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MBF1223 | Financial ManagementPrepared by Dr Khairul Anuar
L5 - Dividends and Dividend Policy
www.mba638.wordpress.com
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Uses of Free Cash Flow: Distributions to
Shareholders
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What is Dividend Policy
• 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.
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Types of Dividends
• Dividends are a permanent distribution of residual
earnings of the corporation to its owners.
• Dividends can be in the form of:
– Cash
– Additional Shares of Stock (stock dividend)
• If a firm is dissolved, at the end of the process, a final
dividend of any residual amount is made to the
shareholders – this is known as a liquidating dividend.
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Distributions to Shareholders
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• 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.
Corporate Profits After Tax
Retained Earnings
Dividends
Dividends a Financing Decision
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Dividends characteristics
• A dividend is a discretionary payment made to shareholders
• The decision to distribute dividends is solely the responsibility of
the board of directors
• Shareholders are residual claimants of the firm (they have the
last, and residual claim on assets on dissolution and on profits
after all other claims have been fully satisfied)
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Dividends Distributions to Shareholders
• The company’s board of directors declares the dividend that
will be paid and decides when the payment will occur:
• Ex-dividend date
• Record date
• Payment date
• Some companies pay dividends once a year while others pay
dividends twice a year –usually as an interim and a final
dividend.
• Occasionally, a firm may pay a one-time, special dividend
that is usually much larger than a regular dividend.
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Mechanics of Cash Dividend Payments
• Declaration Date
• Holder of Record Date
• Ex-dividend Date
• Payment Date
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Mechanics of Cash Dividend Pay
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.
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Mechanics of Cash Dividend Pay
Ex dividend Date
– ex’ means without
– Ex-dividend date: informally called the ex-date—is the date that establishes the recipient of the dividend.
– It is two days before the date of record.
– If you buy before the ex-date, you get any declared dividend; the seller does not. If you buy on or after the ex-date, the seller gets any declared dividend; you do not.
– ‘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.
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Declaration Date
Date of
Record
Date of
Payment
Ex Dividend Date is determined
by the Date of Record.The Board Meets
and passes the
motion to create
the dividend
x business days prior to the Date of Record
Dividend Declaration Time Line
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Ex Dividend Date
Chronology of Declaring and Paying a Cash
Dividend
Figure: PepsiCo dividend dates.
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Dividend Policy
• There is no legal obligation for firms to pay dividends to common shareholders
• Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because:
Board members are jointly and severally liable for any damages they may cause
Board members are constrained by legal rules affecting dividends including:
Not paying dividends out of capital
Not paying dividends when that decision could cause the firm to become insolvent
Not paying dividends in contravention of contractual commitments (such as debt covenant agreements)
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Dividend Reinvestment Plans (DRIPs)
• Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm
• There are two types of DRIPs:
(1) plans that involve only “old stock” that is already outstanding and
(2) plans that involve newly issued stock.
• Stock may be offered at a discount of 3% to 5% below the actual market price
• In either case, the stockholder must pay taxes on the amount of the dividends, even though stock rather than cash is received.
• Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders.
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Stock Dividends
• Stock dividends are similar to stock splits in that they “divide
the pie into smaller slices” without affecting the
fundamental position of the current stockholders.
• Example: On a 5% stock dividend, the holder of 100 shares
would receive an additional 5 shares (without cost); on a
20% stock dividend, the same holder would receive 20 new
shares; and so on.
• The total number of shares is increased, so earnings, dividends, and price per share all decline.
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Stock Dividends
Implications– reduction in the Retained earnings account– reduced capacity to pay future dividends– proportionate share ownership remains unchanged– shareholder’s wealth (theoretically) is unaffected
Effect on the Company– conserves cash– serves to lower the market value of firm’s 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– proportion of ownership remains unchanged– total value of holdings remains unchanged– if former DPS is maintained, this really represents an increased
dividend payout
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Stock Dividends Example
ABC CompanyEquity Accounts
as at February xx, 20x9
Common stock (215,000) $5,000,000Retained earnings 20,000,000Net Worth $25,000,000
The company, on March 1, 2013 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:
Cont’d next page
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Share Repurchases
• Stock repurchases occur when a company buys back some of its own outstanding stock.
• 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
• Stock repurchases are usually made in one of three ways.
(1) A publicly owned firm can buy back its own stock through a
broker on the open market.
