Week 11

Question 1

What is the dividend policy and what is it a subset of?

Answer 1

Dividend policy is a sub-set of the wider issue of financing decision-making. It is the nature of the return provided to shareholders by a firm. It details how much of a company’s earnings are to be paid to shareholders as dividends and how much is to be retained within the firm for investment or other purposes.

Question 2

What two decisions does the dividend decision have a strong relationship with? Why?

Answer 2

There is a strong inter-relationship between the investment, financing, and dividend decision. This is because retained earnings become a component of equity.

Question 3

Is dividend policy affected by capital market imperfections?

Answer 3

In a perfect capital market, dividend policy has no impact on shareholders’ wealth and is, therefore, irrelevant. However by introducing capital market imperfections, either: the dividend policy does not matter, or it does matter, and a high dividend pay-out is preferred, or a low dividend pay-out is preferred.

Question 4

How does a residual dividend policy work?

Answer 4

With the residual dividend policy we treat dividends as a final decision, after the investment decisions have been made. The focus is on the firm determining its capital budget and financing this in line with its target capital structure. They then payout any profit that cannot be invested well. There will be no dividends if investment needs exceed the level of earnings, and large dividends if the firm has few desirable investments. The annual dividends will fluctuate based on earnings levels and investment needs.

Question 5

What is the equation for the dividend in a residual dividend policy?

Answer 5

The dividend will be net income - (target equity ratio)*(total capital budget).

Question 6

Why can using a residual dividend policy over a long period be problematic? What can be a better idea?

Answer 6

Applying a residual dividend policy over a long time period will result in a fluctuating dividend stream and inconsistent dividend signals, as such it may be better to estimate the long-term earnings and investment needs, and determine a target payout based on these requirements.

Question 7

How does a smoothed dividend policy work? What is the payment ratio and dividend amount like over time?

Answer 7

A smoothed (target payout) dividend policy involves a target proportion of annual profits being consistently paid out to shareholders as dividends, where the dividends are the long-run difference between expected profits and expeted investment needs. It is a constant payout ratio, though the dividend payment amount may vary. Leading to a still fluctuating dividend amount based on annual earnings.

Question 8

How does a stable dividend policy work? What is the payment ratio and dividend amount like over time?

Answer 8

The stable dividend policy pays out a constant, potentially increasing, dollar dividend amount each year, with dividend increases based on expected long-term earnings. Firms will actively avoid lowering dividend payments. This leads to a constant and increasing dividend payment amount over time, but a fluctuating payment ratio.

Question 9

Which of the three main dividend policies are consistent with Modigliani-Miller’s suggestion on firm investment policy?

Answer 9

Modigliani-Miller suggest that a firm’s investment policy is set ahead of time and is not impacted by firm changes, a firm should invest in all positive NPV projects to maximise value. Therefore firms should not give up a positive NPV project to increase, or initiate, a dividend payment. This is consistent with a residual or smoothed policy platform, but not a stable policy.

Question 10

How often are dividends typically announced and paid?

Answer 10

Dividends are announced and paid quarterly or twice a year depending on the country.

Question 11

What is the declaration date with regards to dividends?

Answer 11

The declaration date is the announcement date of the planned dividend payment, this will specify the amount of the dividend, the holder-of-record date and the dividend payment date. The holder-of-record date is the date that the company closes its share register, and an investor must be a registered shareholder on this date.

Question 12

What is the ex-dividend date with regards to dividends?

Answer 12

The ex-dividend date is the four business (or trading) days prior to the holder-of-record date and is the date when the right to receive the dividend leaves the share (the time depends on the country). An investor must be the shareholder at the close of trading on the day before the ex-dividend date to be entitled to receive the dividend.

Question 13

What is the payment date with regards to dividends?

Answer 13

The payment date is the date that the dividend amount is actually paid to shareholders, and can be one to two months after the dividend declaration date.

Question 14

What will occur in a perfect world on the ex-dividend date to stock price? What about in the real world and particularly in NZ and AU?

