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INTRODUCTION TO INTRODUCTION TO CORPORATE FINANCE CORPORATE FINANCE Chapter 22 – Dividend Policy Chapter 22 – Dividend Policy

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The policy a company uses to decide how much it will pay out to shareholders in dividends.

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Page 1: Dividend policy

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCE

Chapter 22 – Dividend PolicyChapter 22 – Dividend Policy

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CHAPTER 22CHAPTER 22 Dividend PolicyDividend Policy

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CHAPTER 22 – Dividend Policy 22 - 3

Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Mechanics of Dividend PaymentsMechanics of Dividend Payments• Cash Dividend PaymentsCash Dividend Payments• M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance Theorem• The “Bird in the Hand” ArgumentThe “Bird in the Hand” Argument• Dividend Policy in PracticeDividend Policy in Practice• Relaxing the M&M AssumptionsRelaxing the M&M Assumptions• Stock Dividends and Stock SplitsStock Dividends and Stock Splits• Share RepurchasesShare Repurchases• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions

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Learning ObjectivesLearning Objectives

You should understand the following:You should understand the following:• The mechanics of dividend payments and why they are different The mechanics of dividend payments and why they are different

from interest paymentsfrom interest payments• The difference between a stock split and a stock dividendThe difference between a stock split and a stock dividend• Under what assumptions a dividend payment is irrelevant and Under what assumptions a dividend payment is irrelevant and

what a homemade dividend iswhat a homemade dividend is• Why dividend payments generally reflect the business risk of Why dividend payments generally reflect the business risk of

the firmthe firm• How transactions costs, taxes and information problems give How transactions costs, taxes and information problems give

value to corporate dividend policiesvalue to corporate dividend policies• How stock dividends and stock splits differHow stock dividends and stock splits differ• How a share repurchase program can substitute for a dividend How a share repurchase program can substitute for a dividend

payout policy.payout policy.

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Important Chapter TermsImportant Chapter Terms

• Agency theoryAgency theory• Bird in the hand argumentBird in the hand argument• Cash cowCash cow• Declaration dateDeclaration date• Dividend reinvestment Dividend reinvestment

plansplans• Dividend yieldDividend yield• Equity market Equity market

capitalizationcapitalization• Ex-dividend dateEx-dividend date

• Free cash flowFree cash flow• Holder of recordHolder of record• Homemade dividendsHomemade dividends• Income strippingIncome stripping• Odd lotsOdd lots• Residual theory of Residual theory of

dividendsdividends• Special dividendSpecial dividend• Split sharesSplit shares• Stock dividendStock dividend• Stock splitStock split• Tax clientelesTax clienteles

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What is Dividend Policy?What is Dividend Policy?

Dividend PolicyDividend Policy

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CHAPTER 22 – Dividend Policy 22 - 7

Dividend PolicyDividend PolicyWhat is It?What is It?

• Dividend Policy refers to the explicit or Dividend Policy refers to the explicit or implicit decision of the Board of Directors implicit decision of the Board of Directors regarding the amount of residual earnings regarding the amount of residual earnings (past or present) that should be distributed to (past or present) that should be distributed to the shareholders of the corporation.the shareholders of the corporation.– This decision is considered a This decision is considered a financing decisionfinancing decision

because the profits of the corporation are an because the profits of the corporation are an important source of financing available to the firm. important source of financing available to the firm.

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Types of DividendsTypes of Dividends

Dividend PolicyDividend Policy

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CHAPTER 22 – Dividend Policy 22 - 9

Types of DividendsTypes of Dividends

• Dividends are a permanent distribution of residual Dividends are a permanent distribution of residual earnings/property of the corporation to its owners.earnings/property of the corporation to its owners.

• Dividends can be in the form of:Dividends can be in the form of:– CashCash– Additional Shares of Stock (stock dividend)Additional Shares of Stock (stock dividend)– PropertyProperty

• If a firm is dissolved, at the end of the process, a final If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the dividend of any residual amount is made to the shareholders – this is known as a shareholders – this is known as a liquidating dividendliquidating dividend..

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Dividends and Corporate FinancingDividends and Corporate Financing

Dividend PolicyDividend Policy

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

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

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

Corporate Profits After Tax Retained Earnings

Dividends

Dividends a Financing DecisionDividends a Financing Decision

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Dividends versus Interest ObligationsDividends versus Interest Obligations

InterestInterest• Interest is a payment to lenders for the use of their funds for a given Interest is a payment to lenders for the use of their funds for a given

period of time period of time • Timely payment of the required amount of interest is a legal obligationTimely payment of the required amount of interest is a legal obligation• Failure to pay interest (and fulfill other contractual commitments Failure to pay interest (and fulfill other contractual commitments

under the bond indenture or loan contract) is an act of bankruptcy and under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remediesthe lender has recourse through the courts to seek remedies

• Secured lenders (bondholders) have the first claim on the firm’s assets Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcyin the case of dissolution or in the case of bankruptcy

DividendsDividends• A dividend is a discretionary payment made to shareholdersA dividend is a discretionary payment made to shareholders• The decision to distribute dividends is solely the responsibility of the The decision to distribute dividends is solely the responsibility of the

board of directorsboard of directors• Shareholders are residual claimants of the firm (they have the last, Shareholders are residual claimants of the firm (they have the last,

and residual claim on assets on dissolution and on profits after all and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied) other claims have been fully satisfied)

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The Mechanics of Dividend PaymentsThe Mechanics of Dividend Payments

Dividend PolicyDividend Policy

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CHAPTER 22 – Dividend Policy 22 - 14

Dividend PaymentsDividend PaymentsMechanics of Cash Dividend PaymentsMechanics of Cash Dividend Payments

• Declaration DateDeclaration Date• Holder of Record DateHolder of Record Date• Ex-dividend DateEx-dividend Date• Payment DatePayment Date

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Dividend PaymentsDividend PaymentsMechanics of Cash Dividend PaymentsMechanics of Cash Dividend Payments

Declaration DateDeclaration Date – this is the date on which the Board of Directors meet and declare the dividend. In their this is the date on which the Board of Directors meet and declare the dividend. In their

resolution the Board will set the resolution the Board will set the date of recorddate of record, the , the date of paymentdate of payment and the and the amount of the amount of the dividenddividend for each share class. for each share class.

