Dividend Policy - L Flashcards
(16 cards)
2
Introduction
What happens once a company decides to invest? (2)
What happens once a company decides to give a dividend? (3)
What happens once a company decides to invest?
- The question of how to finance the investment immediately arises.
- Investment decisions and dividend decisions are inherently linked as financing decisions.
What happens once a company decides to give a dividend?
- The question of how to finance the dividend immediately arises.
- Both investment and dividend decisions draw upon the same financial resources.
- Discussions on “shareholder power” and “corporate short-termism,” which lead to high dividend rates, are connected to claims of chronic business under-investment.
Payment of Dividends
How often do UK companies usually pay dividends?
What is an Interim Dividend? (2)
What is a Final Dividend? (2)
How does the Final Dividend compare to the Interim Dividend?
Are international stock exchanges the same as the UK in terms of dividend payments?
Can extraordinary dividends be declared?
How often do UK companies usually pay dividends?
- Twice a year
What is an Interim Dividend?
- Paid during the year
- After publication of interim results
What is a Final Dividend?
- Paid after shareholder approval at AGM
- After year-end
How does the Final Dividend compare to the Interim Dividend?
- Final dividend is usually larger than the interim dividend as companies know their final results
Are international stock exchanges the same as the UK in terms of dividend payments?
- International stock exchanges may have different dividend practices
Can extraordinary dividends be declared?
- Yes, often after restructuring or asset disposals
Practical Constraints
Constraints usually fall into one of four categories: (2,2,1,2)
Legal
- The Companies Act specifies that companies must pay dividends only out of realised profits.
- This can include realised profits the company has made in previous years as well however.
Regulatory & Governmental
- In regulated industries regulatory requirements may impact on the companies ability to pay payments or in certain industries such as Water and Power the regulator may require specific levels of re-investment in infrastructure etc.
- Regulated industries can sometimes also be targeted with “windfall taxes” or “supplementary taxes” on declared profits, further restricting capacity for potential dividends in that year.
Contractual/Obligation based
- Dividend restrictions are often a contractual clause in debt covenants written into bonds or other forms of debt.
Liquidity
- You must have enough cash!
- Dividends are a cash outflow from the company, and therefore the company must either raise the cash from internal free cash flows or from taking on debt.
Dividend Policy vs Share Repurchase (Buyback)
What do key studies by Grullon & Michaely (2002), Brav et al. (2005) and others support?
What are CEOs effectively substituting share buybacks for?
Why do CEOs substitute share buybacks for dividends?
Why do students sometimes get confused about the difference between Share Repurchase and Dividends? (3)
What are the major differences between Share Repurchase and Dividends? (2)
What do key studies by Grullon & Michaely (2002), Brav et al. (2005) and others support?
- A “substitutability hypothesis” of dividends and share buybacks.
What are CEOs effectively substituting share buybacks for?
- Dividends as a form of corporate payout policy.
Why do CEOs substitute share buybacks for dividends?
- To avoid immediate taxation effects.
Why do students sometimes get confused about the difference between Share Repurchase and Dividends?
- Both return value to shareholders.
- Both are cash outflows from the business.
- Both are part of an overall “corporate pay-out strategy.”
What are the major differences between Share Repurchase and Dividends?
- Tax implications.
- Possible % ownership implications.
Dividend Policy: The Academic Debate
Black and Baker
“The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together.”
Fischer Black (1976, p. 5)
“While not fully solving the dividend puzzle, theoretical and empirical studies over the past four decades have provided additional puzzle pieces that move us closer in the direction of resolution. In reality, there is probably some truth to all of the explanations of why corporations pay dividends or repurchase stock at least for some firms. Although evidence shows that fewer corporations are paying dividends, a firm’s distribution policy still matters because it can affect shareholder wealth.”
Baker et al. (2002, p. 256)
Modigliani & Miller (1961) Dividend Irrelevance
What is their argument? (3)
What does it involve? (3)
- M & M argued that share prices were determined by future earning potential NOT dividends paid now
- Thus, share value is determined by investment policy, not the amount of earnings distributed
For Example
New Share price 117p + Dividend of 5p = 122p Previous Share price
M & M argued that a rational investor is actually indifferent to Capital Gains and dividends and prefer 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
What do Modigliani & Miller argue about the dividend decision? (2)
What do Modigliani & Miller not argue about dividends? (2)
Why are shareholders indifferent according to Modigliani & Miller? (3)
What do Modigliani & Miller argue about the dividend decision?
