Week 11 Flashcards
(31 cards)
What is the dividend policy and what is it a subset of?
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.
What two decisions does the dividend decision have a strong relationship with? Why?
There is a strong inter-relationship between the investment, financing, and dividend decision. This is because retained earnings become a component of equity.
Is dividend policy affected by capital market imperfections?
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.
How does a residual dividend policy work?
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.
What is the equation for the dividend in a residual dividend policy?
The dividend will be net income - (target equity ratio)*(total capital budget).
Why can using a residual dividend policy over a long period be problematic? What can be a better idea?
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.
How does a smoothed dividend policy work? What is the payment ratio and dividend amount like over time?
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.
How does a stable dividend policy work? What is the payment ratio and dividend amount like over time?
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.
Which of the three main dividend policies are consistent with Modigliani-Miller’s suggestion on firm investment policy?
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.
How often are dividends typically announced and paid?
Dividends are announced and paid quarterly or twice a year depending on the country.
What is the declaration date with regards to dividends?
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.
What is the ex-dividend date with regards to dividends?
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.
What is the payment date with regards to dividends?
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.
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?
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.
What does Modigliani and Miller’s irrelevence theory suggest about dividend value in a perfect market? Why?
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).
How can shareholders create homemade dividends?
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.
What is the Bird-in-the-hand argument by Lintner and Gordon?
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.
What does the classical tax system cause for dividend income? Does this favour dividend payouts or earnings retention?
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.
What does the Dividend imputation tax system cause for dividend income? Does this favour dividend payouts or earnings retention?
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.
How does the imputation tax system work?
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).
What will occur to the stock price on the ex-dividend date under the imputation tax system vs classical tax systems?
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.
Are taxes the only reason for dividend relevance? What are some relevance reasons??
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.
What are some dividend clientele reasons for dividends?
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.
What is a DRIP? Who are they most popular with?
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.
