Corporate Finance: Laurence Booth - W. Sean Cleary Chapter 22 - Dividend Policy

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary Chapter 22 Dividend Policy
Prepared by Ken Hartviksen
CHAPTER 22 Dividend Policy
Lecture Agenda
Learning Objectives Important Terms Mechanics of Dividend Payments Cash Dividend Payments M&Ms Dividend Irrelevance Theorem The Bird in the Hand Argument Dividend Policy in Practice Relaxing the M&M Assumptions Stock Dividends and Stock Splits Share Repurchases Summary and Conclusions
Concept Review Questions
CHAPTER 22 Dividend Policy 22 - 3
Learning Objectives
You should understand the following: The mechanics of dividend payments and why they are different from interest payments The difference between a stock split and a stock dividend Under what assumptions a dividend payment is irrelevant and what a homemade dividend is Why dividend payments generally reflect the business risk of the firm How transactions costs, taxes and information problems give value to corporate dividend policies How stock dividends and stock splits differ How a share repurchase program can substitute for a dividend payout policy.
Important Chapter Terms

Agency theory Bird in the hand argument Cash cow Declaration date Dividend reinvestment plans Dividend yield Equity market capitalization Ex-dividend date Free cash flow Holder of record Homemade dividends Income stripping Odd lots Residual theory of dividends Special dividend Split shares Stock dividend Stock split Tax clienteles
22 - 5
What is Dividend Policy?

Dividend Policy
Dividend Policy
What is It?
Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation.
This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.
22 - 7
Types of Dividends
Dividend Policy
Types of Dividends
Dividends are a permanent distribution of residual earnings/property of the corporation to its owners. Dividends can be in the form of:
Cash Additional Shares of Stock (stock dividend) Property
If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders this is known as a liquidating dividend.
22 - 9
Dividends and Corporate Financing

Dividend Policy
Dividends a Financing Decision

In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm. When a cash dividend is declared, those funds leave the firm permanently and irreversibly. Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.
Retained Earnings Corporate Profits After Tax Dividends
22 - 11
Dividends versus Interest Obligations

Interest Interest is a payment to lenders for the use of their funds for a given period of time Timely payment of the required amount of interest is a legal obligation Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies Secured lenders (bondholders) have the first claim on the firms assets in the case of dissolution or in the case of bankruptcy Dividends A dividend is a discretionary payment made to shareholders The decision to distribute dividends is solely the responsibility of the board of directors Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)
The Mechanics of Dividend Payments

Dividend Policy
Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date Holder of Record Date Ex-dividend Date Payment Date
22 - 14
Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date
this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class. when CARRIED, this resolution makes the dividend a current liability for the firm.
Date of Record
is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend.
Ex dividend Date
is the date that the value of the firms common shares will reflect the dividend payment (ie. fall in value) ex means without. At the start of trading on the ex-dividend date, the share price will normally open for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend.
Date of Payment
is the date the cheques for the dividend are mailed out to the shareholders.
Dividend Declaration Time Line

2 business days prior to the Date of Record
Declaration Date
Date of Record
Date of Payment
The Board Meets and passes the motion to create the dividend
Ex Dividend Date is determined by the Date of Record. The market value of the shares drops by the value of the dividend per share on market openingcompared to the previous days close.
Trade Settlement and the Ex Dividend Date

Changes in the Settlement Cycle In June 1995 the settlement cycle for all non-money-market Canadian and U.S. securities was reduced from five business days (T + 5) to three business days (T + 3). The rationale for the change stems from the 1987 stock market crash when it was realized that a securities market failure could result in a credit market failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S. broker, increased the need to minimize the risks involved in the clearing and settlement of securities. The shortened settlement cycle requires that the payment of funds and the delivery of securities take place on the third business day after the trade date. This will reduce credit, market and liquidity risks by decreasing posttrade settlement exposure. Ex Dividend Date The date is not chosen by the board of directors, rather it is determined as a result of the exchanges settlement practices and is a function of the date of record.
22 - 17
Dividend Decision and the Board of Directors