Answer 14

In a perfect world the stock price will fall by the amount of the dividend on the ex-dividend date. However, taxes complicate this (as an individual must pay taxes on the dividend), and empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date. With the NZ and AU dividend imputation system, the share price will actually fall by more than the dividend amount due to the value of franking credits.

Question 15

What does Modigliani and Miller’s irrelevence theory suggest about dividend value in a perfect market? Why?

Answer 15

Modigliani and Miller’s irrelevance theory suggests that dividend policy has no effect on firm value in a perfect market because shareholders face no personal or capital gains tax, and can instantaneously and costlessly buy or sell shares. How earnings are split should not affect overall shareholder wealth as return on equity requirement is the same.

For each dollar received in dividends shareholders give up future dividends with a present value of $1.00 (capital gains), which decreases the value of their shares by $1.00. The gain in terms of dividend income is hence exactly offset by the loss in capital gains (represented by the PV of future dividends).

Question 16

How can shareholders create homemade dividends?

Answer 16

Homemade dividends: if dividends are lower than desired, shareholders can sell shares to obtain the desired cash, if dividends are higher than desired shareholders can use the funds to buy additional shares, hence shareholders can do and undo anything they want in terms of capital gains and dividends.

Question 17

What is the Bird-in-the-hand argument by Lintner and Gordon?

Answer 17

The Bird-in-the-hand argument by Lintner and Gordon posits that most shareholders are risk averse, and dividends are perceived as less risky than uncertain future capital gains, they would rather have dividends now than receive them as capital gains later, hence investors should prefer a higher current dividend payout to decrease uncertainty. This theory is flawed in reality, as it contrasts between the risk of future dividends and future capital gains, both are dependent on firm business risk.

Question 18

What does the classical tax system cause for dividend income? Does this favour dividend payouts or earnings retention?

Answer 18

The classical tax system causes double taxation of dividend income at both the company and personal level, this causes the effective tax on earnings retention to be lower than the tax on dividend income. This leads to a preference for earnings retention.

Question 19

What does the Dividend imputation tax system cause for dividend income? Does this favour dividend payouts or earnings retention?

Answer 19

The dividend imputation tax system replaces double taxation of dividends with double taxation of retained earnings, companies have an earnings distribution choice of either earnings retention, or payment of franked dividends(tax credit attached) or unfranked dividends. In this case the preference will deprend on stockholders marginal personal tax rate and shareholder status, resident investors tend to prefer franked dividends.

Question 20

How does the imputation tax system work?

Answer 20

The imputation tax system works by: a company pays tax on domestic-sourced income at the corporate tax rate, a dividend is then paid from the after-tax net income to stockholders. They receive an imputation credit for the amount of corporate tax paid. Hence the dividend income is the dividend + the franking credit (dividendcorporate tax rate)/(1-corporate tax rate). The tax payable for a resident will be dividendpersonal tax rate/(1-corporate tax rate). The after tax individual income = (dividend/(1- corporate tax rate))*(1-personal tax rate + corporate tax rate).

Question 21

What will occur to the stock price on the ex-dividend date under the imputation tax system vs classical tax systems?

Answer 21

Under the imputation system the stock value should go down by the dividend plus the associated tax credit ((dividend*corporate tax rate)/(1-corporate tax rate))on the ex-dividend date. In a classical tax system it should only fall by the dividend amount.

Question 22

Are taxes the only reason for dividend relevance? What are some relevance reasons??

Answer 22

Company dividend payout ratios suggest that taxes are not the only reason for dividend relevance. For example, there is a positive relationship between dividend change and share-price change, an increase in dividend payment increases share price, as the higher dividend is a sign of future profits and dividends. Other reasons may be current income preferences (self-funded retirees may want or need regular current income), dividend stability (shareholders typically prefer less uncertainty, willing to pay for stability), and agency costs( dividends reduce incentives for self-serving managerial actions by removing surplus cash flow.
Relevance reasons include: share issue costs for firm, such as a firm paying dividend meaning they need to issue new shares to fund investments, leading to significant flotation costs, this gives a firm incentive for earnigns retention. Another reason is transaction costs for investors, the costs associated with buying or selling shares, with a low payout investors may need to sell shares, with a high payout investors may need to reinvest, both of which cause brokerage costs.