- It is essentially a financing and investment decision.
- Dividends are residual payments after all +NPV projects are financed.
What do Modigliani & Miller not argue about dividends?
- They do not claim that dividend payments are irrelevant to company valuation.
- They argue that the timing of dividends does not impact valuation.
Why are shareholders indifferent according to Modigliani & Miller?
- If no dividend is paid, but funds are invested in +NPV projects, the share price increases.
- Investors can create their own dividends by selling shares.
- If dividends are paid, shareholders can reinvest by buying more shares.
Modigliani & Miller (1961): Example
Example
Jolly Holidays Ltd is financed entirely by 1m ordinary shares as has net assets which have a NPV of £10m. These net assets include £2m cash which could be invested in a new resort with a net cash inflow worth £4m.
The company has a number of options.
Jolly Holidays Ltd should __________ (______________ ____________ ___________)
But should it pay a _____________?
Jolly Holidays Ltd should invest (Increases shareholder wealth)
But should it pay a dividend?
It could invest AND pay a dividend
Modigliani & Miller (1961): Key Assumptions (3/3,2,1)
- Perfect Capital Markets
- No Transaction costs
- There is a cost to “creating” dividends
- Some people may prefer income to capital gains
- No Issue cost for securities
- Option 3 raises additional finance to replace dividends
- Due there are costs in issuing new shares
- No Tax
- Tax implications exist for dividends and capital gains
Dividend Relevance: “Bird-in-the-hand” Theory
What is the argument (4)
Example
Opinions on the Theory (2)
Argument that dividends are preferable to capital gains because of uncertainty. In basic terms:
- Future gains are uncertain
- Thus, Investors would rather have the money now than leave it tied up in uncertain investments
Therefore, as investors prefer dividends, the dividend policy will influence the MV of the Company.
For example
If the company pays low dividends investors may sell those shares and buy shares in a company which does pay more dividends. Thus, share price would go down for the company which didn’t pay dividends.
Other opinions on the theory
- Baker et al. (2007) & Baker et al. (2008) looked at 291 dividend-paying firms listed on the Toronto Stock Exchange and found some limited support for “Bird-in-the-hand” in that many investors were concerned about riskiness of their future returns if they didn’t receive dividends.
- Dong et al. (2005) examining The Netherlands, and Dhanani (2005) examining the UK (sample size 800 LSE Firms + 200 AIM firms), each found little to support the “Bird-in-the-hand” theory from their large scale surveys.
Dividend Relevance: “Tax Preference Theory” and Clientele Effects
What is the main market imperfection discussed?
What does the tax preference explanation suggest about investor preferences?
Why might investors prefer capital gains over dividends? (2)
What could differences in tax rates result in?
What does the argument posit about investor behavior related to dividend policy changes?
What have academics found difficult to prove? (2)
What does the vast majority of research survey evidence focus on?
What did Graham and Kumar (2006) find in their study?
What is the main market imperfection discussed?
- Taxes represent a major market imperfection.
What does the tax preference explanation suggest about investor preferences?
- Some investors prefer that firms retain cash or engage in share-buybacks instead of paying cash dividends.
Why might investors prefer capital gains over dividends?
- Tax rates on dividends can be different from those on long-term capital gains.
- By having a capital gain rather than a dividend, investors can better structure/plan their tax affairs, such as delaying crystallising a capital gain until the next year when their capital gains allowance is available.
What could differences in tax rates result in?
- Differences in tax rates could result in different tax clienteles regarding dividends.
What does the argument posit about investor behavior related to dividend policy changes?
- Investors will be attracted to companies that best suit their tax needs. If a company changes its existing dividend policy, existing shareholders may sell shares and seek shares that fulfill their requirements, potentially leading to a decrease in share value.
What have academics found difficult to prove?
- Academics have found it difficult to prove the impact of taxation on both stock price and dividend policy.
