1. Lecture: 12 Course Code: MBF702
Investment Analysis
Lecture: 12
Course Code: MBF702

2. Outline RECAP Dividend Types of Dividend
Dividends a financing decision
Dividend payments
Stock dividend
Dividend versus interest obligations
Dividend policy
Dividend policy in practice
Alternatives to paying a dividend

3. Definitions
A 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.

4. 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.

5. 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.
Corporate Profits After Tax
Retained Earnings
Dividends

6. 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.

7. Dividend Declaration Time Line
Declaration Date
Date of
Record
Payment
Ex Dividend Date is determined
by the Date of Record.
The market value of the shares
drops by the value of the dividend
per share on market opening…compared
to the previous day’s close.
The Board Meets
and passes the
motion to create
the dividend
2 business days prior to the Date of Record

8. Stock Dividends Pay additional shares of stock instead of cash
Increases the number of outstanding shares
Small stock dividend
Less than 20 to 25%
If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares
Large stock dividend – more than 20 to 25%

9. 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.

10. Stock Splits
Stock splits – essentially the same as a stock dividend except expressed as a ratio
For example, a 2 for 1 stock split is the same as a 100% stock dividend
Stock price is reduced when the stock splits
Common 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

11. When 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.

12. 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

13. Dividends versus Interest Obligations
Interest is a payment to lenders for the use of their funds for a given period of time
Timely payment of the required amount of interest is a legal obligation
Failure 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 remedies
Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcy
Dividends
A dividend is a discretionary payment made to shareholders
The decision to distribute dividends is solely the responsibility of the board of directors
Shareholders 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)

14. 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)

15. Dividend policy
The 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.

16. Does Dividend Policy Matter?
Dividends matter – the value of the stock is based on the present value of expected future dividends
Dividend policy may not matter
Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm
In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future

17. Why 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

18. Homemade Dividends
Dividend policy is irrelevant when there are no taxes or other market imperfections
Shareholders can effectively undo the firm’s dividend strategy
The shareholder who receives a dividend that is greater than desired can reinvest the excess
The shareholder who receives a dividend that is smaller than desired can sell extra shares of stock

19. Low Dividend Payout
Individuals in upper income tax brackets might prefer lower dividend payouts, with the immediate tax consequences, in favor of higher capital gains
Flotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering total flotation costs
Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends

20. High Dividend Payout Desire for current income
Individuals in low tax brackets
Uncertainty resolution – no guarantee that the higher future dividends will materialize
Taxes
Dividend exclusion for corporations
Tax-exempt investors don’t have to worry about differential treatment between dividends and capital gains

21. Dividends and Signals
Signaling 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 stream
Asymmetric information – managers have more information about the health of the company than investors
Changes in dividends convey information
Dividend increases
Management believes it can be sustained
Expectation of higher future dividends, increasing present value
Signal of a healthy, growing firm

22. Dividends and Signals Dividend decreases
Management believes it can no longer sustain the current level of dividends
Expectation of lower dividends indefinitely; decreasing present value
Signal of a firm that is having financial difficulties

23. Clientele Effect
Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts
Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts
The 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

24. Clientele Effect Cliental Effect: A shareholder makes gain in two ways
- Dividend
Capital Gain

25. Implications 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.

26. Dividend Policy in Practice
Residual dividend policy
Constant growth dividend policy – dividends increased at a constant rate each year
Constant payout ratio – pay a constant percent of earnings each year
Compromise dividend policy
We will talk about the residual policy and the compromise policy in more detail
Given 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?

27. Residual Dividend Policy
Determine capital budget
Determine target capital structure
Finance investments with a combination of debt and equity in line with the target capital structure
Remember that retained earnings are equity
If additional equity is needed, issue new shares
If there are excess earnings, then pay the remainder out in dividends

28. Example – Residual Dividend Policy
Given
Need $5 million for new investments
Target capital structure: D/E = 2/3
Net Income = $4 million
Finding dividend
40% financed with debt (2 million)
60% financed with equity (3 million)
NI – equity financing = $1 million, paid out as dividends
Remind 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%

29. Dividend Stability
Cyclical dividend policy – dividend is a fixed fraction of earnings
Stable dividend policy – all dividend payments are equal

30. Compromise Dividend Policy
Goals, ranked in order of importance
Avoid cutting back on positive NPV projects to pay a dividend
Avoid dividend cuts
Avoid the need to sell equity
Maintain a target debt/equity ratio
Maintain a target dividend payout ratio
Companies want to accept positive NPV projects, while avoiding negative signals

31. Alternatives to Paying a Dividend
Select additional capital budgeting projects
Repurchase shares
Acquire other companies
Purchase financial assets

32. Stock Repurchase Company buys back its own shares of stock
Similar to a cash dividend in that it returns cash from the firm to the stockholders
Another argument for dividend policy irrelevance in the absence of taxes or other imperfections

33. Repurchase 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 price
Repurchase by direct negotiation – a company negotiates with the major shareholder to buy back its shares

34. Information Content of Stock Repurchases
Stock repurchases sends a positive signal that management believes that the current price is low
Tender offers send a more positive signal than open market repurchases because the company is stating a specific price
The stock price often increases when repurchases are announced

35. Advantages 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.

36. Disadvantages 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.

37. Thank you