Graduate School of Business and Law

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BUSM4160 Managerial Finance

Topic 10: Dividend payouts
Overview

1. Distributions to shareholders

2. Dividends vs. share repurchase

3. Dividend irrelevance theorem

4. Dividends and taxes

5. Dividend policies: Payout or retention?

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1. Distribution to shareholders
Dividend payouts
A dividend is a companys contribution of returns to
shareholders made in proportion to shareholders
ownership.
Cash Dividend
Regular cash dividend cash payment made directly to stockholders
at regular intervals (income)
Extra cash dividend indication that the extra amount may not be
repeated in the future (income)
Special cash dividend similar to extra dividend, but definitely wont
be repeated (income)
Liquidating dividend some or all of the business has been sold
(capital gain)

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1. Distribution to shareholders
Dividend payouts
A dividend is a companys contribution of returns
to shareholders made in proportion to
shareholders ownership.
The dividend question
Does the amount of dividends that a company
pays have an impact on the firm value firm?

Net
Dividend payouts
Income
Retained Earnings

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1. Distribution to shareholders
Payout policy
A firm can retain free cash flow - either investing in new
projects or accumulating it - or pay out to shareholders
through a dividend or share repurchase.

What policy choice is better for shareholders?

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1. Distribution to shareholders
Payout policy example: Capital gain or dividend
Consider a firm that can either pay out dividends of $10,000
per year for each of the next two years or can pay $9000 this
year, reinvest the other $1000 into the firm and then pay
$11,120 next year. Investors require a 12% return.

PV = 10,000 / 1.12 + 10,000 / 1.12 = $16,900.51

or
PV = 9000 / 1.12 + 11,120 / 1.12 = $16,900.51

If the company earns the required return, then it doesnt

matter when it pays the dividends!

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1. Distribution to shareholders
Payout process
The companys board of directors declares the dividend and
decides when the payment will occur:
Declaration date: directors authorize payment of dividend
Ex-dividend date: 3 days prior to record day, cant buy share now
and receive the dividend
Record date: if on record as shareholder, will receive payments
Payment date: date payment is made
Most companies in Australia pay dividends twice a year
usually as an interim and a final dividend.
Occasionally, a firm may pay a one-time, special dividend
that is usually much larger than a regular dividend.
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 1. Distribution to shareholders
Dividend declaration procedures in Australia

Declaration Ex-Dividend Record Payment

Date Date Date Date

October 4 October 10 October 25

For example September 20
(Thurs) (Wed)

The board of
directors
declares the
dividend

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 1. Distribution to shareholders
Dividend declaration procedures in Australia

Declaration Ex-Dividend Record Payment

Date Date Date Date

October 4 October 10 October 25

For example September 20
(Thurs) (Wed)

Beginning of
period when
shares are sold
without the
dividend
entitlement.

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 1. Distribution to shareholders
Dividend declaration procedures in Australia

Declaration Ex-Dividend Record Payment

Date Date Date Date

October 4 October 10 October 25

For example September 20
(Thurs) (Wed)

Date on which
if registered
shareholder
then
dividend
entitlement.

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 1. Distribution to shareholders
Dividend declaration procedures in Australia

Declaration Ex-Dividend Record Payment

Date Date Date Date

October 4 October 10 October 25

For example September 20
(Thurs) (Wed)

Date on which
the dividend
checks are
mailed to
shareholders
of record (or
electronic transfers)

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1. Distribution to shareholders
Price behaviour around the Ex-dividend date
In a perfect world, the stock price will fall by the amount of
the dividend on the ex-dividend date
-t -2 -1 0 +1 +2

$P

$P - div
The price drops by Ex-dividend
the amount of the Date
cash dividend
Taxes complicate things a bit. Empirically, the price
drop is less than the dividend and occurs within the
first few minutes of the ex-date
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1. Distribution to shareholders
Legal requirements
Dividends must be paid out of profits (profits include
previous years and current profits);
Dividends are may not to be paid out of capital (to protect
creditors); Asset/Liability test within Corporations Act (2010)
Cannot be paid if it will make company insolvent;
Preference shareholders get paid first.

