FIN2101
Business Finance II
Module 10
Dividend Policy
Student Activities
Reading
Text,Chapter 12
Text Study Guide,Chapter 12
Study Book,Module 10
Appendix 10.1,10.2 and 10.3
Tutorial Activities
Tutorial Workbook,Self Assessment Activity
10.1
Text Study Guide,Chapter 11,All
Cash Dividends
Typically semi-annual in Australia.
Interim dividend paid after the end of
the first half of the year,and a final
dividend usually paid after the AGM.
Can only be paid out of current or
accumulated profits.
Cannot be paid out of capital or if it
would make the company insolvent.
Payment Procedures
Announcement date
Declaration date
Date of record
Ex-dividend date
Payment date
Payment Procedures
1 2 3 4
1 Announcement date
2 Declaration date
3 Ex-dividend date
4 Date of record
5 Payment date
5
Ex-dividend period
Three Approaches
Dividend policy cannot affect
shareholders? wealth in a perfect
capital market and is therefore
irrelevant.
High dividends are best - relevant.
Low dividends are best - relevant.
Relevance Argument
Resolution of uncertainty - the?bird-in-
the-hand? argument/fallacy.
Information content of dividend
announcements – signalling.
Relevance Argument
Clientele effect
–tax
–investors? preferences
Relevance Argument
Agency costs can be reduced by
paying higher dividends.
Issue costs will be minimised if the firm
pays lower dividends.
Shareholders? transaction costs will be
higher,the lower the dividend.
Dividends As An Active
Decision Variable
Management must pay a dividend
before investing in new projects.
A shortfall may arise and could be
overcome in 1 of 3 possible ways:
–reduce investment opportunities;
–issue additional debt finance;
–issue additional equity.
Dividends As An Active
Decision Variable
If management decides to pay a dividend
and then make up the shortfall to fund
the new investments,it obviously
considers dividend policy to be important.
Dividends are,therefore,an active
decision variable.
Irrelevance Argument
Modigliani and Miller.
Earnings are what affect the value of
the firm and not decisions on when
earnings are distributed to investors.
As long as the return is constant,
investors don?t care about how that
return is made up,ie dividend or capital
gain.
Irrelevance Argument
g - k
D
= P
g - k
g + 1 D
= P
s
1
0
s
0
0
b.r - k
b - 1 e
=
g - k
b - 1 e
= P
s
1
s
1
0
b - 1 k
b - 1 e
=
b,k - k
b - 1 e
= P
s
1
ss
1
0
s
1
0
k
e
= P
Value is a function of future earnings,
not future dividends
Passive Residual Approach
Dividends to be paid should be a
residual variable or a passive variable.
Management does not manipulate
dividends to achieve its objective.
Residual Theory of Dividends
First determine the optimal capital budget.
Determine the amount of ordinary equity
needed to finance new investments
according to target capital structure.
If possible,use internal funds (retained
earnings) to meet needs.
Pay cash dividends with left over or residual
internal funds.
Passive Residual Approach
Based on several points.
It is imperative that management takes
advantage of all investment opportunities.
Pay dividends only if there is a surplus.
Maximisation of earnings potential is of
paramount importance.
Investors prefer a capital gain and larger
future dividends to short-term,smaller
payments.
Passive Residual Approach
Key assumptions:
a given investment plan which is not
affected by changes in dividend policy;
a perfectly competitive market (no
transaction,flotation or information costs);
no taxes,therefore investors are indifferent
between receiving dividends or capital gains.
MM on Dividends
MM put forward the passive residual approach.
Dividend policy is irrelevant and investment policy
is all that matters.
,Homemade dividend” notion.
Under the,Active Decision Variable” approach,
the firm is not doing anything for investors that
they can?t already do for themselves.
Investment policy is of paramount importance.
MM on Dividends
A decision on whether or not to pay a
dividend and the level of dividend will
ultimately be affected by the
investment opportunities available.
The choice is simple - dividend or no
dividend.
