Finance 663CM

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Finance 663CM
Financial Management Sobey School of
Business Saint Marys University Instructor Greg
MacKinnon
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Session 3 -Dividend Policy
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Dividend Policy

• dividend distribution (usually of cash) from
  the firm to the owner(s) of the firm
• earnings retained or paid out to shareholders as
  dividends
• how much to pay out is one of most important
  decisions of a corporation
• same decision faced by all firms, even small sole
  proprietorships
• does owner reinvest in the firm to make it grow,
  or take the profits out?

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Types of Dividends

• Three different types of dividend
• Cash Dividend
• most common
• portion of earnings paid out to shareholders
• typically on an ongoing basis
• Stock Dividend
• give shareholders new shares of stock in lieu of
  cash as a dividend
• increases the number of shares outstanding
• same effect as a stock split
• Special Dividend or Stock Repurchase
• special dividend a large, one time dividend
• stock repurchase distribute cash to
  shareholders by firm buying stock

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Cash Dividend

• most common type of dividend
• level of dividends often measured by dividend
  yield
• dividend yield
• measures return earned by investor from
  dividends alone
• firms dividend policy can also be measured by
  payout ratio
• payout ratio
• plowback ratio 1-payout

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Cash Dividend

• dividends paid out of earnings (actually paid out
  of free cash flow)
• typically, dividends are paid on an ongoing
  basis, year after year
• some firms have target payout ratios
• however, despite being paid out of earnings,
  dividends are typically much less volatile than
  EPS
• Why?

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Cash Dividend

• Changes in dividends act as a signal to the
  market about the health and prospects of the firm
• Firm do not like to reduce dividends unless
  absolutely necessary
• A dividend reduction sends a bad signal to the
  market (empirically, approx. 4 drop on average
  in stock price)
• To avoid sending bad signal, firms only raise
  dividend if they are very confident that the new
  level can be maintained in the future
• Therefore, dividends are sticky

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Stock Dividend

• Firm distributes new shares of stock to
  shareholders as a dividend instead of cash
• Only real effect is to increase number of shares
  and dilute the value of each share
• Sometimes used to try and fool investors into
  thinking they are getting a dividend when the
  firm cannot afford it
• A stock split is essentially just a large stock
  dividend

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Stock Splits and Stock Dividends

• Example
• Firm has 100,000 shares, each worth 100
• Does a 2-for-1 stock split
• Doubles number of shares, but does not change
  anything about firm
• There should now be 200,000 shares, each worth
  50
• No difference to shareholders
• However, empirically it turns out that the shares
  are worth a little more than the 50 expected
• On average, stock prices go up about 2-3 when
  stock splits announced
• Why?

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Stock Splits and Stock Dividends

• Usual explanation for benefits of stock split
  optimal trading range
• Keeping share price within an optimal range is
  beneficial
• Keeping price low allows small investors to buy
  shares, increase demand and liquidity of stock
• Do not want price too low however, as transaction
  costs become too high (bid-ask spread as
  proportion of price gets large)

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Special Dividends

• Firms with large amounts of excess cash sometimes
  pay out large dividends
• Firms are normally very explicit about the large
  dividend being a special dividend
• No implication that dividends of that size will
  continue
• Avoids signaling problem
• Another way to distribute cash to shareholders,
  often used when firm has large amount of excess
  cash on hand repurchase of stock

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Stock Repurchase

• Use firms excess cash to buy stock back
• Repurchases are an alternative to dividends for
  distributing cash to shareholders, with some
  advantages over paying cash
• Advantages of Stock Repurchases
• Cash is distributed to shareholders who want it
• Only shareholders who decide to sell get cash
• As repurchases are usually done over time, firm
  has flexibility to scale back or reverse decision

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• Tax advantage to shareholders since cash
  distributed comes to shareholders as a capital
  gain rather than classified as dividend
  dividends are taxed at higher rate
• Purchasing stock provides signal to market that
  firm believes share undervalued typically
  results in increase in share price
• In some firms, control by certain shareholders is
  important and a reduction in number of shares
  increases their percentage ownership

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Dividend Policy

• Many ways to distribute cash to shareholders
• We will concentrate on on-going cash dividends as
  exemplifying a firms dividend policy
• Dividend policy extremely important to value of
  the firm
• Consider typical model for share value assuming
  constant future growth

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• Obviously, as D1 is part of equation, the level
  of dividends affects price of share.
• But, that is not the only effect of dividend
  policy
• Dividends affect growth rate (g)
• The greater the proportion of earnings paid out
  as dividends, the less that is re-invested in the
  firm
• If less is being re-invested in the firm (lower
  retained earnings), than future growth will be
  lower.

