Fundamentals of corproate finance 3e chapter 19

Chapter Nineteen Dividends and Dividend Policy Copyright  2004 McGraw-Hill Australia Pty Ltd 19-1 Chapter Organisation 19.1 19.2 19.3 19.4 19.5 19.6 19.7 Cash Dividends and Dividend Payment Does Dividend Policy Matter? Real-world Factors Favouring a Low Payout Real-world Factors Favouring a High Payout A Resolution of Real-world Factors? Establishing a Dividend Policy Share Repurchase: An Alternative to Cash Dividends 19.8 Share Dividends and Share Splits 19.9 Employee Share Ownership Plans 19.10 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd 19-2 Chapter Objectives • • • • • • • Know the different forms of dividends and the appropriate dividend payment terminology Outline the arguments supporting the case for dividend irrelevance Discuss factors favouring a low or a high payout Explain the residual dividend policy Illustrate the situation of share repurchases vs paying a cash dividend Understand both bonus issues and share splits Outline the various employee share ownership plans Copyright  2004 McGraw-Hill Australia Pty Ltd 19-3 Types of Dividends • A dividend is a payment made out of a firm’s earnings to its owners (shareholders) • Dividends are usually paid in the form of cash • Types of cash dividends include: – – – – regular cash dividends extra dividends special dividends liquidating dividends • Share dividends are also paid, and share repurchases are a dividend alternative Copyright  2004 McGraw-Hill Australia Pty Ltd 19-4 Procedure for Dividend Payment Days Thursday, January 15 Wednesday, January 28 Friday, January 30 Monday, February 16 Declaration date Ex-dividend date Record date Payment date Copyright  2004 McGraw-Hill Australia Pty Ltd 19-5 Procedure for Dividend Payment • Declaration date: the board of directors declares a payment of dividends • Ex-dividend date: if you buy the share on or after this date the seller is entitled to keep the dividend Under ASX rules, shares are traded ex-dividend on and after the seventh business day before the record date • Record date: declared dividends are shareholders of record on a specific date distributable • Payment date: the dividend cheques shareholders of record are mailed to Copyright  2004 McGraw-Hill Australia Pty Ltd to 19-6 The Ex-date Price Drop Ex date -t –2 –1 +1 +2 t Price =$10 Price =$9 The share price will fall by the amount of the dividend on the ex date (Time 0) If the dividend is $1 per share, the price will be equal to $10 – = $9 on the ex date Before ex date (Time –1) On ex date (Time 0) Dividend = $0 Price = $10 Dividend = $1 Price = $9 Copyright  2004 McGraw-Hill Australia Pty Ltd 19-7 Do Dividends Matter? • Yes: the value of a share is based on the present value of expected future dividends • No: the value of a share is not affected by a switch in dividend policy Copyright  2004 McGraw-Hill Australia Pty Ltd 19-8 Does Dividend Policy Matter? Dividend policy versus cash dividends  An illustration of dividend irrelevance  Original dividends $1000 $1000 If RE = 20%: P0 = $1000/1.2 + $1000/1.22 = $1527.78 Copyright  2004 McGraw-Hill Australia Pty Ltd 19-9 Does Dividend Policy Matter? Assume an additional $200 of dividends is offered, financed by an issue of debt or shares New dividend plan: $1000 $1000 +200 –240 $1200 $760 P0 = $1200/1.2 + $760/1.22 = $1 527.78 Copyright  2004 McGraw-Hill Australia Pty Ltd 19-10 Clientele Effect • Shares attract particular groups based on dividend yield and the resulting tax effects • Some investors prefer low dividend payouts and will buy shares in those companies that offer low dividend payouts • Some investors prefer high dividend payouts and will buy shares in those companies that offer high dividend payouts Copyright  2004 McGraw-Hill Australia Pty Ltd 19-17 Residual Dividend Policy • Issue costs eliminate any indifference between financing by internal capital and new shares • Dividends are paid only if profits are not completely used for investment purposes • Desired debt-to-equity ratio is maintained Copyright  2004 McGraw-Hill Australia Pty Ltd 19-18 Residual Dividend Policy Copyright  2004 McGraw-Hill Australia Pty Ltd 19-19 Relationship Between Dividends and Investment Dividends