.0/0.12 = $420 million
 Policy 1: Pay dividends with excess cash
 Before the dividend is paid, the shares trade with the dividend (or cum-dividend) and
when the shares begin to trade ex-dividend the share price drops by the amount of
the dividend (see next slide)
11.49
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Does Payout Policy Affect Firm Value?: Theory
 The firm’s cum-dividend price is the price including the current period’s
dividend, that is…
 PCum-Div = D0 + PV(Future dividends)
𝑃
= 2.00 +
4.80
= 2.00 + 40.00 = $42.00
0.12
 After the ex-dividend date, new shareholders will not receive the current
dividend so the firm’s share price will fall to…
4.80
𝑃
= 𝑃𝑉(Future dividends) =
= $40.00
0.12
 The original shareholders receive $2.00 dividend, and their shares are now worth
$40.00 so their wealth does not change
11.50
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Does Payout Policy Affect Firm Value?: Theory
Policy 1: Pay dividends with excess cash
Cum-Dividend
Ex-Dividend
Cash
$20,000,000
$0
Other assets
$400,000,000
$400,000,000
Total market value
$420,000,000
$400,000,000
Total shares
10,000,000
10,000,000
Share price
$42.00
$40.00
 In a perfect capital market, when a dividend is paid with
excess cash, shareholders will be indifferent because their preand post-dividend wealth remains unchanged
11.51
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Does Payout Policy Affect Firm Value?: Theory
 Policy 2: Repurchase shares and pay no dividend
 Suppose that instead of paying a dividend now the firm uses the $20 million to
repurchase its shares on the open market
 The number of shares repurchased is…
 20000000/42.00 = 476,190 shares
 The number of shares outstanding after the repurchase are…
 10000000 – 476190 = 9,523,810 shares
 After the repurchase, the firm’s expected dividend per share will increase to…
 48000000/9523810 = $5.04 per share
 P0 = 5.04/0.12 = $42.00
 How has the wealth of original shareholders changed?
11.52
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Does Payout Policy Affect Firm Value?: Theory
Policy 2: Repurchase shares and pay no dividend
Before repurchase
After repurchase
Cash
$20,000,000
$0
Other assets
$400,000,000
$400,000,000
Total market value
$420,000,000
$400,000,000
Total shares
10,000,000
9,523,810
Share price
$42.00
$42.00
 In perfect capital markets, an open market share repurchase
has no effect on the share price, and the share price is the
same as the cum-dividend price if a dividend were paid
instead
11.53
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Does Payout Policy Affect Firm Value?: Theory
 What if investors have different preferences for cash versus shares? Would this
not result in payout policy affecting firm value?
 Example: An investor owns 2,000 shares of Genron. What is this investor’s
situation after a dividend payment versus the share repurchase if she does not sell
her shares back to the firm?
Dividend
Repurchase
Market value of shares 40.00(2000) = $80,000 42.00(2000) = $84,000
Cash from dividend
Total value
2.00(2000) = $4,000
$84,000
$84,000
11.54
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Does Payout Policy Affect Firm Value?: Theory
 If the firm repurchases shares but this shareholder wants cash, she can raise cash
by selling shares
 That is, investors can create their own homemade dividend
 To raise $4,000 in cash, she needs to sell…
 4000/42 ≈ 95 shares
 Value of shares remaining = 1905 × 42.00 ≈ $80,000
 If the firm pays a dividend and this shareholder prefers shares, she can use the
dividend paid to purchase additional shares
 Number of shares purchased…
 4000/40 = 100 shares
 Value of total shares = 2100 × 40.00 = $84,000
11.55
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Does Payout Policy Affect Firm Value?: Theory
 The investor’s wealth does not change as a result of the firm’s decision to pay
dividends versus repurchase shares. What the firm does the investor can undo!
Repurchase and sell shares
Dividend and buy shares
42.00(1905) ≈ $80,000
40.00(2100) = $84,000
42.00(95) ≈ $4,000
$84,000
$84,000
 By selling shares or reinvesting dividends investors can replicate either
of the firm’s payout method on their own
 In perfect capital markets, investors are indifferent between the firm
distributing funds via dividends or share repurchases
11.56
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Does Payout Policy Affect Firm Value?: Theory
 Policy 3: Pay a higher dividend and issue new equity
 Suppose the firm wants to pay a dividend larger than $2.00 per share right now, but
it only has $20 million in cash today
 Assume the firm wants to pay a $48 million dividend now rather than in one year’s time
(as planned)
 The firm would need an additional $28 million to pay the larger dividend now. To do
this, the firm decides to raise the cash by selling new shares
 Given a current share price of $42.00, the firm could raise $28 million by selling
666,667 shares
 28000000/42.00 = 666,667 shares
 The total number of shares outstanding after the share issue is 10,666,667 shares
11.57
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Does Payout Policy Affect Firm Value?: Theory
 So, the new dividend per share is…
 48000000/10,666,667 = $4.50
 The cum-dividend share price is…
 PCum-Div = D0 + PV(Future dividends)
 PCum-Div = 4.50 + 4.50/0.12 = $42.00
 There is a trade-off between current and future dividends…
 A higher dividend now implies lower dividends in the future
 A lower dividend now implies higher dividends in the future
 In perfect capital markets, holding fixed the investment policy of a firm, the firm’s
choice of dividend policy is irrelevant and does not affect the share price today
11.58
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Does Payout Policy Affect Firm Value?: Theory
 Summary of outcomes from the three payout policies
Dividend per share paid
Initial
share price
Year 0
Year 1
Year 2
...
Policy 1
$42.00
$2.00
$4.80
$4.80
...
Policy 2
$42.00
$0.00
$5.04
$5.04
...
Policy 3
$42.00
$4.50
$4.50
$4.50
...
