FINS5514: Capital Budgeting and
Financing Decisions
Lecture 8: The Dividend Decision
RWJ – Chap 17
Topics Covered Today
_________________________________________________________________________________
• What Dividends Are and How They are Paid
• The Theories Relating Dividends to Firm Value
• Share Repurchases
• Stock Dividends and Stock Splits
• Dividend Imputation
2
Dividends
_________________________________________________________________________________
• A sum of money paid regularly (typically quarterly) by
a company to its shareholders out of its profits (or
reserves)
– Mainly made in cash but stock dividends are
occasionally given.
• The most popular types of dividends are:
– Regular dividends : firm expects to maintain payments in
the future
– Special dividends : one off payment that is highly
unlikely to be repeated
3
Dividends (continued)
_________________________________________________________________________________
• The way that dividends are distributed is carefully laid
out by law.
• In Australia, one day between ex divided and record
date
1 working
days later
Declaration
date
Ex-dividend
date
Record
date
Payment
date
Dividend
goes with
shares
4
Dividends (continued)
_________________________________________________________________________________
• Declaration date
– The dividend is announced
• Ex-dividend date
– Stocks purchased before this date (with/cum dividend), get the
next dividend.
– Stocks purchased after this date (ex-dividend) do not.
• Record date
– Recorded owners on this date get the next dividend.
– The delay allows firm records to be up-dated after the ex-
dividend date
• Payment date
– Dividends are distributed to the shareholders
5
Dividends (cont)
_________________________________________________________________________________
Price around ex dividend date:
If include taxes, price drops by less than dividend
6
Miller-Modigliani Dividend Irrelevancy Theory
_________________________________________________________________________________
• (M&M, 1961) showed that in absence of frictions:
– Dividend policy has no effect on the value of a
firm’s share prices or the cost of equity.
– Dividend policy is, therefore, irrelevant
7
Miller-Modigliani Dividend Irrelevancy Theory
_________________________________________________________________________________
• Relies on the assumption that perfect capital
markets exist:
– There are no transaction costs or taxes
– Investors have homogeneous expectations
– Investors are rational and price takers
– Investors know the decisions managers have taken
regarding current and future production and
investment
– All firms belong to the same risk class and do not
grow
8
Miller-Modigliani Dividend Irrelevancy Theory
_________________________________________________________________________________
• Shareholders do not need the firm to issue dividends as
they can achieve the same effect “at home”
– If an investor requires cash, they can sell some of their
shares.
– This has the same effect as receiving a dividend, so
dividends are irrelevant
9
MM Dividend Irrelevancy, An Example
_____________________________________________________________________
• A company is valued at $1 million and has 1
million shares outstanding.
– The shares are trading at $1 each
• The firm’s income exactly covers its needs for
investment so any dividend will be paid for with
an issue of new shares.
• The firm wants to issue a dividend of $0.20
10
MM Dividend Irrelevancy, An Example
_____________________________________________________________________________________
• The impact on the firm and the share price
will be:
Firm Share Price
Current Value 1,000,000 1.00
Dividend payments 200,000 0.20
@ 0.2 per share
Remaining 800,000 0.80
Amount from new issue 200,000
Value after issue 1,000,000
11
MM Dividend Irrelevancy, An Example
___________________________________________________________________
• The new shares will be issued at $0.80 each (the
value of the shares after paying the “old”
shareholders).
• To raise $200,000 it is necessary to issue
250,000 new shares at $0.8 each
• After the issue, there will be 1,250,000 shares
and the firm is worth $1m so the price will be
$0.8 per share
12
MM Dividend Irrelevancy, An Example
_________________________________________________________________________________
• Now consider a shareholder with 100 shares in this firm.
• What happens to the wealth of this shareholder under
the MM theory?
• There are two options to consider
– The firm pays the dividend,
– The firm does not pay and the shareholder creates the
same effect for themselves
13
MM Dividend Irrelevancy, An Example
___________________________________________________________________
• If the firm pays the dividend, the effect is:
Value of investment at beginning 100
Cash dividend @ $0.2 per share 20
(funded through the issue of new stock)
Residual value of investment 80
(taking into account the issue of new shares)
Composition of investment:
100 shares @ 0.8 and $20 cash
Shareholder total wealth at end: $100
14
MM Dividend Irrelevancy, An Example
___________________________________________________________________
• Alternatively, the shareholder can achieve
the same effect without the dividend:
Value of investment at beginning 100
Sell 20 shares at $1 each share 20
Residual value of investment 80
Composition of investment:
80 shares at $1 each and 20 cash
Shareholder total wealth at end $100
15
MM Dividend Irrelevancy, An Example
___________________________________________________________________
• Thus, according to M&M, dividends are
irrelevant
• Investors will not pay more for a share that
pays high dividends than a share that pays
low dividends
– Therefore, dividend policy cannot influence the
share price or the cost of equity of the firm.