Dividend Policy - MM Position
Company Z
1 million shares,no debt
Value,$5m
Assets,$4m + $1m cash
Investment
Opportunity,Invest $1m cash to return $2m
Options:
Choice 1 Pay no dividend
Invest $1m cash
Choice 2(A) Pay dividend of $1m cash
Don’t invest
Choice 2(B) Pay dividend
Fund investment by share issue
Value to Shareholder - Choice 1
V =
V + R - O
N
=
5 + 2 - 1
1
=
6
1
= $ 6
S
Value to Shareholder - Choice 2(A)
V =
V - D
N
+ D i v i d e n d R e c e i v e d
=
5 - 1
1
+ 1
= 4 + 1
= $ 5
S
Value to Shareholder - Choice 2(B)
V =
V - D + S + R - O
N + N
+ D i v i d e n d
=
5 - 1 + 1 + 2 - 1
1 + 0,2
+ 1
S
S
V =
4 + 1 + 1
1,2
+ 1
=
6
1,2
+ 1
= $ 6
S
Homemade Dividend Example
2 firms,A & B,identical risk and income
streams.
k = 10%.
Net income = $5 000 on 5 000 shares.
An investor has 100 shares in each.
Each has an identical investment
opportunity generating 30% on a $5 000
outlay (ie $1 500 p.a.).
Homemade Dividend
Dividend Policy A:
No dividend payout
Use retained earnings to fund the
investment
Dividend Policy B:
100% dividend payout
Fund investment with new share issue
Firms A and B Now
Firm A Firm B
Value
NI/k $5 000/0.1 $50 000 $50 000
Dividend
NI/n $5 000/5 000 $1 $1
Price
V/n $50 000/5 000 $10 $10
Firms A and B Later
Firm A Firm B
NI $5 000 + $1 500 $5 000 + $1 500
= $6 500 = $6 500
V $6 500/0.1 $6 500/0.1
= $65 000 = $65 000
Firms A and B Later
Firm A Firm B
P $65 000/5 000 $65 000/5 500*
= $13 = $12
* The firm issues 500 shares @ $10 to
finance the investment.
Firms A and B Later
Investor now has 100 shares in Firm A
@ $13 = $1 300 total value.
Investor now has 100 shares in Firm B
@ $12 plus $100 dividend income (@$1
per share),giving a total value of $1 300.
Homemade Dividend
If the investor requires dividend income
from Firm A,he/she could sell 7.7 shares
($100/$13) to raise approximately $100.
This is what is referred to as a
“homemadedividend”.
Shareholder’s Wealth - Firm A
The investor’s position would then be:
92.3 shares @ $13 $1 200
Plus,$100 cash 100
Shareholder’s Wealth $1 300
Conclusion
The shareholder?s wealth position is the
same under either plan.
An individual investor would be indifferent
between Company A and Company B which
are identical in every respect except for
dividend policy.
The dividend policy is therefore irrelevant.
The Evidence
Most companies have a long-term target
dividend payout ratio.
Managers are concerned more about the
change in dividends than the absolute level
of dividends.
Dividends are?smoothed? relative to profits.
Reluctance to change dividends to a level
that cannot be sustained in the future.
Dividend Policy and the
Classical Tax System
Companies should adopt a stable or
smoothed? policy to minimise changes in
payouts which can cause major variations in
share price.
The target payout ratio should be low
enough to minimise the need for share
issues.
Dividend Policy and the
Imputation System
When the company tax rate = the top
personal marginal tax rate,the optimal
policy for Australian companies owned by
resident shareholders would be to pay the
maximum possible franked dividends and
adopt a dividend reinvestment plan to limit
the outflow of cash.
Dividend Policy and the
Imputation System
More complex for 3 reasons:
Tax-exempt and non-resident shareholders cannot
use imputation tax credits.
Company tax rate ≠ top personal tax rate,
meaning that some resident shareholders may
prefer the retention of profits.
Non-tax factors such as the information effects of
changes in dividends are still important.
Dividend Policy In Practice
Most companies appear to try to pay some
dividend and to maintain a stable dividend
policy over time.
Management obviously therefore thinks that
dividend policy is important.
If they didn?t think that dividends affect the
value of the firm,they wouldn?t pay a
dividend to shareholders.
Factors Affecting Dividend Policy
Legal constraints.
Firm?s capacity to pay – available excess
cash.
Contractual constraints – loan covenants.
Growth prospects.
Owner considerations:
– tax status of the firm?s owners;
– owners? investment opportunities;
– potential dilution of ownership.
Types of Dividend Policies
Constant-payout-ratio
– A certain % of earnings is paid each period.
Regular dividend policy
– Payment of a fixed-dollar dividend each period.
