Chapter Nineteen

Dividends and Dividend Policy

19-1

Chapter Organisation
19.1
19.2
19.3
19.4
19.5
19.6
19.7

Cash Dividends and Dividend Payment

Does Dividend Policy Matter?
Real-world Factors Favouring a Low Payout
Real-world Factors Favouring a High Payout
A Resolution of Real-world Factors?
Establishing a Dividend Policy
Share Repurchase: An Alternative to Cash
Dividends
19.8 Share Dividends and Share Splits

19-2

Chapter Objectives

Know the different forms of dividends and the appropriate

dividend payment terminology.
Outline the arguments supporting the case for dividend
irrelevance.
Discuss factors favouring a low or a high payout.
Explain the residual dividend policy.
Illustrate the situation of share repurchases vs paying a cash
dividend.
Understand both bonus issues and share splits.
Outline the various employee share ownership plans.

19-3

Types of Dividends
A dividend is a payment made out of a firms

earnings to its owners (shareholders).

Dividends are usually paid in the form of cash.
Types of cash dividends include:

regular cash dividends

extra dividends
special dividends
liquidating dividends.

Share dividends are also paid, and share

repurchases are a dividend alternative.

19-4

Procedure for Dividend Payment

Days
Thursday,
January
15

Wednesday,
January
28

Friday,
January
30

Monday,
February
16

Declaration
date

Ex-dividend
date

Record
date

Payment
date

19-5

Procedure for Dividend Payment

Declaration date: the board of directors declares a payment

of dividends.

Ex-dividend date: if you buy the share on or after this date

the seller is entitled to keep the dividend. Under ASX rules,
shares are traded ex-dividend on and after the seventh
business day before the record date.

Record date: declared dividends are

shareholders of record on a specific date.

distributable

to

Payment date: the dividend

shareholders of record.

are

to

cheques

mailed

19-6

The Ex-date Price Drop

Ex date
-t

. . .

+1

+2 . . . t

Price =$10

Price =$9

The share price will fall by the amount of the dividend on the ex
date (Time 0). If the dividend is $1 per share, the price will be
equal to $10 1 = $9 on the ex date.
Before ex date (Time 1)

Dividend = $0

Price = $10

On ex date (Time 0)

Dividend = $1

Price = $9

19-7

Do Dividends Matter?
Yes: the value of a share is based on the present

value of expected future dividends.

No: the value of a share is not affected by a switch
in dividend policy.

19-8

Does Dividend Policy Matter?

Dividend policy versus cash dividends
n

An illustration of dividend irrelevance

u

Original dividends
0

$1000

$1000

If RE = 20%: P0 = $1000/1.2 + $1000/1.22 = $1527.78

19-9

Does Dividend Policy Matter?

Assume an additional $200 of dividends is offered,
financed by an issue of debt or shares. New dividend
plan:

$1000

$1000

+200

240

$1200

$760

P0 = $1200/1.2 + $760/1.22 = $1 527.78

19-10

Dividend Policy Irrelevance

Any increase in dividends at one point is offset exactly by a

decrease somewhere else.
An alternative explanation is home-made dividends.
Individual investors can undo corporate dividend policy by
reinvesting dividends or selling shares.
Companies may help with creating home-made dividends by
offering shareholders automatic dividend reinvestment plans
(DRIPs).

19-11

Dividends and the Real World

A low payout is better if one considers:
Taxes: Optimal dividend policy is determined by various
shareholder situations. Some shareholders prefer high
franked dividends, others prefer the company to pay no
dividend and retain the funds for reinvestment (tax on
dividend income vs capital gains tax).
Flotation costs: Higher dividend payouts may require a new
share issue, which could be expensive and decrease the
value of the firm.
Dividend restrictions: Debt contracts might limit the
percentage of income that can be paid out as dividends.

19-12

Dividends and the Real World

A high payout is better if one considers:

Desire for current income instead of capital gain.

Uncertainty resolution: bird-in-hand story.

Tax benefits: There are some investors who do receive

favourable tax treatment from holding high dividends (e.g.
corporate investors).

Legal benefits.

19-13

To Date

Based on the home-made dividend argument, dividend policy

is irrelevant.

Because of high taxation of some individual investors, a highdividend policy may be best.

Because of new issue costs, a low-dividend policy is best.

19-14

Dividends and Signals

Changes in dividends convey information

Dividend increases:
Management believes it can be sustained.
Expectation of higher future dividends, increasing
present value.
Signal of a healthy, growing firm.