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• Common amongst analysts to estimate future growth
  as
• g (1-payout ratio) ROE
• Where ROE is the return on equity expected from
  future projects of the firm.
• In the dividend growth model, g is the rate of
  growth in dividends it is also the rate of
  growth in the stock price
• Therefore, a firms dividend policy affects the
  return investors receive from dividends, and
  also the return they receive in the form of
  capital gains

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• A firms dividend policy is a trade-off between
  providing shareholders returns in the form of
  dividends, or in the form of capital gains
• Essentially a choice between cash versus a higher
  stock price
• The dividend growth model can be rearranged to
  give
• The return to a shareholder is broken down into
  dividend yield and capital gains.
• Dividend policy determines the breakdown how
  investors earn their money

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• Example
• Firm expects EPS next year to be 1.50.
• Payout ratio is 27.5 (this is average in US).
• Required return on stock (r) is 15.
• ROE expected on future projects of firm is 15.
• What is affect of varying the dividend policy?
• What happens if the payout ratio is changed?
• (Assume no changes in the firms investments and
  that any change provides no signal to the market
  and does not change required return.)

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• Dividend policy in this case does not affect
  value of the firm and does not affect the return
  earned by shareholders
• It simply affects where the return comes from
  (dividends versus capital gains)
• If shareholders do not care where they get their
  income, then it makes sense that dividend policy
  does not matter
• The result that dividend policy is irrelevant
  depends on two key things
• Retained earnings are invested in projects which
  return an ROE equal to required return (r)
• Investors really are indifferent between income
  from dividends and income from capital gains.
• Lets now look at each of these two assumptions

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Effect of a Firms Expected ROE

• Example
• Consider a sole proprietorship. The owner takes
  some cash out of the firm each year. Assume owner
  pays no taxes.
• From current business set-up, owner expects to
  take 100,000 out of the company next year, and
  this is expected to grow at 5 per year
  thereafter.
• The company has 1,000,000 in extra cash on hand
  right now.
• The owner could take the 1,000,000 out of firm
  now in cash, or could keep the money in the firm
  and use it to expand business. What should the
  owner do?
• If the owner takes the cash, he could invest it
  elsewhere (with the same level of risk as the
  company) and expect to earn 10.

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Affect of a Firms Expected ROE

• Key Conclusion
• If a firm has NPVgt0 projects which it can
  undertake, then it should retain earnings to fund
  these.
• These projects earn an ROE that is higher than
  the return an investor could earn if they took
  the dividends and invested themselves.
• If firms have good investment opportunities
  available that are not available to individual
  investors, then the firm should retain more
  earnings to fund the investments.

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Affect of a Firms Expected ROE

• The same result can be shown using the dividend
  growth model.
• Example
• EPS 3
• r 18
• Payout 27.5
• Firm has potential investments available which
  have ROE 20
• D1 3(0.275) 0.825
• g (1-payout)ROE (1 - 0.275)0.2 14.5
• Stock price P 0.825/(0.18 -0.145) 23.57

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• Firm has good investments available. If it
  reduces dividends and invests more, then
  shareholders are better off.
• Reduce payout to 20.
• D1 0.2(3) 0.60
• g (1 0.2)0.2 16
• Stock Price P 0.60/(0.18 0.16) 30
• Stock price rises and shareholders benefit from
  change in dividend policy because the firm has
  good investment opportunities.

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Affect of a Firms Expected ROE

• Implication
• Firms with lots of investment opportunities
  should generally pay lower dividends than firms
  in mature industries with few investment
  opportunities.
• Empirically, this is found to be true.
• Analysis of whether a firms dividend policy is
  appropriate often centers round
  estimating/examining investment opportunities
  available to the firm.

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Are investors really indifferent between
dividends and capital gains?

• Assume that any investments a firm makes are NPV
  0
• Investments themselves would not create or
  destroy value.
• As before, dividends then merely determine where
  an investor gets income from dividends versus
  capital gains
• Is dividend policy irrelevant in this case?
• Do investors care how they get income?

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Are investors really indifferent between
dividends and capital gains?

• Modigliani and Miller looked at this question
• Conclusion Dividend policy is irrelevant if
• Dividends provide no signal about the firm.
• Firm projects are NPV 0.
• There are no transaction costs in buying/selling
  shares.
• There are no taxes.

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• M Ms idea is that investors can replicate any
  dividend policy they might like by buying or
  selling shares.
• Since investors can create any dividend policy
  they want, what a firm chooses to do is
  irrelevant.
• Example A firm pays large dividends, but a
  certain investor would prefer not to get cash,
  would prefer increase in stock value.
• Investor simply takes dividends and uses them to
  buy more shares
• Example A firm pays no dividends, provides
  returns to investor in capital gains form, but a
  certain investor would prefer getting current
  income
• Investor simply sells some shares as the price
  goes up, creating homemade dividends.
• Investor gets current income even though firm
  pays no dividends.

