2Outline RECAP Dividend Types of Dividend Dividends a financing decisionDividend paymentsStock dividendDividend versus interest obligationsDividend policyDividend policy in practiceAlternatives to paying a dividend
3DefinitionsA scrip dividend is a dividend payment which takes the form of new share instead of cash, it converts profit reserves into issued share capital.A scrip or bonus issue (also referred to as capitalization issue) involves the issue of new shares to existing shareholders in proportion to their existing holdings.
4Types of DividendsDividends are a permanent distribution of residual earnings/property of the corporation to its owners.Dividends can be in the form of:CashAdditional Shares of Stock (stock dividend)PropertyIf 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.
5Dividends 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.Corporate Profits After TaxRetained EarningsDividends
6Dividend Payments Mechanics of Cash Dividend Payments Declaration Datethis 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 Recordis 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 Dateis 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 Paymentis the date the cheques for the dividend are mailed out to the shareholders.
7Dividend Declaration Time Line Declaration DateDate ofRecordPaymentEx Dividend Date is determinedby the Date of Record.The market value of the sharesdrops by the value of the dividendper share on market opening…comparedto the previous day’s close.The Board Meetsand passes themotion to createthe dividend2 business days prior to the Date of Record
8Stock Dividends Pay additional shares of stock instead of cash Increases the number of outstanding sharesSmall stock dividendLess than 20 to 25%If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 sharesLarge stock dividend – more than 20 to 25%
9Dividend Payments Stock Dividends Stock dividends simply amount to distribution of additional shares to existing shareholdersThey 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.
10Stock SplitsStock splits – essentially the same as a stock dividend except expressed as a ratioFor example, a 2 for 1 stock split is the same as a 100% stock dividendStock price is reduced when the stock splitsCommon explanation for split is to return price to a “more desirable trading range”www: Click on the web surfer icon to find out about upcoming stock splits and dividends
11When should a firm consider splitting its stock? There’s a widespread belief that the optimal price range for stocks is $20 to $80.Stock splits can be used to keep the price in the optimal range.Stock splits generally occur when management is confident, so are interpreted as positive signals.
12Dividend Payments Stock Dividends Implicationsreduction in the R/E accountreduced capacity to pay future dividendsproportionate share ownership remains unchangedshareholder’s wealth (theoretically) is unaffectedEffect on the Companyconserves cashserves to lower the market value of firm’s stock modestlypromotes wider distribution of shares to the extent that current owners divest themselves of shares...because they have moreadjusts the capital accountsdilutes EPSEffect on Shareholdersproportion of ownership remains unchangedtotal value of holdings remains unchangedif former DPS is maintained, this really represents an increased dividend payout
13Dividends versus Interest Obligations Interest is a payment to lenders for the use of their funds for a given period of timeTimely payment of the required amount of interest is a legal obligationFailure 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 remediesSecured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcyDividendsA dividend is a discretionary payment made to shareholdersThe decision to distribute dividends is solely the responsibility of the board of directorsShareholders 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)
14Dividend Policy Dividends, Shareholders and the Board of Directors There is no legal obligation for firms to pay dividends to common shareholdersShareholders 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 causeBoard members are constrained by legal rules affecting dividends including:Not paying dividends out of capitalNot paying dividends when that decision could cause the firm to become insolventNot paying dividends in contravention of contractual commitments (such as debt covenant agreements)
15Dividend policyThe primary objective of a dividend policy of a company is to maximize shareholder wealth which depends on both the current dividends & capital gain.The major reasons for using retained earnings to finance new investments rather than to pay higher dividends & then borrow or raise more equity to finance the projects are as follows:Using funds from retained earnings means that the project can be undertaken without the involvement of either the shareholders or any outsider.It saves issue cost which would have been incurred if new equity had been issued.it avoids the possibility of change in control of the entity , a risk that usually follows issue of equity.
