1. Corporate Finance Fundamentals
FN1 Module 7
January 26, 2015

2. 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

3. 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

4. 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

5. 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

6. 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. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 7.1 Dividend Policy and Payment Procedures
Other Practical Issues
Corporate control
Cash position
Debt covenants
Legal restrictions
Growth opportunities

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 7.3 Factors Affecting Dividend Polices
There are two dominate features that influence dividend policy:
Stability
Industry norms

25. 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

26. 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

27. 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

28. 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?

29. 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

30. 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?

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

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