Low-regular-and-extra dividend policy
– Payment of a low regular dividend,
supplemented by an?extra? dividend when
earnings warrant it.
Pages 439-40 of text.
Other Dividends
Dividend reinvestment plans (DRPs)
Dividend election schemes (DESs)
Bonus share plans (BSPs)
Share splits
Share buy-backs
Dividend Reinvestment Plans
Shareholders have the option of reinvesting all or
part of their dividends in additional shares.
Price is at a discount (2.5%-10%) to the market
price.
Dividends remain taxable to the investor as if paid
in cash,and franking credits attaching to the
dividends are received.
Cost-effective way of raising new capital – no
prospectus or other disclosures required.
Dividend Election Schemes
Offer shareholders the option of receiving their
dividends in one or more of a number of forms.
Options include:
– fully franked dividends;
– unfranked dividends;
– bonus shares.
Enabled firms to,stream” imputation credits to
particular classes of investors.
Now restricted to bonus share plans and overseas
dividend plans.
Bonus Share Plans
Shareholders receive dividends in the form of
shares.
The number issued is proportional to cash
dividends foregone.
Advantages:
– To shareholder,information content.
– To company,conserves cash.
A drawback is that shareholders do not receive
franking credits,and this reduces the popularity of
BSPs.
Share Splits
Involve issuing new free shares on a pro-rata
basis to current shareholders.
It is argued that shareholders will benefit because
the share price will not fall precisely in proportion
to the increase in the number of shares
(information content).
Conserve cash.
Often used to lower the share price and thus
enhance trading.
Share Buy-Backs
The company repurchases shares from its
shareholders.
Motives:
– provide a tax-effective dividend for shareholders;
– remove small shareholdings from the share register;
– enhance shareholders value (decrease the number of
shares and therefore increase EPS; positive information
content);
– help discourage an unfriendly takeover.
Share Buy-Backs
In 1995,total repurchases by listed
companies in Australia was $770m.
In 1999,the corresponding figure was $8.8b.
Legal restrictions in Australia to protect
creditors and shareholders.
In any 12-month period,a company may
only buy up to 10% of its paid-up capital.
Business Finance II
Module 10
Dividend Policy
Student Activities
Reading
Text,Chapter 12
Text Study Guide,Chapter 12
Study Book,Module 10
Appendix 10.1,10.2 and 10.3
Tutorial Activities
Tutorial Workbook,Self Assessment Activity
10.1
Text Study Guide,Chapter 11,All
Cash Dividends
Typically semi-annual in Australia.
Interim dividend paid after the end of
the first half of the year,and a final
dividend usually paid after the AGM.
Can only be paid out of current or
accumulated profits.
Cannot be paid out of capital or if it
would make the company insolvent.
Payment Procedures
Announcement date
Declaration date
Date of record
Ex-dividend date
Payment date
Payment Procedures
1 2 3 4
1 Announcement date
2 Declaration date
3 Ex-dividend date
4 Date of record
5 Payment date
5
Ex-dividend period
Three Approaches
Dividend policy cannot affect
shareholders? wealth in a perfect
capital market and is therefore
irrelevant.
High dividends are best - relevant.
Low dividends are best - relevant.
Relevance Argument
Resolution of uncertainty - the?bird-in-
the-hand? argument/fallacy.
Information content of dividend
announcements – signalling.
Relevance Argument
Clientele effect
–tax
–investors? preferences
Relevance Argument
Agency costs can be reduced by
paying higher dividends.
Issue costs will be minimised if the firm
pays lower dividends.
Shareholders? transaction costs will be
higher,the lower the dividend.
Dividends As An Active
Decision Variable
Management must pay a dividend
before investing in new projects.
A shortfall may arise and could be
overcome in 1 of 3 possible ways:
–reduce investment opportunities;
–issue additional debt finance;
–issue additional equity.
Dividends As An Active
Decision Variable
If management decides to pay a dividend
and then make up the shortfall to fund
the new investments,it obviously
considers dividend policy to be important.
Dividends are,therefore,an active
decision variable.
Irrelevance Argument
Modigliani and Miller.
Earnings are what affect the value of
the firm and not decisions on when
earnings are distributed to investors.
As long as the return is constant,
investors don?t care about how that
return is made up,ie dividend or capital
gain.
