Corporate Finance Fundamentals FN1 Module 7 January 26, 2015

DIVIDEND POLICY AND LEASING 7.1 Dividend Policy and Payment Procedures 7.2 Alternative Dividend Policies 7.3 Factors Affecting Dividend Policies 7.4 Stock Dividends And Stock Splits 7.5 Share Repurchases 7.6 Analyzing The Lease Versus Buy Decision

7.1 Dividend Policy and Payment Procedures 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

7.1 Dividend Policy and Payment Procedures Dividends a Financing Decision 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

7.1 Dividend Policy and Payment Procedures Dividend Payments Five important dates for dividends Declaration Date Record Date Ex-dividend Date (Ex-Date) Payment Date Dividend-on Date

7.1 Dividend Policy and Payment Procedures Declaration Date 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

7.1 Dividend Policy and Payment Procedures Dividend Payments Record Date The date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend

7.1 Dividend Policy and Payment Procedures Dividend Payments Ex-dividend Date (Ex-Date) 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

7.1 Dividend Policy and Payment Procedures Dividend Payments Payment Date The date the cheques for the dividend are mailed out to the shareholders Dividend-on Date The last day you can buy shares in time to be entitled to dividend declared on those shares Dividend Declaration Time Line See excel slide 9

7.1 Dividend Policy and Payment Procedures Dividend Policy – Conceptual Dividends are the distributions of earnings to shareholders The financial executive must decide whether to reinvest the earnings, or pay them out as dividends There are four factors to consider when making this decision

7.1 Dividend Policy and Payment Procedures Four Factors The company’s investment opportunities The investor’s other investment opportunities The tax implications The investor’s current consumption needs

7.1 Dividend Policy and Payment Procedures The Company’s Investment Opportunities If the company has investment projects that will provide a positive NPV, then it would be in the shareholders’ best interest if the firm pursues these projects Basically, this means that the company would earn more on the funds than the shareholder could If earnings are retained by the firm, floatation costs on equity would not be a consideration

7.1 Dividend Policy and Payment Procedures The Investors’ Other Investment Opportunities If the firm has not been able to identify any projects that would earn an adequate return, and/or the investors have other investment opportunities that would generate a higher return than the firm presently could achieve, then the earnings should be paid out as dividends

7.1 Dividend Policy and Payment Procedures The Tax Implications Investors are concerned with the after tax returns Must consider the effect of any changes in tax treatment for dividend and capital gains income

7.1 Dividend Policy and Payment Procedures The Investors’ Current Consumption Needs Investors’ current consumption needs should NOT affect the dividend policy If shareholders require current income, they have the option of selling their shares, if no dividends are forthcoming

7.1 Dividend Policy and Payment Procedures Dividend Policy in Practice Dividends provide a signal to the market Dividends that are steady or steadily increasing send a positive signal to the market This ability to signal expectations about the firm is one of the most important aspects of dividend decisions in the real world

7.1 Dividend Policy and Payment Procedures Other Practical Issues Corporate control Cash position Debt covenants Legal restrictions Growth opportunities

7.1 Dividend Policy and Payment Procedures Other Practical Issues An increase in the current dividend payout is viewed as a message that management anticipates a permanently higher level of cash flows from investment An increase in dividend is often accompanied by an increase in share price

7.2 Alternative Dividend Policies Three Alternative Dividend Polices Constant Dividend Payout Ratio Policy The firm pays out the same percentage of earnings, say 30%, as dividends on an ongoing basis See excel slide 19

7.2 Alternative Dividend Policies Residual Dividend Policy The firm pays out dividends equal to its free cash flow Free cash flow = cash flow from operations – capital expenditures Dividends = net earnings – equity required for investments See excel slide 20

7.2 Alternative Dividend Policies Constant Dollar Dividend Policy The firm pays out the same dollar amount per outstanding common share each period, say $1.25 In practice this is by far the most common policy observed for Canadian, publicly-traded, companies that pay dividends See excel slide 21

7.3 Factors Affecting Dividend Polices There are 4 factors that may limit a firm’s ability to follow its dividend policy 1. Legal and mandated restrictions Lenders may impose restrictions on dividends to protect payments to debt holders 2. Firm liquidity The amount of cash on hand affects the firm’s ability to pay dividends

7.3 Factors Affecting Dividend Polices There are 4 factors that may limit a firm’s ability to follow its dividend policy 3. Earnings volatility If a firm has widely fluctuating earnings, it will likely maintain a low dividend payout ratio If earnings are stable, the firm is in a better position to pay a larger percentage of its earnings as dividends 4. Control To maintain shareholder control, particularly in small and medium size firms, firms will maintain low payout ratios to retain earnings to meet investment needs

7.3 Factors Affecting Dividend Polices There are two dominate features that influence dividend policy: Stability Industry norms

7.3 Factors Affecting Dividend Polices Stability Firms resist cutting dividends to avoid conveying negative signals about their prospects This is consistent with the signaling hypothesis and expectations view of dividend policy Corporations also try to convey stability of earnings by keeping the frequency and the timing of dividend payments consistent over time Dividend stability and increasing dividend payouts over time are both signs of stability and high quality of earnings