– when CARRIED, this resolution makes the dividend a current liability for the firm.when CARRIED, this resolution makes the dividend a current liability for the firm.

Date of RecordDate of Record – is the date on which the shareholders register is closed after the trading day and all those is the date on which the shareholders register is closed after the trading day and all those

who are listed will receive the dividend.who are listed will receive the dividend.

Ex dividend DateEx dividend Date – is the date that the value of the firm’s common shares will reflect the dividend payment (ie. is the date that the value of the firm’s common shares will reflect the dividend payment (ie.

fall in value)fall in value)– ‘‘ex’ means without.ex’ means without.– At the start of trading on the ex-dividend date, the share price will normally open for trading 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 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 that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend.declared dividend.

Date of PaymentDate of Payment – is the date the cheques for the dividend are mailed out to the shareholders.is the date the cheques for the dividend are mailed out to the shareholders.

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Declaration Date

Date ofRecord

Date ofPayment

Ex Dividend Date is determined by the Date of Record.The market value of the sharesdrops by the value of the dividendper share on market opening…comparedto the previous day’s close.

The Board Meetsand passes themotion to createthe dividend

2 business days prior to the Date of Record

Dividend Declaration Time LineDividend Declaration Time Line

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Changes in the Settlement CycleChanges in the Settlement Cycle• In June 1995 the settlement cycle for all non-money-market Canadian and In June 1995 the settlement cycle for all non-money-market Canadian and

U.S. securities was reduced from five business days (T + 5) to U.S. securities was reduced from five business days (T + 5) to three three business daysbusiness days (T + 3). (T + 3).

• The rationale for the change stems from the 1987 stock market crash The rationale for the change stems from the 1987 stock market crash when it was realized that a securities market failure could result in a when it was realized that a securities market failure could result in a credit market failure. The gridlock created in 1990 by the bankruptcy of credit market failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S. broker, increased the need to Drexel Burnham Lambert, a large U.S. broker, increased the need to minimize the risks involved in the clearing and settlement of securities.minimize the risks involved in the clearing and settlement of securities.

• The shortened settlement cycle requires that the payment of funds and The shortened settlement cycle requires that the payment of funds and the delivery of securities take place on the the delivery of securities take place on the third business daythird business day after the after the trade date. This will reduce credit, market and liquidity risks by trade date. This will reduce credit, market and liquidity risks by decreasing post-trade settlement exposure.decreasing post-trade settlement exposure.

Ex Dividend DateEx Dividend Date• The date is not chosen by the board of directors, rather it is determined as The date is not chosen by the board of directors, rather it is determined as

a result of the exchanges settlement practices and is a function of the a result of the exchanges settlement practices and is a function of the date of record.date of record.

Trade Settlement and the Ex Dividend Trade Settlement and the Ex Dividend DateDate

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Dividend Decision and the Board of Dividend Decision and the Board of DirectorsDirectors

Dividend PolicyDividend Policy

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CHAPTER 22 – Dividend Policy 22 - 19

Dividend PolicyDividend PolicyDividends, Shareholders and the Board of DirectorsDividends, Shareholders and the Board of Directors

• There is no legal obligation for firms to pay dividends There is no legal obligation for firms to pay dividends to common shareholdersto common shareholders

• Shareholders cannot force a Board of Directors to Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision the BOD’s right to make the dividend decision because:because:– Board members are jointly and severally liable for any damages Board members are jointly and severally liable for any damages

they may causethey may cause– Board members are constrained by legal rules affecting Board members are constrained by legal rules affecting

dividends including:dividends including:• Not paying dividends out of capitalNot paying dividends out of capital• Not paying dividends when that decision could cause the firm to Not paying dividends when that decision could cause the firm to

become insolventbecome insolvent• Not paying dividends in contravention of contractual commitments Not paying dividends in contravention of contractual commitments

(such as debt covenant agreements)(such as debt covenant agreements)

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Dividend PaymentsDividend Payments

Dividend PolicyDividend Policy

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Dividend PaymentsDividend PaymentsDividend Reinvestment Plans (DRIPs)Dividend Reinvestment Plans (DRIPs)

• Involve shareholders deciding to use the cash Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firmdividend proceeds to buy more shares of the firm– DRIPs will buy as many shares as the cash dividend allows with DRIPs will buy as many shares as the cash dividend allows with

the residual deposited as cashthe residual deposited as cash– Leads to shareholders owning odd lots (less than 100 shares)Leads to shareholders owning odd lots (less than 100 shares)

• Firms are able to raise additional common stock Firms are able to raise additional common stock capital continuously at no cost and fosters an on-capital continuously at no cost and fosters an on-going relationship with shareholders.going relationship with shareholders.

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Dividend PaymentsDividend PaymentsStock DividendsStock Dividends

• Stock dividends simply amount to distribution of Stock dividends simply amount to distribution of additional shares to existing shareholdersadditional shares to existing shareholders

• They represent nothing more than recapitalization They represent nothing more than recapitalization of earnings of the company. (that is, the amount of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E of the stock dividend is transferred from the R/E account to the common share account.account to the common share account.

• Because of the Because of the capital impairment rule capital impairment rule stock stock dividends reduce the firm’s ability to pay dividends reduce the firm’s ability to pay dividends in the future.dividends in the future.

