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CORPORATE FINANCE
Chapter 22 Dividend Policy
CHAPTER 22
Dividend Policy
Lecture Agenda
Learning Objectives
Important Terms
Mechanics of Dividend Payments
Cash Dividend Payments
M&Ms Dividend Irrelevance Theorem
The Bird in the Hand Argument
Dividend Policy in Practice
Relaxing the M&M Assumptions
Stock Dividends and Stock Splits
Share Repurchases
Summary and Conclusions
Concept Review Questions
CHAPTER 22 Dividend Policy
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Learning Objectives
You should understand the following:
The mechanics of dividend payments and why they are different
from interest payments
The difference between a stock split and a stock dividend
Under what assumptions a dividend payment is irrelevant and
what a homemade dividend is
Why dividend payments generally reflect the business risk of the
firm
How transactions costs, taxes and information problems give value
to corporate dividend policies
How stock dividends and stock splits differ
How a share repurchase program can substitute for a dividend
payout policy.
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Agency theory
Bird in the hand argument
Cash cow
Declaration date
Dividend reinvestment
plans
Dividend yield
Equity market
capitalization
Ex-dividend date
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Dividend Policy
What is It?
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Types of Dividends
Dividend Policy
Types of Dividends
Dividends are a permanent distribution of residual
earnings/property of the corporation to its owners.
Dividends can be in the form of:
Cash
Additional Shares of Stock (stock dividend)
Property
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Retained Earnings
Corporate Profits After Tax
Dividends
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Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date
Holder of Record Date
Ex-dividend Date
Payment Date
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Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date
this is 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.
Date of Record
is the date on which the shareholders register is closed after the trading day and all those
who are listed will receive the dividend.
Ex dividend Date
is the date that the value of the firms 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.
Date of Payment
is the date the cheques for the dividend are mailed out to the shareholders.
CHAPTER 22 Dividend Policy
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Declaration Date
Date of
Record
Date of
Payment
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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 three
business days (T + 3).
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 credit
market failure. The gridlock created in 1990 by the bankruptcy of Drexel
Burnham Lambert, a large U.S. broker, increased the need to minimize the
risks involved in the clearing and settlement of securities.
The shortened settlement cycle requires that the payment of funds and
the delivery of securities take place on the third business day after the
trade date. This will reduce credit, market and liquidity risks by
decreasing post-trade settlement exposure.
Ex Dividend Date
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Dividend Policy
Dividends, Shareholders and the Board of Directors
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Dividend Payments
Dividend Policy
Dividend Payments
Dividend Reinvestment Plans (DRIPs)
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Dividend Payments
Stock Dividends
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Dividend Payments
Stock Dividends
Implications
conserves cash
serves to lower the market value of firms stock modestly
promotes wider distribution of shares to the extent that current owners divest themselves of
shares...because they have more
adjusts the capital accounts
dilutes EPS
Effect on Shareholders
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Dividend Payments
Stock Dividend Example
ABC Company
Equity Accounts
as at February xx, 20x9
Common stock (215,000)
$5,000,000
Retained earnings
20,000,000
Net Worth
$25,000,000
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.
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:
$40.00 (21,500) = $860,000
This stock dividend will result in $860,000 being transferred from the retained
earnings account to the common stock account:
next page...
CHAPTER 22 Dividend Policy
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Dividend Payments
Stock Dividend Example
After the stock dividend:
ABC Company
Equity Accounts
as at March 1, 20x9
Common stock (236,500)
Retained earnings
Net worth
$5,860,000
19,140,000
$25,000,000
The market price of the stock will be affected by the stock dividend:
New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36
The individual shareholders wealth will remain unchanged.
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Dividend Payments
Stock Splits
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Dividend Payments
Stock Split Example
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 that the
firms stock price will continue to rise given the firms outstanding
financial performance. Currently, the companys shares are trading for
$150 and the companys shareholders equity accounts are as follows:
Commons shares (100,000 outstanding)
Retained earnings
Net Worth
$1,500,000
15,000,000
$16,500,000
$1,500,000
15,000,000
$16,500,000
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Dividend Payments
Further Stock Split Examples
A 4 for 3 Stock Split:
$1,500,000
15,000,000
$16,500,000
$1,500,000
15,000,000
$16,500,000
Clearly the Board can use stock splits and reverse stock splits to place the firms
stock in a particular trading range.
CHAPTER 22 Dividend Policy
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Dividend Payments
Stock Split Effects
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Stock Splits
recapitalization of earnings
no change in proportional
ownership
odd lots created
theoretically, no value to
the investor
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Figure 22 -1 illustrates:
Aggregate after-tax profits run at approximately 6% of GDP but
are highly variable
Aggregate dividends are relatively stable when compared to
after-tax profits.