16
MM Dividend Irrelevancy (continued)
_____________________________________________________________________________
• The assumptions underlying M&M are not
realistic.
• Relaxing these assumptions leads to the
alternative theories for dividend policy.
– homogenous expectations
– taxes
17
The Bird-in-the-Hand Theory
_________________________________________________________________________________
• Contrary to the assumption in M&M, investors are not
homogenous and have different preferences.
• Some investors are risk averse
– This means that they would prefer to have a certain
dividend now rather than wait for potential capital gains in
the future.
– This is the Bird-in-the-Hand theory
“a bird in the hand is worth two in
the bush”
18
The Bird-in-the-Hand Theory (continued)
_________________________________________________________________________________
• Implies that investors value companies that pay high
dividends more than companies that pay low dividends.
– Therefore, dividend policy is positively related to share
price.
• Also suggested that the cost of capital will decrease as
dividends increase.
– Investors are more confident of receiving dividends than
capital gains therefore the cost of equity (cost of capital)
goes down
19
The Tax Preference Theory
_________________________________________________________________________________
• Another assumption in M&M is that there are no taxes.
– Again, this is unrealistic
• Tax rates will influence shareholders preferences for
dividends compared to capital gains.
20
The Tax Preference Theory (cont)
_________________________________________________________________________________
• Two ways that tax can influence investors preferences:
– Dividends are taxed as income. Income tax is usually
higher than capital gains tax.
– Capital gains tax can be deferred if the shareholder does
not sell their shares.
• Suggests that shareholders would prefer capital gains to
dividends
21
The Tax Preference Theory (cont)
_________________________________________________________________________________
• Thus investors value companies that pay low dividends
and invest for future capital gains more than companies
that pay high dividends.
– Therefore, dividend policy is negatively related to share
price.
• This implies that shareholders will want higher capital
gains to make up for their greater exposure to income
tax.
– Thus the cost of equity will increase
22
Other Aspects of Dividend Policy
_________________________________________________________________________________
• Two other important aspects of dividend policy
– The informational content of dividends and the signaling
hypothesis
– The clientele effect of dividends
23
The Signaling Hypothesis for Dividends
_________________________________________________________________________________
• M&M assumed that all investors have the same
information about the firm as the managers:
– This is unrealistic
• Differences in how much information individual
investors have about their company
• Asymmetric information between investors and
managers allows the managers to use the company’s
dividend policy to signal information
24
The Signaling Hypothesis for Dividends (cont)
_________________________________________________________________________________
• Dividends can be used to signal information about the
future prospects of the firm.
– Managers like to keep dividends stable
– Will not increase dividends if they are not confident of
maintaining that payout ratio.
– Therefore, increasing dividends can be a signal that the
managers are confident about the future prospects of the
firm.
25
The Clientele Effect
_________________________________________________________________________________
• Dividends have a “clientele effect”
• People invest in companies whose dividend policy
matches their preferences.
– Past dividend policy will influence the kinds of people who
own shares in the company now.
– Thus current investors are people who have decided that
the firm matches their preferences.
– Can make it difficult for the firm to change its dividend
policy.
26
Dividend Stability
_________________________________________________________________________________
• Investors prefer firms that do not make too many
changes in their dividends over time.
• If the firm keeps increasing dividends, then is seen as a
positive signal.
– However, can result in problems funding investments or
maintaining future dividends.
• If the firm cuts dividends, is often perceived as a
negative signal even if the firm uses the money to invest
in other projects
27
Dividend Stability (continued)
_________________________________________________________________________________
• The solution is for the firm to try to balance the
shareholders desires and its needs for money for
investment.
• Keeping dividends stable is very important.
– The firm needs to consider its growth rate for the future
and the stability of its earnings when deciding on the
dividend payout.