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Dividend PaymentsDividend PaymentsStock DividendsStock Dividends

ImplicationsImplications– reduction in the R/E accountreduction in the R/E account– reduced capacity to pay future dividendsreduced capacity to pay future dividends– proportionate share ownership remains unchangedproportionate share ownership remains unchanged– shareholder’s wealth (theoretically) is unaffectedshareholder’s wealth (theoretically) is unaffected

Effect on the CompanyEffect on the Company– conserves cashconserves cash– serves to lower the market value of firm’s stock modestlyserves to lower the market value of firm’s stock modestly– promotes wider distribution of shares to the extent that current owners divest themselves of promotes wider distribution of shares to the extent that current owners divest themselves of

shares...because they have moreshares...because they have more– adjusts the capital accountsadjusts the capital accounts– dilutes EPSdilutes EPS

Effect on ShareholdersEffect on Shareholders– proportion of ownership remains unchangedproportion of ownership remains unchanged– total value of holdings remains unchangedtotal value of holdings remains unchanged– if former DPS is maintained, this really represents an increased dividend payoutif former DPS is maintained, this really represents an increased dividend payout

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Dividend PaymentsDividend PaymentsStock Dividend ExampleStock Dividend Example

ABC CompanyABC CompanyEquity AccountsEquity Accounts

as at February xx, 20x9as at February xx, 20x9Common stock (215,000)Common stock (215,000) $5,000,000$5,000,000Retained earningsRetained earnings 20,000,000 20,000,000Net WorthNet Worth $25,000,000$25,000,000

The company, on March 1, 20x9 declares a 10 percent stock dividend when the 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.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 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:This will mean issuing 21,500 shares. The value of the shares is:

$40.00 (21,500) = $860,000$40.00 (21,500) = $860,000

This stock dividend will result in $860,000 being transferred from the retained This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:earnings account to the common stock account:

next page...next page...

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Dividend PaymentsDividend PaymentsStock Dividend ExampleStock Dividend Example

After the stock dividend:After the stock dividend:

ABC CompanyABC CompanyEquity AccountsEquity Accounts

as at March 1, 20x9as at March 1, 20x9

Common stock (236,500)Common stock (236,500) $5,860,000$5,860,000Retained earningsRetained earnings 19,140,00019,140,000Net worthNet worth $25,000,000$25,000,000

The market price of the stock will be affected by the stock dividend:The market price of the stock will be affected by the stock dividend:

New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36

The individual shareholder’s wealth will remain unchanged.The individual shareholder’s wealth will remain unchanged.

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Dividend PaymentsDividend PaymentsStock SplitsStock Splits

• Although there is no theoretical proof, there is some Although there is no theoretical proof, there is some who believe that an optimal price range exists for a who believe that an optimal price range exists for a company’s common shares.company’s common shares.

• It is generally felt that there is greater demand for It is generally felt that there is greater demand for shares of companies that are traded in the $40 - $80 shares of companies that are traded in the $40 - $80 dollar range.dollar range.

• The purpose of a stock split is to decrease share price.The purpose of a stock split is to decrease share price.• The result is:The result is:

– increase in the number of share outstandingincrease in the number of share outstanding– theoretically, no change in shareholder wealththeoretically, no change in shareholder wealth

• Reasons for use:Reasons for use:– better share price trading rangebetter share price trading range– psychological appeal (signalling affect)psychological appeal (signalling affect)

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Dividend PaymentsDividend PaymentsStock Split ExampleStock Split Example

The Board of Directors of XYZ Company is considering using a stock The Board of Directors of XYZ Company is considering using a stock split to put its shares into a better trading range. They are confident split to put its shares into a better trading range. They are confident that the firm’s stock price will continue to rise given the firm’s that the firm’s stock price will continue to rise given the firm’s outstanding financial performance. Currently, the company’s shares outstanding financial performance. Currently, the company’s shares are trading for $150 and the company’s shareholders equity accounts are trading for $150 and the company’s shareholders equity accounts are as follows:are as follows:

Commons shares (100,000 outstanding)Commons shares (100,000 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,000 15,000,000Net WorthNet Worth $16,500,000$16,500,000

A 2 for 1 Stock Split:A 2 for 1 Stock Split:

New Share Price = PNew Share Price = P00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00

The firm’s equity accounts:The firm’s equity accounts:Commons shares (200,000 outstanding)Commons shares (200,000 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,000 15,000,000Net WorthNet Worth $16,500,000$16,500,000

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Dividend PaymentsDividend PaymentsFurther Stock Split ExamplesFurther Stock Split Examples

A 4 for 3 Stock Split:A 4 for 3 Stock Split:New Share Price = PNew Share Price = P00[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50

The firm’s equity accounts:The firm’s equity accounts:Commons shares (133,333 outstanding)Commons shares (133,333 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,000 15,000,000Net WorthNet Worth $16,500,000$16,500,000

A 3 for 4 Reverse Stock Split:A 3 for 4 Reverse Stock Split:New Share Price = PNew Share Price = P00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00

The firm’s equity accounts:The firm’s equity accounts:Commons shares (75,000 outstanding)Commons shares (75,000 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,000 15,000,000Net WorthNet Worth $16,500,000$16,500,000

Clearly the Board can use stock splits and reverse stock splits to place the firm’s Clearly the Board can use stock splits and reverse stock splits to place the firm’s stock in a particular trading range.stock in a particular trading range.

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Dividend PaymentsDividend PaymentsStock Split EffectsStock Split Effects

• shareholders wealth should remain unaffected:shareholders wealth should remain unaffected:

Original Holdings: (100 shares @ $150/share) = Original Holdings: (100 shares @ $150/share) = $15,000$15,000

After a 4 for 1 split: (400 shares @ $37.50/share) = After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000$15,000

• the above will hold true if there is no the above will hold true if there is no psychological appeal to the stock split. psychological appeal to the stock split.

• There is some evidence that the share price of There is some evidence that the share price of companies which split stock is more bouyant companies which split stock is more bouyant because of a positive signal being transferred to because of a positive signal being transferred to the market by this action.the market by this action.