New investment Copyright  2004 McGraw-Hill Australia Pty Ltd 19-20 Key Concepts in Dividend Policy • Dividend stability—dividends are only increased if the increase is sustainable • Dividend streaming—shareholders can choose different dividend schemes to suit their tax position (franked vs unfranked dividends) • Special dividends—‘one-off’’ extra dividends • Dividend reinvestment schemes—company reinvests individuals’ dividends into fully paid shares of the company Avoids transactions costs and need for prospectus, and shares are usually offered at a discount Copyright  2004 McGraw-Hill Australia Pty Ltd 19-21 Australian Equity Raisings 2001 Source: Australian Stock Exchange Copyright  2004 McGraw-Hill Australia Pty Ltd 19-22 Share Repurchases • Company buys back its own shares • Similar to a cash dividend in that it returns cash from the firm to the shareholders • This is another argument for dividend policy irrelevance in the absence of taxes or other imperfections Copyright  2004 McGraw-Hill Australia Pty Ltd 19-23 Share Repurchases • • • • • Equal access purchase Offer made by company to all shareholders to purchase shares in the same proportion as their holdings On-market purchase Purchase by a company of its own shares on the open market Employee share purchase Repurchase shares from employees that were issued under employee incentive scheme Selective purchase Repurchase of shares from specific shareholders Odd-lot purchase Repurchase of small parcels of shares Copyright  2004 McGraw-Hill Australia Pty Ltd 19-24 Cash Dividend versus Share Repurchase Assume no taxes, commissions or other market imperfections Consider a firm with 50 000 shares outstanding, net profit of $100 000 and the following balance sheet Copyright  2004 McGraw-Hill Australia Pty Ltd 19-25 Cash Dividend versus Share Repurchase (continued) • Price per share is $20 ($1 000 000/50 000) • EPS = $2.00 ($100 000/50 000) • PE ratio = 10 • The firm is considering either: – Paying a $1 per share cash dividend OR – Repurchasing 2500 shares at $20 a share Copyright  2004 McGraw-Hill Australia Pty Ltd 19-26 Cash Dividend versus Share Repurchase (continued) Cash Dividend Option Cash Other Assets Total $ 50 000 900 000 $ 950 000 $ Debt 950 000 Equity $ 950 000 Total Price per share is $19.00 ($950 000/50 000) EPS = $2.00 ($100 000/50 000) PE ratio = 10 Copyright  2004 McGraw-Hill Australia Pty Ltd 19-27 Cash Dividend versus Share Repurchase (continued) Share Repurchase Option Cash Other Assets Total $ 50 000 900 000 $ 950 000 $ Debt 950 000 Equity $ 950 000 Total Price per share is $20.00 ($950 000/47 500) EPS = $2.10 ($100 000/47 500) PE ratio = 9.5 Copyright  2004 McGraw-Hill Australia Pty Ltd 19-28 Share Dividends and Share Splits Bonus shares and share splits: • involve issuing new shares on a pro-rata basis to the current shareholders • not change the firm’s assets, earnings, risk assumed and investors’ percentage of ownership in the company • increase the number of shares outstanding • reduce the value per share A common explanation is to adjust the share price to a ‘more desirable trading range’ Copyright  2004 McGraw-Hill Australia Pty Ltd 19-29 Reverse Splits • The firm reduces the number of shares outstanding • Reasoning: – reduction in transaction costs – increase in share marketability (trading range) – regain respectability Copyright  2004 McGraw-Hill Australia Pty Ltd 19-30 Share Ownership Plans • Encourage the financial participation of employees in the company, including: – fully paid shares – partly paid shares – special classes of shares – options – phantom or shadow shares – employee share trusts Copyright  2004 McGraw-Hill Australia Pty Ltd 19-31 .. .Chapter Organisation 19. 1 19. 2 19. 3 19. 4 19. 5 19. 6 19. 7 Cash Dividends and Dividend Payment Does Dividend Policy Matter?... Australia Pty Ltd 19- 3 Types of Dividends • A dividend is a payment made out of a firm’s earnings to its owners (shareholders) • Dividends are usually paid in the form of cash • Types of cash dividends... Copyright  2004 McGraw-Hill Australia Pty Ltd 19- 9 Does Dividend Policy Matter? Assume an additional $200 of dividends is offered, financed by an issue of debt or shares New dividend plan: $1000