Dividend Policy
Dividend Policy
Dividends, Shareholders and the Board of Directors
There is no legal obligation for firms to pay dividends to common shareholders Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BODs right to make the dividend decision because:
Board members are jointly and severally liable for any damages they may cause Board members are constrained by legal rules affecting dividends including:
Not paying dividends out of capital Not paying dividends when that decision could cause the firm to become insolvent Not paying dividends in contravention of contractual commitments (such as debt covenant agreements)
22 - 19
Dividend Payments
Dividend Policy
Dividend Payments
Dividend Reinvestment Plans (DRIPs)
Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm
DRIPs will buy as many shares as the cash dividend allows with the residual deposited as cash Leads to shareholders owning odd lots (less than 100 shares)
Firms are able to raise additional common stock capital continuously at no cost and fosters an ongoing relationship with shareholders.
22 - 21
Dividend Payments
Stock Dividends
Stock dividends simply amount to distribution of additional shares to existing shareholders They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account. Because of the capital impairment rule stock dividends reduce the firms ability to pay dividends in the future.
Dividend Payments
Stock Dividends
Implications

reduction in the R/E account reduced capacity to pay future dividends proportionate share ownership remains unchanged shareholders wealth (theoretically) is unaffected conserves cash serves to lower the market value of firms stock modestly promotes wider distribution of shares to the extent that current owners divest themselves of shares...because they have more adjusts the capital accounts dilutes EPS proportion of ownership remains unchanged total value of holdings remains unchanged if former DPS is maintained, this really represents an increased dividend payout
Effect on the Company

Effect on Shareholders

22 - 23
Dividend Payments
Stock Dividend Example
ABC Company Equity Accounts as at February xx, 20x9 Common stock (215,000) $5,000,000 Retained earnings 20,000,000 Net Worth $25,000,000 The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share. This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is: $40.00 (21,500) = $860,000 This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:
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Dividend Payments
Stock Dividend Example
After the stock dividend:
ABC Company Equity Accounts as at March 1, 20x9 Common stock (236,500) Retained earnings Net worth $5,860,000 19,140,000 $25,000,000
The market price of the stock will be affected by the stock dividend: New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36 The individual shareholders wealth will remain unchanged.
22 - 25
Dividend Payments
Stock Splits
Although there is no theoretical proof, there is some who believe that an optimal price range exists for a companys common shares. It is generally felt that there is greater demand for shares of companies that are traded in the $40 - $80 dollar range. The purpose of a stock split is to decrease share price. The result is:
increase in the number of share outstanding theoretically, no change in shareholder wealth
Reasons for use:

better share price trading range psychological appeal (signalling affect)
Dividend Payments
Stock Split Example
The Board of Directors of XYZ Company is considering using a stock split to put its shares into a better trading range. They are confident that the firms stock price will continue to rise given the firms outstanding financial performance. Currently, the companys shares are trading for $150 and the companys shareholders equity accounts are as follows:
Commons shares (100,000 outstanding) Retained earnings Net Worth $1,500,000 15,000,000 $16,500,000
A 2 for 1 Stock Split:

New Share Price = P0[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00
The firms equity accounts:

Commons shares (200,000 outstanding) Retained earnings Net Worth
$1,500,000 15,000,000 $16,500,000

22 - 27
Dividend Payments
Further Stock Split Examples
A 4 for 3 Stock Split:
New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50

A 3 for 4 Reverse Stock Split:
New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00

Clearly the Board can use stock splits and reverse stock splits to place the firms stock in a particular trading range.
Dividend Payments
Stock Split Effects
shareholders wealth should remain unaffected:

Original Holdings: (100 shares @ $150/share) = $15,000 After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000
the above will hold true if there is no psychological appeal to the stock split. There is some evidence that the share price of companies which split stock is more bouyant because of a positive signal being transferred to the market by this action.
Stock Dividends versus Stock Splits

Stock Dividends
lowers stock price slightly little psychological appeal recapitalization of earnings no change in proportional ownership odd lots created theoretically, no value to the investor -
Stock Splits
large drop in stock price much stronger potential signalling effect no recapitalization same odd lots rare same
22 - 30
Cash Dividend Payments

The Macro Perspective
Figure 22 -1 illustrates:
Aggregate after-tax profits run at approximately 6% of GDP but are highly variable Aggregate dividends are relatively stable when compared to after-tax profits.
They are sustained in the face of drops in profit during recessions They are held reasonably constant in the face of peaks in aggregate profits.
(See Figure 22 - 1 on the following slide)
22 - 31

Aggregate Dividends and Profits
FIGURE 22-2
22 - 32

The Macro Perspective
Figure 22 -2 illustrates:
Aggregate Dividend payouts further illustrates the effects of relatively stable dividend payouts in the face of profit volatility:
The normal aggregate dividend payout rate is about 40% of after-tax profit When profits drop and dividends are held constant, payout rates rise to 100%
(See Figure 22 - 2 on the following slide)
22 - 33

Aggregate Dividend Payouts
FIGURE 22-3
22 - 34

The Macro Perspective - Question
Why are dividends smoothed and not matched to profits?
22 - 35

The Micro Perspective
Table 22 -1 contains dividend yields for selected companies.

