BBK34133 | Investment Analysis Prepared by Dr Khairul Anuar

L6 – Dividend and Dividend Policy

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What is Dividend Policy

• 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

• Dividends are a permanent distribution of residual earnings of

the corporation to its owners.

• Dividends can be in the form of:

– Cash

– Additional Shares of Stock (stock dividend)

• 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.

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Distributions to Shareholders

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The “clientele effect”

• Different groups of investors, or clienteles, prefer different dividend policies.

• Firm’s past dividend policy determines its current clientele of investors.

• Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies due to a change in payout policy.

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The “information content,” or “signaling,”

hypothesis

• Investors view dividend changes as signals of management’s view of the future. Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable.

• Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

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• In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm.

• When a cash dividend is declared, those funds leave the firm permanently and irreversibly.

• Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.

Dividends a Financing Decision

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Dividends characteristics

• A dividend is a discretionary payment made to shareholders

• The decision to distribute dividends is solely the responsibility of the board of directors

• Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)

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Distributions to Shareholders

• The company’s board of directors declares the dividend that will be paid and decides when the payment will occur:

• Ex-dividend date

• Record date

• Payment date

• Some companies pay dividends once year while others pay dividends twice a year –usually as an interim and a final dividend.

• Occasionally, a firm may pay a one-time, special dividend that is usually much larger than a regular dividend.

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Mechanics of Cash Dividend Pay

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.

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Mechanics of Cash Dividend Pay

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.

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Declaration Date

Date of

Record

Date of

Payment

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

x business days prior to the Date of Record

Dividend Declaration Time Line

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Dividend Policy

• 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)

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Dividend Reinvestment Plans (DRIPs)

• Also referred to as stock dividends

• 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

Shareholders can automatically reinvest their dividends in

shares of the company‟s common stock.

• Firms are able to raise additional common stock capital

continuously at no cost and fosters an on-going relationship with shareholders.

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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 firm‟s ability to pay dividends

in the future.

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Stock Dividends

Implications – reduction in the Retained earnings 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

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Stock Dividends Example

ABC Company

Equity Accounts

as at February xx, 20x9

Common stock (21,500) $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:

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Share Repurchases

• Repurchases: Buying own stock back from

stockholders.

• 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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Stock Repurchases

• Reasons for repurchases:

– As an alternative to distributing cash as dividends.

– To dispose of one-time cash from an asset sale.

– To make a large capital structure change.

– To use when employees exercise stock options.

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• called treasury stock

• non-voting

• may not receive dividends

• if not retired, can be resold unlike the U.S., (in some

countries shares repurchased are cancelled eg.

Canada)

Repurchased Shares

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Scenario: Company A: Current earnings=$4.4m,

Current no of shares=1.1 m shares

Current share price = $20

Repurchase = 100,000 shares (0.1 m shares)

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] x [EPSnew]

= [5] x [$4.40] = $22.00 per share

Repurchase Example

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• EPS should increase following the repurchase if

earnings after-tax remains the same

• should result with a higher market price per

outstanding share

• shareholders not selling their shares back to the

firm will enjoy a capital gain if the repurchase

increases the share price.

Effects of A Share Repurchase

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Share repurchase as a signal

• The announcement of an intended repurchase

might send a signal that affects stock price, and

the previous events that led to cash available for

a distribution affect stock price

Summary of Dividends vs. Repurchases

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Dividend Versus Retention of Cash

Agency costs of retaining cash

• There is no benefit to shareholders when a firm holds cash

above and beyond its future investment or liquidity needs.

• Managers may use this cash inefficiently by continuing

money-losing pet projects, paying excessive executive

perks or overpaying for acquisitions.

• Leverage is one way to reduce a firm‟s access cash.

• Paying out cash can boost the share price by reducing

managers ability and temptation to waste resources.

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Advice for the Financial Manager

Overall, as a financial manager, you should consider the

following when making payout policy decisions:

• For a given payout amount, try to maximise the after-tax

payout to the shareholders. Repurchases and dividends are

often taxed differently and one can have an advantage over

the other.

• Repurchases and special dividends are useful for making

large, infrequent distributions to shareholders - neither implies

any expectation of repeated payouts.

• Starting and increasing a regular dividend is seen by

shareholders as an implicit commitment to maintain this level

of regular payout indefinitely.

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Advice for the Financial Manager

• Because regular dividends are seen as an implicit

commitment, they send a stronger signal of financial strength

to shareholders - However, this signal comes with a cost

because regular payouts reduce a firm‟s financial flexibility.

• Be mindful of future investment plans - There are transaction

costs associated with both distributions and raising new

capital, so it is expensive to make a large distribution and then

raise capital to fund a project.

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Our Company intends to distribute yearly dividends of RM700 million or up to 90% of our normalized PATAMI, whichever is higher. Dividends will be paid only if approved by our Board out of funds available for such distribution. The actual amount and timing of dividend payments will depend upon our level of cash and retained earnings, results of operations, business prospects, monetization of non-core assets, projected levels of capital expenditure and other investment plans, current and expected obligations and such other matters as our Board may deem relevant.”

Dividend Policy

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PETALING JAYA: Westport Holdings Bhd is dangling a 75% dividend payout policy to woo investors to its initial public offering (IPO) of 813.19 million shares of 10 sen par value. ”The 75% dividend payout policy is a target we hope to achieve every year,” said chief executive officer at the company s prospectus launch in Kuala Lumpur yesterday. 2010 2011 2012 2013 Divided per share (sen) 6.7 6.7 9.0 9.6 Dividend payout ratio 70.2% 63.1% 75.0% 75.0%

Westport dangles 75% dividend ‘carrot’ September 20, 2013

Microsoft Boosts Dividend by 22%, Sets $40 Billion Buyback

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Microsoft Corp moved to share more of its cash hoard with shareholders, boosting its quarterly dividend by 22% and renewing a $40 billion authorization to buy back its shares. Microsoft unveiled a $40 billion share buyback plan and boosted its quarterly dividend by 22%, continuing the shareholder-friendly moves it has pushed in recent years. The announcement Tuesday comes two days before a highly anticipated meeting with financial analysts and follow a series of surprise changes at the software giant, including a plan to seek a successor to Chief Executive Steve Ballmer and a $7 billion deal to buy Nokia Corp.'s 2.19% smartphone business. Microsoft has raised its dividend eight times since 2004, in announcements that typically come in September. But the latest increase was greater than predicted by some analysts, who see Microsoft's moves to return cash to shareholders as a way to defuse dissatisfaction with the company's share price.

Wall Street Journal, Updated Sept. 17, 2013

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