1. © 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 14: Dividend Policy

2. © 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter examines the factors that influence a company’s choice of dividend policy  The pros and cons of dividend policies  The mechanics of dividend payments  Stock dividends  Share repurchase plans

3. © 2004 by Nelson, a division of Thomson Canada Limited 3 Dividends  When a company earns a profit, there are only two things it can do with the earnings: Pay a dividend to the shareholders Retain the earnings in the form of Retained Earnings  The choice as to how to divide firm earnings between Retained Earnings and Dividends and the implications of the choice made is the subject of this chapter.

4. © 2004 by Nelson, a division of Thomson Canada Limited 4 Influencing the Value of the Firm  Investment Decisions Determine the level of future earnings and future potential dividends  Financing Decisions Influence the cost of capital, which can determine the number of acceptable investment opportunities  Dividend Decisions Influence the amount of equity in a firm’s capital structure and the cost of capital

5. © 2004 by Nelson, a division of Thomson Canada Limited 5 Determinants of Dividend Policy  Legal Constraints A firm’s capital cannot be used to pay dividends (capital impairment restriction) Dividends can only be paid out of past & present net earnings (net earnings restriction) Dividends cannot be paid when a firm is insolvent (insolvency restriction)  Restrictive Covenants & Sinking Funds Usually imposed by creditors to prevent excessive withdrawals by owners

6. © 2004 by Nelson, a division of Thomson Canada Limited 6 Determinants of Dividend Policy  Tax considerations Investment income can be received as a capital gain or as a dividend The marginal tax rate will determine which form of income is preferred by investors  Liquidity and Cash Flow Considerations Dividends represent an outflow of cash  Access to New Equity and Debt Capital A firm may decide to pay dividends and simultaneously issue new equity or borrow

7. © 2004 by Nelson, a division of Thomson Canada Limited 7 Determinants of Dividend Policy  Variability of Earnings (stable vs. growth) The more stable the earnings pattern, the greater the percentage of earnings the firm can safely pay out as a dividend  Inflation During periods of high inflation, the firm may need to retain more earnings to fund the replacement of fixed assets

8. © 2004 by Nelson, a division of Thomson Canada Limited 8 Determinants of Dividend Policy  Shareholder Preference Firms often develop “clienteles” that are attracted to the firm’s stated dividend policy  Protection Against Dilution If the firm pays dividends and issues new equity, existing shareholders will be diluted if they do not purchase a portion of the new equity sold

9. © 2004 by Nelson, a division of Thomson Canada Limited 9 Dividend Irrelevance  Miller & Modigliani (MM) argue that dividends are irrelevant (under certain assumptions)  MM argue that firm value is determined by the firm’s investment policy, not dividend policy  MM’s assumptions for dividend irrelevance No taxes No transaction costs No issuance costs (for selling new equity) Existence of a fixed investment policy

10. © 2004 by Nelson, a division of Thomson Canada Limited 10 Dividend Irrelevance  MM recognize that changes in dividend policy affect share prices They argue this is due to the informational content conveyed by the change, not the change itself  Changes in dividend policy have a signaling effect – it signals management beliefs about future firm prospects  The existence of clienteles should not affect share price, since one clientele is as good as another clientele

11. © 2004 by Nelson, a division of Thomson Canada Limited 11 Are Dividends Relevant? ? What happens when the assumptions are relaxed? MM probably correct, given their restrictive assumptions.

12. © 2004 by Nelson, a division of Thomson Canada Limited 12 Are Dividends Relevant?  Risk aversion (Bird in the Hand Theory) Dividends represent a regular, certain return, thereby lowering risk and increasing firm value  Transaction costs With no transaction costs, investors can sell a portion of their shares to “create” a dividend In reality, transactions costs are real and significant  Taxes Investors care only about their after-tax return Thus taxes affect the preferred form of income

13. © 2004 by Nelson, a division of Thomson Canada Limited 13 Relevance of Dividends  Issuance (Flotation) costs The existence of issuance costs reduces the attractiveness of paying dividends and issuing equity  Agency costs are reduced when management is subjected to market scrutiny