(2) The firm can make a tender offer, under which it permits
stockholders to send in (that is, “tender”) shares in exchange for a
specified price per share. In this case, the firm generally indicates
it will buy up to a specified number of shares within a stated time
period (usually about two weeks). If more shares are tendered
than the company wants to buy, purchases are made on a pro
rata basis.
(3) The firm can purchase a block of shares from one large holder on
a negotiated basis. This is a targeted stock repurchase.
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• called treasury stock
• non-voting
• may not receive dividends
• if not retired, can be resold unlike the U.S., (in some countries
shares repurchased are cancelled eg. Canada)
Repurchased Shares
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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
Repurchase Example
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• EPS should increase following the repurchase if earnings after-
tax remains the same
• a higher market price per outstanding share of common stock
should result
• stockholders not selling their shares back to the firm will enjoy a
capital gain if the repurchase increases the stock price.
Effects of A Share Repurchase
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Summary of Dividends vs. Repurchases
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Dividend Versus Retention of Cash
Agency costs of retaining cash
• There is no benefit to shareholders when a firm holds cash above and beyond its future investment or liquidity needs.
• Managers may use this cash inefficiently by continuing money-losing pet projects, paying excessive executive perks or overpaying for acquisitions.
• Leverage is one way to reduce a firm’s access cash.
• Paying out cash can boost the share price by reducing managers ability and temptation to waste resources.
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Stock Splits
• Division of existing shares into multiple shares.
• If management of Porters believe the best range for most stocks is from $20 to $80 per share, they would probably declare a 2-for-1 stock split, thus
doubling the number of shares outstanding,
halving the earnings and dividends per share, and
thereby lowering the stock price.
• Each stockholder would have more shares, but each share would be worth less.
• If the post-split price were $40, then Porter’s stockholders would be exactly as well off as before the split.
• However, if the stock price were to stabilize above $40, stockholders would be better off. Stock splits can be of any size—for example, the stock could be split 2-for-1, 3-for-1, 1.5-for-1, or in any other way.
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Reverse Splits / Consolidation of shares
• Process by which shares are effectively merged to form a smaller number of proportionally more valuable shares.
• There are many ways to effect this; one simple way is for the corporation to cancel a uniform fraction of each shareholder's shares .
• For example, International Pictures Corp. (IPIX) developed the iPIX computer imaging technology, which allows a user to “walk through” a 360-degree view.
• Its stock price was in the $30 range prior to the dot-com crash of April 2000, but by August 2001 its price had fallen to $0.20 per share. One of Nasdaq’s listing requirements is that the stock price must be above $1 per share, and Nasdaq was threatening to delist IPIX.
• To drive its price up, IPIX had a 1-10 reverse stock split before trading began on August 23, 2001, with its shareholders exchanging 10 shares of stock for a single new share. In theory, the stock price should have increased by a factor of 10, to around $2, but IPIX closed that day at a price of $1.46. Evidently, investors saw the reverse split as a negative signal. IPIX continued to struggle and declared bankruptcy in 2006, eventually auctioning off virtually all of its assets.
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Clientele Effect
• Different groups, or clienteles, of stockholders prefer different dividend payout policies.
• Eg. retired individuals, pension funds, and university endowment funds generally prefer cash income, so they may want the firm to pay out a high percentage of its earnings. Such investors are often in low or even zero tax brackets, so taxes are of no concern.
On the other hand, stockholders in their peak earning years might prefer reinvestment, because they have less need for current investment income and would simply reinvest dividends received—after first paying income taxes on those dividends.
• If a firm retains and reinvests income rather than paying dividends, those stockholders who need current income would be disadvantaged. The value of their stock might increase, but they would be forced to go to the trouble and expense of selling some of their shares to obtain cash
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Signaling Effect
• Different investors have different views on both the level of future dividend payments and the uncertainty inherent in those payments, and managers have better information about future prospects than public stockholders.
• It has been observed that an increase in the dividend is often accompanied by an increase in the price of a stock and that a dividend cut generally leads to a stock price decline.
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Signaling Effect
• Miller & Modigliani: Corporations are reluctant to cut dividends, which implies that corporations do not raise dividends unless they anticipate higher earnings in the future.
• Thus, MM argued that a higher than expected dividend increase is a signal to investors that the firm’s management forecasts good future earnings.
• Conversely, a dividend reduction, or a smaller than expected increase, is a signal that management is forecasting poor earnings in the future.