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-- lowers stock price slightlylowers stock price slightly -- large drop in stock pricelarge drop in stock price

-- little psychological appeallittle psychological appeal -- much stronger potentialmuch stronger potentialsignalling effectsignalling effect

-- recapitalization of earningsrecapitalization of earnings -- no recapitalizationno recapitalization

-- no change in proportionalno change in proportional -- samesame

ownershipownership

-- odd lots createdodd lots created -- odd lots rareodd lots rare

-- theoretically, no value totheoretically, no value to -- samesame

the investorthe investor

Stock Dividends versus Stock SplitsStock Dividends versus Stock Splits

Stock Dividends Stock Splits

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Cash Dividend PaymentsCash Dividend PaymentsThe Macro PerspectiveThe Macro Perspective

• Figure 22 -1 illustrates:Figure 22 -1 illustrates:– Aggregate after-tax profits run at approximately 6% of GDP but Aggregate after-tax profits run at approximately 6% of GDP but

are highly variableare highly variable– Aggregate dividends are relatively stable when compared to Aggregate dividends are relatively stable when compared to

after-tax profits.after-tax profits.• They are sustained in the face of drops in profit during recessionsThey are sustained in the face of drops in profit during recessions

• They are held reasonably constant in the face of peaks in aggregate They are held reasonably constant in the face of peaks in aggregate profits.profits.

(See Figure 22 - 1 on the following slide)(See Figure 22 - 1 on the following slide)

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Cash Dividend PaymentsCash Dividend PaymentsAggregate Dividends and ProfitsAggregate Dividends and Profits

FIGURE 22-2

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Cash Dividend PaymentsCash Dividend PaymentsThe Macro PerspectiveThe Macro Perspective

• Figure 22 -2 illustrates:Figure 22 -2 illustrates:– Aggregate Dividend payouts further illustrates the Aggregate Dividend payouts further illustrates the

effects of relatively stable dividend payouts in the face effects of relatively stable dividend payouts in the face of profit volatility:of profit volatility:

• The normal aggregate dividend payout rate is about 40% of The normal aggregate dividend payout rate is about 40% of after-tax profitafter-tax profit

• When profits drop and dividends are held constant, payout When profits drop and dividends are held constant, payout rates rise to 100%rates rise to 100%

(See Figure 22 - 2 on the following slide)(See Figure 22 - 2 on the following slide)

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Cash Dividend PaymentsCash Dividend PaymentsAggregate Dividend PayoutsAggregate Dividend Payouts

FIGURE 22-3

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Cash Dividend PaymentsCash Dividend PaymentsThe Macro Perspective - QuestionThe Macro Perspective - Question

• Why are dividends smoothed and not Why are dividends smoothed and not matched to profits?matched to profits?

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Cash Dividend PaymentsCash Dividend PaymentsThe Micro PerspectiveThe Micro Perspective

• Table 22 -1 contains dividend yields for Table 22 -1 contains dividend yields for selected companies.selected companies.– The companies chosen here illustrate the dramatic The companies chosen here illustrate the dramatic

differences between companies:differences between companies:• Some pay no dividendsSome pay no dividends• Some pay consistent cash dividends representing substantial Some pay consistent cash dividends representing substantial

yields on current shares pricesyields on current shares prices– The highest yields are found in the case of Income Trusts and The highest yields are found in the case of Income Trusts and

large stable ‘blue-chip’ financials and utilitieslarge stable ‘blue-chip’ financials and utilities

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Cash Dividend PaymentsCash Dividend PaymentsDividend YieldsDividend Yields

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average% % % % % % % % % %

BCE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31Celestica Inc. 0 0 0 0 0 0 0 0 0 0 0.00CIBC 3.67 3.07 2.85 3.37 3.17 2.9 3.48 3.28 3.31 3.57 3.27Cott Corporation 0.23 0.53 0.54 0 0 0 0 0 0 0 0.13Kinross Gold Corporation 0 0 0 0 0 0 0 0 0 0 0.00TransAlta Corporation 6.22 5.16 4.52 5.35 5.59 4.06 4.92 5.73 5.88 4.51 5.19Yellow Pages Income Fund 7.34 7.09 7.22

Table 22-1 S&P/TSX 60 Index Dividend Yields

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Modigliani and Miller’s Dividend Modigliani and Miller’s Dividend Irrelevance TheoremIrrelevance Theorem

M&M, Dividends and Firm ValueM&M, Dividends and Firm Value

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Modigliani and Miller’s Dividend Irrelevance Modigliani and Miller’s Dividend Irrelevance TheoremTheorem

The value of M&M’s Dividend Irrelevance The value of M&M’s Dividend Irrelevance argument is that in the end, it shows where argument is that in the end, it shows where value can be created with dividend policy and value can be created with dividend policy and why.why.

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M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value

Start with the single-period DDM:Start with the single-period DDM:

1

110 )K(

PDP

e

[ 22-1]

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M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value

• Multiply by the number of shares outstanding Multiply by the number of shares outstanding ((mm) to convert the single stock price model to ) to convert the single stock price model to a model to value the whole firm:a model to value the whole firm:

1

)( 1100 )K(

PDmVmP

e

[ 22-2]

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M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremAssumptionsAssumptions

• No TaxesNo Taxes• Perfect capital marketsPerfect capital markets

– large number of individual buyers and sellerslarge number of individual buyers and sellers– costless informationcostless information– no transaction costsno transaction costs

• All firms maximize valueAll firms maximize value• There is no debtThere is no debt

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M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value

• Without debt, sources and uses of funds identity Without debt, sources and uses of funds identity (sources = uses) can be expressed as:(sources = uses) can be expressed as:

• Where:Where: XX represents cash flow from operationsrepresents cash flow from operations II represents investmentrepresents investment X – I X – I is free cash flowis free cash flow mDmD11 is dividend to current shareholders at time 1 is dividend to current shareholders at time 1

1111 mDInPX [ 22-3]

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M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value

• Solving for dividends paid out (Solving for dividends paid out (mDmD11 ): ):

1111 InPXmD

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M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value

• If a firm pays out dividends that exceeds its free cash If a firm pays out dividends that exceeds its free cash flow (X –I), then it must issue new common shares to flow (X –I), then it must issue new common shares to pay for these dividends.pay for these dividends.

