CHAPTER 13 DIVIDEND POLICY

Chapter outline Introduction Dividend policy issues Is it important to have a dividend policy? The level of dividend payout The dividend payment process Payout policy options Stock splits and consolidations Conclusion

Learning outcomes By the end of this chapter, you should be able to: Explain certain dividend policy issues, such as information content of dividends, the clientele effect and the relevance and irrelevance of the dividend policy Review the factors that influence both a high and a low dividend payout Describe the various models that can be used to determine the level of payout Discuss the dividend payment process and the various dividend options available to the company Examine stock splits and consolidations.

Introduction Dividend policy The approach a company chooses to adopt towards dividend payments Will the company pay a dividend? How big will the dividend payment be? How often will shareholders receive a dividend?

Dividend policy issues If a company generates a net profit after tax, it has a number of choices on how to allocate the earnings Maintain ongoing operations of the company Pay dividends to shareholders Repay debts incurred by the company Expansion Buy back shares from the marketplace

Dividend policy issues Most frequently used: paying dividends and expansions Dividends: Shareholders’ income will increase Less money available to invest in future projects Expansion: Profitable investments may increase the future income of the company Investors might perceive non-payment as a negative signal

Distribution of net profit

Dividend policy issues Depending on investor’s preference, company’s decision to pay a dividend (or not) could have a favourable or negative impact on the share price Formula to determine value of share price: Where: P0 = Value of the share D1 = Dividend that will be paid r = Required return g = Dividend growth rate

Dividend policy issues The dividend being paid is important in determining the value of a share If the dividend increases, the share price will increase If the dividend decreases, the share price should also decrease What is the best policy for dividend payments? Two factors that influence perception of dividend payment as positive or negative: Information content Clientele effect

Information content The information conveyed to the public with a dividend announcement If conceived as positive: positive effect on the share price (↑) Dividend increase Things are going well and there are funds available to increase the current income of investors, managers have confidence in the future Dividend cut The company has not performed so well and all available funds are reinvested in the company

Clientele effect Not all investors are the same and have the same needs Some prefer a cash dividend (in need of current income) – would also prefer a high payout ratio Others prefer that funds are reinvested in the company (in need of capital gains – increase in the share price) – would prefer a low payout ratio

Clientele effect When a company’s dividend policy changes, investors might adjust their shareholding and this might influence the share price If the company changes the dividend policy (from a high payout to a low payout), all investors in need of current income will sell their shares and this will have a negative effect on the share price If shares are sold – supply increase – share price decrease If shares are bought – demand increase – share price increase

Homemade dividends If we trade in a perfect market, investors that are dissatisfied with the dividend policy of the company, can create their own homemade dividend Important to note: homemade dividends are only possible if costs and taxes are not taken into account (perfect and efficient market)

Homemade dividends You want current income in the form of dividends. You expect R200 on date 1 and R100 on date 2, but receive R190 on date 1 and R111 on date 2. The earnings can be reinvested at a rate of 10%. You are in need of R200 on date 1, but only received R190. Therefore, you could sell R10 worth of shares and add that to the dividend of R190 to have a total of R200. You receive R111 on date 2, but were only in need of R100. You gave up R10 in shares on date 1, that could have earned 10%, meaning that you gave up a total of R11 (R10 + 10%). Because you gave up a total of R11, you will have a total of R100 (R11 – R11) on date 2.