Question 23

What are some dividend clientele reasons for dividends?

Answer 23

Dividend clientele: Shareholders have different tax and/or income preferences, shareholders will invest in firms with a suitable dividend policy for them, this choice may influence firm value, the benefit of switching by shareholders is offset by the transaction costs, meaning firms adopt a dividend payout policy for which there is excess demand, this is known as the ‘clientele effect’ of dividend policy.

Question 24

What is a DRIP? Who are they most popular with?

Answer 24

Dividend reinvestment plans (DRIPs) allow shareholders to reinvest cash dividends back into additional shares of the firm, often at a discount to the effective purchase price of new shares, this is a brokerage-free means for investors to buy additional shares, they are attractive to investors who do not need regular income and to firms that have ongoing capital budget funding requirements.

Question 25

What are stock dividends? Who are they popular for?

Answer 25

Stock dividends are an alternative to normal cash dividends, they involve paying dividends by issuing new shares. They are equivalent to shareholders reinvesting dividends through a DRIP, and are attractive to firms who are short of cash flows, or who would like to reinvest their earnings into investment opportunities.

Question 26

What occurs to stock price following a stock dividend or DRIP?

Answer 26

In a stock dividend the number of shares outstanding increases by no cash changes, so the stock price goes down. A DRIP also loses value as a result of paying out cash, however choosing to reinvest this cash will not change the stock price further.

Question 27

What is the motivation for a stock split? What is the effect on stock price afterwards?

Answer 27

The typical motivation for a stock split is to keep the share price in a range that is attractive to small investors, this will make the stock more attractive to small investors, which increases the demand for and liquidity of the stock, which may in turn increase the stock price. On average, announcements of stock splits are associated with a very small increase in stock price. Typically firms attempt to keep their share prices below $100.

Question 28

What is dividend policy choice mainly influenced by?

Answer 28

Profitability, earnings certainty or consistency, investment funding requirements, capital structure constraints and capital issue costs, national and/or state taxation policy, the source of earnings, or domicile where earnings are taxed (ability to pay franked dividends in imputation tax system), Characteristics or major shareholders, and the availability of dividend alternatives, such as dividend reinvestment plans or share repurchases.

Question 29

What is a share buy-back? What normally happens to the stock price upon announcement?

Answer 29

A share buy-buck involves a company making an offer to buy their shares at a fixed or market price, these shares are removed from the issued capital of the company and retired, this could be financed from retained earnings or debt, and will influence the ownership structure of the firm, the capital structure, EPS and possibly the share price. The announcement of a share repurchase normally has a positive impact on company share prices.

Question 30

What are the potential ways to perform a share buyback?

Answer 30

Share buy-backs could be on-market, buying back shares via a broker on the open market, equal access repurchase, the firm making an offer to buy the same proportion of shares from each shareholder, selective (off-market) repurchase, in which a block of shares are acquired from specified shareholders in off-market transactions at a specified or negotiated price, an employee share repurchase, in which shares are repurchased from employees that were issued under an employee incentive scheme, or a minimum holding (odd lot) repurchase, which is a repurchase of small parcel of shares that are difficult to sell on-market.

Question 31

What are the main reasons for performing a share buy-back?

Answer 31

Share repurchases are useful for several reasons:

• Dividend substitution (a share repurchase can be a way to pay an additional dividend, potentially when dividend payments are limited as a result of earnings or tax).
• Shareholder preferences for dividends vs capital gains.
• Improved performance measures(immediate increase in EPS, a signal of improved performance, also an increase in effective debt to equity ratio, which may have a positive signaling effect).
• Financial flexibility (Repurchases preserve financial flexibility, whereas dividends represent an ongoing commitment to future payments, dividends signal a permanent increase in earnings, repurchase represents a temporary increase).
• Removal of particular shareholds
• Free cash flow (for firms with no positive NPV investments, it is better to return cash to investors than waste on bad investments or perquisites.
• Information asymmetry and signalling (Share buybacks can signal undervalued shares)
• Executive compensation (may be used by firms distributing options as part of their executive compensation, as dividends will lower share and option values).