Dividend Policy: Foundations of Finance - Pearson

Topic 5 Dividend Policy Chapter 13 Dividend Policy and Internal Financing Copyright © 2020 Pearson Education Ltd. All Rights Reserved Learning Objectives 13.1 Describe the trade-off between paying dividends and retaining (reinvesting) firm profits. 13.2...

Topic 5 Dividend Policy Chapter 13 Dividend Policy and Internal Financing Copyright © 2020 Pearson Education Ltd. All Rights Reserved Learning Objectives 13.1 Describe the trade-off between paying dividends and retaining (reinvesting) firm profits. 13.2 Explain how dividend policy affects a company’s stock price: The three views 13.3 Discuss the constraints on dividend policy, commonly used dividend policies, and payment procedures. 13.4 Describe why firms sometimes pay noncash dividends. 13.5 Distinguish between the use of cash dividends and share repurchases. Copyright © 2020 Pearson Education Ltd. All Rights Reserved How Do Firms Distribute Firm Profits to Their Stockholders? Copyright © 2020 Pearson Education Ltd. All Rights Reserved Dividends Dividends are distribution from the firm’s assets to the shareholders. Firms are not obligated to pay dividends or maintain a consistent policy with regard to dividends. Dividends could be paid in cash or stocks. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Dividend Policy A firm’s dividend policy includes two components: – Dividend payout ratio  Indicates amount of dividend paid relative to the company’s earnings.  Example: If dividend per share is $1 and earnings per share is $4, the payout ratio is 25 percent (1/4). – Stability of dividends over time Problem 13-1, 13-2 Copyright © 2020 Pearson Education Ltd. All Rights Reserved  Warren Buffett ‘Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, ‘Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI.’ And that’s it – no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.’ Excerpt from Warren Buffet letter to shareholders (1984) Required: What is Mr. Buffet suggesting?___________________. Copyright © 2020 Pearson Education Ltd. All Rights Reserved  Introduction Investment decisions and dividend decisions are by their very nature interlinked financing decisions for companies. Once the decision to invest has been made, the question of how to finance it immediately come into play. Once the decision to give a dividend has been made, the question of how to finance it immediately come into play. Both decisions are effectively drawing upon the companies same financing resources. That is why contemporary discussions about “shareholder power” and “Corporate short-termism” leading to high rates of dividends are linked with claims of chronic business under-investment. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Dividend Policy Trade-Offs If management has decided how much to invest and has chosen the debt-equity mix, the decision to pay a large dividend means retaining less of the firm’s profits. This means the firm will have to rely more on external equity financing. Similarly, a smaller dividend payment will lead to less reliance on external financing. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Dividend-versus-Retention Trade-Offs Copyright © 2020 Pearson Education Ltd. All Rights Reserved Uses of Free Cash Flow Copyright © 2020 Pearson Education Ltd. All Rights Reserved  FT.com: Linking Dividend Policy to Investment Policy and Business Strategy FT.com: AA shares tumble nearly 30% after dividend cut Shares in the AA fell almost 30 per cent after the breakdown cover provider slashed its dividend and warned of lower profits as it embarks on a technology drive. The company laid out a three-year plan to increase its use of vehicle-monitoring systems to spot breakdowns pre-emptively, and expand its insurance business. It will spend an extra £45m this year in both operational and capital spending, as well as another £54m over the next two years, specifically developing new services. As a result, the dividend has been cut from 9p to 2p, and it has cut full-year profit forecasts for next year to £335m-£345m, compared with expectations of £390m-£395m for the year until April.Simon Breakwell, chief executive, acknowledged that the investment would cut short-term profits but said it was “vital to our long-term success”. Question: Analysts at Morgan Stanley said the plan was “necessary, but not without pain and risk”. 