Lecture Agenda
Learning Objectives Important Terms Mechanics of Dividend Payments Cash Dividend Payments M&Ms Dividend Irrelevance Theorem The Bird in the Hand Argument Dividend Policy in Practice Relaxing the M&M Assumptions Stock Dividends and Stock Splits Share Repurchases Summary and Conclusions
Concept Review Questions
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Learning Objectives
You should understand the following: The mechanics of dividend payments and why they are different from interest payments The difference between a stock split and a stock dividend Under what assumptions a dividend payment is irrelevant and what a homemade dividend is Why dividend payments generally reflect the business risk of the firm How transactions costs, taxes and information problems give value to corporate dividend policies How stock dividends and stock splits differ How a share repurchase program can substitute for a dividend payout policy.
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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.
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Types of Dividends
Dividend Policy
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. dividend.
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Dividend Payments
Mechanics of Cash Dividend Payments
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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 record, 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 firms 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 exat 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 exdeclared dividend.
Date of Payment
is the date the cheques for the dividend are mailed out to the shareholders.
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Declaration Date
Date of Record
Date of Payment
The Board Meets and passes the motion to create the dividend
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 openingcompared to the previous days close.
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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 BODs 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)
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Dividend Payments
Dividend Policy
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 onongoing relationship with shareholders.
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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 firms ability to pay dividends in the future.
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Dividend Payments
Stock Dividends
Implications
reduction in the R/E account reduced capacity to pay future dividends proportionate share ownership remains unchanged shareholders wealth (theoretically) is unaffected
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
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Dividend Payments
Stock Dividend Example
ABC Company Equity Accounts as at February xx, 20x9 $5,000,000 20,000,000 $25,000,000
The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share. This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is: $40.00 (21,500) = $860,000 This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:
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Dividend Payments
Stock Dividend Example
After the stock dividend:
ABC Company Equity Accounts as at March 1, 20x9 Common stock (236,500) Retained earnings Net worth $5,860,000 19,140,000 $25,000,000
The market price of the stock will be affected by the stock dividend: New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36 The individual shareholders wealth will remain unchanged.
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Dividend Payments
Stock Splits
Although there is no theoretical proof, there is some who believe that an optimal price range exists for a companys 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
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Stock Split Example
The Board of Directors of XYZ Company is considering using a stock split to put its shares into a better trading range. They are confident that the firms stock price will continue to rise given the firms outstanding financial performance. Currently, the companys shares are trading for $150 and the companys shareholders equity accounts are as follows:
Commons shares (100,000 outstanding) Retained earnings Net Worth $1,500,000 15,000,000 $16,500,000
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Further Stock Split Examples
A 4 for 3 Stock Split:
New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50
Clearly the Board can use stock splits and reverse stock splits to place the firms stock in a particular trading range.
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Dividend Payments
Stock Split Effects
the above will hold true if there is no psychological appeal to the stock split. There is some evidence that the share price of companies which split stock is more bouyant because of a positive signal being transferred to the market by this action.
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Stock Splits
large drop in stock price much stronger potential signalling effect no recapitalization same odd lots rare same
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Figure -1 illustrates:
Aggregate after-tax profits run at approximately 6% of GDP but afterare highly variable Aggregate dividends are relatively stable when compared to afterafter-tax profits.
They are sustained in the face of drops in profit during recessions They are held reasonably constant in the face of peaks in aggregate profits.
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The companies chosen here illustrate the dramatic differences between companies:
Some pay no dividends Some pay consistent cash dividends representing substantial yields on current shares prices
The highest yields are found in the case of Income Trusts and large stable blue-chip financials and utilities blue-
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Table
S&P/TSX
Average %
4.29 0 3.31 0 0 5.88 7.34
%
2.52 0 2.85 0.54 0 4.52
%
1.41 0 3.37 0 0 5.35
%
1.07 0 3.17 0 0 5.59
%
3.15 0 2.9 0 0 4.06
%
3.99 0 3.48 0 0 4.92
%
4.08 0 3.28 0 0 5.73
%
4.44 0 3.57 0 0 4.51 7.09 3.31 0.00 3.27 0.13 0.00 5.19 7.22
CE Celesti a In . CI C C tt C rp ration Kinross old Corporation Trans lta Corporation Yello Pa es In ome nd
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[ -1]
D1 P 1 P0 ! (1 Ke )
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Multiply by the number of shares outstanding (m) to convert the single stock price model to a model to value the whole firm:
[ -2]
m( 1 1 ) ! V0 ! (1 e )
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Without debt, sources and uses of funds identity (sources = uses) can be expressed as:
[ -3]
X 1 nP1 ! I1 mD1
represents cash flow from operations represents investment is free cash flow is dividend to current shareholders at time 1
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Where:
X I XI mD1
mD1 ! X 1 nP1 I1
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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 2 we get:
[ -4]
X1 I1 [(m n) P ! 1 ! (1 K )
The value of the firm is the value of the next periods free cash flow (X1 I1) plus the next periods equity market (X value
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The firm value is determined as the present value of the free cash flows to the equity holders:
V lue h s nothin to do with dividends
[ -5]
X t It ! (1 K ) t t !1
E
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
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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.