• Thus, MM argued that investors’ reactions to changes in dividend policy do not necessarily show that investors prefer dividends to retained earnings. Rather, they argue that price changes following dividend actions simply indicate that there is important information, or signaling, content in dividend announcements.
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• Stability
– Stable dividend payout Ratio
– Stable Dividends or Steadily changing Dividends
Stability in Dividend Payout
Constraints on dividend payments
• Constraints on dividend payments can affect distributions, as the following examples illustrate.
1. Bond indentures. Debt contracts often limit dividend payments to earnings generated after the loan was granted. Also, debt contracts often stipulate that no dividends can be paid unless the current ratio, times-interest-earned ratio, and other safety ratios exceed stated minimums.
2. Preferred stock restrictions. Typically, common dividends cannot be paid if the company has omitted its preferred dividend.
3. Impairment of capital rule. Dividend payments cannot exceed the balance sheet item “retained earnings.” This legal restriction, known as the “impairment of capital rule,” is designed to protect creditors.
4. Availability of cash. Cash dividends can be paid only with cash, so a shortage of cash in the bank can restrict dividend payments. However, the ability to borrow can offset this factor.
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Advice for the Financial Manager
Overall, as a financial manager, you should consider the
following when making payout policy decisions:
• For a given payout amount, try to maximise the after-tax
payout to the shareholders. Repurchases and dividends are
often taxed differently and one can have an advantage over
the other.
• Repurchases and special dividends are useful for making
large, infrequent distributions to shareholders - neither implies
any expectation of repeated payouts.
• Starting and increasing a regular dividend is seen by
shareholders as an implicit commitment to maintain this level
of regular payout indefinitely.
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Advice for the Financial Manager
• Because regular dividends are seen as an implicit
commitment, they send a stronger signal of financial strength
to shareholders - However, this signal comes with a cost
because regular payouts reduce a firm’s financial flexibility.
• Be mindful of future investment plans - There are transaction
costs associated with both distributions and raising new
capital, so it is expensive to make a large distribution and then
raise capital to fund a project.
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Dividend Policy of Corporations
• “Turk Telekom Group - Our dividend policy is to distribute 100% of
distributable profit which is calculated based on Capital Markets
Board regulations. The Board takes into account short-term financial
liabilities of the Group and covenants agreed with the lenders while
deciding on the dividend distribution proposal, as well.”
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Our Company intends to distribute yearly dividends of RM700 million or up to 90% of our normalized PATAMI, whichever is higher.
Dividends will be paid only if approved by our Board out of funds available for such distribution. The actual amount and timing of dividend payments will depend upon our level of cash and retained earnings, results of operations, business prospects, monetization of non-core assets, projected levels of capital expenditure and other investment plans, current and expected obligations and such other matters as our Board may deem relevant.”
Dividend Policy
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PETALING JAYA: Westport Holdings Bhd is dangling a 75% dividend payout policy to woo investors to its initial public offering (IPO) of 813.19 million shares of 10 sen par value.
”The 75% dividend payout policy is a target we hope to achieve every year,” said chief executive officer at the company s prospectus launch in Kuala Lumpur yesterday.
2010 2011 2012 2013Divided per share (sen) 6.7 6.7 9.0 9.6Dividend payout ratio 70.2% 63.1% 75.0% 75.0%
Westport dangles 75% dividend ‘carrot’September 20, 2013
Microsoft Boosts Dividend by 22%, Sets $40 Billion
Buyback
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Microsoft Corp moved to share more of its cash hoard with shareholders, boosting its quarterly dividend by 22% and renewing a $40 billion authorization to buy back its shares.Microsoft unveiled a $40 billion share buyback plan and boosted its quarterly dividend by 22%, continuing the shareholder-friendly moves it has pushed in recent years. The announcement Tuesday comes two days before a highly anticipated meeting with financial analysts and follow a series of surprise changes at the software giant, including a plan to seek a successor to Chief Executive Steve Ballmer and a $7 billion deal to buy Nokia Corp.'s 2.19% smartphone business.Microsoft has raised its dividend eight times since 2004, in announcements that typically come in September. But the latest increase was greater than predicted by some analysts, who see Microsoft's moves to return cash to shareholders as a way to defuse dissatisfaction with the company's share price.
Wall Street Journal, Updated Sept. 17, 2013
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