They are sustained in the face of drops in profit during recessions
They are held reasonably constant in the face of peaks in aggregate
profits.
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Figure 22 -2 illustrates:
Aggregate Dividend payouts further illustrates the
effects of relatively stable dividend payouts in the face
of profit volatility:
The normal aggregate dividend payout rate is about 40% of
after-tax profit
When profits drop and dividends are held constant, payout
rates rise to 100%
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[ 22-1]
D1 P1
P0
(1 Ke )
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[ 22-2]
m( D1 P1 )
mP0 V0
(1 Ke )
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No Taxes
Perfect capital markets
large number of individual buyers and sellers
costless information
no transaction costs
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[ 22-3]
X 1 nP1 I1 mD1
Where:
X
I
XI
mD1
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mD1 X 1 nP1 I1
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[ 22-4]
X1 I1 [(m n) P1 V1 ]
V0
(1 K )
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X t It
V0
t
(
1
K
)
t 1
[ 22-5]
Value has
nothing
to do with
dividends
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Rate of
Return
MC=MR
IOS
WACC
$177,607
Million
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ROE1 BVPS
Inv
ROE 2 K e
(
)
Ke
(1 K e )
Ke
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D1
P0
Gordon
P1 P0
P0
M&M
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Conclusions:
Firms cannot change underlying operational
characteristics by changing the dividend
The dividend should reflect the firms operations
through the residual value of dividends
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Dt (Dt* -Dt-1 )
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[ 22-8]
Dt a (1 b) Dt-1 cE1
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Implications
The speed of dividend adjustment is only about 30
percent
Firms are very reluctant to fully adjust
Firms do not follow a policy of paying a constant
proportion of earnings out as dividends
Dividend policy in practice does not follow M&Ms
irrelevance arguments because the real world does
not match the assumptions used.
CHAPTER 22 Dividend Policy
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Transactions Costs
Underwriting costs are very high, providing a strong
incentive for firms to finance growth out of free cash
flow
Facing these high underwriting costs firms:
With high growth rates have little incentive to pay dividends
With volatile earnings conserve cash from year to year to
finance projects and therefore pay very conservative
dividends
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et
et*
dt*
dt
Time
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Agency Theory
Investors are wary of senior management so they seek to put
controls in place.
There is a fear that managers may waste corporate resources by
over-investing in low or poor NPV projects.
Gordon Donaldson argued this is the reason for the pecking
order managements tend to use when raising capital
Shareholders would prefer to receive a dividend and then have
management file a prospectus, justifying investment in projects and
the need to raise the capital that was just distributed as a dividend.
Shareholders are prepared to pay those additional underwriting
costs as an agency cost incurred to monitor and assess
management.
CHAPTER 22 Dividend Policy
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dt
P0
t
(1 k ) 6
t 1 (1 k )
P0
$454 million
MYW
$143 million
$330 million
dt
min($30, P6 1)
Pref
(1 k ) 6
t 1 (1 k ) t
6
P6 min($30, P6 1)
IR
(1 k ) 6
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Share Repurchases
Simply another form of payout policy.
An alternative to cash dividend where the
objective is to increase the price per share
rather than paying a dividend.
Since there are rules against improper
accumulation of funds, firms adopt a policy of
large infrequent share repurchase programs.
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Share Repurchases
Dividend Policy
Share Repurchases
allowed under the OBCA and CBCA
reasons for use:
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tender offer:
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Repurchased Shares
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Repurchase Example
Current EPS
= [total earnings] / [# of shares] = $4.4 m / 1.1 m =
$4.00
Current P/E ratio
= $20 / $4 = 5X
EPS after repurchase of 100,000 shares
= $4.4 m / 1.0 = $4.40
Expected market price after repurchase:
= [p/e][EPSnew] = [5][$4.40] = $22.00 per share
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Why?
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Before Borrowing:
Assets:
Cash
Fixed Assets
Total Assets
Liabilities:
10
140
$150
0% Debt
Long-term Debt
0
Common Stock
50
Retained Earnings 100
Total Claims
$150
25% Debt
Liabilities:
60
140
$200
Long-term Debt
50
Common Stock
50
Retained Earnings 100
Total Claims
CHAPTER 22 Dividend Policy
$200
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Total Assets
Liabilities:
60
140
$200
Current liabilities
Long-term Debt
Common Shares
Retained earnings
Total Claims
50
50
50
50
$200
33% Debt
Liabilities:
10
140
$150
Long-term Debt
Common Stock
Retained earnings
Claims
CHAPTER 22 Total
Dividend
Policy
50% Debt
50
50
50
$150
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