payout policy Flashcards
companies that distribute cash to their shareholders do so in 2 main ways?
- paying dividends
- repurchasing shares
what 2 questions does the payout policy involve?
- how much cash, if any, to pay to shareholders
- the form of payment needs to be decided i.e. should the company pay dividends or repurchase shares?
decisions on a company’s payout policy should be consistent with?
the company’s overall objective to maximise shareholders’ wealth
how often do australian companies make dividend payments?
Companies in Australia typically make two dividend payments each year
business decisions include
what is dividend policy?
investment, financing and dividend
dividend policy –> Determining how much of a company’s profit is to be paid to shareholders as dividends and how much is to be retained
payout policy tree diagram
who is responsible for the company’s dividend decisions
Provided that the legal requirements and the exchange’s listing requirements are met, a company’s dividend decisions are at the discretion of its directors.
when do companies in Australia pay dividend?
In Australia, companies generally pay an interim dividend after the end of the first half of the financial year and a final dividend after the company’s Annual General Meeting.
important dates for dividend
what is the record date?
A company’s Board of Directors, when announcing a dividend, specific a ‘record date’.
- This is the day which the company’s ‘books’ will close for the purpose of determining who is currently a shareholder, and hence entitled to receive the dividend.
what is the ex-dividend date?
For shares listed on the Australian Securities Exchange (ASX), the rules of the exchange specify an ex-dividend date, which is 4 days before the dividend’s record date
- date on which a share begins trading ex-dividend. a person who purchases on or after the ex-dividend date will not be eligible to receive dividends
investors who purchase their shares before the ex-dividend date,
buy the shares cum-dividend and are entitled to receive the dividend.
why is that those who purchases the shares ex-dividend are not elibible to receive the dividend?
it takes 3 days to be registered when purchasing a share
what is a franked dividend?
dividend paid out of Australian company profits on which company income tax has been paid and which carries a franking credit
When a dividend is declared, the company must state
the extent to which the dividend is franked. When a dividend is paid, the company is required to provide each shareholder with a dividend statement.
what does the dividend statement contain?
This statement shows the
- amount of the dividend and the date of payment
- the amount of any franked and unfranked parts of the dividend
- if the dividend is fully or partially franked, the amount of the franking credit.
what is repurchasing shares an alternative way of?
distributing cash to shareholders
what is the payable date?
aka Distribution Date
A date, generally within a month after the record date, on which a firm mails dividend checks to its registered stockholders
A company purchases its own shares on the stock market and then proceeds to
nto either cancel them (Australia) or retain them as treasury stock (US).
legal requirements regarding buybacks
what is the general rule and what is the exception to sharebuybacks?
s. 259A of the Corporations Act generally precludes a company from purchasing its own shares.
Exceptions were introduced in 1989 and later revised in 1995
legal rquirements regarding buybacks
how much can the company repurchase?
general companies are able to repurchase up to 10 per cent of their ordinary shares in a 12-month period
share repurchases
what happens once the transfer of ownership has been processed
In each case, once the transfer of ownership has been processed the shares must be cancelled.
is payout policy important to shareholders?
in many cases, a payment is inappropiate b/c
the company has attractive investment opportunities and shareholders are expected to receive a greater benefit if the company’s cash is used to take up these opportunities instead of paying it out now.
is payout policy important to shareholders?
3 payout/dividend policies that might be adopted
- Residual dividend policy
- Smoothed dividend policy
- Constant payout policy
is payout policy important to shareholders?
what is residual dividend policy?
- pay out as dividends any profits that, in the opinion of management, cannot be invested profitably
is payout policy important to shareholders?
what is smoothed dividend policy?
- management sets a target dividend-payout ratio
- the target aims for dividends to equal the long-run difference between expected profits and expected investment needs
- The amount of each dividend is changed only when this long-run difference changes
is payout policy important to shareholders?
what is the dividend payout ratio?
target proportion of annual profits to be paid out as dividend.
is payout policy important to shareholders?