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MC=MR
WACC
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Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern.
They dont need management declare a cash dividend, they can create their own. Conclusion: under the assumptions of M&Ms model, the investor is indifferent to the firms dividend policy.
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Risk is a real world factor. Firms that reinvest free cash flow, put that money at risk there is no certainty of investment outcome those forfeit dividends that are reinvestedcould be lost! Remember the two-stage DDM? two-
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[ -6]
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.
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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 nonfirms 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 - 5 on the following slide:
M&M argue that dividends and capital gains are perfect substitutes
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The Bird-in-the-Hand Argument Bird-in-theM&M versus Gordons Bird in the Hand Theory
- 5 F GURE OPTIMAL INVESTMENT
D1 P0
Gordon M&M
P P0 1 P0
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The Bird-in-the-Hand Argument Bird-in-theM&M versus Gordons Bird in the Hand Theory
Conclusions:
Firms cannot change underlying operational characteristics by changing the dividend The dividend should reflect the firms operations through the residual value of dividends
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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:
[ -7]
t
! (
* t
t-1
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The target dividend Dt* Lintner suggested is a function of the firms optimal payout rate of the firms underlying earnings (Et) leading to the following equation: (E
[ -8]
Dt ! a (1 b) Dt-1 cE1
The coefficient on lagged dividends was estimated at 0.70 indicating an adjustment speed (b) coefficent of (b 0.30. The coefficient on current earnings (c) was estimated at (c 0.15
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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&Ms irrelevance arguments because the real world does not match the assumptions used.
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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
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et et * dt * dt
Time
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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 overover-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.
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Conclusion firms should not change dividend policy drastically since it upsets the existing ownership base.
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nd C pit l
,
15.69 18.85 13.83 18.00 20.74 21.71 26.06 22.86 17.05 21.34
in
,
20.04 20.35 13.83 18.00 20.74 21.71 26.06 22.86 19.06 22.63
Income evel
itish Columbia Albe ta Onta io Quebe Nova otia i i en s Capital gains i i en s Capital gains Di i en s Capital gains Di i en s Capital gains Divi en s Capital gains
,
6.19 15.58 8.03 16.00 8.24 15.58 15.42 19.19 8.75 18.48
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Tax clienteles help to explain the financial engineering whereby different parts of the return by the firm are stripped, repackaged and sold to different investors as illustrated in Figure 7. (See the following slide) Split shares are shares sold as the dividends and capital gains parts.
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$454 million
MYW
$330 million $143 million
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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.
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Share Repurchases
Dividend Policy
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.
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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.
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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.
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Repurchased Shares
called treasury stock (U.S.) non-voting (U.S.) nonmay not receive dividends (U.S.) if not retired, can be resold (U.S.) unlike the U.S., repurchases in Canada do not involve shares that can be placed into treasury stock - they are canceled
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Repurchase Example
Current EPS = [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00 Current P/E ratio = $20 / $4 = 5X EPS after repurchase of 100,000 shares = $4.4 m / 1.0 = $4.40 Expected market price after repurchase: = [p/e][EPSnew] = [5][$4.40] = $.00 per share [p/e][EPS
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Why?
Before Borrowing:
Assets: Cash 10 Fixed Assets 140 Total Assets $150 Liabilities: Long-term Debt 0 Common Stock 50 Retained Earnings 100 Total Claims $150 0% Debt
25% Debt
$200
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Total Assets
$200
33% Debt
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