• Substituting into Equation 22 – 2 we get:Substituting into Equation 22 – 2 we get:

• The value of the firm is the value of the next period’s The value of the firm is the value of the next period’s free cash flow (free cash flow (XX11 –I –I11) plus the next period’s equity ) plus the next period’s equity market value…market value…

)1(

])[(X 11110 K

VPnmIV

[ 22-4]

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CHAPTER 22 – Dividend Policy 22 - 46

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value

• The firm value is determined as the present value of The firm value is determined as the present value of the free cash flows to the equity holders:the free cash flows to the equity holders:

• The dividend is equal to the free cash flow each The dividend is equal to the free cash flow each period, and dividends are therefore a residual after period, and dividends are therefore a residual after the firm has taken care of all of its investment the firm has taken care of all of its investment requirements – this is the requirements – this is the Residual Theory of Residual Theory of DividendsDividends

)1(1

0

tt

tt

K

IXV[ 22-5]

Value has nothing

to do with dividends

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CHAPTER 22 – Dividend Policy 22 - 47

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremResidual Theory of DividendsResidual Theory of Dividends

The The Residual Theory of DividendsResidual Theory of Dividends suggests that suggests that logically, each year, management should:logically, each year, management should:

– Identify free cash flow generated in the previous periodIdentify free cash flow generated in the previous period

– Identify investment projects that have positive NPVsIdentify investment projects that have positive NPVs

– Invest in all positive NPV projectsInvest in all positive NPV projects• If free cash flow is insufficient, then raise external capital – in If free cash flow is insufficient, then raise external capital – in

this case no dividend is paidthis case no dividend is paid

• If free cash flow exceeds investment requirements, the residual If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.amount is distributed in the form of cash dividends.

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CHAPTER 22 – Dividend Policy 22 - 48

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremResidual Theory of Dividends - ImplicationResidual Theory of Dividends - Implication

The implication of the The implication of the Residual Theory of DividendsResidual Theory of Dividends are:are:

Investment decisions are independent of the firm’s dividend Investment decisions are independent of the firm’s dividend policypolicy• No firm would pass on a positive NPV project because of the lack of No firm would pass on a positive NPV project because of the lack of

funds, because, by definition the incremental cost of those funds is funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken.only if the project is undertaken.

• If the firm can’t make good use of free cash flow (ie. It has no If the firm can’t make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to distributed back to shareholders in the form of dividends for them to invest on their own.invest on their own.

• The firm should operate where Marginal Cost equals Marginal The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure 22 – 4 on the following slide:Revenue as seen in Figure 22 – 4 on the following slide:

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CHAPTER 22 – Dividend Policy 22 - 49

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremInternal Funds, Investment, and DividendsInternal Funds, Investment, and Dividends

22 - 4 FIGURE

$11,976 Million

Rate of Return

WACC

Internal Funds Available

OPTIMAL INVESTMENT

IOS

$177,607 Million

MC=MR

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CHAPTER 22 – Dividend Policy 22 - 50

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremHomemade DividendsHomemade Dividends

• Shareholders can buy or sell shares in an Shareholders can buy or sell shares in an underlying company to create their own cash underlying company to create their own cash flow pattern.flow pattern.– They don’t need management declare a cash They don’t need management declare a cash

dividend, they can create their own.dividend, they can create their own.

Conclusion: under the assumptions of M&M’s model, Conclusion: under the assumptions of M&M’s model, the investor is indifferent to the firm’s dividend policy.the investor is indifferent to the firm’s dividend policy.

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The “Bird-in-the-Hand” Argument The “Bird-in-the-Hand” Argument

Dividend PolicyDividend Policy

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CHAPTER 22 – Dividend Policy 22 - 52

The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M’s Assumptions RelaxedM&M’s Assumptions Relaxed

• Risk is a real world factor.Risk is a real world factor.• Firm’s that reinvest free cash flow, put that Firm’s that reinvest free cash flow, put that

money at risk – there is no certainty of money at risk – there is no certainty of investment outcome – those forfeit dividends investment outcome – those forfeit dividends that are reinvested…could be lost!that are reinvested…could be lost!

• Remember the two-stage DDM?Remember the two-stage DDM?

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CHAPTER 22 – Dividend Policy 22 - 53

The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M’s Assumptions RelaxedM&M’s Assumptions Relaxed

• Remember the two-stage DDM?Remember the two-stage DDM?

– The first term is the present value of existing opportunities The first term is the present value of existing opportunities (PVEO)(PVEO)

– The second term is the present value of growth opportunities The second term is the present value of growth opportunities (PVGO)(PVGO)

– These forecast returns face risks of new market entrants to These forecast returns face risks of new market entrants to compete for the excess profits forecast in emerging opportunities compete for the excess profits forecast in emerging opportunities making PVGO extremely vulnerable.making PVGO extremely vulnerable.

)ROE

()K(1

Inv 2

e

1

e

e

e K

K

K

BVPSROEP

[ 22-6]

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CHAPTER 22 – Dividend Policy 22 - 54

The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M’s Assumptions RelaxedM&M’s Assumptions Relaxed

• Myron Gordon suggests that dividends are more stable Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued than capital gains and are therefore more highly valued by investors.by investors.

• This implies that investors perceive non-dividend paying This implies that investors perceive non-dividend paying firms to be riskier and apply a higher discount rate to firms to be riskier and apply a higher discount rate to value them causing the share price to fall.value them causing the share price to fall.