1. What is the link between the The group aims to get more customers to install telematics technology, which monitors the car’s cut in the dividend and the engine and other systems. This will enable the detection of a problem before it happens, allowing a motorist to fix it and avoid calling out an AA van. It is trialling the systems in 5,000 vehicles, but company's investment? hopes to roll them out eventually to as many customers as possible. Mr Breakwell said the technology had the potential to “profoundly change” the way the group operates, although the AA is expecting no additional revenues or profits from the service in the short term. It will also launch 65 more roadside vans, on top of the 2,100 already in service, in order to cut its reliance on third-party 2. If AA didn’t invest now, what garages for call-outs that it cannot attend, as well as expanding its insurance business. may be the future effects on The dividend will remain at 2p “until such time as the board are satisfied that profit and free cash flow enable a change in dividend policy”. future value creation? Further Reading: Campbell, P. (2018) AA shares tumble nearly 30% after dividend cut, Financial Times, 21st Feburary 2018 Copyright © 2020 Pearson Education Ltd. All Rights Reserved  Dividend Considerations Basic questions in determining a corporate Dividend Policy. If there are no attractive investments, we have no great ideas, perhaps should we just increase the dividend and give the money to the shareholders instead? If we do have great investments or ideas, and finance is difficult to obtain or expensive, perhaps we should lower the dividend to use internally generated monies instead? Copyright © 2020 Pearson Education Ltd. All Rights Reserved Does Dividend Policy Matter to Stockholders? Copyright © 2020 Pearson Education Ltd. All Rights Reserved Dividend Policy & Shareholder Wealth Dividend Policy should aim to Maximise Shareholders Wealth. o A dividend payment would only do so if: P1  D P0 Where: P0 = Previous Share Price (before dividend payout) P1 = New Share Price (after dividend payout) For Example New Share price 120 + Dividend of 5 > 122 Previous Share price  The dividend payment is maximizing shareholder’s wealth Copyright © 2020 Pearson Education Ltd. All Rights Reserved Three Views There are three basic views with regard to the impact of dividend policy on share prices: – Dividend policy is irrelevant - Modigliani & Miller (M&M). – High dividends will increase share prices. – Low dividends will increase share prices. Copyright © 2020 Pearson Education Ltd. All Rights Reserved View 1 (Dividend Irrelevance) Dividend policy is irrelevant (Modigliani & Miller). – Irrelevance implies shareholder wealth is not affected by dividend policy (whether the firm pays 0 percent or 100 percent of its earnings as dividends). – This view is based mainly on two assumptions: (a) Perfect capital markets (b) Firm’s investment and borrowing decisions have been made and will not be altered by dividend payment. Copyright © 2020 Pearson Education Ltd. All Rights Reserved  Modigliani & Miller’s dividend irrelevance proposition Dividend policy is irrelevant to share value. Assumptions for model: – There are no taxes. – There are no transaction costs. – All investors can borrow and lend at the same interest rate. – All investors have free access to all relevant information. – Investors are indifferent between dividends and capital gains. Any money paid out as dividends could quickly be replaced by having a new issue of shares. ‘Homemade dividends’ can be created by the shareholder selling part of their shares. Copyright © 2020 Pearson Education Ltd. All Rights Reserved  Modigliani & Miller Dividend Irrelevance proposition The critical point is that in this hypothetical, perfect world the pattern of dividend makes no difference to shareholders’ wealth.  Shareholders’ wealth is determined purely by the investment returns. M & M argued that a rational investor is actually indifferent to Capital Gains and Dividends A rational investor would want to maximise the Market Value of the company through investment policy.  Which involves Investing in +NPV projects to Increase the +NPV cash flows  Which increases Share Price  Which increases Shareholder Wealth Copyright © 2020 Pearson Education Ltd. All Rights Reserved View 2 High dividends increase stock value. – This position is based on “bird-in-the-hand dividend theory,” which argues that investors may prefer “dividend today” because it is less risky compared to “uncertain future capital gains.” – This implies a higher required rate for discounting a dollar of capital gain than a dollar of dividends. Copyright © 2020 Pearson Education Ltd. All Rights Reserved View 3 Low dividends increase stock values. – Tax rates on capital gains and dividends range from 0 percent to 20 percent, depending on recipient’s income and tax bracket. – However, current dividends are taxed immediately, while the tax on capital gains can be deferred until the stock is actually sold.  