Dividend decreases:
Management believes it can no longer sustain the
current level of dividends.
Expectation of lower dividends indefinitely; decreasing
present value.
Signal of a firm that is having financial difficulties.

The information content makes it difficult to interpret the

effect of the dividend policy of the firm.
19-15

Clientele Effect
Shares attract particular groups based on dividend

yield and the resulting tax effects.

Some investors prefer low dividend payouts and
will buy shares in those companies that offer low
dividend payouts.
Some investors prefer high dividend payouts and
will buy shares in those companies that offer high
dividend payouts.

19-16

Residual Dividend Policy

Issue costs eliminate any indifference between

financing by internal capital and new shares.

Dividends are paid only if profits are not completely

used for investment purposes.

Desired debt-to-equity ratio is maintained.

19-17

Residual Dividend Policy

Row
1
2
3
4
5
6

(1)
After-tax
earnings
1 000
1 000
1 000
1 000
1 000
1 000

(2)
New
investment
3 000
2 000
1 500
1 000
500
0

(3)
Additional
debt
1 000
667
500
333
167
0

(4)
(5)
(6)
Retained Additional
earnings
shares
Dividends
1 000
1 000
0
1 000
333
0
1 000
0
0
667
0
333
333
0
667
0
0
1 000

19-18

Relationship Between Dividends and

Investment
Dividends

999
666
333
0
-333
0

500

1000

1500

2000

2500

3000

New investment
19-19

Key Concepts in Dividend Policy

Dividend stabilitydividends are only increased if the

increase is sustainable.

Dividend streamingshareholders can choose different

dividend schemes to suit their tax position

Special dividendsone-off extra dividends.

Dividend reinvestment schemescompany reinvests

individuals dividends into fully paid shares of the company.
Avoids transactions costs and need for prospectus, and
shares are usually offered at a discount.

19-20

Share Repurchases
Company buys back its own shares.
Similar to a cash dividend in that it returns cash

from the firm to the shareholders.

This is another argument for dividend policy

irrelevance in the absence of taxes or other

imperfections.

19-21

Share Repurchases

Equal access purchase

Offer made by company to all shareholders to purchase
shares in the same proportion as their holdings.
On-market purchase
Purchase by a company of its own shares on the open
market.
Employee share purchase
Repurchase shares from employees that were issued under
employee incentive scheme.
Selective purchase
Repurchase of shares from specific shareholders.

19-22

Cash Dividend versus Share

Repurchase
Assume no taxes, commissions or other market
imperfections.
Consider a firm with 50 000 shares outstanding, net
profit of $100 000 and the following balance sheet.
Cash
Other Assets
Total

$ 100 000
900 000
$1 000 000

0
1 000 000
$1 000 000

Debt
Equity
Total

19-23

Cash Dividend versus Share

Repurchase (continued)

Price per share is $20 ($1 000 000/50 000).

EPS = $2.00 ($100 000/50 000).

PE ratio = 10.

The firm is considering either:

Paying a $1 per share cash dividend.
OR
Repurchasing 2500 shares at $20 a share.
19-24

Cash Dividend versus Share

Repurchase (continued)
Cash Dividend Option
Cash
Other Assets
Total

50 000
900 000

$ 950 000

0 Debt
950 000 Equity

$ 950 000 Total

Price per share is $19.00 ($950 000/50 000).

EPS = $2.00 ($100 000/50 000).
PE ratio = 10.

19-25

Cash Dividend versus Share

Repurchase (continued)
Share Repurchase Option
Cash
Other Assets
Total

50 000
900 000

$ 950 000

0 Debt
950 000 Equity

$ 950 000 Total

Price per share is $20.00 ($950 000/47 500).

EPS = $2.10 ($100 000/47 500).

PE ratio = 9.5.

19-26

Share Dividends and Share Splits

Bonus shares and share splits:
involve issuing new shares on a pro-rata basis to the current
shareholders

do not change the firms assets, earnings, risk assumed and

investors percentage of ownership in the company

increase the number of shares outstanding

reduce the value per share

A common explanation is to adjust the share price to a more

desirable trading range.

19-27

Reverse Splits

The firm reduces the number of shares outstanding.

Reasoning:
reduction in transaction costs
increase in share marketability (trading range)
regain respectability.

19-28

Share Ownership Plans

Encourage the financial participation of employees in the

company, including:
fully paid shares
partly paid shares
special classes of shares

19-29