Smoothed dividend policy
give an example of how the dividend changes when the long run difference changes
- the dividend per share will be increased if there is an increase in profit that is regarded as sustainable, but it will not be changed in response to fluctuations in profit that are believed to be only temporary.
- Similarly, if profit falls, the dividend per share will be maintained unless the outlook for profits is so poor that the current dividend level is considered to be unsustainable.
what is the constant payout policy?
the dividend-payout ratio remains essentially the same each year (if managers are concerned to avoiding fluctuations in payout ratio)
the irrelevance of payout policy
Modigliani and Miller (MM) (1961) argued
that a company’s dividend policy has no effect on shareholders’ wealth was
the irrelevance of payout policy
Modigliani and Miller (MM) (1961) aruged that a company’s dividend policy has no effect on shareholders’ wealth
Their analysis demonstrated the irrelevance of dividend policy under the following assumptions:
- The company has a given investment plan, and has determined how much of the assets to be acquired will be financed by borrowing.
- There is a perfectly competitive capital market, with no taxes, transaction costs, flotation costs or information costs.
- investors are rational so they always prefer more wealth to less and are equally satisfied with a given increase in wealth
- investors are indifferent between receiving dividends or capital gains (increase in value of the shares they hold)
the irrelevance of payout policy
suppose that a company is to increase its dividend payment
To define dividend policy, suppose that a company is to increase its dividend payment.
- With the investment plan and the borrowing decision fixed, the extra funds used to pay the higher dividend can be replaced from only one source: a new share issue.
the irrelevance of payout policy
suppose that a company is to reduce its dividend payment
To define dividend policy, suppose that a company is to reduce its dividend payment.
- there is only one way that the surplus cash can be used—that is, to repurchase some shares
irrelevance of dividend policy
as illustrated by increasing/reducing dividends in the MM framework, the dividend policy involves
- in the MM framework,dividend policy involves a trade-off between higher or lower dividends and issuing or repurchasing ordinary shares.
- Using this approach, MM proved that dividend policy is irrelevant to shareholders’ wealth
irrelevance of dividend policy
Essentially, MM’s argument is that
the value of a company depends only on its investments - the earning power of its assets
irreleavance of dividend policy
essentially, mm’s argument is that the value of company depends only on its investments
MM: Company issue new shares to pay dividends.
For old shareholders, increase in dividend = decline in per share value as future dividend is diverted to new shareholders
irrelevance of dividend payout policy
what happens when the investor does not want cash?
If dividends gets paid and the investor does not want the cash, they can reinvest dividends into new shares.
irrelevance of dividend payout policy
In perfect capital markets, investors can either
nreinvest dividends (to buy shares) or sell shares (to receive cash)
they can replicate either payout method on their own.
Thus, dividend policy does not matter for a firm.
irrelevance of dividend
give an example
The $15 000 cash has been reserved for an investment opportunity that has not yet been taken up. Suppose that management decides instead to use the cash to pay a dividend of $15 000, and then issues more shares to new shareholders to replace the cash and proceed with the new investment. What is the effect of these transactions on the value of the existing shares and shareholders’ wealth?
the original shareholders have?
The original shareholders have suffered a capital loss of $15 000, exactly offsetting the dividend of $15 000, which is now cash in their hands.
- By having the ABC Company pay a dividend, its original shareholders have converted part of their stake in the company into cash of $15 000.
- Since the stake transferred to the new shareholders is also worth $15 000, the net change in the wealth of the original shareholders is zero.
irrelevance of payout policy
Paying a dividend and then issuing new shares to replace the cash paid out involves
Paying a dividend and then issuing new shares to replace the cash paid out involves a transfer of ownership between the ‘old’ and ‘new’ shareholders.