Thus, using present value of money, capital gains have definite financial advantage for shareholders. – Thus stocks that allow tax deferral (i.e., low dividends and high capital gains) will possibly sell at a premium relative to stocks that require current taxation (i.e., high dividends and low capital gains). Copyright © 2020 Pearson Education Ltd. All Rights Reserved Some Other Explanations Which dividend policy is right? Although no single definitive answer has yet been found that is acceptable to all, the following plausible explanations have been developed: a) The Residual Dividend Theory b) Clientele Effect c) The Information Effect d) Agency Costs e) The Expectations Theory Copyright © 2020 Pearson Education Ltd. All Rights Reserved a) Residual Dividend Theory Determine the optimal capital budget. Determine the amount of equity needed for financing. – First, use retained earnings to supply this equity. – If retained earnings still available, distribute the residual as dividends. Dividend policy will be influenced by (a) investment opportunities or capital budgeting needs, and (b) availability of internally generated capital. Copyright © 2020 Pearson Education Ltd. All Rights Reserved b) The Clientele Effect Different groups of investors have varying preferences toward dividends. For example, – some investors may prefer a fixed income stream so would prefer firms with high dividends, while – some investors, such as wealthy investors, would prefer to defer taxes and will be drawn to firms that have low dividend payout and large capital gains.  Thus, there will be a clientele effect. Firms attract a given clientele, depending on their started dividend policy. Copyright © 2020 Pearson Education Ltd. All Rights Reserved C) The Information Effect Evidence shows that a large, unexpected change in dividends can have a significant impact on the stock prices. A firm’s dividend policy may be seen as a signal about firm’s financial condition. Thus, high dividend could signal expectations of high earnings in the future and vice versa.  This information effect will have a positive effect on share price. Copyright © 2020 Pearson Education Ltd. All Rights Reserved d) Agency Costs Conflicts often exist between stockholders and a firm’s management. The stock price of a company owned by investors who are separate from management may be less than the stock price of a closely held firm. – This potential difference in price is called Agency Cost. Dividend policy may be perceived as a tool to minimize agency costs. – Dividend payment may require managers to issue stock to finance new investments, and – New investors will be attracted only if they are convinced that the capital will be used profitably. – Thus, payment of dividends indirectly monitors management’s investment activities, and  helps reduce agency costs, and  may enhance the value of the firm. Copyright © 2020 Pearson Education Ltd. All Rights Reserved e) The Expectations Theory Expectation theory suggests that the market reaction does not only reflect response to the firms actions, – It also indicates investors’ expectations about the ultimate decision to be made by management. Thus, if the amount of dividend paid is equal to the dividend expected by shareholders, the market price of stock will remain unchanged. However, market will react if dividend payment is not consistent with shareholders expectations. – Thus, deviation from expectations is more important than actual dividend payment. Copyright © 2020 Pearson Education Ltd. All Rights Reserved  THE DIVIDEND DECISION Copyright © 2020 Pearson Education Ltd. All Rights Reserved Forces promoting a high pay-out some clienteles; owner control (agency theory); uncertainty (‘bird-in-the-hand’); signalling. THE DIVIDEND DECISION Copyright © 2020 Pearson Education Ltd. All Rights Reserved  Forces promoting a low pay-out tax systems; some clienteles; Forces promoting a high pay-out high growth potential of the firm; some clienteles; instability of underlying earnings; owner control (agency theory); management desire to avoid the uncertainty (‘bird-in-the-hand’); risk of a future dividend cut; signalling. liquidity. THE DIVIDEND DECISION Copyright © 2020 Pearson Education Ltd. All Rights Reserved  Forces promoting a low pay-out tax systems; some clienteles; Forces promoting a high pay-out high growth potential of the firm; some clienteles; instability of underlying earnings; owner control (agency theory); management desire to avoid the uncertainty (‘bird-in-the-hand’); risk of a future dividend cut; signalling. liquidity. THE DIVIDEND DECISION Forces promoting stable dividend clientele preferences; signalling; owner control (agency theory); management desire to avoid the risk of a future dividend cut; stability raises credit standing for debt issues. Copyright © 2020 Pearson Education Ltd. All Rights Reserved  Forces promoting a low pay-out tax systems; some clienteles; Forces promoting a high pay-out high growth potential of the firm; some clienteles; instability of underlying earnings; owner control (agency theory); management desire to avoid the uncertainty (‘bird-in-the-hand’); risk of a future dividend cut; signalling. liquidity. THE DIVIDEND DECISION Force promoting a fluctuating Forces promoting stable dividend dividend clientele preferences; dividend as a residual: signalling; positive NPV project owner control (agency theory); availability takes precedence. management desire to avoid the risk of a future dividend cut; stability raises credit standing for debt issues. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Conclusions on Dividend Policy (1 of 2) What are we to conclude? Some conclusions about the relevance of dividend policy: 1. As a firm’s investment opportunities increase, its dividend payout ratio should decrease.  Because of flotation costs, internally generated equity financing is preferable to selling stock (in terms of the wealth of the current common shareholders.) 2. Investors use the dividend payment as a source of information of expected earnings.  The dividend may carry greater weight than a statement by management that earnings will be increasing or decreasing. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Conclusions on Dividend Policy (2 of 2) 3. Relationship between stock prices and dividends may exist due to implications of dividends for taxes and agency costs. - (Desire to minimize or defer taxes and to minimize agency costs). 4. Based on expectations theory, firms should avoid surprising investors with regard to dividend policy. 5. The firm’s dividend policy should effectively be treated as a long-term residual. - Dividends should be paid if internal funds remain after the firm has undertaken all acceptable investments. - If, over the long term, the entire amount of internally generated capital is needed for reinvestment in the company, then no dividend should be paid. Copyright © 2020 Pearson Education Ltd. All Rights Reserved The Dividend Decision in Practice Copyright © 2020 Pearson Education Ltd. All Rights Reserved Practical Constraints of Dividend (1 of 2) 1. Legal Restrictions – Statutory restrictions may prevent a company from paying dividends. – The Companies Act specifies that companies must pay dividends only out of realised profits. This can include realised profits the company has made so far. 2. Regulatory & Governmental − In regulated industries regulatory requirements may impact on the companies ability to pay Dividends; or in certain industries such as Water and Power the regulator may require specific levels of re-investment in infrastructure etc. 3. Contractual/Obligation based − Dividend restrictions are often a contractual clause in debt covenants written into bonds or other forms of debt. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Practical Constraints of Dividend (2 of 2) 4. Liquidity Constraints – A firm may show a large amount of retained earnings, but it must have cash to pay dividends. 5. Earnings Predictability – A firms with stable and predictable earnings is more likely to pay larger dividends. 6. Maintaining Ownership Control – Ownership of common stock gives voting rights. – If existing stockholders are unable to participate in a new offering, control of current stockholders is diluted and issuing new stock will be considered unattractive. – Hence, the amount of dividend payment will be limited. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Practical Constraints: Unexpected Events Business Case: BP Post-Gulf of Mexico Oil Spill Dividend Policy change BP will take a much more conservative approach to its future dividend policy when it reinstates its pay-out to investors, its new chief executive indicated in an interview with the Financial Times, as the UK oil group tries to recover from the Gulf of Mexico spill. Bob Dudley said that in the past BP had paid a very high dividend "which took a lot of the free cash flow of the company [and] which probably constrained some of its ability to continue to invest". "So, in many ways, the ability to reset the dividend gives us a different view of strategy than we had before, it frees us up," he added. The comments are the clearest signal yet that Mr Dudley intends to take a different approach to his predecessors on dividends. Under both Tony Hayward, Mr Dudley's immediate predecessor, and Lord Browne, BP became one of the biggest payers of dividends in the UK. The company paid out about $10bn in dividends last year. BP suspended its dividend payments for this year in June as part of a series of steps to stabilise its financial position in the wake of mounting costs from the oil spill on April 20. On Tuesday the company reaffirmed its intention to review future dividends next February. Financial Times, November 3rd , 2010, “BP to take conservative approach to dividend in wake of spill costs” Copyright © 2020 Pearson Education Ltd. All Rights Reserved Alternative Dividend Policies (1 of 2) 1. Constant dividend payout ratio – The percentage of earnings paid out in dividends is held constant. – Because €5.6 earnings million are not constant, the dollar amount of dividend will vary every year. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Alternative Dividend Policies (2 of 2) 2. Stable dollar dividend per share – This policy maintains a relatively constant dollar of dividend every year. – Management will increase the dollar amount only if they are convinced that such increase can be maintained. 