Payout Policy Flashcards
Dividends-basics of dividends
- It usually means a cash dividend (sometimes, a stock dividend)
- Dividend restrictions may exist to protect creditors
- Companies distinguish between
• Regular dividends: expected to be maintained in the future
• Special dividends: less likely to be repeated - Measures of dividends
•Dividend per share (DPS): dividend dollar amount per share • Dividend yield: DPS divided by share price
• Dividend payout ratio: DPS divided by EPS
Dividends in Au
- Typically paid semi-annually (interim & final)
- Dividend announcements coincide with profit announcements
- The new dividend payment rules in 2010 replaced the traditional “profits test” with “solvency test”
- Mostly paid in cash
- Franked dividends carry credits for tax paid by the company
Dividends payment process
- Announcement Date: The firm announces its next dividend, as well as its record and payment dates
- Cum-dividend Date: Last day when shares are traded with the right to receive the dividend (5 days before record date)
- Ex-dividend Date: First day when shares are traded without the right to receive the dividend (day after the cum-dividend date)
- Record Date (Books Close Date): Shareholders are recorded to receive the dividend
- Payment Date: Dividend checks mailed out
Dividend Drop-off Ratio
- Cum-dividend and Ex-dividend share prices
- Drop-off Ratio = (𝑃cum − 𝑃ex)/Dividend
- In perfect capital markets, drop-off ratio is equal to one
- The actual price drop = (1-td)/(1-tcg)
- Recent trends showing ratio of price change to dividends approach 1
M-M’s Dividend Irrelevance Theorem
- What does M&M say?
• In perfect capital markets the value of a firm is
independent of its payout policy
• Proofs: - Paying dividends is a zero NPV transaction
- In perfect capital markets, investors who want dividends can replicate dividends by selling part of their holdings in companies that don’t pay dividends(homemade dividends-Since investors can replicate dividends by selling part of their holdings in companies, they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm.
- In perfect capital markets, investors who don’t want dividends can replicate a no-dividend stock by reinvesting their dividends
Factors Affecting Dividend Policy
• Modigliani-Miller Theorem (Benchmark):
Dividend policy is irrelevant (no effect on firm value) under perfect market assumptions
• What are we missing from the M-M’s view?
• Taxes
• Issue and transaction costs
• Information asymmetry and signalling
• Agency costs (FCF problem)
Factors Affecting Dividend Policy- F1. Issue and Transaction Costs
- High dividends may imply need for more frequent capital raisings in order to fund investment plan
- Will incur transaction costs in raising capital
• Direct costs: prospectus preparation, legal advice, brokerage,
underwriting fees
• Indirect costs: dilution in ownership/value of existing s/h if new shares are issued or restrictive covenants enforced by new debtholders
3, Therefore, the higher the costs associated with raising capital, the lower the expected level of dividends
Factors Affecting Dividend Policy- F2. Info Asymmetry & Signaling
- Information asymmetry between management and s/h ShareholdersManagement
- Dividends can be signals to the market that managers believe that firms have good cash flow prospects in the future
- Evidence: a strong price reaction to dividend announcements
- On average, the share price increased by about 0.24% around the announcement date
- Management is reluctant to decrease dividends as it conveys a very negative signal to the market about future prospects
- only increase dividends especially when the increase is sustainable
Factors Affecting Dividend Policy－ Agency Costs (FCF Problem)
- Excess cash can lead to agency problems if managers are empire-builders:
- Managers are reluctant to return excess cash to investors
- May instead increase their sphere of influence (“Empire Building”) through negative NPV projects and takeovers • May waste money on perks
- Higher dividend payout implies that:
• less money available for managerial perk consumption and
overinvestment
• more funds need to be raised externally - Effect:
• Higher payout disciplines management to use remaining funds
efficiently - Caveat: dividends are discretionary
• But, sticky dividends imply that dividends can also be a strong commitment
Factors Affecting Dividend Policy－tax implication
• Distinction b/w taxation of dividend income and that of capital gain is the key issue
• Since capital gain tax (CGT) is paid when capital gain is realized, investors can delay tax payment, which is “cheaper” due to TVM
• Under a classical tax system, it is common that CGT is less than tax on dividends (so, investors prefer capital gains to dividends)
• Under an imputation system, the effective tax rate on dividends can be much lower because of franking credits
• So, an imputation tax system tends to favour the payment of high dividends than a classical tax system.
A gross-up dividend is the dividend including franking credit.
Factors Affecting Dividend Policy－tax implication
• Capital gains tax is lower if stocks held over one year • As of 21 September 1999, if stock is held longer than 12
months, maximum CGT is 50% of personal marginal tax rate
• For superannuation funds, the discount is 33.33%, so 66.66% of the capital gain is subject to CGT
• Capital gains cannot benefit from franking credits for the tax already paid by the company (so, double taxation)
Will shareholders prefer dividends or capital gains?
• If 𝑡𝑝 < 𝑡𝑐, shareholders receive tax returns on dividends but pay tax on capital gains, so prefer dividends
• If 𝑡𝑝 > 𝑡𝑐,
• Shareholders with still relatively low tax rate may prefer dividends
as capital gains are subject to double taxation
• Shareholders may prefer capital gains if able to defer realisation of capital gains until personal tax rate falls or to get discounted tax treatment after 12 months
• non-resident shareholders?
• A clientele based explanation for paying dividends – investors buy stocks in companies that have dividend policies they like
What to do with high payout rates–Imputation increases incentives to pay out high proportion of profits as dividends. This can create two problems:
• Problem 1: Can lead to fluctuating dividend
• Solution - signal to market that portion of the dividend is
of a “non-recurring” nature (a special dividend)
• Problem 2: May result in the firm running short of cash
• Solution - Dividend Reinvestment Plans (DRPs) allow
high dividend without loss of cash (very small rights issues)
Share buybacks (share repurchase)
• There are legal requirements associated with buybacks, but generally companies can repurchase up to 10 per cent of their ordinary shares in a 12-month period (10/12 rule)
Different types of share buyback
- Equal access buyback – repurchase from all shareholders on a pro-rata basis
- Selective buyback – repurchase from specific, limited number of shareholders (requires approval by > 75% of non-selling shareholders)
- On-market buyback – repurchase through normal stock exchange trading
- Employee share scheme buyback