• The difference between the M&M and Gordon The difference between the M&M and Gordon arguments are illustrated in Figure 22 - 5 on the arguments are illustrated in Figure 22 - 5 on the following slide:following slide:– M&M argue that dividends and capital gains are perfect M&M argue that dividends and capital gains are perfect

substitutessubstitutes

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CHAPTER 22 – Dividend Policy 22 - 55

The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand TheoryM&M versus Gordon’s Bird in the Hand Theory

0

1

P

D

22 - 5 FIGURE

Gordon

OPTIMAL INVESTMENT

M&M

0

01

P

PP

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CHAPTER 22 – Dividend Policy 22 - 56

The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand TheoryM&M versus Gordon’s Bird in the Hand Theory

Conclusions:Conclusions:– Firms cannot change underlying operational Firms cannot change underlying operational

characteristics by changing the dividendcharacteristics by changing the dividend– The dividend should reflect the firm’s operations The dividend should reflect the firm’s operations

through the residual value of dividendsthrough the residual value of dividends

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Dividend Policy in PracticeDividend Policy in Practice

Dividend PolicyDividend Policy

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Dividend Policy in PracticeDividend Policy in Practice

• Firms smooth their dividendsFirms smooth their dividends– Firms tend to hold dividends constant, even in the Firms tend to hold dividends constant, even in the

face of increasing after-tax profitface of increasing after-tax profit– Firms are very reluctant to cut dividendsFirms are very reluctant to cut dividends

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Dividend Policy in PracticeDividend Policy in PracticeLintner’s Work on Dividend AdjustmentLintner’s Work on Dividend Adjustment

• John Lintner suggested a partial adjustment John Lintner suggested a partial adjustment model to explain the smoothing of dividend model to explain the smoothing of dividend behaviour illustrating that firms slowly behaviour illustrating that firms slowly change dividends as they move toward a new change dividends as they move toward a new target level:target level:

1 ) -Dβ(DΔD t-*tt [ 22-7]

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CHAPTER 22 – Dividend Policy 22 - 60

Dividend Policy in PracticeDividend Policy in Practice Lintner’s Work on Dividend AdjustmentLintner’s Work on Dividend Adjustment

• The target dividend The target dividend DDtt** Lintner suggested is a function Lintner suggested is a function

of the firm’s optimal payout rate of the firm’s underlying of the firm’s optimal payout rate of the firm’s underlying earnings (earnings (EEtt) leading to the following equation:) leading to the following equation:

• The coefficient on lagged dividends was estimated at The coefficient on lagged dividends was estimated at 0.70 indicating an adjustment speed (0.70 indicating an adjustment speed (bb) coefficent of ) coefficent of 0.30. 0.30.

• The coefficient on current earnings (The coefficient on current earnings (cc) was estimated at ) was estimated at 0.150.15

)1( 11 cEDbaD t-t [ 22-8]

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CHAPTER 22 – Dividend Policy 22 - 61

Dividend Policy in PracticeDividend Policy in Practice Lintner’s Work on Dividend AdjustmentLintner’s Work on Dividend Adjustment

ImplicationsImplications– The speed of dividend adjustment is only about 30 The speed of dividend adjustment is only about 30

percentpercent– Firms are very reluctant to fully adjustFirms are very reluctant to fully adjust– Firms do not follow a policy of paying a constant Firms do not follow a policy of paying a constant

proportion of earnings out as dividendsproportion of earnings out as dividends

Dividend policy in practice does not follow M&M’s Dividend policy in practice does not follow M&M’s irrelevance arguments because the real world does irrelevance arguments because the real world does

not match the assumptions used.not match the assumptions used.

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CHAPTER 22 – Dividend Policy 22 - 62

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsWelcome to the Real World!Welcome to the Real World!

Transactions CostsTransactions Costs– Underwriting costs are very high, providing a strong Underwriting costs are very high, providing a strong

incentive for firms to finance growth out of free cash incentive for firms to finance growth out of free cash flowflow

– Facing these high underwriting costs firms:Facing these high underwriting costs firms:• With high growth rates have little incentive to pay dividendsWith high growth rates have little incentive to pay dividends• With volatile earnings conserve cash from year to year to With volatile earnings conserve cash from year to year to

finance projects and therefore pay very conservative finance projects and therefore pay very conservative dividendsdividends

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Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsWelcome to the Real World!Welcome to the Real World!

Dividends and SignallingDividends and Signalling– Under conditions of information asymmetry, shareholders and Under conditions of information asymmetry, shareholders and

the investing public watch for management signals (actions) the investing public watch for management signals (actions) about what management knows.about what management knows.

– Management is therefore very cautious about dividend Management is therefore very cautious about dividend changes…they don’t want to create high expectations (this is the changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)to negative earnings surprises (the sticky dividend phenomenon)

(The Signalling Model is explained in Figure 22 – 6 found on the next slide.)(The Signalling Model is explained in Figure 22 – 6 found on the next slide.)

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CHAPTER 22 – Dividend Policy 22 - 64

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsThe Signalling ModelThe Signalling Model

22 - 6 FIGURE

et

$

1 2 3 Time

et*

dt*

dt

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CHAPTER 22 – Dividend Policy 22 - 65

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsWelcome to the Real World!Welcome to the Real World!

Agency TheoryAgency Theory– Investors are wary of senior management so they seek to put Investors are wary of senior management so they seek to put

controls in place.controls in place.– There is a fear that managers may waste corporate resources There is a fear that managers may waste corporate resources

by over-investing in low or poor NPV projects.by over-investing in low or poor NPV projects.– Gordon Donaldson argued this is the reason for the pecking Gordon Donaldson argued this is the reason for the pecking

order managements tend to use when raising capitalorder managements tend to use when raising capital• Shareholders would prefer to receive a dividend and then have Shareholders would prefer to receive a dividend and then have

management file a prospectus, justifying investment in projects and management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend.the need to raise the capital that was just distributed as a dividend.

• Shareholders are prepared to pay those additional underwriting Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess costs as an agency cost incurred to monitor and assess management.management.