14. © 2004 by Nelson, a division of Thomson Canada Limited 14 Conclusions Regarding Dividend Policy  Empirical evidence is mixed Some studies found that, due to tax effects, investors require a higher pretax return on high-dividend shares Other studies found no difference  Many practitioners believe that dividends are important due to: Their informational content External equity is expensive

15. © 2004 by Nelson, a division of Thomson Canada Limited 15 Passive Residual Policy  Suggests that a firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the shareholder’s required return  Would imply that dividends fluctuate significantly, based on earnings & investment opportunities  In practice, firms can smooth their dividends payments by using debt and varying their earnings retention policy

16. © 2004 by Nelson, a division of Thomson Canada Limited 16 Stable Dollar Dividend Policies  Firms are reluctant to reduce dividends; shareholders like a stable dividend stream  Increases in dividends tend to lag earnings  Investors prefer stable dividends because: Dividend changes convey information Many shareholders depend on dividend income Stability tends to reduce uncertainty, thereby lowering the firm’s cost of capital Certain institutions can only hold the shares of firms with a record of continuous and stable dividends

17. © 2004 by Nelson, a division of Thomson Canada Limited 17 Other Dividend Payment Policies  Constant Payout Ratio Pays a constant percent of earnings as dividends Causes the dividend to fluctuate

18. © 2004 by Nelson, a division of Thomson Canada Limited 18 Other Dividend Payment Policies  Small Regular Dividends Plus Extras Shareholders can depend on regular payout Accommodates changing earnings and investment requirements

19. © 2004 by Nelson, a division of Thomson Canada Limited 19 Other Dividend Payment Policies  Small Firms and Dividends Tend to pay out a smaller percent of earnings Rapid growth requires capital; small firms retain more of their income to fund growth Small firms have limited access to capital markets

20. © 2004 by Nelson, a division of Thomson Canada Limited 20 Multinational Firms & Dividends  Primary means of transferring funds to parent company  Important issues to consider include: Tax Foreign Exchange Political risk Funds availability Financing needs

21. © 2004 by Nelson, a division of Thomson Canada Limited 21 Paying Dividends Declaration Date Ex-Dividend Date Record Date Payment Date Two Days Usually Four Weeks

22. © 2004 by Nelson, a division of Thomson Canada Limited 22 Dividend Reinvestment Plan  Cash dividends reinvested automatically into additional shares  Purchase new or existing shares Purchasing new shares raises new equity capital for the firm  No brokerage commissions  Income tax liability

23. © 2004 by Nelson, a division of Thomson Canada Limited 23 Stock Dividends  Stock dividends are similar to stock splits  Both increase the number of shares outstanding  Accounting transaction Transfer pre-dividend market value from retained earnings to other stockholder’s equity  Market price of common shares should decline in proportion to the number of new shares issued

24. © 2004 by Nelson, a division of Thomson Canada Limited 24 Reasons for Stock Dividends  Broaden the ownership of the firm’s shares  May result in an effective increase in cash dividends, provided the level of cash dividends per share is not reduced  Reduction in share price may broaden the appeal of the stock to investors Thus may result in a real increase in market value

25. © 2004 by Nelson, a division of Thomson Canada Limited 25 Share Repurchase  By Tender Offer in the open market or by negotiation with large holders  Acquired shares may be cancelled or held as Treasury stock  Reduces the number of shares outstanding Increases EPS for the remaining shareholders  Stock repurchase programs are usually publicly announced

26. © 2004 by Nelson, a division of Thomson Canada Limited 26 Share Repurchase  Advantages Converts dividend income into capital gains Greater financial flexibility Greater control over timing Signaling effect  Disadvantages Company may overpay for the stock Tax avoidance Some current shareholders may be unaware

27. © 2004 by Nelson, a division of Thomson Canada Limited 27 Major Points  Firm profits are split into Retained Earnings and Dividends. Dividend policy explicitly states how the firm intends to make this split.  In a perfect world, it would not matter whether the firm paid dividends or not.  In the real world, where taxes and transaction costs exist, dividends probably do matter.  Dividends can be paid in cash or stock. In both cases, stock price declines on ex-dividend date  Share repurchases reduce shares outstanding, thereby pushing up the future price of the stock.