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• M M Dividend Irrelevance depends on certain
  assumptions.
• In real world, there are transaction costs
• It costs money to buy/sell shares
• Therefore, it is not free for an investor to
  replicate any dividend policy that they want
• Therefore, a firm's dividend policy does matter
  (if investors have a preference for a certain
  type of income)
• Possible (partial) solution Dividend
  Reinvestment Plans (DRIPs)
• Second big assumption is taxes.
• Investors DO care about how they earn income from
  stock.
• Dividend income is not a perfect substitute for
  capital gains income because the two forms of
  income are taxed differently.

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Dividend Policy and Taxes

• Dividend policy determines how investors receive
  income.
• This is an important issue because dividends are
  taxed more heavily than capital gains.
• In Canada
• Only 50 of a capital gain is taxable
• Dividends are taxed as regular income, although
  dividend tax credit reduces the excess taxation
• Ceteris paribus, investors prefer income to be in
  form of capital gains.

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Dividend Policy and Taxes

• Because dividends are taxed more highly than
  capital gains, taxable investors prefer small or
  no dividends (all else being equal).
• Firms which pay dividends have to offer higher
  before tax returns in order to compensate
  investors for the higher tax they must pay.
• Implication Firms with high dividends should
  have lower share prices than identical firms with
  lower dividends.
• Dividend policy does matter.
• Implication Tax free investors (e.g. pension
  funds) will prefer to invest in high dividend
  stocks.

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Dividend Policy and Taxes

• Recent Events
• United States
• reduced taxation of dividends a few years ago.
• Both capital gains and dividends are now taxed at
  same rate (15).
• Canada
• November 25, 2005 - Reduced effective tax rate on
  dividends
• Increased dividend gross up to 45 (from 25) and
  increased dividend tax credit to 19 from 13.3
• Implication should be that after this tax change,
  firms should change dividend policies and begin
  paying out more dividends
• Anecdotal evidence in US indicates that this
  seems to be true.

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Dividend Policy and Taxes

• Note even if dividends and capital gains are
  taxed at same rate, there is still a tax
  advantage in capital gains
• Tax timing option
• Taxes on capital gains are only paid when
  realized
• Investors can therefore decide when to sell
  shares and pay tax
• Valuable option
• Investors can sell shares and realize gain when
  most advantageous for tax purposes
• Dividends do not have this option
• Also means that taxes on capital gains can be
  delayed
• Present value of taxes to be paid is less if the
  shares are to be sold far into the future

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Dividend Policy and Taxes

• In the extreme, the tax disadvantage of dividends
  means that firms should pay no dividends
• As long as they have NPV gt 0 or NPV 0 projects
  to invest in, investors prefer not to get any
  dividends paid to them.
• What mitigates the tax effect?
• Why do firms pay dividends?

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Factors Favouring Paying Dividends

• Tax Free Investors
• Tax exempt investors do not worry about taxation
  aspects of dividends
• Generally, tax exempt investors will prefer high
  dividend paying stocks (as their pre-tax returns
  are higher)
• There may be demand from tax-exempt investors for
  high dividend stocks
• If there are enough tax-exempt investors, and not
  enough high dividend stocks available, the excess
  demand may push stock prices up
• Firms may choose to pay high dividends to attract
  this type of investor
• This is a form of the Clientele Effect in
  dividends

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Factors Favouring Paying Dividends

• 2. Agency Problems
• If firm does not pay dividends then management
  retains control of funds
• If there are NPV gt 0 projects available, this
  is fine
• However, if no good investments are available,
  there may be incentive for management to invest
  in NPV lt 0 projects simply to retina control of
  the funds
• That is, management may waste money
• This may offset the tax disadvantage to investors
  of getting the funds paid out as dividends

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Factors Favouring Paying Dividends

• 3. Signaling
• firm s can use their dividend policy to signal
  to the market the firms prospects.
• Increasing dividends signals that the management
  is confident in the future.
• Some Investors Preference for Current Income
• Some investors simply prefer current income
• People who need cashflow, or live off of income
  from investments
• Firms may attempt to serve this clientele by
  paying dividends

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Factors Favouring Paying Dividends

• In the end, there does exist a tax disadvantage
  to dividends
• However, many firms do pay dividends
• Some, or all, of these other factors must be
  important in the real world.

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Conclusion

• Three main decisions facing a firm
• Capital Budgeting
• Capital Structure
• Dividend Policy
• All of these are related

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Conclusion

• Dividend policy depends on availability of good
  investments
• good investments determined by capital
  budgeting analysis
• Dividend policy affects capital structure
• Paying higher dividends keeps stock price low
  (less growth)
• Over time this lowers value of equity and makes
  firm more leveraged
• Capital structure affects cost of capital
• Affects the capital budgeting decisions of the
  firm

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Conclusion

• The decisions faced by any firm are complicated
  and interrelated
• In the end, there is no way to know the true
  best solution
• Financial analysis techniques and concepts
  provide a framework for evaluating the decisions
• There is always risk involved in making financial
  decisions, financial analysis simply seeks to
  reduce the risk and make people aware of it so it
  can be managed appropriately.