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CHAPTER 22 – Dividend Policy 22 - 66

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsWelcome to the Real World!Welcome to the Real World!

Taxes and the Clientele EffectTaxes and the Clientele Effect– Table 22 -3 (on the following slide) illustrates that different Table 22 -3 (on the following slide) illustrates that different

classes of investors face different tax bracketsclasses of investors face different tax brackets– Preference for dividends versus capital gains income depends Preference for dividends versus capital gains income depends

on the province of residence and taxable income level leading to on the province of residence and taxable income level leading to tax clienteles.tax clienteles.

• High income earners tend to prefer capital gains (there is an High income earners tend to prefer capital gains (there is an additional tax incentive for such individuals in that they can choose additional tax incentive for such individuals in that they can choose the timing of the sale of their investment…remember only ‘realized’ the timing of the sale of their investment…remember only ‘realized’ capital gains are subject to taxcapital gains are subject to tax

• Low income earners tend to prefer dividendsLow income earners tend to prefer dividends

Conclusion – firm’s should not change dividend policy drastically Conclusion – firm’s should not change dividend policy drastically since it upsets the existing ownership base.since it upsets the existing ownership base.

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Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsTaxesTaxes

Income Level $25,000 $50,000 $75,000 $100,000

British Columbia Dividends 2.52 6.19 15.69 20.04Capital gains 12.45 15.58 18.85 20.35

Alberta Dividends 3.63 8.03 13.83 13.83Capital gains 12.63 16.00 18.00 18.00

Ontario Dividends 0.00 8.24 20.74 20.74Capital gains 10.65 15.58 21.71 21.71

Quebec Dividends 5.95 15.42 26.06 26.06Capital gains 14.37 19.19 22.86 22.86

Nova Scotia Dividends 0.00 8.75 17.05 19.06Capital gains 12.02 18.48 21.34 22.63

Table 22-3 Individual Tax Rates (% ) on Dividends and Capital Gains

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CHAPTER 22 – Dividend Policy 22 - 68

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsRepackaging Dividend-Paying SecuritiesRepackaging Dividend-Paying Securities

• Tax clienteles help to explain the financial Tax clienteles help to explain the financial engineering whereby different parts of the engineering whereby different parts of the return by the firm are stripped, repackaged return by the firm are stripped, repackaged and sold to different investors as illustrated in and sold to different investors as illustrated in Figure 22 – 7. (See the following slide)Figure 22 – 7. (See the following slide)

• Split shares are shares sold as the dividends Split shares are shares sold as the dividends and capital gains parts.and capital gains parts.

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Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsMYW’s B Corporation SharesMYW’s B Corporation Shares

)1()1(

6

16

00

tt

t

k

P

k

dP

)1()1(

6

16

00

tt

t

k

P

k

dP

MYW

)1(

)1,30min($

)1(Pref

6

166

t t

t

k

P

k

d

)1(

)1,30min($

)1(Pref

6

166

t t

t

k

P

k

d

22 - 7 FIGURE

$143 million$330 million

$454 million

)1(

)1,30min($IR

666

k

PP

)1(

)1,30min($IR

666

k

PP

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CHAPTER 22 – Dividend Policy 22 - 70

Share RepurchasesShare Repurchases

• Simply another form of payout policy.Simply another form of payout policy.• An alternative to cash dividend where the An alternative to cash dividend where the

objective is to increase the price per share objective is to increase the price per share rather than paying a dividend.rather than paying a dividend.

• Since there are rules against improper Since there are rules against improper accumulation of funds, firms adopt a policy of accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.large infrequent share repurchase programs.

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Share RepurchasesShare Repurchases

Dividend PolicyDividend Policy

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• allowed under the OBCA and CBCAallowed under the OBCA and CBCA• reasons for use:reasons for use:

– Offsetting the exercise of executive stock optionsOffsetting the exercise of executive stock options– Leveraged recapitalizationsLeveraged recapitalizations– Information or signalling effectsInformation or signalling effects– Repurchase dissident sharesRepurchase dissident shares– Removing cash without generating expectations for future Removing cash without generating expectations for future

distributionsdistributions– Take the firm private.Take the firm private.

Share RepurchasesShare Repurchases

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• they are usually done on an irregular basis, so a they are usually done on an irregular basis, so a shareholder cannot depend on income from this source.shareholder cannot depend on income from this source.

• if regular repurchases are made, there is a good chance if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were that Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax and will assess tax

• there may be some agency problems - if managers have there may be some agency problems - if managers have inside information, they are purchasing from shareholders inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.at a price less than the intrinsic value of the shares.

Disadvantages of Share RepurchasesDisadvantages of Share Repurchases

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• tender offer:tender offer:– this is a formal offer to purchase a given number of shares at a this is a formal offer to purchase a given number of shares at a

given price over current market price.given price over current market price.

• open market purchase:open market purchase:– the purchase of shares through an investment dealer like any the purchase of shares through an investment dealer like any

other investorother investor

– this is not designed for large block purchases.this is not designed for large block purchases.

• private negotiation with major shareholdersprivate negotiation with major shareholders

In any repurchase program, the securities commission In any repurchase program, the securities commission requires disclosure of the event as well as all other requires disclosure of the event as well as all other material information through a prospectus.material information through a prospectus.