Homemade dividends You expect R200 and R100 in dividends on date 1 and 2 respectively, but receive R220 and R78 on date 1 and 2 instead. You can reinvest the dividends at a rate of 10%. You are in need of R200, but received R220, therefore the extra R20 can be reinvested at 10%, giving a total of R22 (R20 + 10%). You are in need of R100 on date 2, but only receives R78. The additional R20 that was reinvested (now R22), can now be added to the R78 to give a total of R100 (R78 + R22)

Dividend irrelevance According to Miller and Modigliani (M&M) when a market is efficient (without taxes, flotation and transaction costs), then the dividend policy of a company would have no influence on the share price Strongly efficient market: one in which all information (both public and inside information) is reflected in the share price Markets are generally not efficient We cannot ignore real-world factors such as taxes, flotation and transaction costs

Example 13.1 Keep It Ltd and Distribute It Ltd are the same size, in the same industry and have the same investment opportunities. Both companies have: Total assets = R1 000 000 Net cash flow (2009) = R300 000 Generated a return of 10% Investors that require a return of 10% Invested R300 000 in positive NPV projects in 2010 Have 250 000 shares outstanding Current share price = R4 per share (R1 000 000 / 250 000) Keep It Ltd wish to retain the full amount of R300 000 (no dividends will be distributed to shareholders Distribute It Ltd want to pay out the entire R300 000 in dividends to shareholders

Example 13.1 Keep It Ltd Distribute It Ltd Value of the company: R1 mil + R300 000 = R1 300 000 Share price: R1 300 000 / 250 000 = R5,20 Div 2009 + share price change R = share price 2009 R0 + (R5,20 – R4,00) R = R4,00 R = 30% Distribute It Ltd Dividend: R300 000 / 250 000 = R1,20 Share price: R1 000 000 / 250 000 = R4 2010 NPV projects To generate R300 000, the company would have to sell 75 000 shares (R300 000 / 4). Total shares: 325 000 shares Total market value: 325 000 x R4 = R1 300 000 Div 2009 + share price change R = share price 2009 R1,20 + (R4,00 – R4,00) R = R4,00 R = 30%

Dividend relevance Not all investors are the same: some prefer current income, others prefer capital gains Four common explanations for dividend relevance: The bird-in-the-hand explanation The information content / signaling explanation The tax preference explanation The agency explanation If we lived in a world without any market imperfections, we would be indifferent towards either dividends or capital gains

Deciding on the dividend level The need for current income Some investors require a high dividend payment Investors that live off the returns of their investments The perception of a decline in risk Better to have money now (dividends) than wait for money that may never come (capital gains) Taxes When individual tax rates are higher than corporate tax rates, an investor would prefer a low dividend payment and vice versa Flotation costs If all net profit paid out as dividends, company needs external financing to fund positive NPV projects Flotation costs associated with issuing new shares – expensive

Different models The residual distribution level Fixed dividend cover Dividends only paid out if all other financially feasible investment opportunities have been financed Whatever is left will be paid out as dividends Fixed dividend cover A fixed percentage of earnings If the business is doing well, shareholders will share in the good fortune If business is doing poorly, shareholders receive a lower payout

Different models Constant growth Keep dividends stable and provide a constant income to investors The company strives to pay out a fixed dividend per share until the level of earnings rise and management is certain that this level will be maintained, then the dividend payment will increase

Dividend payment process Declaration date: Date on which the dividend is declared by board of directors Last date to trade cum-dividend: Shareholders on this date qualify for the dividend payment. If shares are sold after this date, they still receive dividends Ex-dividend date: Date after a person buys the specific share is not entitled to a dividend

Dividend payment process Last day to register/record date: Date is set on which all shareholders that should receive a dividend have to be registered Date of payment: When the share register is finalised and all the shareholders that are to receive dividends are registered, the dividend cheques are mailed to shareholders

Dividend payment process dates for Pick ’n Pay

Cash dividend Most common form of dividend payment (once or twice a year) Final dividend: Usually declared after the final financial statements of the financial year have been published Interim dividend: Usually declared after the interim financial statements of the financial year have been published Usually smaller than the final dividend

Share dividend Issue dividends in the form of shares instead of cash The company would issue more shares to shareholders Advantages: No tax consequences Tax will only be paid when shares are sold for profit

