Dividend Policy What is It?

1. Dividend PolicyWhat 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. CHAPTER 22 – Dividend Policy

2. Objectives • Study the relationship between a firm’s dividend policy and the market value of its common stock. • Review types of dividend policies followed by firms. CHAPTER 22 – Dividend Policy

3. Dividend PaymentsMechanics 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. CHAPTER 22 – Dividend Policy

4. 2 business days prior to the Date of Record Date of Payment Date of Record Declaration Date 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 Dividend Declaration Time Line CHAPTER 22 – Dividend Policy

5. Dividend PolicyDividends, 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) CHAPTER 22 – Dividend Policy

6. 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. CHAPTER 22 – Dividend Policy

7. Dividend PaymentsDividend 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 on-going relationship with shareholders. CHAPTER 22 – Dividend Policy

8. Dividend PaymentsStock 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. CHAPTER 22 – Dividend Policy

9. Dividend PaymentsStock 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 CHAPTER 22 – Dividend Policy

10. Dividend PaymentsStock Dividend Example ABC Company Equity Accounts as at February xx, 20x9 Common stock (215,000) $5,000,000 Retained earnings 20,000,000 Net Worth $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: next page... CHAPTER 22 – Dividend Policy

11. Dividend PaymentsStock Dividend Example After the stock dividend: ABC Company Equity Accounts as at March 1, 20x9 Common stock (236,500) $5,860,000 Retained earnings 19,140,000 Net worth $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 shareholder’s wealth will remain unchanged. CHAPTER 22 – Dividend Policy

12. Dividend PaymentsStock Splits • Although there is no theoretical proof, there is some who believe that an optimal price range exists for a company’s 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 • Reasons for use: • better share price trading range • psychological appeal (signalling affect) CHAPTER 22 – Dividend Policy

13. Dividend PaymentsStock Split Effects • shareholders wealth should remain unaffected: Original Holdings: (100 shares @ $150/share) = $15,000 After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000 • 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. CHAPTER 22 – Dividend Policy

14. Stock Dividends versus Stock Splits - lowers stock price slightly - large drop in stock price - little psychological appeal - much stronger potential signalling effect - recapitalization of earnings - no recapitalization - no change in proportional - same ownership - odd lots created - odd lots rare - theoretically, no value to - same the investor Stock Dividends Stock Splits CHAPTER 22 – Dividend Policy

15. Modigliani and Miller’s Dividend Irrelevance Theorem M&M, Dividends and Firm Value

16. M&M’s Dividend Irrelevance TheoremAssumptions • No Taxes • Perfect capital markets • large number of individual buyers and sellers • costless information • no transaction costs • All firms maximize value • There is no debt CHAPTER 22 – Dividend Policy

17. Miller-Modigliani (MM) ’s Dividend Irrelevance Theorem • Ass.: taxes=transaction costs=0 and • Firm’s investment policy is unaffected by dividend policy • Firmvalue (0 div.) = Firmvalue (­ div.) HOW? • S/Hs receive returns in 2 forms: • Dividends & Stock Price appreciation (CGs) • ­ dividends, ¯ the CG and vice-versa • Overall S/H’s returns are identical • Indifferent to dividend policy CHAPTER 22 – Dividend Policy

18. M&M’s Dividend Irrelevance TheoremHomemade Dividends • Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern. • They don’t need management declare a cash dividend, they can create their own. Conclusion: under the assumptions of M&M’s model, the investor is indifferent to the firm’s dividend policy. CHAPTER 22 – Dividend Policy

19. Residual Dividend Theory • Flotation costs cause outside equity to be more expensive than inside equity, i.e., retained earnings. • Financing investments internally (and decreasing dividends) instead of issuing new stock may be favored. • Residual dividend theory says that a dividend would be paid only when internally generated funds remain after financing the firm's investments CHAPTER 22 – Dividend Policy

20. Expectations Theory • As the time approaches for management to announce the amount of the next dividend, investors form expectations as to how much the dividend will be. The investor then compares the actual dividend announced with the expected dividend. • If the amount of the dividend is as expected, even if it represents an increase from prior years, the market price of the stock will remain unchanged. However, if the dividend is higher or lower than expected, the investors will reassess their perceptions about the firm and the value of the stock. CHAPTER 22 – Dividend Policy

21. The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed • Risk is a real world factor. • Firm’s that reinvest free cash flow, put that money at risk – there is no certainty of investment outcome – those forfeit dividends that are reinvested…could be lost! • Remember the two-stage DDM? CHAPTER 22 – Dividend Policy

22. [ 22-6] The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed • Remember the two-stage DDM? • 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. CHAPTER 22 – Dividend Policy

