Corporate Finance 5QQMN533

Workshop 4

Dividends Payout Policy

Dr. Mingzhu Wang

1
 Supplementary Reading
• BMAE (14th edition) Chapter 15 Payout Policy
• BMA (13th edition) Chapter 16 Payout Policy

2
 Learning Objectives
• How dividends are paid?
• Various Dates related to Dividend Payment

• Dividend policy practices

• Dividend types

• Dividend alternative – share repurchase

3
 Uses of Free Cash flow
A firm’s payout policy is the way it chooses between the
alternative ways to distribute free cash flow to equity holders.

4
 Dividends
• Unless a dividend is declared by the board of directors of a
corporation, it is not a liability of the corporation.
• A corporation cannot default on an undeclared dividend.

• The payment of dividends by the corporation is not a business

expense and hence are not tax-deductible.

• Dividends received by individual shareholders are, for the most

part, considered ordinary income by the tax authority and are
fully taxable. But there is an intra-corporate dividend exclusion.
5
 Various Dates related to Dividend Payment
• Declaration Date – Board declares the dividend. Such dividend
becomes a liability of the firm
• Ex-dividend Date (Ex-date)
• Occurs one business day prior to record date
• If stock bought on or after this date, investor will not receive
the upcoming dividend
• Stock price generally drops by approximately the amount of
the dividend
• Record Date – Holders of record are identified, and they will
receive the dividend payment
• Payable Date – money is transferred or checks are mailed 6
 Sample Dividend Dates for Walmart (WMT)
For example, Walmart (WMT) paid $0.53 per share dividend on
January 2, 2020.

The payment went to shareholders who had purchased Walmart

stock prior to the ex date of December 5, 2019.

The company had previously declared the dividend on February 19,

2019, and the record date was set as December 6, 2019.

Only shareholders who had purchased Walmart stock prior to the ex-
date were entitled to the cash payment.
7
The Ex Date Price Drop for a stock priced at $10
paying $1 cash dividend

8
 Does Dividend Policy Matter?
• Dividends matter – the value of the stock is based on the
present value of expected future dividends

• Dividend policy may not matter (Miller and Modigiliani,

1961)
• Dividend policy is the strategy a company follows with
regard to the amount and timing of dividend payments.
• Dividend policy is the decision to pay dividends versus
retaining funds to reinvest in the firm
• If the firm reinvests capital now, it will grow and pay
higher dividends in the future
9
 Illustration of Irrelevance
• Consider a firm that can either pay out dividends of £10,000 per
year for each of the next two years, or can pay £9,000 this year,
reinvest the other £1,000 into the firm, and then pay £11,120
next year. Investors require a 12% return.
• Market Value with constant dividend = £16,900.51
• Market Value with reinvestment = £16,900.51

• If the company will earn the required return, then when it pays
the dividends is not so relevant

10
 Theories on investor preference for dividends

• As shown previously, the Miller-Modigliani theorem (MM)

argues that given perfect capital markets dividend policy is
irrelevant.

• “Bird in hand” theory contends that investors value cash

dividends today more than uncertain capital gains in the
future.

• Dividend clientele theory argues that in countries in which

dividends are taxed at higher rates than capital gains, taxable
investors should prefer that companies reinvest earnings in
profitable growth opportunities or repurchase shares so they
receive more of the return in the form of capital gains. 11
 Dividend Clientele Effects

• Some investors prefer low dividend payouts, and will buy

stock in those companies that offer low dividend payouts.

• Some investors prefer high dividend payouts, and will buy

stock in those companies that offer high dividend payouts.

• Catering theory of Baker and Wurgler (2004) predicts that

companies adapt their dividend policy over time to changing
investor tastes.

12
 Information Content of Dividends
• Stock prices generally rise with unexpected increases in dividends and fall
with unexpected decreases in dividends.

• Changes in the dividend send a signal about management’s view

concerning future prospects.

• Information asymmetry exists between shareholders and managers.

Investors may refuse to believe reported earnings unless backed up by
appropriate dividends. Therefore dividends can signal “true” value of
firms.