Irrelevance Argument
g - k
D
= P
g - k
g + 1 D
= P
s
1
0
s
0
0
b.r - k
b - 1 e
=
g - k
b - 1 e
= P
s
1
s
1
0
b - 1 k
b - 1 e
=
b,k - k
b - 1 e
= P
s
1
ss
1
0
s
1
0
k
e
= P
Value is a function of future earnings,
not future dividends
Passive Residual Approach
Dividends to be paid should be a
residual variable or a passive variable.
Management does not manipulate
dividends to achieve its objective.
Residual Theory of Dividends
First determine the optimal capital budget.
Determine the amount of ordinary equity
needed to finance new investments
according to target capital structure.
If possible,use internal funds (retained
earnings) to meet needs.
Pay cash dividends with left over or residual
internal funds.
Passive Residual Approach
Based on several points.
It is imperative that management takes
advantage of all investment opportunities.
Pay dividends only if there is a surplus.
Maximisation of earnings potential is of
paramount importance.
Investors prefer a capital gain and larger
future dividends to short-term,smaller
payments.
Passive Residual Approach
Key assumptions:
a given investment plan which is not
affected by changes in dividend policy;
a perfectly competitive market (no
transaction,flotation or information costs);
no taxes,therefore investors are indifferent
between receiving dividends or capital gains.
MM on Dividends
MM put forward the passive residual approach.
Dividend policy is irrelevant and investment policy
is all that matters.
,Homemade dividend” notion.
Under the,Active Decision Variable” approach,
the firm is not doing anything for investors that
they can?t already do for themselves.
Investment policy is of paramount importance.
MM on Dividends
A decision on whether or not to pay a
dividend and the level of dividend will
ultimately be affected by the
investment opportunities available.
The choice is simple - dividend or no
dividend.
Dividend Policy - MM Position
Company Z
1 million shares,no debt
Value,$5m
Assets,$4m + $1m cash
Investment
Opportunity,Invest $1m cash to return $2m
Options:
Choice 1 Pay no dividend
Invest $1m cash
Choice 2(A) Pay dividend of $1m cash
Don’t invest
Choice 2(B) Pay dividend
Fund investment by share issue
Value to Shareholder - Choice 1
V =
V + R - O
N
=
5 + 2 - 1
1
=
6
1
= $ 6
S
Value to Shareholder - Choice 2(A)
V =
V - D
N
+ D i v i d e n d R e c e i v e d
=
5 - 1
1
+ 1
= 4 + 1
= $ 5
S
Value to Shareholder - Choice 2(B)
V =
V - D + S + R - O
N + N
+ D i v i d e n d
=
5 - 1 + 1 + 2 - 1
1 + 0,2
+ 1
S
S
V =
4 + 1 + 1
1,2
+ 1
=
6
1,2
+ 1
= $ 6
S
Homemade Dividend Example
2 firms,A & B,identical risk and income
streams.
k = 10%.
Net income = $5 000 on 5 000 shares.
An investor has 100 shares in each.
Each has an identical investment
opportunity generating 30% on a $5 000
outlay (ie $1 500 p.a.).
Homemade Dividend
Dividend Policy A:
No dividend payout
Use retained earnings to fund the
investment
Dividend Policy B:
100% dividend payout
Fund investment with new share issue
Firms A and B Now
Firm A Firm B
Value
NI/k $5 000/0.1 $50 000 $50 000
Dividend
NI/n $5 000/5 000 $1 $1
Price
V/n $50 000/5 000 $10 $10
Firms A and B Later
Firm A Firm B
NI $5 000 + $1 500 $5 000 + $1 500
= $6 500 = $6 500
V $6 500/0.1 $6 500/0.1
= $65 000 = $65 000
Firms A and B Later
Firm A Firm B
P $65 000/5 000 $65 000/5 500*
= $13 = $12
* The firm issues 500 shares @ $10 to
finance the investment.
Firms A and B Later
Investor now has 100 shares in Firm A
@ $13 = $1 300 total value.
Investor now has 100 shares in Firm B
@ $12 plus $100 dividend income (@$1
per share),giving a total value of $1 300.
Homemade Dividend
If the investor requires dividend income
from Firm A,he/she could sell 7.7 shares
($100/$13) to raise approximately $100.
This is what is referred to as a
“homemadedividend”.