23. The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed • 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 firms to be riskier and apply a higher discount rate to value them causing the share price to fall. • M&M argue that dividends and capital gains are perfect substitutes CHAPTER 22 – Dividend Policy

24. The “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand Theory Conclusions: • Firms cannot change underlying operational characteristics by changing the dividend • The dividend should reflect the firm’s operations through the residual value of dividends CHAPTER 22 – Dividend Policy

25. Some Practical Considerations • Legal restrictions: • A corporation may not pay a dividend • If the firm's liabilities exceed its assets. • If the amount of the dividend exceeds the accumulated profits (retained earnings). • If the dividend is being paid from capital invested in the firm. • Debt holders and Preferred stockholders may impose restrictive provisions on management, such as common dividends not being paid from earnings prior to the payment of interest or preferred dividends. CHAPTER 22 – Dividend Policy

26. Some Practical Considerations • Liquidity Position: • The amount of a firm's retained earnings and its cash position are seldom the same. Thus, the company must have adequate cash available as well as retained earnings to pay dividends. • Absence or lack of other sources of financing: • All firms do not have equal access to the capital markets. Consequently, companies with limited financial resources may rely more heavily on internally generated funds. • Earning predictability: • A firm that has a stable earnings trend will generally pay a larger portion of its earnings in dividends. If earnings fluctuate significantly, a larger amount of the profits may be retained to ensure that enough money is available for investment projects when needed. CHAPTER 22 – Dividend Policy

27. Some Practical Considerations • Ownership control: • For many small firms, and certain large ones, maintaining the controlling vote is very important. These owners would prefer the use of debt and retained profits to finance new investments rather than issue new stock. • Inflation: • Because of inflation, the cost of replacing equipment has increased substantially. Depreciation funds tend to become insufficient. Hence, greater profit retention may be required. CHAPTER 22 – Dividend Policy

28. 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. CHAPTER 22 – Dividend Policy

29. Share Repurchases 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. CHAPTER 22 – Dividend Policy

30. Disadvantages of Share Repurchases • they are usually done on an irregular basis, so a shareholder cannot depend on income from this source. • 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. CHAPTER 22 – Dividend Policy

31. Methods of Share Repurchases • tender offer: • this is a formal offer to purchase a given number of shares at a given price over current market price. • open market purchase: • the purchase of shares through an investment dealer like any other investor • this is not designed for large block purchases. • 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. CHAPTER 22 – Dividend Policy

32. Effects of A Share Repurchase • EPS should increase following the repurchase if earnings after-tax remains the same • a higher market price per outstanding share of common stock should result • stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price. CHAPTER 22 – Dividend Policy

33. Advantages of Share Repurchases • signal positive information about the firm’s future cash flows • used to effect a large-scale change in the firm’s capital structure • increase investor’s return without creating an expectation of higher future cash dividends • reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, without creating a continuing incremental cash drain • capital gains treated more favourably than cash dividends for tax purposes. CHAPTER 22 – Dividend Policy

34. Disadvantages of Share Repurchases • signal negative information about the firm’s future growth and investment opportunities • the provincial securities commission may raise questions about the intention • share repurchase may not qualify the investor for a capital gain CHAPTER 22 – Dividend Policy

35. Borrowing to Pay Dividends • Is this legal? is it possible to do? • Yes • the firm must have the ability and capacity to borrow • the firm must have sufficient retained earnings to allow it to pay the dividend • the firm must have sufficient cash on hand to pay the cash dividend • the firm must NOT have agreed to any limitations on the payment of dividends under the bond indenture. • Why? • A possible answer is to signal to the market that the board is confident about the firm’s ability to sustain cash dividends into the future. CHAPTER 22 – Dividend Policy

36. Borrowing to Pay DividendsAn Example • The foregoing example illustrates: • it is possible for a firm with ‘borrowing capacity’ to borrow funds to pay cash dividends. • this is not possible if the lenders insist on restrictive covenants that limit or prevent this from occurring. • the cash for the dividend must be present in the cash account. • payment of dividends reduces both the cash account on the asset side of the balance sheet as well as the retained earnings account on the ‘claims’ side of the balance sheet. • in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. (Bondholders in this example may have thought their firm would have only a 25% debt ratio….after the dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.) CHAPTER 22 – Dividend Policy

37. Dividend policy summary • No definite conclusion can be reached about the optimal dividend policy • Investors in aggregate cannot be shown to uniformly prefer either high or low dividends • Individual investors, however, have strong dividend preferences and will tend to invest in companies whose dividend policies match their preferences • Regardless of the payout ratio, investors prefer a stable, predictable dividend policy CHAPTER 22 – Dividend Policy

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