• Firms could cheat in the short run by paying high dividends. However not
worthwhile in the long run because of costly consequences. 13
 Restrictions on dividend levels
• Companies are not free to pay whatever dividend they
choose

• Restrictions may be imposed by lenders

• Excessive dividend payments would not leave enough to

pay the company’s debts

• Dividends can only be paid out of realised profits 14

 Measures of dividend policy
Many businesses express their dividend policy in terms of one of
the following ratios:
• Dividend coverage ratio = Earnings / Dividends
• The higher this ratio, the lower the risk that dividends will be affected by
poor performance
• Dividend payout ratio = Dividends / Earnings
• The lower this ratio, the lower the risk that dividends will be affected by
poor performance
• Dividend yield = Annual Dividends Per Share / Stock Price
• Trailing dividend yield = A dividend yield based on the observed dividend during the
previous 12 months.
• Forward dividend yield = A dividend yield based on the anticipated dividend during
the next 12 months. 15
 Dividend Policy Practices
• Stable Dividend Policy – regular dividends

• Constant dividend payout ratio – a constant percentage of earnings

is paid out in dividends each year

• Constant growth dividend policy – dividends, increased at a

constant rate each year

• Residual dividend policy

• Compromise dividend policy

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 Residual Dividend Policy
1. Determine capital budget

2. Identify target capital structure

3. Finance investments with a combination of debt and equity in

accord with the target capital structure
• If additional equity is needed, issue new shares

4. If there are excess earnings, then pay the remainder out in

dividends 17
 Residual Dividend Policy - Example
• Given
• Need £5 million for new investments
• Target capital structure: Debt/Equity = 2/3
• Net Income = £4 million

• Finding dividend
• 40% of £5 million financed with debt (£2m)
• 60% of £5 million financed with equity (£3m)
• NI – equity financing = £4 million - £3 million = £1 million, paid out as
dividends

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 Compromise Dividend Policy
• Goals ranked in order of importance:
• Do not forego positive NPV projects to pay a dividend
• Avoid dividend cuts
• Avoid the need to issue equity
• Maintain a target debt/equity ratio
• Maintain a target dividend payout ratio

• Companies want to accept positive NPV projects while

avoiding negative signals
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 Types of Dividends
• Regular Dividends: paid according to a pre-announced schedule, e.g., semi-
annually;

• Special Dividends: a one-time dividend payment a firm makes, usually larger

than regular dividends;

• Stock Dividend: a dividend paid in new shares of stock rather than cash;

• Stock Split: equivalent to stock dividend except expressed as a ratio;

• Liquidating Dividend: a return of capital to shareholders from a business

operation that is being terminated. It is paid from the liquidation of assets.
20
 Stock Dividends
• Distribute additional shares of stock instead of cash

• Increases the number of outstanding shares

• Small stock dividend

• Usually less than 20-25%
• If you own 100 shares and the company declared a 10%
stock dividend, you would receive an additional 10 shares

• Large stock dividend – usually more than 20-25%

21
 Stock Splits

• Stock splits – equivalent to stock dividend except expressed as

a ratio.
• For example, a 2-for-1 stock split is the same as a 100%
stock dividend.

• Stock price is reduced when the stock splits.

• Common explanation for split is to return price to a “more

desirable trading range.
22
 Stock Repurchases / Buy back
• Company buys back its own shares of stock
• Open market – company buys its own stock in the open market
• Tender offer – company states a purchase price and a desired number of
shares
• Similar to a cash dividend in that it returns cash from the firm to the
stockholders
• Stock repurchase allows investors to decide if they want the current cash
flow and associated tax consequences
• Investors face capital gains taxes instead of ordinary income taxes (lower
rate)
• In the current tax structure, repurchases may be more desirable due to the
options they provide stockholders
• The Taxman recognizes this and will not allow a stock repurchase for the sole
purpose of allowing investors to avoid taxes
23
 Information Content of Stock Repurchases
• Stock repurchase sends a positive signal that management
believes that the current price is low.
• Tender offers send a more positive signal than open market
repurchases because the company is fixing a specific price.
• The stock price often increases when repurchases are
announced.

• But share repurchases could also send a negative signal that

the company has few positive NPV opportunities.
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 Dividends v. Repurchases

• Example: Dividend Payout of KBS Corporation

• The board of the KBS Inc is meeting to decide how to pay out $20
million in excess cash to shareholders. The Ex-date is December 12.

• KBS has no debt, its equity cost of capital equals its unlevered
cost of capital of 12%.