- Saadi and Dutta (2009, p. 139) conclude that theoretical and empirical evidence provide contradictory results.
What does the vast majority of research survey evidence focus on?
- The vast majority of research survey evidence focuses on large-scale surveys asking companies and managers if tax has played a major role in determining the dividend policy.
What did Graham and Kumar (2006) find in their study?
- Graham and Kumar (2006) looked at 60,000 households and found clear evidence of “dividend preferences varying in a manner consistent with tax characteristics.”
Dividend Relevance: Asymmetric information, Signalling and the Informational Content of Dividends
What is the informational content of dividends? (2)
What is the common perception of high and low dividends?
What is the reality about high and low dividends? (3)
What does research evidence suggest about dividends? (2)
What advice is given to management regarding dividend cuts?
What is the informational content of dividends?
- Investors don’t have access to internal information (Asymmetric information).
- Investors see dividends as giving information on a company’s performance and/or prospects (Signalling).
What is the common perception of high and low dividends?
- High dividends = good news, and low dividends = bad news.
What is the reality about high and low dividends?
- High dividends may indicate a lack of attractive investments, leading to lower future returns.
- Low dividends may indicate many attractive investments, leading to better future prospects.
- The market tends to be short-sighted.
What does research evidence suggest about dividends?
- Strong evidence from numerous large-scale studies supports the idea that capital markets view dividends as informative.
- Baker et al. (2010) provides an excellent summary of signalling research.
What advice is given to management regarding dividend cuts?
- If a company cuts its dividend, it must communicate the reason carefully, or else share price and shareholder wealth could suffer.
Dividend Relevance: Agency Costs
Why might paying out high dividends shortly after issuing shares or bonds be considered inefficient? (3)
What is the agency cost explanation? (3)
Why might increased scrutiny by markets add value? (2)
Why might paying out high dividends shortly after issuing shares or bonds be considered inefficient?
- Shareholders will be taxed on dividends.
- Issuing new shares is costly.
- Raising new debt could have been avoided.
What is the agency cost explanation?
- Shareholders may insist on high payouts to gain control over their money.
- Shareholders aim to avoid managers investing in poor projects or pet projects.
- Managers must raise funds externally and are forced to do so under greater market scrutiny.
Why might increased scrutiny by markets add value?
- It forces managers to justify spending.
- Investors are better able to monitor managers’ investment and operating decisions.
Summary of leading Dividend Relevance Theories (picture)
Forces Influencing Dividend Policy: High, Low, Fluctuating, and Stable Payouts (4/4,6,1,5)
What are the forces promoting a high payout?
- Some clienteles
- Owner control (agency theory)
- Uncertainty (“bird-in-the-hand”)
- Signalling
What are the forces promoting a low payout?
- Tax systems
- Some clienteles
- High growth potential of the firm
- Instability of underlying earnings
- Management desire to avoid the risk of a future dividend cut
- Liquidity
What is the force promoting a fluctuating dividend?
- Dividend as a residual: positive NPV project availability takes precedence
What are the forces promoting a 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
Conclusions: Dividends in Practice
What do company attitudes to dividends suggest?
What does the company tend to avoid? (2)
What does the company aim for?
What does the company not appear to be doing?
What does the text suggest about surplus earnings and investments? (2)
What is highly unlikely according to the text?
What happens at the two extremes? (2)
What do company attitudes to dividends suggest?
- Dividends are relevant, with firm managers placing great importance on their levels.
What does the company tend to avoid?
- A very low dividend, which could lead to a loss of investor confidence.
- A very high dividend, as it may be unsustainable in the long term.
What does the company aim for?
- Stable dividends with steady growth.
What does the company not appear to be doing?
- Simply distributing surplus.
What does the text suggest about surplus earnings and investments?
- The company has roughly the same surplus earnings available each year after retention for attractive investments.
- The company consistently finds a similar level of attractive investments.
What is highly unlikely according to the text?
- Stability means no big surprises for investors.
What happens at the two extremes?
- If profits decline, managers often maintain dividends to signal that the earnings drop is temporary and to support the share price.
- If profits are very high, directors tend to be cautious and avoid declaring an excessively large dividend to ensure sustainability and minimize future uncertainty.
