Principles of Corporate Finance Brealey, Myers, Partington and Robinson 1st Australian Edition The Dividend Controversy Slides by Matthew Will and Graham Partington Irwin/McGraw Hill Chapter 16 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16- Topics Covered How Dividends Are Paid How Do Companies Decide on Dividend Payments? Information in Dividends Dividend Policy is Irrelevant The Rightists Taxes and the Radical Left The Middle of the Roaders Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16- Defining Dividend Policy What is the effect of dividend policy holding invest and borrowing decisions constant? Investment - Borrowing - Cash from Operations = Share issue - Dividends So dividend policy is a trade off between share issues and dividend payments Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16- Dividend Payments Declaration Date - Date when the company announces the dividend Two announcements per year - Interim and Final Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16- Dividend Payments Declaration Date - Date when the company announces the dividend Two announcements per year - Interim and Final Ex-Dividend Date - Date that determines whether a shareholder is entitled to a dividend payment; anyone holding share before this date is entitled to a dividend Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16- Dividend Payments Declaration Date - Date when the company announces the dividend Two announcements per year - Interim and Final Ex-Dividend Date - Date set by ASX that determines whether a shareholder is entitled to a dividend payment; anyone holding share before this date is entitled to the dividend Books Close (Record Date) - Person who owns share on this date receives the dividend Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16- Dividend Payments Five Trading Days About one month on average Share trades cum-dividend Declaration date Ex-dividend date Books close date Payment date Share price falls ©2000 McGraw-Hill Book Company Australia Pty Ltd Irwin/McGraw Hill PPT t/a Principles of Corporate Finance by Brealey et al 16- Dividend Payments Many companies have dividend election plans, which allow you to take dividends as cash, or shares, or some combination of both Cash Dividend - Distribution of cash to a firm’s shareholders Dividends must notionally be “paid” from profits not capital The cash dividend can be regular or special and may have franking credits (full or partial) attached ©2000 McGraw-Hill Book Company Australia Pty Ltd Irwin/McGraw Hill PPT t/a Principles of Corporate Finance by Brealey et al 16- Dividend Payments Share Dividends - Distribution of shares to shareholders Bonus issues - Extra shares issued as a dividend May be a general issue to all shareholders, or shareholders may participate in a bonus plan Distribution from “income” attracts income tax, but distribution from “capital” does not Bonus shares create more paper, not more value Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16- 10 Dividend Reinvestment Plans DRPs or DRIPs - Investor’s elect to reinvest their dividend in the company rather than take them in cash The company issues new shares which the shareholder’s get at a small discount (say 5%) to the ex-div price DRP’s are an important source of equity finance, but sometimes a company has more cash coming in than it can use, and the DRP is suspended Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 10 16- 20 Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend They also require $1,000 for current investment needs Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend Record Date Cash 1,000 Asset Value 9,000 Total Value 10,000 + New Proj NPV 2,000 12,000 # of Shares 1,000 price/share $12 Irwin/McGraw Hill Pmt Date 9,000 9,000 2,000 11,000 1,000 $11 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 20 16- 21 Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend They also require $1,000 for current investment needs Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend Record Date Pmt Date Post Pmt Cash 1,000 1,000 (91sh @ $11) Asset Value 9,000 9,000 9,000 Total Value 10,000 + 9,000 10,000 New Proj NPV 2,000 2,000 2,000 12,000 12,000 12,000 # of Shares 1,000 1,000 1,091 price/share $12 $11 $11 ©2000 McGraw-Hill Book Company Australia Pty Ltd NEW SHARES ARE ISSUED PPT t/a Principles of Corporate Finance by Brealey et al 21 Irwin/McGraw Hill 16- 22 Dividend Policy is Irrelevant Example - continued - Shareholder Value Share Cash Record Date 12,000 Total Value 12,000 Share = 1,000 sh @ $12 = 12,000 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 22 16- 23 Dividend Policy is Irrelevant Example - continued - Shareholder Value Share Cash Record 12,000 Pmt 11,000 1,000 Total Value 12,000 12,000 Share = 1,000sh @ $11 = 11,000 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 23 16- 24 Dividend Policy is Irrelevant Example - continued - Shareholder Value Share Cash Record 12,000 Pmt 11,000 1,000 Post 12,000 Total Value 12,000 12,000 12,000 Share = 1,091sh @ $11 = 12,000 If old shareholders purchase the new issue with the cash dividend proceeds, their position is exactly as before Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 24 16- 25 Dividends Increase Value If firm does not pay dividends, the price does not fall on the ex-dividend date so the shareholders return comes as a capital gain The rightists argue that dividends are more stable than risky capital gains, so paying higher dividends should increase value However, in an