Methods of Share RepurchasesMethods of Share Repurchases

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• called treasury stock (U.S.)called treasury stock (U.S.)• non-voting (U.S.)non-voting (U.S.)• may not receive dividends (U.S.)may not receive dividends (U.S.)• if not retired, can be resold (U.S.)if not retired, can be resold (U.S.)• unlike the U.S., repurchases in Canada do not unlike the U.S., repurchases in Canada do not

involve shares that can be placed into involve shares that can be placed into treasury stock - they are canceledtreasury stock - they are canceled

Repurchased SharesRepurchased Shares

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Current EPSCurrent EPS

= [total earnings] / [# of shares] = $4.4 m / 1.1 m = = [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00$4.00

Current P/E ratioCurrent P/E ratio

= $20 / $4 = 5X= $20 / $4 = 5X

EPS after repurchase of 100,000 sharesEPS after repurchase of 100,000 shares

== $4.4 m / 1.0 = $4.40 $4.4 m / 1.0 = $4.40

Expected market price after repurchase:Expected market price after repurchase:

= [p/e][EPS= [p/e][EPSnewnew] = [5][$4.40] = $22.00 per share] = [5][$4.40] = $22.00 per share

Repurchase ExampleRepurchase Example

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• EPS should increase following the repurchase EPS should increase following the repurchase if earnings after-tax remains the sameif earnings after-tax remains the same

• a higher market price per outstanding share a higher market price per outstanding share of common stock should resultof common stock should result

• stockholders not selling their shares back to stockholders not selling their shares back to the firm will enjoy a capital gain if the the firm will enjoy a capital gain if the repurchase increases the stock price.repurchase increases the stock price.

Effects of A Share RepurchaseEffects of A Share Repurchase

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• signal positive information about the firm’s future cash signal positive information about the firm’s future cash flowsflows

• used to effect a large-scale change in the firm’s capital used to effect a large-scale change in the firm’s capital structurestructure

• increase investor’s return without creating an increase investor’s return without creating an expectation of higher future cash dividendsexpectation of higher future cash dividends

• reduce future cash dividend requirements or increase reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, cash dividends per share on the remaining shares, without creating a continuing incremental cash drainwithout creating a continuing incremental cash drain

• capital gains treated more favourably than cash capital gains treated more favourably than cash dividends for tax purposes.dividends for tax purposes.

Advantages of Share RepurchasesAdvantages of Share Repurchases

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• signal negative information about the firm’s signal negative information about the firm’s future growth and investment opportunitiesfuture growth and investment opportunities

• the provincial securities commission may the provincial securities commission may raise questions about the intentionraise questions about the intention

• share repurchase may not qualify the investor share repurchase may not qualify the investor for a capital gainfor a capital gain

Disadvantages of Share RepurchasesDisadvantages of Share Repurchases

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Borrowing to Pay DividendsBorrowing to Pay Dividends

SignallingSignalling

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• Is this legal? is it possible to do?Is this legal? is it possible to do?• YesYes

– the firm must have the ability and capacity to borrowthe firm must have the ability and capacity to borrow– the firm must have sufficient retained earnings to allow it the firm must have sufficient retained earnings to allow it

to pay the dividend to pay the dividend – the firm must have sufficient cash on hand to pay the the firm must have sufficient cash on hand to pay the

cash dividendcash dividend– the firm must NOT have agreed to any limitations on the the firm must NOT have agreed to any limitations on the

payment of dividends under the bond indenture.payment of dividends under the bond indenture.

• Why?Why?– A possible answer is to signal to the market that the A possible answer is to signal to the market that the

board is confident about the firm’s ability to sustain cash board is confident about the firm’s ability to sustain cash dividends into the future.dividends into the future.

Borrowing to Pay DividendsBorrowing to Pay Dividends

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Assets: Liabilities:

Cash 10 Long-term Debt 0Fixed Assets 140 Common Stock 50

Retained Earnings 100

Total Assets $150 Total Claims $150

After Borrowing…before cash dividend:Assets: Liabilities:

Cash 60 Long-term Debt 50Fixed Assets 140 Common Stock 50

Retained Earnings 100

Total Assets $200 Total Claims $200

Before Borrowing: 0% Debt

25% Debt

Borrowing to Pay DividendsBorrowing to Pay DividendsAn ExampleAn Example

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Assets: Liabilities:

Cash 60 Current liabilities 50Fixed Assets 140 Long-term Debt 50

Common Shares 50Retained earnings 50

Total Assets $200 Total Claims $200

After Cash Dividend payment of $50Assets: Liabilities:

Cash 10 Long-term Debt 50Fixed Assets 140 Common Stock 50

Retained earnings 50

Total Assets $150 Total Claims $150

After Dividend Declaration…before date of payment.

50% Debt

33% Debt

Borrowing to Pay DividendsBorrowing to Pay DividendsAn Example …An Example …

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• The foregoing example illustrates:The foregoing example illustrates:– it is possible for a firm with ‘borrowing capacity’ to borrow funds to it is possible for a firm with ‘borrowing capacity’ to borrow funds to

pay cash dividends.pay cash dividends.

– this is not possible if the lenders insist on restrictive covenants that this is not possible if the lenders insist on restrictive covenants that limit or prevent this from occurring.limit or prevent this from occurring.

– the cash for the dividend must be present in the cash account.the cash for the dividend must be present in the cash account.

– payment of dividends reduces both the cash account on the asset payment of dividends reduces both the cash account on the asset side of the balance sheet as well as the retained earnings account side of the balance sheet as well as the retained earnings account on the ‘claims’ side of the balance sheet.on the ‘claims’ side of the balance sheet.

– in the absence of restrictions, it is possible to transfer wealth from in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. the bondholders to the stockholders. (Bondholders in this example (Bondholders in this example may have thought their firm would have only a 25% debt ratio….after the 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 dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.)75% to 66%.)

Borrowing to Pay DividendsBorrowing to Pay DividendsAn ExampleAn Example

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Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:

– About the different types of dividends including, regular and About the different types of dividends including, regular and special cash dividends, stock dividends, stock splits as well as special cash dividends, stock dividends, stock splits as well as share repurchases.share repurchases.

– M&M’s dividend irrelevance argument and the real world factors M&M’s dividend irrelevance argument and the real world factors such as transactions costs, taxes, clientele effects and such as transactions costs, taxes, clientele effects and signalling tend to favour real-world dividend relevancesignalling tend to favour real-world dividend relevance

– Tax motives and other reasons explain why firms might want to Tax motives and other reasons explain why firms might want to repurchase their shares.repurchase their shares.