Dividend Policy

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.
 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.
 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
 Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date
 this is 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
 is the date on which the shareholders register is closed after the trading day and all those who are listed
will receive the dividend.

Ex dividend Date
 is the date that the value of the firm’s common shares will reflect the dividend payment (ie. 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 ex-dividend date and beyond WILL NOT receive the declared dividend.

Date of Payment
 is the date the cheques for the dividend are mailed out to the shareholders.
 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)
 Dividend Payments
Dividend Reinvestment Plans (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 on-going relationship
with shareholders.
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.
 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
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)
 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 - same
the investor
 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.
M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

Start with the single-period DDM:

D1 P
[ 22-1] P0  1
(1Ke )
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:

m 1
(D P1)
[ 22-2] 0
mP V0
(1Ke)
 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
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 represents cash flow from operations
I represents investment
X–I is free cash flow
 mD1 is dividend to current shareholders at time 1
M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

Solving for dividends paid out (mD1 ):

mD1  X 1  nP1  I1
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:

X11
I [(
mn 1
)P V]
0
1
[ 22-4] V
(
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…
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:

Value has
 nothing
Xt It
[ 22-5] V0  to do with
t1 (
1 K) t 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
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.
 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:
M&M’s Dividend Irrelevance Theorem
Internal Funds, Investment, and Dividends

22 - 4 FIGURE

OPTIMAL INVESTMENT
Rate of
MC=MR
Return

IOS

WACC

Internal Funds Available

$11,976 $177,607
Million Million
 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.
 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?
 The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed
 Remember the two-stage DDM?


ROEBVPS
InvROEK
[ 22-6]  1
P  ( 2 e)
Ke 
(1K
)
e K
e

 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.
 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
The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory

22 - 5 FIGURE

OPTIMAL INVESTMENT
D1
P0

Gordon
M&M
P1  P0
P0
 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
 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
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] ΔD
t  *
β(D
t -D1)
t-
 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:

t
D 
a(
1b)
D cE
[ 22-8]
t-
1 1

 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
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.
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
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.)

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.
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.
 Relaxing the M&M Assumptions
Taxes

Table 22-3 Individual Tax Rates (% ) on Dividends and Capital Gains

Income Level $25,000 $50,000 $75,000 $100,000

British Columbia Dividends 2.52 6.19 15.69 20.04

Capital gains 12.45 15.58 18.85 20.35
Alberta Dividends 3.63 8.03 13.83 13.83
Capital gains 12.63 16.00 18.00 18.00
Ontario Dividends 0.00 8.24 20.74 20.74
Capital gains 10.65 15.58 21.71 21.71
Quebec Dividends 5.95 15.42 26.06 26.06
Capital gains 14.37 19.19 22.86 22.86
Nova Scotia Dividends 0.00 8.75 17.05 19.06
Capital gains 12.02 18.48 21.34 22.63
 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.
 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.
 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.
 Methods of Share Repurchases
 tender offer:
 this is a formal offer to purchase a given number of shares at a given
price over current market price.
 open market purchase:
 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.
 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.
 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.
 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
 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.