28
Share Repurchases
_________________________________________________________________________________
• An alternative to cash dividends
• Firm buys back its own shares
• This can be done in three ways
1. Buying on the market (on market)
2. A tender offer to the shareholders
3. Private negotiation (Greenmail)
29
Share Repurchases, An Example
_________________________________________________________________________________
• Consider the following firm:
Earnings for distribution $1,000,000
Number of shares 400,000
Earnings per share $2.50
Market price per share (P) $50.00
Market value of firm $20,000,000
P/E ratio (P/EPS) 20
• This firm wants to distribute $800,000 to its shareholders as
either a share repurchase or a cash dividend
30
Share Repurchases, An Example
_________________________________________________________________________________
• Share repurchase:
• The firm decides to pay $50 per share in the repurchase
– The firm can afford to buy _16000____ shares
– That will leave __384000_________ shares outstanding
• After the repurchase:
– share price = (pre MV-cash for repurchase)/number of
shares outstanding after repurchase
=_____$50___________________________
31
Share Repurchases, An Example
_________________________________________________________________________________
• How does this compare to paying a dividend?
– If the firm paid the same amount ($800,000) out as a cash
dividend, it would be ___$2___ per share
– Price per share after dividend : __$48__________
– In terms of the shareholder total wealth, there is no
difference between a share repurchase and a dividend.
• Only difference is how the money is paid to the shareholder:
– With the cash dividend, the shareholder receives _$2_ per
share + hold share worth _$48__= __$50___
– With the repurchase, either sell share for _$50___or hold
share worth __$50___ after repurchase
32
Share Repurchases (cont.)
_________________________________________________________________________________
• Three main reasons for share repurchases:
1. The firm has excess cash
₋ distribute cash to shareholders by repurchasing stock
instead of paying dividends
2. The capital structure has too much equity
₋ raises debt finance and uses that money to repurchase
shares
₋ alters the capital structure to a more preferable
arrangement
33
Share Repurchases (cont.)
_________________________________________________________________________________
3. Firm has given employees stock options which
dramatically increase the number of shares
when the options are exercised.
₋ Firm repurchases stock from the market to maintain a
reasonable share price.
34
Advantages to Share Repurchases
_________________________________________________________________________________
• Investors see repurchases as a positive signal implying
that shares are undervalued.
– However, there is no negative signal if a firm does not
repurchase shares.
• Shareholders have more choice.
– If they need cash, they sell some shares. If not, they
retain their stock.
– With cash dividends, there is no choice and income tax
must be paid
35
Advantages to Share Repurchases
_________________________________________________________________________________
• Managers are reluctant to increase dividends in case
they cannot sustain the new level in future.
– If the firm has excess cash, a repurchase is a good way to
distribute it without altering dividends
• Companies decide on a target cash distribution level
and split that amount into dividend and repurchase
portions.
– Firm keeps dividends low and stable but it has flexibility to
respond if earnings change.
36
Disadvantages to Share Repurchases
_________________________________________________________________________________
• Shareholders may have preferences between dividends
and capital gains.
– Dividends are dependable but future share prices are
uncertain.
• Firm must avoid paying too high a price for the shares
or they will disadvantage shareholders who retain their
shares.
– Could depress the price too far and the remaining owners
lose out.
37
Stock Dividends
_________________________________________________________________________________
• An issue of dividends made in the form of additional
shares rather than as a cash payment.
– This does not affect the proportion of the total shares that
each shareholder owns.
38
Stock Dividends, An example
_________________________________________________________________________________
• A shareholder has 200 shares in a firm.
• The company issues a 5% stock dividend
– This means that the shareholder gets an extra _10__
shares for free
– The proportion of the firm that the shareholder owns is
the same after the dividend as it was before.
• Issuing a stock dividend will reduce the share price, the
earnings per share and the dividends per share.
• Usually issued to constrain the firms share price
– Any increase in the dividend each year is matched to any
increase in the firm’s earnings over the same time period.
39
Stock Splits
_________________________________________________________________________________
• A stock split occurs when a firm increases the number
of shares it has outstanding
– This is done by multiplying the shares by some number.
– For example, in a 3 for 1 stock split, each outstanding share
becomes 3 shares.
• Often used to reduce the share price if the managers
believe the stock price is too high.
40
Stock Splits (continued)
_________________________________________________________________________________
• When a stock split occurs, the share price and earnings
per share will fall
– The shareholder total wealth, however, is unaffected.