efficient market, the cash dividend and the capital gain will have the same value, and the risk can be eliminated by taking a homemade dividend Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 25 Market Imperfections and Dividends 16- 26 • Taxes—If you can find a way to save tax you can create extra value • Information asymmetries—If managers have more information than investors, and investors infer some of this information from dividend announcements, then dividend signalling will affect value • Conflicts between managers, and shareholders— There is nothing more difficult to control than a fistful of cash Managers may misuse it Increasing the flow of dividends can reduce this risk Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 26 16- 27 Market Imperfections and Dividends • Capital rationing—Perhaps the firm cannot readily finance its dividends Instead dividends and investments may be competing uses for internally generated funds In this case dividend policy affects the value of the firm indirectly through its impact on investment (This is a relatively rare event for large Australian public companies who will normally raise finance by issuing debt) • Transactions costs _Reducing total transactions costs for investors and the firm increases shareholder wealth ©2000 McGraw-Hill Book Company Australia Pty Ltd Irwin/McGraw Hill PPT t/a Principles of Corporate Finance by Brealey et al 27 16- 28 Clientele Effects Many different dividend clienteles exist (eg widows and orphans) with definite preferences for a particular dividend policy Will they pay a premium for their preferred policy? Perhaps, but only if it is in short supply Smart corporate treasurers should adjust dividend supply to the premium policies, and by expanding supply eliminate the premium Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 28 16- 29 Dividends Decrease Value Tax Consequences: Companies can convert dividends into capital gains by reducing their dividend payout If dividends are taxed more heavily than capital gains, (as under a classical tax system) taxpaying investors should welcome such a move and value the firm more favorably But perhaps it is not so simple variety of tax clienteles, including tax exempts and those who are taxed less on gains Companies may adjust supply to match clienteles Investors arrange their affairs to minimise/avoid tax Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 29 16- 30 High Payout Lower Price if Dividend Tax Exceeds Gains Tax Firm A (No Dividend Firm B (High Dividend) Next year’s expected price Dividend Total pretax payoff Today’s share price Capital gain Before-tax rate of return (percent) $112.50 $0 $112.50 $100 $12.50 12.5 x100 =12.5 100 $102.50 $10.00 $112.50 $96.67 $5.83 15.83 x 100 = 16.4 96.67 Tax on dividend at 50 percent Tax on capital gains at 20 percent Total after-tax income (dividends plus capital gains less taxes) After-tax rate of return (percent) $0 20 x 12.50 = $2.50 50 x 10 = $5.00 20 x 5.83 = $1.17 (0 + 12.50) -2.50 = $10.00 (10.00 + 5.83) -(5.00 + 1.17) = $9.66 10 x 100 = 10.0 100 9.66 x 100 = 10.0 96.67 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 30 16- 31 Tax System and Dividend Policy In U.S.(classical tax system), some shareholders are taxed twice (figures in dollars) Rate of Income tax Operating Income Corporate tax (Tc=.35) After Tax income (paid as div) Income tax Cash to Shareholder 0% 100 35 65 65 39.60% 100 35 65 25.7 39.3 Effective tax rate for shareholders 60.7% Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 31 16- 32 Imputation Tax System The Australian Imputation System is designed to avoid double taxation for some investors The objective is to tax corporate income distributed as dividends at an effective rate equal to the investor’s personal tax Taxable income for dividends received is computed as: Div/(1-Tc) and personal tax is therefore Div/(1-Tc) x Tp But a franking credit of Div/(1-Tc) x Tc is allowed for corporate tax paid So the shareholder only pays Div/(1-Tc) x (Tp - Tc) Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 32 16- 33 Imputation Tax and Dividend Policy Effect of Imputation for Different Investors Dividends are fully franked and there is a 100% payout ratio Operating income Corporate tax After tax income Grossed up dividend Income tax Tax credit Balance of tax due (rebateable) Dividend after all taxes Irwin/McGraw Hill Tax Exempt 0% 100 36 64 100 0 64 Investor Tax Rates Super Fund Hypothetical High Rate 15% 36% 47% 100 100 100 36 36 36 64 64 64 100 100 100 15 36 47 36 36 36 (21) 11 85 64 53 Overseas 25% 100 36 64 64 16 0* 16 48 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 33 16- 34 Dividends under Imputation The evidence is that one dollar of fully franked dividends is valued at more than one dollar This implies firms should try and pay dividends sufficient to exhaust their imputation credits Weighed against this must be the instability in dividends that might result and consequent adverse signalling effects Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 34 ... Ltd PPT t/a Principles of Corporate Finance by Brealey et al 14 16- 15 Lintner Model v Imputation Managers following the Lintner model are concerned about dividend stability Investors can only... seems that the Lintner model has survived Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 15 16- 16 Dividend Signalling... 85 64 53 Overseas 25% 100 36 64 64 16 0* 16 48 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 33 16- 34 Dividends under Imputation The