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2. Dividends vs. share repurchase
Share repurchases (buybacks)
Here, the firm uses cash to buy its own issued shares.
The shares are then typically cancelled and held in the
corporate treasury; they can be reissued if company needs
to raise equity in the future.

Types of buybacks:
On-market buyback: announces it will buy over the next year
Off-market buyback: shareholders offered to sell according to
tender process
Dutch auction: shareholders nominate price
Selective buyback: only one or some of its shareholders
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2. Dividends vs. share repurchase
Share repurchases: Example
Austral has 2 million shares currently outstanding at $15 per
share. It declares a 50% stock dividend. How many shares
will be outstanding after the dividend is paid?
A 50% stock dividend will increase the number of shares by
50%: 2 million1.5 = 3m. shares
After the stock dividend, what is the new price per share and
what is the new value of the firm?
The value of the firm was $2m $15 per share = $30m. After
the dividend, the value will remain the same
Price per share = $30m/ 3m shares = $10 per share

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2. Dividends vs. share repurchase
Dividends vs. share repurchases
Dividends Share repurchases
How is cash distributed Cash payments made on Shares are bought back
to shareholders per-share basis to all from some shareholders
shareholders
Participation Involuntary (everyone Voluntary (shareholders
with a share receives a decide whether to sell
dividend) back)
Effect on share price Share price drops by the Share price is unaffected
amount of the dividend as long as shares are
repurchased at fair
(market) price

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3. Dividend irrelevance theorem
Miller and Modigliani (1961):
The value of firm is determined by the earning power of the
firm's assets; how the earning stream is split between
dividends and retained earnings is irrelevant.
A firms value will be the same whether it pays a high, low
or no dividend:
In perfect capital markets, holding fixed the investment
! policy of a firm, the firms choice of dividend policy is
irrelevant and does not affect the initial share price.

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3. Dividend irrelevance theorem
By using share repurchases or equity issues a firm can
easily alter its dividend payments.
While dividends do determine share prices, a firms choice
of dividend policy does not.
The value of a firm ultimately derives from its underlying
free cash flow which pays the dividends.
Markets however are not perfect.

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3. Dividend irrelevance theorem
Dividend irrelevance theorem Opposing view

The value of a firm is DEPENDENT of its dividend policy.

IMPERFECT MARKETS

Higher dividends
Increase
share price. Value
of the Dividend
Firm Policy
Lower dividends
Increase
share price.

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3. Dividend irrelevance theorem
Why would a high pay-out add value?

Increase current income

Higher return will drive up price
This will maximise shareholder wealth
Who would like this?
Retirees
Groups prohibited from spending principle (trusts and
endowments)
Taxes
Tax-exempt investors dont have to worry about
differential treatment between dividends and capital
gains (e.g. self-managed superfunds in pension
mode)
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3. Dividend irrelevance theorem
Why would a small pay-out add value?
Taxes
Dividends are taxed immediately but taxes on capital
gains are not taxed until the share is sold and therefore
can be deferred indefinitely.
Individuals in upper income tax brackets might prefer
lower dividend payouts, in favour of higher capital gains
with a deferred tax liability.
Flotation costs
Low payouts means more retained earnings which would
minimise flotation costs.

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4. Dividends and taxes
Taxes are an important market imperfection that influence a
firms decision to pay dividends or repurchase shares.
Shareholders typically must pay:
Taxes on the dividends they receive at their relevant marginal tax
rate; and
Capital gains taxes when they sell their shares

How are dividends and capital gains taxed in the hands of

shareholders in Australia, and what are the implications for
the firm?

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4. Dividends and taxes
Dividend imputation system
Provides a mean by which Australian companies are able to
pass on credits to their shareholder for corporate taxes
already paid by attaching franking credits.
Franking credit: A tax credit that can be used to offset
personal taxes payable on dividend income.
Capital gains tax discount: For shares held for more than
one year (if bought after September 1999)
Allows individual shareholders to reduce their capital gain by
50% (33.3% for Superannuation Funds) if shares were held
longer than 12 months.