Shareholder’s Wealth - Firm A
The investor’s position would then be:
92.3 shares @ $13 $1 200
Plus,$100 cash 100
Shareholder’s Wealth $1 300
Conclusion
The shareholder?s wealth position is the
same under either plan.
An individual investor would be indifferent
between Company A and Company B which
are identical in every respect except for
dividend policy.
The dividend policy is therefore irrelevant.
The Evidence
Most companies have a long-term target
dividend payout ratio.
Managers are concerned more about the
change in dividends than the absolute level
of dividends.
Dividends are?smoothed? relative to profits.
Reluctance to change dividends to a level
that cannot be sustained in the future.
Dividend Policy and the
Classical Tax System
Companies should adopt a stable or
smoothed? policy to minimise changes in
payouts which can cause major variations in
share price.
The target payout ratio should be low
enough to minimise the need for share
issues.
Dividend Policy and the
Imputation System
When the company tax rate = the top
personal marginal tax rate,the optimal
policy for Australian companies owned by
resident shareholders would be to pay the
maximum possible franked dividends and
adopt a dividend reinvestment plan to limit
the outflow of cash.
Dividend Policy and the
Imputation System
More complex for 3 reasons:
Tax-exempt and non-resident shareholders cannot
use imputation tax credits.
Company tax rate ≠ top personal tax rate,
meaning that some resident shareholders may
prefer the retention of profits.
Non-tax factors such as the information effects of
changes in dividends are still important.
Dividend Policy In Practice
Most companies appear to try to pay some
dividend and to maintain a stable dividend
policy over time.
Management obviously therefore thinks that
dividend policy is important.
If they didn?t think that dividends affect the
value of the firm,they wouldn?t pay a
dividend to shareholders.
Factors Affecting Dividend Policy
Legal constraints.
Firm?s capacity to pay – available excess
cash.
Contractual constraints – loan covenants.
Growth prospects.
Owner considerations:
– tax status of the firm?s owners;
– owners? investment opportunities;
– potential dilution of ownership.
Types of Dividend Policies
Constant-payout-ratio
– A certain % of earnings is paid each period.
Regular dividend policy
– Payment of a fixed-dollar dividend each period.
Low-regular-and-extra dividend policy
– Payment of a low regular dividend,
supplemented by an?extra? dividend when
earnings warrant it.
Pages 439-40 of text.
Other Dividends
Dividend reinvestment plans (DRPs)
Dividend election schemes (DESs)
Bonus share plans (BSPs)
Share splits
Share buy-backs
Dividend Reinvestment Plans
Shareholders have the option of reinvesting all or
part of their dividends in additional shares.
Price is at a discount (2.5%-10%) to the market
price.
Dividends remain taxable to the investor as if paid
in cash,and franking credits attaching to the
dividends are received.
Cost-effective way of raising new capital – no
prospectus or other disclosures required.
Dividend Election Schemes
Offer shareholders the option of receiving their
dividends in one or more of a number of forms.
Options include:
– fully franked dividends;
– unfranked dividends;
– bonus shares.
Enabled firms to,stream” imputation credits to
particular classes of investors.
Now restricted to bonus share plans and overseas
dividend plans.
Bonus Share Plans
Shareholders receive dividends in the form of
shares.
The number issued is proportional to cash
dividends foregone.
Advantages:
– To shareholder,information content.
– To company,conserves cash.
A drawback is that shareholders do not receive
franking credits,and this reduces the popularity of
BSPs.
Share Splits
Involve issuing new free shares on a pro-rata
basis to current shareholders.
It is argued that shareholders will benefit because
the share price will not fall precisely in proportion
to the increase in the number of shares
(information content).
Conserve cash.
Often used to lower the share price and thus
enhance trading.
Share Buy-Backs
The company repurchases shares from its
shareholders.
Motives:
– provide a tax-effective dividend for shareholders;
– remove small shareholdings from the share register;
– enhance shareholders value (decrease the number of
shares and therefore increase EPS; positive information
content);
– help discourage an unfriendly takeover.
Share Buy-Backs
In 1995,total repurchases by listed
companies in Australia was $770m.
In 1999,the corresponding figure was $8.8b.
Legal restrictions in Australia to protect
creditors and shareholders.
In any 12-month period,a company may
only buy up to 10% of its paid-up capital.
