Dividends: Payout Ratio, Yield, and Types

Basics of Dividends

• Dividends generally mean a cash dividend, but can sometimes be a stock dividend
• A firm can change the level of dividends at any point, dividends are not fixed
• Dividend restrictions may exist to protect creditors
• Companies often distinguish between regular and special dividends
• Regular dividends are expected dividends that are expected to continue in the future.
• Special dividends are less likely to be consistent
• Several figures commonly measure dividend payout
• Dividend per share (DPS) refers to the dollar amount per share.
• Dividend yield can be calculated by dividing DPS by share price
• The dividend payout ratio can be found by dividing DPS by EPS (earnings per share)

Dividends in Australia

• Dividends are typically paid semi-annually, referred to as interim and final
• Dividend announcements coincide with announcements of profit
• New dividend payment rules now use a "solvency test", implemented in 2010, replaced the traditional "profits test."
• The solvency test specifies that assets must exceed liabilities prior to dividend declaration and the excess must be sufficient for covering dividend payment
• The dividend payment must be reasonable and fair
• The dividend payment doesn't materially prejudice the creditor's ability to pay
• Dividends are mostly paid in cash
• Franked dividends provide tax credits that account for tax paid by the corporation

Dividend Payment Process

• The announcement date is when a firm declares its next dividend and establishes key dates like the record and payment dates
• The cum-dividend date refers to the final date to trade shares to be eligible for dividend payment, usually five days before the record date
• The ex-dividend date is the first date that shares are traded without dividend eligibility
• The record date is when shareholders are formally recorded to receive a dividend
• The payment date is when dividends are distributed

Dividend Drop-Off Ratio

• Drop-off Ratio = (Cum-dividend Price - Ex-dividend Price)/Dividend
• A perfect capital market would have a drop-off ratio equal to one, suggesting full price adjustment.
• The difference between the tax rate on dividends and the tax rate on capital gains determines the relationship between the price change on the ex-dividend day and dividend amount.
• If dividends and capital gains are taxed the same, Price change should equal the dividend
• if dividends are taxed at a higher rate, the price change should be less than the dividend amount
• if dividends are taxed at a lower rate, the Price change should be greater than the dividend

Miller-Modigliani's Dividend Irrelevance Theorem

• The value of a firm is independent of its payout policy in perfect capital markets
• The Theorem assumes no tax differentials exist, companies can freely issue stock, and excess cash is not misused
• The theorem suggests the value of a firm isn't impacted by changing its dividend policies assuming its overall investment policies and cash flows stay consistent
• Paying dividends is considered a zero net present value (NPV) transaction
• The value of a firm before dividends is equivalent to value after paying dividends while adding their value
• Investors can create their own dividend policy, which can be achieved through selling shares or reinvesting, for example

Factors Affecting Dividend Policy

• Modigliani-Miller Theorem presents dividend policy as irrelevant under perfect market assumptions
• Real-world firm behavior suggests dividends are important and deviate from the M-M view
• The factors that contribute to dividend policy may include
  • Resolution of uncertainty
  • Issuance and transaction costs
  • Information asymmetry and signalling
  • Agency costs (Free Cash Flow problem)
  • Taxes

Resolution of Uncertainty

• Investors may prefer cash now as "A bird in the hand is better than two in the bush"
• Investors may see dividend payouts as being less uncertain than that of capital gains
• Dividend-paying firms could have a greater value
• However, investors can resolve uncertainty associated with capital gains by immediately selling shares
• A change in investment policy will be a deciding factor in the change of firm value than paying dividends
• Paying dividends and raising equity to replace those funds will not affect a firms overall risk

Issuance and Transaction Costs

• High dividends may lead to more capital raisings to fund investment plans
• Companies bear transaction costs when raising capital
  • Direct costs such as advice, brokerage and underwriting fees
  • Indirect costs such as restrictive covenants or s/h dilution
• There is a generally an inverse relationship between high costs of capital and decreased dividend levels

Information Asymmetry & Signaling

• Asymmetry exists between external shareholders compared to management
• the market analyzes dividend payouts from management
• Dividends can show good cash flow to the market
• The price for dividend stocks may rise

Agency Costs (Free Cash Flow Problem)

• When managers build empires, excess cash leads to agency issues
  • Managers will be reluctant to give the excess cash to investors, using it to gain influence
    • It has been shown the management team may waste on perks
  • This can be offset through a high dividend payout
    • There will be a need for more raised external money
      • Giving s/h an opportunity to observe
  • Higher payout plans will force management to use money effectively
• Dividends are often discretionary
  • However, in some cases dividend amounts can be sticky so managers commit to keeping up their payouts and may result in a strong outlook

Tax Implications

• the distinction between the tax of dividends versus capital gains

• CGT is paid when the capital gain is actually realised

  • Cheaper
  • Can delay payment

• Classical tax systems usually see lower tax dividend taxes that capital gains

  • Shareholder prefer dividends to dividends
    • Dividends are taxed at the shareholder's rate
    • Dividends are effectively taxed twice

• Under and imputation based taxation

  • Lower due to franking credits

• Therefore it's possible that high dividend payments can happen with classical taxation

Imputation Tax System in Australia

• Classical Tax system in Australia until June 1987
  • Same as the US
    • Double taxation
• Australia now has an imputation tax system from 1987
  • Franking credits can be attached
    • Eliminates double taxation
  • Valid for tax paid and shareholders of resident companies
  • fully franked dividends

Share Buybacks

• Corporations buying own shares.
• Generally able to do this with 10/12 rule where 10% is purchased within 12 months
• It is treated as the reverse of an issuance of equities
• It has been shown the numbers on markets is much higher than off markets
• As of late 2023 changes have been made such that the previous taxation advantage is no longer applicable to off market share

Why Buyback shares

• Flexibility in finances
• To give increased equity
• To give increased dividends
• To improve performance output
• When markets are not good
• For stock options