Corporate Finance: Dividend Policy

• Corporate Financial Decision Making concerns payout policy, focusing on dividends and share buybacks.

Basics of Dividends

• Dividends typically refer to cash dividends, though stock dividends also exist.
• The level of dividends can be changed by the firm at any time.
• Dividend restrictions may exist to protect creditors.
• Companies distinguish between regular dividends, expected to be maintained in the future, and special dividends, which are less likely to be repeated.
• Dividend per share (DPS) measures dividends, representing the dividend dollar amount per share.
• Dividend yield measures DPS divided by share price.
• Dividend payout ratio measure DPS divided by EPS, ie earnings per share.
• Companies are more likely to increase dividends than decrease them.
• Dividends tend to follow earnings.

Dividends in Australia

• Dividends are typically paid semi-annually, as interim and final dividends.
• Dividend announcements coincide with profit announcements.
• In 2010, dividend payment rules replaced the "profits test" with a "solvency test".
• Solvency test measures that assets must exceed liabilities immediately before the dividend declaration, with the excess sufficient for the payment; the payment must be fair and reasonable to shareholders, and must also not prejudice the company's ability to pay creditors.
• Dividends are mostly paid in cash.
• Franked dividends carry credits for tax paid by the company.

Dividends Payment Process

• Announcement Date indicates when the firm announces its next dividend, along with record and payment dates.
• Cum-dividend Date is the last day when shares are traded with the right to receive the dividend, five days before the record date.
• Ex-dividend Date marks the first day when shares are traded without the right to receive the dividend.
• Record Date (Books Close Date) refers to when shareholders are recorded to receive the dividend.
• Payment Date refers to when dividends are paid.
• For NAB in 2013, an interim dividend of $0.93 per share was announced 9 May 2013, up from the $0.90 per share.
• NAB key dates in 2013:
  • Announcement date was 9 May
  • Ex-dividend date was 30 May
  • Record date was 5 June
  • Payment date was 16 July
• At announcement, the share price fell $0.69.
• On the ex-div date the share price fell $0.87.
• On the books close date, the share price fell $0.67.
• On the payment date share price up $0.07.

Dividend Drop-off Ratio

• Dividend drop-off ratio concerns cum-dividend and ex-dividend share prices.
• Drop-off Ratio = (PCUM - PEX)/Dividend.
• In perfect capital markets, the drop-off ratio would be equal to one.
• The actual price drop might be closer to some measure of the after-tax value of the dividend for the average investor.
• In a market stable for the average investor, selling before and after ex-dividend date creates indifference. Thus (PCUM - PEX) / Div. = (1-td) / (1-tcg), where td and tcg are personal tax rates on dividends and capital gains.
• Key Relationships:
  • If dividends and capital gains taxed equally, Price change = Dividend.
  • If dividends are taxed at a higher rate than capital gains, Price change < Dividend.
  • If dividends are taxed at a lower rate than capital gains, Price change > Dividend.
• In 1966-1969:
  • Ordinary tax rate = 70%
  • Capital gains rate = 28%
  • Price chg / Dividend = 0.78
• In 1981-1985:
  • Ordinary tax rate = 50%
  • Capital gains rate = 20%
  • Price chg / Dividend = 0.85
  • In 1986-1990:
    • Ordinary tax rate = 28%
    • Capital gains rate = 28%
    • Price chg / Dividend = 0.90

Miller-Modigliani's Dividend Irrelevance Theorem

• In perfect capital markets, the value of a firm is independent of its payout policy.
• Underlying assumptions:
  • No tax differences for investors occur between dividends and capital gains.
  • If companies pay too much in cash, they can issue new stock to replace the cash, with no flotation costs or signaling consequences.
  • If companies pay too little in dividends, they do not use the excess cash for bad projects or acquisitions.
• Implications involve, if a firm's investment policies don't change, the value of the firm cannot change as it changes dividends;
  • paying dividends is a zero NPV transaction, so that the value of the firm before paying dividends must equal the value of the firm after paying dividends plus the value of the dividends; and

Factors Affecting Dividend Policy

• Factors include Modigliani-Miller Theorem (Benchmark), as the dividend policy is irrelevant and there is no effect on firm value under perfect market assumptions.
• Missing elements entail the Resolution of uncertainty, issuance and transaction costs, information asymmetry and signaling, agency costs (Free Cash Flow problem), and taxes.
• Resolution of uncertainty concerns investor preference, with "a bird in the hand is better than two in the bush"; they see dividends as less uncertain than capital gains, hence they consider dividend paying firms of greater value.
• Investors can resolve uncertainty associated with capital gains by selling shares immediately.
• With only investment policy able to change firm value, investors see paying dividends and raising equity to replace funds not changing the firm's riskiness.
• Issuance and Transaction Costs involve the implication of high dividends needing more frequent capital raisings to fund investment plans, and that the companies will incur transaction costs in raising capital.
• Direct costs involve preparation, legal advice, brokerage and underwriting fees.
• Indirect costs involve value of dilution in ownership if new shares issued or restrictive covenants enforced on existing debtholders.
• Thus, the higher the costs linked with raising capital, the lower the expected level of dividends.
• Information asymmetry exists between management and shareholders, and the market is constantly seeking signals from management.

Tax Implications

• Distinction between dividend income and capital gain taxation is key.
• Since capital gain tax (CGT) is paid when capital gain is realized, investors can delay tax payment, which is "cheaper" due to reduced time value of money.
• Under the classical tax system, CGT is commonly less than tax on dividends, so investors prefer capital gains to dividends.
• Dividends are paid from after-tax profits and taxable at the personal tax rate.
• Under an imputation system, the effective tax rate on dividends can be much lower due to franking credits.
• An imputation tax system favours the payment of high dividends compared with a classical tax system.
• Since July 1987, Australia uses an imputation tax system.
• This allows companies to attach franking credits to dividends paid.
• The shareholders get tax credits that undo the corporate tax already paid on the dividends (i.e., reducing double taxation).

Share Buybacks

• Corporations purchase their own shares from shareholders, seen as opposite to equity issues.
• Legal requirements are associated with buybacks, but generally companies can repurchase up to 10 per cent of their ordinary shares in a 12-month period (10/12 rule).
• On-market buybacks repurchase through normal stock trading, and whole buyback price is seen as capital proceeds.
• As of late 2023, tax law changes in Australia mean there is no tax advantage with off-market buybacks, ie share schemes or selective buybacks.
• More firms are buying back stock, rather than dividends.
• Firms perform buybacks to improve performance measures, signalling and undervaluation, financial flexibility, and employee share options.
• With buybacks, earnings is divided by number of shares i.e. the less shares the higher the earnings.
• A share repurchase stock market response seems similar to a dividend payment for similar cash amounts involved.
• Unlike dividends, stock call option holders prefer a share repurchase to a dividend payout as share repurchases shares do not depreciate like ex-dividend price drop-offs.

Dividends vs. Stock Repurchases

• Dividends are paid by firms with higher permanent operating cash flows.
• Repurchases are used by firms with higher temporary, non-operating cash flows.
• Firms repurchasing shares also have much more volatile cash flows and distributions.
• Firms repurchase stock following poor stock market performance and increase dividends following good performance.
• Australian data suggests that managers favour off-market buybacks to distribute franking credits; buybacks are larger (relative to on-market buybacks), and firms generate more cash flows.
• On-market buybacks are more likely to be used when the firm is undervalued.