Share dividend A company declares a 15% share dividend. The company has a total of 1 000 000 shares outstanding (at a price of R5 a share) and you have a total of 150 000 shares. Total worth of company is R5 000 000 (1 000 000 x R5) Your shareholding would increase to 172 500 shares (150 000 + 15%) Shares outstanding would increase to 1 150 000 shares (1 000 000 + 15%) If nothing changes within the business, then the share price would drop to R4,35 (R5 000 000 / 1 150 000 shares) Your shareholding worth would change from R750 000 (150 000 x R5) to R750 030 (172 500 x R4,348)

Share repurchase A company communicates that there is no better investment than the company itself Company buys its own shares If a company buys back shares, that would reduce the number of shares outstanding Normally occurs when shares are undervalued

Share repurchase You own 150 000 shares in a company and the company has a total of 1 000 000 shares outstanding. The company decides to repurchase 200 000 shares at the current share price of R5 at a total cost of R1 million. This decrease the number of shares outstanding to 800 000 shares The company has total assets of R5 million, this would increase the share price to R6,25 (R5 000 000/800 000)

Stock splits When shares are overvalued – too expensive For instance, a 2-1 share split: For every share you own, that specific share will be divided into 2 You will have double the number of shares you had before The share price will also halve (making shares more popular, creating a higher demand)

Stock splits Suppose that you own 700 shares at a price of R6 a share (total of R4 200). The company declares a 3-for-1 stock split. You will now have a total of 2 100 shares (700 x 3) The price per share will be R2 (R6 / 3) The total investment remains R4 200 (2 100 x 2)

Consolidations Also known as reverse stock splits When shares are undervalued or if the company wants to increase the price per share to avoid being delisted For instance, a 2-1 reverse share split: For every share you own, that specific share will be multiplied by 2 You will have halve the number of shares you had before The share price will also double (increasing the share price to a more respectable level)

Consolidations Suppose that you own 600 shares at a price of R3 a share (total of R1 800). The company declares a 3-for-1 reverse stock split / consolidation. You will now have a total of 200 shares (600/3) The price per share will be R9 (R3 x 3) The total investment remains R1 800 (200 x 9)

Conclusion A company has various options available when deciding on what it should do with its net earnings. These include: Maintaining current operations Paying outstanding debts Expanding the company through profitable investments Repurchasing shares Paying dividends. When a dividend is declared, a signal is sent to the market about the company. The market can regard the signal as either positive or negative. The signal that a dividend declaration sends to the market is referred to as information content.

Conclusion (cont.) The clientele effect is the principle that not all investors are the same. Some may prefer a high dividend payout, whereas others expect the company to reinvest the funds for growth. A homemade dividend is the concept that investors who prefer a high dividend payout, but receive a low payout or perhaps none, may sell the shares and the earnings from the sale of the shares in order to satisfy their desire for current income. In an efficient and perfect market, the dividend policy of a company will be irrelevant, because investors will receive the same return on their investment either through a dividend payment or a capital gain.

Conclusion (cont.) The four reasons why a dividend policy is believed to be relevant are: The bird-in-the-hand theory The information content theory The tax preference theory The agency theory. In a real-world context we have taxes and costs and, therefore, the dividend policy of a company may have an impact on the share price.

Conclusion (cont.) The factors that support a high payout policy are: A need for current income Investors’ perception of a decline in risk. The factors that support a low payout policy are: If individual taxes are lower than corporate tax rates, then investors prefer lower dividend payments The flotation cost to issue new shares is very expensive, whereas retaining earnings may benefit the company more than paying out dividends and then having to finance positive NPV projects from new shares.

Conclusion (cont.) Companies have various options available when choosing a dividend policy: The residual distribution model Fixed dividend cover Constant growth. Various dates are of significance in the dividend payment process: The declaration date The ex-dividend date The record date The date of payment.

Conclusion (cont.) In terms of dividend payment methods, a company may either pay out a cash dividend, a share dividend or repurchase its own shares. Stock splits and consolidations are not technically dividend payments because there is no change in the cash flow of the company. They are methods used to either increase or decrease the number of shares by splitting or consolidating the current shares. Both have an influence on the share price.