– For example, a shareholder has 10 shares worth $20 each
before a 2 for 1 stock split.
– After the split, each share is worth $10__ but the
shareholder now has _20__ shares.
41
• Reverse Stock Splits
– proportional to the investor’s current holdings
– 1: 5 five reverse split, each investor swaps five old shares
for one new one
– reducing the number of shares
– Transaction costs may reduce
– Share liquidity may improve
– Share price increases may improve the firm’s image
42
Impact of Share Dividends and Stock Splits on
the Share Price
_________________________________________________________________________________
• Both activities increase the number of shares, so it is no
surprise that the share price falls.
• However when the split / stock dividend is announced,
the share price (on average) rises.
– Splits and stock dividends are thought to signal future
increases in earnings and managerial confidence in the
performance of the company
– But if the firm does not announce high earnings within a
short time period, the price will fall again.
43
Impact of Share Dividends and Stock Splits on
Share Liquidity
_________________________________________________________________________________
• Stock splits and dividends can decrease the liquidity of
the shares:
– Lower priced stocks are harder to sell and have higher
transaction costs, in percentage terms, than high priced
shares
• could make it harder for the shareholder to sell their stock
– Conversely, more shares makes things easier and can
reduce transaction costs
44
Dividends in Australia
_________________________________________________________________________________
• There are two tax systems used in the world today
– The classical taxation system
– The imputation system
• The tax system can have a big impact on dividends and
shareholder preferences
45
The Classical Taxation System, An Example
_________________________________________________________________________________
• Dividends are effectively taxed twice
– Corporate tax and then personal income tax
• Consider the following firm:
Firm operating income $1000
Corporation tax @ 40% $ 400
After-tax income (dividends) $ 600
Income tax @ 47% $ 282
Cash received by shareholders $ 318
46
The Imputation System
_________________________________________________________________________________
• The dividend imputation system was introduced in
Australia in 1987.
• The imputation system works by:
– The company generates income which is taxed at the
company tax rate.
– The amount that remains after the corporate tax has been
paid is then distributed to the shareholders as dividends.
47
The Imputation System (cont)
_________________________________________________________________________________
• These dividends are known as fully-franked dividends as
the tax has been paid in full.
– A dividend on which the tax has not been paid is an
unfranked dividend
• The shareholders are informed about their franking
credits with their dividends.
– Franking credits off-set the shareholders income tax
liability.
48
The Imputation System, An Example
_________________________________________________________________________________
• Consider an individual who pays income tax at 15%
Operating income $1000
Corp tax @ 40% $ 400
After-tax income $ 600
Grossed-up Div $1000
Income tax $ 150
Tax credit $ 400
Tax due from shareholder -$ 250
Cash to shareholder $ 850
The calculation of
corporate tax is
the same as under
the classical
system
The shareholder
receives the total
(or grossed-up)
dividend
49
The Imputation System, An Example
_________________________________________________________________________________
Operating income $1000
Corp tax @ 40% $ 400
After-tax income $ 600
Grossed-up Div $1000
Income tax $ 150
Tax credit $ 400
Tax due from shareholder -$ 250
Cash to shareholder $ 850
This income is
taxed at the
individual’s income
tax rate, here it is
15%
The shareholder
has a tax credit to
the value of the
tax paid by the
firm 50
The Imputation System, An Example
_________________________________________________________________________________
Operating income $1000
Corp tax @ 40% $ 400
After-tax income $ 600
Grossed-up Div $1000
Income tax $ 150
Tax credit $ 400
Tax due from shareholder -$ 250
Cash to shareholder $ 850
This leaves the
balance of the tax
either owing to the
government or, as
in this case, owed
to the shareholder
The shareholder’s
cash is calculated
using the taxes paid
and the tax credit
51
The Imputation System
_________________________________________________________________________________
• Depending on the shareholders personal tax rate, the
amount of tax owing (or owed) will be different and the
amount received by the shareholder will also differ
• For example:
52
The Imputation System, An Example
_____________________________________________________________________________
Income tax rate 15% 30% 47%
Operating income 1000 1000 1000
Corporate tax @ 40% 400 400 400
After tax income 600 600 600
Grossed up Dividend 1000 1000 1000
Income tax 150 300 470
Tax credit 400 400 400
Tax due from shareholder -250 -100 70
S’holder cash received 850 700 530
53