• The firm expects to generate future free cash flows of $48 million
per year.
25
 Dividend Alternative
• With 10 million shares outstanding → KBS can pay a $2 dividend.
• KBS anticipates paying $4.80 per share each year.
• Cum-dividend: when a stock trades before the ex-dividend date,
entitling anyone who buys the stock to the dividend
• ⇒ The cum-dividend price of KBS will be
Pcum = Current dividend + PV(Future dividend)
4.80
= 2+ = 2 + 40 = $42
0.12
⇒ After the ex-dividend date, price of KBS will be
Pex = PV(Future dividend) = 4.80
= $40
0.12
26
Summary: Dividend Alternative

27
 Example: Repurchase Alternative

• Suppose that KBS uses the $20 million to repurchase its shares on
the open market instead.

• With an initial share price of $42, KBS will repurchase $20 million /
$42 per share = 476,000 shares.

• The repurchase leaves 10 million - 0.476 million = 9.524 million

shares outstanding.

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 Summary: Repurchase Alternative
⇒ The net effect is that the share price remains unchanged

29
 Summary: Repurchase Alternative (cont’d.)
• It should not be surprising that the repurchase had no effect on the
stock price.

• After the repurchase, the future dividend would rise to:

$48 million / 9.524 million shares = $5.04 per share.

• KBS’s share price is therefore

Prep = 5.04 = $42
0.12

30
 Payout Practices by nonfinancial firms (2011-2020)

Pay Dividends?
Yes No
Repurchase? Yes 24.1% 23.7%
No 12% 40.1%
Source: Compustat

31
 Case Study 1: Wilkins Chemical Company
• Franklin is the treasurer of Wilkins Chemical Company, a manufacturer
of specialty chemicals used in industrial manufacturing and
increasingly in technology applications. Wilkins Chemical is selling one
of its older divisions for £70 million cash. Franklin is considering
whether to recommend a special dividend of £70 million or
repurchase of 2 million shares of Wilkins common stock in the open
market. He is reviewing some possible effects of the buyback with the
company’s financial analyst.
• Wilkins has a long-term record of gradually increasing earnings and
dividends. Wilkins’s board has also approved capital spending of £15
million to be entirely funded out of this year’s earnings. 32
Book value of equity £750 million (£30 a share)
Shares outstanding 25 million
12- month trading range £25–£35
Current share price £35
After- tax cost of borrowing 7%
Estimated full year earnings £25 million
Last year’s dividends £9 million
Target capital structure (market value) 35% debt, 65% equity

1) What would be the most likely tax environment in which Wilkins Chemical’s
shareholders would prefer that Wilkins repurchase its shares (share buybacks)
instead of paying dividends?
Solution: Shareholders would prefer that the company repurchase its shares instead
of paying dividends when the tax rate on capital gains is lower than the tax rate on
dividends. 33
2) Please explain what kind of signal Wilkins’s share buyback could be?
Solution: Management sometimes undertakes share repurchases
when it views shares as being underpriced in the marketplace.

3) Assume that Wilkins Chemical funds its capital spending entirely out
of its estimated full-year earnings. If Wilkins uses a residual dividend
policy, determine Wilkins’ implied dividend payout ratio.
Solution:
1. Earnings available for dividends = Earnings – Capital spending = £25
million – £15 million = £10 million;
2. Dividend payout ratio: £10 million/£25 million = 40%.
34
4) Assume that Wilkins Chemical would like to maintain the target
capital structure and funds the equity portion of its capital spending
out of its estimated full-year earnings. If Wilkins uses a residual
dividend policy, determine Wilkins’s implied dividend payout ratio.

Solution:
1. Out of the capital spending of £15 million, 65% is funded using
equity. £15 million × 65%= £9.75million.
2. Dividend payout ratio=(£25 million-£9.75million)/£25million= 61%.

35
 Case Study 2: Beta Products

• Alpha is an analyst in the research department of an international

securities firm. Alpha is currently analysing Beta Products, a publicly
traded global consumer goods company located in the U.K. Selected
data for Beta are presented in below Exhibit.
• Exhibit: Selected Financial Data for Beta Products
Most Recent Fiscal Year Current
Pretax income £280 million Shares outstanding 100 million
Net income after tax £182 million Book value per share £25.60
Cash flow from operations £235 million Share price £20.00
Capital expenditures £175 million
Earnings per share £1.82
36
 Case Study 2 (Cont.)
• Beta currently does not pay a dividend, and the company operates
with a target capital structure of 40% debt and 60% equity. However,
on a recent conference call, Beta’s management indicated that they
are considering four payout proposals:
• Proposal #1: Issue a 10% stock dividend.
• Proposal #2: Repurchase £40 million in shares using idle cash.
• Proposal #3: Repurchase £40 million in shares by borrowing £40
million at an after-tax cost of borrowing of 8.50%.
• Proposal #4: Initiate a regular cash dividend based on a residual
dividend policy.