 What about the real world? Evidence indicates that managers pay a lot
of attention to their payout policies, as does the market
 What market imperfections have we not considered?
11.59
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Does Payout Policy Affect Firm Value?: Practice
 In theory payout policy does not matter but all evidence indicates that managers pay
a lot of attention to payout policy, as does the market
 This means that there are market imperfections that need to be considered
 The differential tax treatment of dividend income versus capital gains is the most
obvious market imperfection that can result in shareholders preferring other payout
alternatives over dividend payments, or vice versa
 We examine this difference in the tax treatment of dividends by comparing a firm’s
dividend policy under…
 A classical tax system
 An imputation tax system (briefly)
11.60
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividend Policy in a Classical Tax System
 Recall that under a classical tax system…
 From one dollar of corporate earnings, the shareholder ends up with (1 – tc)(1 – tp)
dollars of after-personal-tax dividend and dividends are effectively taxed twice
 tc = The corporate tax rate
 tp = The marginal personal tax rate
 Long-term capital gains (that is, over 12 months or more) are taxed at a lower rate
than dividends and the effective tax rate on capital gains may even approach zero if
the sale of shares is postponed well into the future, or forever
 Shareholders will pay lower taxes if a firm uses share repurchases rather than dividends
 The optimal dividend policy would be to pay no dividends at all!
11.61
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Dividend Policy in a Classical Tax System
 Note that the preference for share repurchases rather than dividends depends on the
difference between the dividend tax rate and the capital gains tax rate
 As a result of their different tax rates investors will have varying preferences regarding
dividends resulting in shareholder “clienteles”
 Shareholder “clienteles” imply…
 Shareholders who pay high taxes will tend to prefer low (or no) dividend-paying firms
 Shareholders who do not pay taxes (or pay low taxes) will prefer high dividend-paying
firms
 What does this analysis suggest about dividend policy at the company level?
11.62
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividend Policy in an Imputation Tax System
 Under an imputation tax system in Australia…
 Earnings distributed as “franked” dividends to resident shareholders are effectively
taxed only once at the shareholder’s (marginal) personal tax rate
 Long-term capital gains (that is, over 12 months or more) are taxed at half the rate of
ordinary income
 If all of the firm’s shares were held by resident shareholders with marginal tax
rates less than the corporate tax rate, then the optimal dividend policy would be to
pay as much dividends as would exhaust all the available franking credits
 However…
 Not all shareholders are resident shareholders
 Individuals whose personal marginal tax rates are higher than the corporate tax rate
would prefer the retention of earnings (or share repurchases) over dividends
11.63
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Dividend Policy in an Imputation Tax System
 The implication is that shareholder “imputation clienteles” may exist at the firm
level
 The interaction of capital gains tax and the imputation tax system means that
shareholders with low marginal tax rates would prefer earnings to be paid out as fully
franked dividends
 Shareholders in high marginal tax rates may tend to prefer earnings to be retained (or
shares to be repurchased instead)
 What does this analysis suggest about dividend policy at the company level?
11.64
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividend Policy and Non-Tax Explanations
 The non-tax related explanations of why dividend policy may matter relate to
various factors, including…
 Cash retention to cover potential future cash shortfalls
 Cash retention to help fund future growth opportunities
 Cash retention to avoid financial distress
 Payment of excessive cash to avoid the inefficient use of funds such as excessive
executive perks, over-paying for acquisitions, etc
 Paying dividends to provide credible signals to the market
11.65
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Dividend Policy and Non-Tax Explanations
 Research and surveys of managers has found that…
 Managers prefer to maintain relatively constant dividends over time
 Firms change dividends infrequently and dividends tend to be much less volatile than
earnings
 Managers believe that investors prefer stable dividends with sustained growth over time
 Managers want to maintain a long-term target level of dividends as a fraction of earnings
 Implication: Firms raise their dividends only when they perceive a long-term
sustainable increase in the expected level of future earnings, and cut dividends only
as a last resort. That is, dividends tend to be sticky over time
11.66
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Dividend Policy and Non-Tax Explanations
 The dividend signaling hypothesis captures the notion that dividend changes reflect
managers’ views about a firm’s future earning prospects
 If firms smoothen their dividends, the firm’s dividend payment decision may contain
information regarding management’s expectations of future earnings
 When a firm increases its dividend, it typically sends a positive signal to investors
that management expects to be able to afford the higher dividend for the foreseeable
future
 When would an increase in dividends be viewed as a negative signal?
 When a firm decreases its dividend, it may signal that management has given up
hope that earnings will rebound in the near term and so need to reduce the dividend
to save cash
11.67
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Does Dividend Policy Matter?
 Markets are not perfect and market imperfections drive managers to pay attention to
do “what the market wants”
 Taxes are the obvious market imperfection but in some cases the irrelevance of
dividend policy may still hold
 The classical tax system versus the imputation tax system
 Dividends do contain information and possess strong “signaling” elements as well.
Increase in dividends may signal positive future earnings
 Dividends also impose managerial discipline and may result in lowering the “agency
costs” between management and shareholders
 Some of these issues are considered in detail in FNCE20005 Corporate Financial
Decision Making
11.68
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Week 11: Capital Structure and Payout Policy II
FNCE10002 Principles of Finance
The University of Melbourne
Key Concepts: What We’ve Done This Week
 Dividend policy relates to the trade-off between retaining earnings and paying out
dividends
 In perfect capital markets, payout policy will not affect firm value and shareholder
wealth
 Payout policy becomes important when we consider personal taxes and other market
imperfections
 The imputation tax system eliminates double taxing of dividend income and may
encourage higher dividend payout ratios
 Dividends contain information and possess strong “signaling” elements as well. An
increase in dividends may signal positive future earnings
11.69
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