Dividend Policy

1
Dividend Policy

• Firm has 2 choices
• Pay dividend
• Reinvest funds instead of paying out
• Dividend policy is the time pattern of dividend
  payout
• Should the firm pay out a large percentage or
  small percentage of profits and when?

2
Life Cycle of Dividend Policy
3
The Irrelevance of Dividend Policy

• Investors only care about total returns
• Not how they are divided between dividends and
  capital gains
• Dividends are merely a financing decision
• Only important driver of value is future earnings
  power

4
Clientele Effect

• Some investors prefer low dividend payouts and
  will buy shares in those companies that offer low
  dividend payouts
• Some investors prefer high dividend payouts and
  will buy shares in those companies that offer
  high dividend payouts

5
Implications of 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?

6
Factors Favouring Low Payout

• Tax
• STC 12.5 CGT 10
• retentions lead to capital gains ? lower tax
• if no ve NPV projects free cash flow
• (a) pay dividend
• if personal lt corporate tax rate
• (b) invest in short term instruments
• if personal gt corporate tax rate

7
Factors Favouring High Payout

• Desire for current income
• Widows and orphans
• Shares with relatively high degree of safety and
  dividend income
• Uncertainty resolution
• Bird in hand theory
• Dividends are less risky than capital gains

8
Information Content of Dividends

• 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
• Signal of a healthy, growing firm
• Dividend decreases
• Management believes it can no longer sustain the
  current level of dividends
• Signal of a firm that is having financial
  difficulties

9
Lintners Study (1956)

• 1. Firms set target dividend payout ratios.
• 2. They change dividends to match long-term
  sustainable shifts in earnings.
• 3. Managers increase dividends only if they feel
  they can be maintained.
• 4. Managers are more concerned about dividend
  changes than about levels of dividends. WHY?

10
Academic Thinking on Dividend Policy

• Dividend payout ratio should primarily reflect
• Expected capital requirements
• (above expected operating cash flow)
• Riskiness of the business
• (variability of cash flow)
• Target capital structure
• (also partly related to risk)
• Availability and cost of outside capital

11
How does theory measure up to reality?

• Models versus Perceptions.
• Academia makes provision for broad range of
  dividend theories.
• Problem is no single theory has been proven to
  hold up in the market over extended periods.
• Current prevailing view is that signalling
  (information content) and clientele effects are
  observable but true driver is market sentiment
  vis-à-vis growth and safety.

12
Alternative Share Buybacks

• Buyback shares
• Tender offer company states a purchase price
  and a desired number of shares
• Open market buys shares in the open market
• Reduces cash and equity
• Simple method for changing capital structure
• Value of the firm will be the same regardless of
  whether dividend paid or shares repurchased

13
Common Rationales

• Deploy excess cash
• (shortage of viable investments)
• To increase share price
• (management believes shares underpriced)
• Replace cash dividends
• (possible tax advantages)
• Prevent dilution of earnings
• (enhance EPS, or prevent reduction in EPS caused
  by exercise of share options)
• Rationalize capital structure
• (Higher D/E can be sustained)

14
Current US Situation

• Historically, dividend paying stocks favoured.
  (Quarterly payments expected from good
  companies)
• WHY?
• Move to growth stocks in last two decades,
  especially with advent of technology and IT
  sector.
• IT firms actually penalised for paying good
  dividends to shareholders.
• After bull markets of last few years, companies
  sitting on large cash reserves (if no profitable
  opportunities exist, pay out to shareholders?)

15
Current issues favouring payout?

• Bush regime pushing through tax cuts (lower tax
  rates to apply to 2010 and divs not taxed in
  hands of shareholders)
• Scepticism concerning accounting profits. (Enron,
  et al)
• Current volatility in markets means share holders
  desire safety, which can be accomplished by
  paying certain stream of dividends versus
  uncertainty of future share prices.

16
Current issues against payout?

• Emergence of more small-cap firms, high on growth
  but low on cash. (Fama and French, 2001)
• Buybacks preferred over dividends. (discretionary
  versus compulsory)
• Academic theory irrelevance of dividends
• Future uncertainty (war, oil prices, etc.)

17
So are academic views upheld?

• Given the above there is little evidence for
  signalling and the clientele effect.
• Indeed, the prevalent driver of dividend policy
  in the US seems to be sentiment as proposed by
  Baker and Wurgler (2002).

18
What is the South African situation?

• Bhana (1991) finds indications that announcements
  of dividends have significant impact on share
  pricing in the direction of the announcement.
  positive (negative) announcement increase
  (decrease)
• Therefore strong proof that information content
  holds for SA.
• Importantly, overreaction hypothesis also holds
  market reacts correctly for positive
  announcement but overreacts for negative
  announcements.