7.3 Factors Affecting Dividend Polices Industry Norms Financial managers often consult industry norms when setting their dividend policies A growing industry such as software sector, is likely to be associated with low payout dividend policies Companies in a mature industry, such as telecommunications and other utility companies, or banks, can afford higher payout ratios because of either relatively limited investment opportunities or lower business risk

7.3 Factors Affecting Dividend Polices Other Concepts Firms resist cutting dividends to avoid conveying negative signals about their prospects Firms avoid paying dividends during the early stages of their life cycles

7.4 Stock Dividends and Stock Splits Purpose of a stock split is to reduce price to a popular trading range Investor owns 100 shares with a current price of $40 per share. Company announces a 2:1 split 2 new shares for every 1 old share Investor now holds 200 shares at adjusted price of $20 a share Impact on the investors proportionate ownership?

7.4 Stock Dividends and Stock Splits Ignoring tax effects, stock dividends and stock splits do not change a shareholder’s financial position If you owned 10% of a company before the dividend or split, you will still own 10% of the company afterwards While you own more shares in the company, there are also more shares outstanding, so your percentage of ownership remains unchanged Moreover, cash has not flowed from the company to you, so the composition of your wealth remains unchanged as well

7.4 Stock Dividends and Stock Splits Consolidation or Reverse Split To raise market price and improve a company’s ability to refinance Investor owns 1,000 shares with a current price of $0.40 per share. Company announces a 1:10 reverse split 1 new share for every 10 old share Investor now holds 100 shares at adjusted price of $4 a share Impact on the investors proportionate ownership?

7.4 Stock Dividends and Stock Splits DRIP (Dividend Reinvestment Plan) Dividends are used to purchase additional stock in the company and not paid as cash Taxable same as cash dividends but shareholders benefit by saving on commission By purchasing the stock through DRIP, you benefit from dollar cost averaging

7.4 Stock Dividends and Stock Splits Are in the form of additional stock rather than cash Are typically paid by rapidly growing companies Are treated as regular dividends for tax purposes

7.5 Share Repurchase A company may reacquire its shares by paying cash to shareholders in return for their share rights Such share repurchases decrease the number of shares outstanding The repurchased shares (that are held in the company treasury as opposed to being immediately re-sold) are called treasury shares They are issued shares, but they are not counted as outstanding

7.5 Share Repurchase Share repurchases as alternative to cash dividends When a firm has accumulated cash from retained earnings and wants to distribute the cash to shareholders, it can repurchase its own shares in the open market instead of paying cash dividends This causes the number of outstanding shares to decrease, and both the book value and market value per share to increase See excel slide 34

7.5 Share Repurchase Share repurchases decrease the number of shares outstanding and lead to a higher market price per share Treasury shares are repurchased shares held in the firm’s treasury and not immediately re-sold Shareholder’s who wish to receive cash can sell a portion of their holdings to substitute for the cash dividends Share repurchases are perfect substitutes for cash dividends when markets are perfect Shareholders who pay higher taxes on dividends than on capital gains prefer stock repurchases to dividends

7.5 Share Repurchase Reasons a Firm May Wish to Repurchase its Shares Offset the exercise of executive stock options to maintain a constant number of outstanding shares Re-align the firm’s capital structure Send a market signal that management considers the firm’s share value underpriced Repurchase shares of dissident shareholders Return cash to shareholders without creating future dividend expectations Take the firm private

7.5 Share Repurchase In an open market purchase, the firm acquires shares at the going market price In an offer to purchase, shareholders tender their shares at a premium within the particular time period In a negotiated purchase, the firm purchases a large block of shares from one or more holders on a negotiated basis

7.6 Analyzing the Lease versus Buy Decision Evaluating the Lease Decision Leasing provides an alternative to buying an asset If a company needs an asset and has the opportunity to lease it, it must compare the cash flows from leasing with the cash flows from buying in order to determine which is better

7.6 Analyzing the Lease versus Buy Decision Evaluating the Lease Decision The four main differences in cash flows for a company that leases an asset instead of buying it: It does not have to pay for the asset up front It does not have to sell the asset when it is finished with it It makes regular lease payments. If it’s an operating lease, the payments are tax deductible. (Tax Shield Benefits) It does not get to depreciate the asset if it is an operating lease

7.6 Analyzing the Lease versus Buy Decision Lease versus buy decision using equivalent loan approach: For assignment and examination purposes, you must know how to use the equivalent loan approach Identify the cost and benefits of leasing, as opposed to those of borrowing to buy Discount the incremental costs and benefits of leasing at the after-tax cost of debt

7.6 Analyzing the Lease versus Buy Decision Lease versus buy decision using equivalent loan approach: Identify an equivalent loan that exactly commits the firm to the same cash outflows that the lease would Leasing is preferable to borrowing, if the amount of the equivalent loan is less than the initial investment outlay saved under the lease A positive NPV of leasing means the firm should lease rather than borrow to buy

7.6 Analyzing the Lease versus Buy Decision Example from the Module Notes Computer Illustration 7.6-1 See excel slide 42