- Provided the terms of this transfer are fair, neither party gains nor loses—that is, the new shareholders receive shares that are worth the price paid for them and, for each dollar they receive in dividends, the old shareholders give up future dividends with a present value of $1, which reduces the value of their shares by $1.
why may dividends be a better way of reducing agency costs than share repurchases
both share repurchases and paying dividends can reduce agency costs of free cash flows, but paying dividends is better b/c it represents a stronger commitment to continuing to pay out cash
repurchasing shares
what is an open market repurchase
¡When a firm repurchases shares by buying shares in the open market
¡Open market share repurchases represent about 95% of all repurchase transactions.
repurchasing shares (open) market
describe tender offer
- A public announcement of an offer to all existing security holders to buy back a specified amount of outstanding securities at a pre-specified price (typically set at a 10%-20% premium to the current market price) over a pre-specified period of time (usually about 20 days
repurchasing shares (open) market
what happens when shareholders do not tender enough shares
If shareholders do not tender enough shares, the firm may cancel the offer and no buyback occurs.
repurchasing shares
what is a targeted repurchase
¡When a firm purchases shares directly from a
specific shareholder
repurchasing shares
targeted repurchase
what is greenmail
nWhen a firm avoids a threat of takeover and removal of its management by a major shareholder by buying out the shareholder, often at a large premium over the current market price
Institutional Features of Dividends
list the 3 dividend types
- cash dividend
- stock dividend
- special dividend
what is a stock dividend
¡Equivalent to a stock split
¡When a company issues a dividend in shares of stock rather than cash to its shareholders
what is a special dividend
A one-time dividend payment a firm makes, which is usually much larger than a regular dividend
Why repurchase shares?
- dividend substitution
- improved EPS
- tax reasons why companies might prefer to pay dividends over repurchases, or vice versa
why repurchase shares?
describe dividend substitution
share repurchases have been substituted for dividends
A rapid growth of repurchases in Australia:
$770m in the 1995 financial year, up to $16b in 2010, but then declined to $13b in 2011 and $8.6b in 2012.
describe growth of share repurchases in the US
nIn 1999 and 2000, US industrial companies distributed more cash to shareholders through share repurchases than dividends.
describe the classical tax system
tax system that operates in the US and which operated in Australia until 30 June 1987; under this system company profits, and dividends paid from those profits, are taxed separately—that is, profit paid as a dividend is effectively taxed twice
In Australia, a classical tax system operated until
1 July 1987, when an imputation system was introduced.
australia uses an imputation tax system
as of 2010,
as of 2010, t0 = 30%
under the imputation tax system, what does the shareholder receive
- The shareholder receives a tax credit equal to the franking credit.
- The credit can be used to offset tax liabilities associated with any other form of income.
- The tax credit cannot be carried forward but excess or unused tax credits are refunded as of July 2000
Imputation and Dividend Policy (cont..)
how will this benefit resident investors?
- The franking credits attached to franked dividends can be used to reduce investors’ personal tax liabilities
- Since the alternative to dividends is capital gains, which are subject to company tax and CGT, higher dividends will mean that less CGT is payable by investors.
* If all franking credits are not paid out, the credits that are retained are potentially wasted as they have no value except when accompanying dividend payments. (At best, their value is discounted if they are used to offer franking credits on future dividends.)
what is the imputation tax system?
- system under which resident shareholders can use tax credits associated with franked dividends to offset their personal income tax. The system eliminates the double taxation inherent in the classical tax system
- resident shareholders are given a credit for the Australian income tax paid by a company on its taxable income.
what did the imputation tax system intend to do?
to eliminate the double taxation of company profits in the classical tax system
describe income company tax in the imputation tax system
- at the current company income tax rate of 30 cents in the dollar, $100 of company profit will result in $30 being paid in company tax. It is critical to understand that this amount of $30 is therefore both profit earned by the company and company tax paid.
- The imputation system recognises this dual nature by adding $30 to the shareholder’s income and also giving shareholders credit for $30 of tax paid.
imputation tax system
if company income tax is 30c and company earns $100 profit where $30 is paid as company tax, what happens to franked dividends
- maximum franked dividend that could be paid is $70.
- Each dollar of franked dividend carries a franking credit equal to tc/(1 − tc).
- Therefore, a franked dividend of $70 will carry a franking credit of $70 × 0.30/(1 − 0.30) = $30.
- Shareholders who receive a franked dividend of $70 will include in their taxable income both the dividend received ($70) and the franking credit ($30). The shareholders’ taxable income is thus $100.