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4. Dividends and taxes
Dividend imputation
For example, if an Australian company generates profits for
a shareholder of $100 before company tax, pays $30 tax
and distributes $70 as income the franking credit attached
to the dividend would be $30.
If the tax payable by the shareholder is assessed at $45,
the $30 franking credit is offset against the $45 to reduce
the tax payable to $15.
Without the imputation system, income tax would be
levied twice, when profit is made by the income and !
when income is received by the shareholder (called
double taxation, e.g. USA).

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4. Dividends and taxes: Example

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4. Dividends and taxes
Optimal dividend policy with taxes
When personal tax payable on dividends is less than the
personal tax payable on capital gains, shareholders will pay
lower taxes if a firm uses dividends for all payouts rather
than share purchases.
Under this scenario, the optimal dividend policy is to
structure all payouts as dividends.
The reverse holds when personal taxes payable on
dividends exceed personal taxes payable on capital gains.
Corporations smooth dividends: Dividends are more likely
to rise following a permanent increase in earnings.

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4. Dividends and taxes
Corporations smooth dividends
1. Level of Dividends
Managers tend to think of dividend payout (DPO) in terms
of a proportion of income & also think investors are entitled
to a fair share of corporate income.
Firms think in terms of a long term target DPO
2. Change in Dividends.
Managers avoid making a change in the level of DPO if it
will have to be reversed later.
Thus, the level of dividend is more stable than the level of
earnings. Firms smooth out changes in their dividend
relative to changes in their earnings.

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5. Dividend policies: Payout or retention?

1. Bird-in-Hand Theory
Receiving a dividend now with certainty is better than
expected capital gains in the future without certainty.

Subscribes to the view that high

dividends add to the value of a firm.

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5. Dividend policies: Payout or retention?

2. Residual Dividends Theory

Dividends should be paid only if money is left over
after financing all profitable investments.

Subscribes to the view that low

dividends add to the value of a firm.

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5. Dividend policies: Payout or retention?

3. Clientele Effect Theory

Some investors are attracted to companies that pay
Clienteles for various dividend payout policies
high dividends and some are attracted to companies
are pay
that likely
lowto form in the following way:
dividends.
Group Stock Type

High Tax Bracket Individuals Zero-to-Low payout

Low Tax Bracket Individuals Low-to-Medium payout
Tax-Free Institutions Medium payout
Corporations High payout
Once the clienteles have been satisfied, a corporation is
unlikely to create value by changing its dividend policy. 30
5. Dividend policies: Payout or retention?

3. Clientele Effect Theory

Once the clientele is satisfied, a corporation is unlikely
to create further value by changing its dividend policy.

Subscribes to the view

that the value of a firm is
dependent on its dividend
policy.

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5. Dividend policies: Payout or retention?

4. Signaling Theory
Management that pays a high dividend is in effect
sending a signal to the market that the company is
doing well.

Subscribes to the view that high dividends add to the value of a firm.

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5. Dividend policies: Payout or retention?

5. Agency Cost Theory

Paying dividends reduces agency costs.
Agency costs Keep management honest.

Happy
shareholder

Lots of
External Financing
dividends
puts a company
under the scrutiny
of the ASIC

Subscribes to the view that high dividends add to the value of a firm.

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5. Dividend policies: Payout or retention?

6. Expectations Theory
Management should pay dividends that meet shareholders
expectations, based on historic performance.

Subscribes to the view that the value of a firm is dependent of its

dividend policy.

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5. Dividend policies: Payout or retention?

Summary and conclusions

Optimal payout ratio yet to be determined quantitatively - We
need a Nobel Prize scholar!
In a perfect capital market, dividend policy is irrelevant
A firm should not reject positive NPV projects to pay a
dividend
Personal taxes and issue costs are real-world considerations
of dividend payouts
Many firms appear to have along-run target dividend-payout
policy - dividend stability and smoothing
There appears to be some information content in dividend
payments

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End of Topic 10

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