3. A small regular dividend plus a year-end extra – The company follows the policy of paying a small, regular dividend plus a year-end extra dividend in prosperous years. Problem 13-7, 13-9 Copyright © 2020 Pearson Education Ltd. All Rights Reserved Important Dates Declaration date – The date when the dividend is formally declared by the board of directors (for example, February 6) Date of record – Investors shown to own stocks on this date receive the dividend (February 16) Ex-dividend date – Two working days prior to date of record (for example, February 15). Shareholders buying stock on or after ex-dividend date will not receive dividends. Payment date – The date when dividend checks are mailed (for example, March 9) Copyright © 2020 Pearson Education Ltd. All Rights Reserved Stock Dividends and Stock Splits Copyright © 2020 Pearson Education Ltd. All Rights Reserved Stock Dividends A stock dividend entails the distribution of additional shares of stock in lieu of cash payment. While the number of common stock outstanding increases, the firm’s investments and future earnings prospects do not change. Problem 13-12 Copyright © 2020 Pearson Education Ltd. All Rights Reserved Stock Splits A stock split involves exchanging more (or less in the case of “reverse” split) shares of stock for firm’s outstanding shares. Although the number of common stock outstanding increases (or decreases in the case of reverse split), the firm’s investments and future earnings prospects do not change. Stock splits and stock dividends are far less frequent than cash dividends. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Stock Repurchases Copyright © 2020 Pearson Education Ltd. All Rights Reserved Stock Repurchases (Stock Buyback) A stock repurchase (stock buyback) occurs when a firm repurchases its own stock. This results in a reduction in the number of shares outstanding. From shareholder’s perspective, a stock repurchase has potential tax advantage as opposed to cash dividends. Note that stock repurchase will increase the stock price (i.e future capital gain) Capital gain is taxed later, when the stock is sold, whereas dividend is taxed immediately. Therefore, the tax deferral advantage of stock repurchase occurs. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Stock Repurchase—Benefits A means of providing an internal investment opportunity An approach for modifying the firm’s capital structure A favorable impact on earnings per share The elimination of a minority ownership group of stockholders The minimization of the dilution in earnings per share associated with mergers The reduction in the firm’s costs associated with servicing small stockholders Copyright © 2020 Pearson Education Ltd. All Rights Reserved Investor’s Preference: Dividend or Stock Repurchases If there are no taxes, no commission when trading stocks, and no information content assigned to a dividend, the investor should be indifferent. Copyright © 2020 Pearson Education Ltd. All Rights Reserved Dividend Policy vs Share Repurchase (Buyback) Key Studies support a “substitutability hypothesis” of dividends and share buybacks − In other words, CEO’s are effectively substituting share buybacks for dividends as a form of corporate payout policy. Why? For the avoidance of immediate taxation effects. Students sometimes get confused at the difference of Share Repurchase and Dividends. − Both are methods of returning value to shareholders − Both are cash outflows from the business − Both are part of an overall “Corporate pay-out strategy” − Major differences are tax implications & possible % ownership implications Copyright © 2020 Pearson Education Ltd. All Rights Reserved A Share Repurchase as a Dividend, Financing, Investment Decision When a firm repurchases stock when it has excess cash, it can be regarded as a dividend decision. If a firm issues debt and then repurchases stock, it alters the debt-equity mix and thus can be regarded as a financing or capital structure decision. If a firm repurchases stock because it feels the prices are depressed, the decision to repurchase may be seen as an investment decision. Of course, no company can survive or prosper by investing only in its own stock! Copyright © 2020 Pearson Education Ltd. All Rights Reserved Stock Repurchase Procedure Open Market – Shares are acquired from a stockbroker at the current market price. Tender Offer – An offer is made by the company to buy a specified number of shares at a predetermined price, set above the current market price. Purchase – Is made from one or more major stockholders Copyright © 2020 Pearson Education Ltd. All Rights Reserved Key Terms Agency costs Bird-in-the-hand dividend theory Clientele effect Constant dividend payout ratio Date of record Declaration date Dividend payout ratio Ex-dividend date Expectations theory Information asymmetry Payment date Perfect capital markets Residual dividend theory Small, regular dividend plus a year-end extra Stable dollar dividend per share Stock dividend Stock repurchase (stock buyback) Stock split Tender offer Copyright © 2020 Pearson Education Ltd. All Rights Reserved  FINAL EXAM REVIEW QUESTIONS Study Problems Ch 13 13-1 13-15 13-2 13-16 13-4 13-7 13-9 Copyright © 2020 Pearson Education Ltd. All Rights Reserved