37
1) Would the implementation of Proposal #1 affect the proportionate
ownership of shareholders?

Solution: The implementation of Proposal #1 would generally lead to

shareholders having the same proportionate ownership as before
implementation. The implementation of Proposal #1, a stock dividend,
would not affect a shareholder’s proportionate ownership because all
shareholders would receive the same proportionate increase in shares.
Stock dividends, which are generally not taxable to shareholders, do not
impact an investor’s total cost basis (they merely reduce the cost basis per
share).
38
2) If Beta’s management implemented Proposal #2 at the current share price shown in
Exhibit, what would Beta’s book value per share change after the implementation of
Proposal #2?
Solution: If Beta implemented Proposal #2, a repurchase of £40 million in shares, the
resulting book value per share (BVPS) would be £25.71, calculated as follows:
• Beta has a current BVPS of £25.60; therefore, total book value of equity is £2,560
million (= £25.60 × 100,000,000 shares).
• The number of shares Beta would repurchase is £40 million/£20.00 per share = 2
million shares.
• Beta shareholders’ book value of equity after the buyback would be £2,520 million (=
£2,560 million – £40 million).
• The number of shares after the buyback would be 98 million (= 100 million – 2 million).
• The BVPS after the buyback would be £2,520 million/98 million = £25.71.
39
 More generally

Let’s assume BVPS0 is the book value per share before the share
repurchase, and BVPS1 is the book value per share after the share
repurchase.
If BVPS0 > Share Repurchase Price, BVPS1 > BVPS0, i.e. BVPS increases
after the repurchase;
If BVPS0 = Share Repurchase Price, BVPS1 = BVPS0, i.e. BVPS doesn’t
change after the repurchase. Theoretically, share repurchase has no
impact on share price and BVPS.
If BVPS0 < Share Repurchase Price, BVPS1 < BVPS0, i.e. BVPS decreases
after the repurchase.
40
3) Based on Exhibit, if Beta’s management implemented Proposal #3 at
the current share price, how would earnings per share change?

Solution: In the case of external funding, a company’s earnings per share

will increase if the stock’s earnings yield, which is the ratio of earnings per
share (EPS) to share price, exceeds the after-tax cost of borrowing. Beta’s
earnings yield is 9.10% (= £1.82/£20.00), which exceeds the after-tax cost
of borrowing of 8.50%.
More generally,
If Earning Yield > After-tax cost of borrowing, EPS will increase;
If Earning Yield = After-tax cost of borrowing, EPS will not change;
If Earning Yield < After-tax cost of borrowing, EPS will decrease.
41
4) Based on Exhibit and Beta’s target capital structure, what is the total
dividend that Beta would have paid last year under a residual dividend
policy?

Solution: The dividend under a residual dividend policy would be £77

million, calculated as follows:
• Equity portion: £175 million*60%=£105million.
• £182 million-£105million=£77 million

42
5) Based on Beta’s target capital structure, how would Proposal #4 affect
the default risk of Beta’s debt?
Solution: Beta is financed by both debt and equity; therefore, paying
dividends can increase the agency conflict between shareholders and
bondholders. The payment of dividends reduces the cash cushion
available for the disbursement of fixed required payments to
bondholders. All else equal, dividends increase the default risk of debt.

6) How would the implementation of Proposal #4 signal to Alpha and

other investors with regard to the future earnings growth of Beta?
Solution: Dividend initiations convey positive information and are
associated with future earnings growth, whereas dividend omissions or
reductions convey negative information and are associated with future
earnings problems. 43
 Revision
• A firm’s dividend payout policy is the way it chooses between the
alternative ways to distribute free cash flow to equity holders.
• There are various dates related to dividend payment, including
Declaration, ex-dividend, record and payable date.
• Dividend policy can be measured using dividend coverage ratio, dividend
payout ratio, or dividend yield.
• There are five dividend policy practices: Stable dividend policy, constant
dividend payout ratio; constant growth dividend policy; residual &
compromise dividend policies.
• Types of dividends include regular/special dividend, Stock Split (Stock
Dividend), return of capital and liquidating dividends.
44