16Does Dividend Policy Matter? Dividends matter – the value of the stock is based on the present value of expected future dividendsDividend policy may not matterDividend policy is the decision to pay dividends versus retaining funds to reinvest in the firmIn theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future
17Why Dividend Policy Doesn’t Matter? Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years or can pay $9,000 in one year, reinvest the other $1,000 into the firm and then pay $11,120 in two years. Investors require a 12% return.Market Value with constant dividend:Market Value with reinvestment:If the company will earn the required return, then it doesn’t matter when it pays the dividends
18Homemade DividendsDividend policy is irrelevant when there are no taxes or other market imperfectionsShareholders can effectively undo the firm’s dividend strategyThe shareholder who receives a dividend that is greater than desired can reinvest the excessThe shareholder who receives a dividend that is smaller than desired can sell extra shares of stock
19Low Dividend PayoutIndividuals in upper income tax brackets might prefer lower dividend payouts, with the immediate tax consequences, in favor of higher capital gainsFlotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering total flotation costsDividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends
20High Dividend Payout Desire for current income Individuals in low tax bracketsUncertainty resolution – no guarantee that the higher future dividends will materializeTaxesDividend exclusion for corporationsTax-exempt investors don’t have to worry about differential treatment between dividends and capital gains
21Dividends and SignalsSignaling Effects: dividends declared by a company serve as a signal to the shareholders of the financial performance & future prospects It is important to maintain a constant streamAsymmetric information – managers have more information about the health of the company than investorsChanges in dividends convey informationDividend increasesManagement believes it can be sustainedExpectation of higher future dividends, increasing present valueSignal of a healthy, growing firm
22Dividends and Signals Dividend decreases Management believes it can no longer sustain the current level of dividendsExpectation of lower dividends indefinitely; decreasing present valueSignal of a firm that is having financial difficulties
23Clientele EffectSome investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payoutsSome investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payoutsThe company can influence its cliental by way of its dividend policy, it can lead to the following advantages:- Attracts high profile clients- Resist takeovers if there are large corporate entities who have invested for long term strategic purposes rather than for short term profit making
24Clientele Effect Cliental Effect: A shareholder makes gain in two ways - DividendCapital Gain
25Implications of the Clientele Effect What do you think will happen if a firm changes its policy from a high payout to a low payout?What do you think will happen if a firm changes its policy from a low payout to a high payout?If this is the case, does dividend POLICY matter?If a firm changes its policy, it will just have different investors. Consequently, dividend policy won’t affect the value of the stock.
26Dividend Policy in Practice Residual dividend policyConstant growth dividend policy – dividends increased at a constant rate each yearConstant payout ratio – pay a constant percent of earnings each yearCompromise dividend policyWe will talk about the residual policy and the compromise policy in more detailGiven the information content of dividends, will a constant growth policy be good for the stockholders?Given the information content of dividends – will a constant payout ratio be good for stockholders?
27Residual Dividend Policy Determine capital budgetDetermine target capital structureFinance investments with a combination of debt and equity in line with the target capital structureRemember that retained earnings are equityIf additional equity is needed, issue new sharesIf there are excess earnings, then pay the remainder out in dividends
28Example – Residual Dividend Policy GivenNeed $5 million for new investmentsTarget capital structure: D/E = 2/3Net Income = $4 millionFinding dividend40% financed with debt (2 million)60% financed with equity (3 million)NI – equity financing = $1 million, paid out as dividendsRemind students how to get % debt and % equity given D/E:If D/E = 2/3, then V = = 5, so D/V = 2/5 = 40% and E/V = 3/5 = 60%
29Dividend StabilityCyclical dividend policy – dividend is a fixed fraction of earningsStable dividend policy – all dividend payments are equal
30Compromise Dividend Policy Goals, ranked in order of importanceAvoid cutting back on positive NPV projects to pay a dividendAvoid dividend cutsAvoid the need to sell equityMaintain a target debt/equity ratioMaintain a target dividend payout ratioCompanies want to accept positive NPV projects, while avoiding negative signals
31Alternatives to Paying a Dividend Select additional capital budgeting projectsRepurchase sharesAcquire other companiesPurchase financial assets
32Stock Repurchase Company buys back its own shares of stock Similar to a cash dividend in that it returns cash from the firm to the stockholdersAnother argument for dividend policy irrelevance in the absence of taxes or other imperfections
33Repurchase methods Buy in the open market Buy back a fixed number of shares at a fixed price – a company will make a tender offer to repurchase a specific number of shares, typically at a premium to the market priceRepurchase by direct negotiation – a company negotiates with the major shareholder to buy back its shares
34Information Content of Stock Repurchases Stock repurchases sends a positive signal that management believes that the current price is lowTender offers send a more positive signal than open market repurchases because the company is stating a specific priceThe stock price often increases when repurchases are announced
35Advantages of Repurchases Stockholders can tender or not.Helps avoid setting a high dividend that cannot be maintained.Repurchased stock can be used in take-overs or resold to raise cash as needed.Income received is capital gains rather than higher-taxed dividends.Stockholders may take as a positive signal--management thinks stock is undervalued.
36Disadvantages of Repurchases May be viewed as a negative signal (firm has poor investment opportunities).Selling stockholders may not be well informed, hence be treated unfairly.Firm may have to bid up price to complete purchase, thus paying too much for its own stock.