The companies chosen here illustrate the dramatic differences between companies:
Some pay no dividends Some pay consistent cash dividends representing substantial yields on current shares prices
The highest yields are found in the case of Income Trusts and large stable blue-chip financials and utilities
22 - 36

Dividend Yields
Table 22-1 S&P/TSX 60 Index Dividend Yields

1996 %
BCE Celestica Inc. CIBC Cott Corporation Kinross Gold Corporation TransAlta Corporation Yellow Pages Income Fund 4.69 0 3.67 0.23 0 6.22
1997 %
3.42 0 3.07 0.53 0 5.16
1998 %
2.52 0 2.85 0.54 0 4.52
1999 %
1.41 0 3.37 0 0 5.35
2000 %
1.07 0 3.17 0 0 5.59
2001 %
3.15 0 2.9 0 0 4.06
2002 %
3.99 0 3.48 0 0 4.92
2003 %
4.08 0 3.28 0 0 5.73
2004 %
4.29 0 3.31 0 0 5.88 7.34
2005 %
4.44 0 3.57 0 0 4.51 7.09
Average
3.31 0.00 3.27 0.13 0.00 5.19 7.22
22 - 37
Modigliani and Millers Dividend Irrelevance Theorem

M&M, Dividends and Firm Value
Modigliani and Millers Dividend Irrelevance Theorem

The value of M&Ms Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.
22 - 39
M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value
Start with the single-period DDM:
[ 22-1]
D1 + P 1 P0 = (1 + Ke )
22 - 40

Multiply by the number of shares outstanding (m) to convert the single stock price model to a model to value the whole firm:
[ 22-2]
m( D1 + P ) 1 mP0 = V0 = (1 + Ke )
22 - 41

Assumptions
No Taxes Perfect capital markets

large number of individual buyers and sellers costless information no transaction costs
All firms maximize value There is no debt
22 - 42

Without debt, sources and uses of funds identity (sources = uses) can be expressed as:
[ 22-3]
X 1 + nP = I1 + mD1 1
Where:
X I XI mD1 represents cash flow from operations represents investment is free cash flow is dividend to current shareholders at time 1

Solving for dividends paid out (mD1 ):
mD1 = X 1 + nP I1 1
22 - 44

If a firm pays out dividends that exceeds its free cash flow (X I), then it must issue new common shares to pay for these dividends. Substituting into Equation 22 2 we get:
[ 22-4]
X1 I1 + [(m + n) P = V1 ] 1 V0 = (1 + K )
The value of the firm is the value of the next periods free cash flow (X1 I1) plus the next periods equity market value

The firm value is determined as the present value of the free cash flows to the equity holders:
[ 22-5]
X t It V0 = (1 + K )t t =1
Value has nothing to do with dividends
The dividend is equal to the free cash flow each period, and dividends are therefore a residual after the firm has taken care of all of its investment requirements this is the Residual Theory of Dividends

Residual Theory of Dividends
The Residual Theory of Dividends suggests that logically, each year, management should:
Identify free cash flow generated in the previous period Identify investment projects that have positive NPVs Invest in all positive NPV projects
If free cash flow is insufficient, then raise external capital in this case no dividend is paid If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.

Residual Theory of Dividends - Implication
The implication of the Residual Theory of Dividends are:

Investment decisions are independent of the firms dividend policy
No firm would pass on a positive NPV project because of the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken. If the firm cant make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own. The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure 22 4 on the following slide:

Internal Funds, Investment, and Dividends
22 - 4 FIGURE OPTIMAL INVESTMENT
Rate of Return IOS
MC=MR
WACC
Internal Funds Available

$11,976 Million $177,607 Million
22 - 49

Homemade Dividends
Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern.
They dont need management declare a cash dividend, they can create their own.
Conclusion: under the assumptions of M&Ms model, the investor is indifferent to the firms dividend policy.
The Bird-in-the-Hand Argument

Dividend Policy

M&Ms Assumptions Relaxed
Risk is a real world factor. Firms that reinvest free cash flow, put that money at risk there is no certainty of investment outcome those forfeit dividends that are reinvestedcould be lost! Remember the two-stage DDM?
22 - 52

Remember the two-stage DDM?

[ 22-6]
P=
ROE 2 K e ROE1 BVPS Inv + ( ) Ke (1 + K e ) Ke
The first term is the present value of existing opportunities (PVEO) The second term is the present value of growth opportunities (PVGO) These forecast returns face risks of new market entrants to compete for the excess profits forecast in emerging opportunities making PVGO extremely vulnerable.

Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by investors. This implies that investors perceive non-dividend paying firms to be riskier and apply a higher discount rate to value them causing the share price to fall. The difference between the M&M and Gordon arguments are illustrated in Figure 22 - 5 on the following slide:
M&M argue that dividends and capital gains are perfect substitutes

M&M versus Gordons Bird in the Hand Theory
22 - 5 FIGURE
D1 P0
OPTIMAL INVESTMENT
Gordon M&M
P P0 1 P0
22 - 55

M&M versus Gordons Bird in the Hand Theory
Conclusions:
Firms cannot change underlying operational characteristics by changing the dividend The dividend should reflect the firms operations through the residual value of dividends
22 - 56
Dividend Policy in Practice

Dividend Policy

Firms smooth their dividends
Firms tend to hold dividends constant, even in the face of increasing after-tax profit Firms are very reluctant to cut dividends
22 - 58

Lintners Work on Dividend Adjustment
John Lintner suggested a partial adjustment model to explain the smoothing of dividend behaviour illustrating that firms slowly change dividends as they move toward a new target level:
[ 22-7]
Dt = (Dt* -Dt-1 )
22 - 59

The target dividend Dt* Lintner suggested is a function of the firms optimal payout rate of the firms underlying earnings (Et) leading to the following equation:
[ 22-8]
Dt = a + (1 b) Dt-1 + cE1
The coefficient on lagged dividends was estimated at 0.70 indicating an adjustment speed (b) coefficent of 0.30. The coefficient on current earnings (c) was estimated at 0.15 CHAPTER 22 Dividend Policy 22 - 60

Implications
The speed of dividend adjustment is only about 30 percent Firms are very reluctant to fully adjust Firms do not follow a policy of paying a constant proportion of earnings out as dividends
Dividend policy in practice does not follow M&Ms irrelevance arguments because the real world does not match the assumptions used.
Relaxing the M&M Assumptions

Welcome to the Real World!
Transactions Costs
Underwriting costs are very high, providing a strong incentive for firms to finance growth out of free cash flow Facing these high underwriting costs firms:
With high growth rates have little incentive to pay dividends With volatile earnings conserve cash from year to year to finance projects and therefore pay very conservative dividends
22 - 62

Dividends and Signalling

Under conditions of information asymmetry, shareholders and the investing public watch for management signals (actions) about what management knows. Management is therefore very cautious about dividend changesthey dont want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they dont want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)
(The Signalling Model is explained in Figure 22 6 found on the next slide.)
22 - 63

The Signalling Model
22 - 6 FIGURE
et et* dt* dt
Time
22 - 64

Agency Theory
Investors are wary of senior management so they seek to put controls in place. There is a fear that managers may waste corporate resources by over-investing in low or poor NPV projects. Gordon Donaldson argued this is the reason for the pecking order managements tend to use when raising capital
Shareholders would prefer to receive a dividend and then have management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend. Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess management.
22 - 65

Taxes and the Clientele Effect

Table 22 -3 (on the following slide) illustrates that different classes of investors face different tax brackets Preference for dividends versus capital gains income depends on the province of residence and taxable income level leading to tax clienteles.
High income earners tend to prefer capital gains (there is an additional tax incentive for such individuals in that they can choose the timing of the sale of their investmentremember only realized capital gains are subject to tax Low income earners tend to prefer dividends
Conclusion firms should not change dividend policy drastically since it upsets the existing ownership base.

Taxes
Table 22-3 Individual Tax Rates (% ) on Dividends and Capital Gains
Income Level
British Columbia Alberta Ontario Quebec Nova Scotia Dividends Capital gains Dividends Capital gains Dividends Capital gains Dividends Capital gains Dividends Capital gains
$25,000
2.52 12.45 3.63 12.63 0.00 10.65 5.95 14.37 0.00 12.02
$50,000
6.19 15.58 8.03 16.00 8.24 15.58 15.42 19.19 8.75 18.48
$75,000
15.69 18.85 13.83 18.00 20.74 21.71 26.06 22.86 17.05 21.34
$100,000
20.04 20.35 13.83 18.00 20.74 21.71 26.06 22.86 19.06 22.63
22 - 67

Repackaging Dividend-Paying Securities
Tax clienteles help to explain the financial engineering whereby different parts of the return by the firm are stripped, repackaged and sold to different investors as illustrated in Figure 22 7. (See the following slide) Split shares are shares sold as the dividends and capital gains parts.
22 - 68

MYWs B Corporation Shares
22 - 7 FIGURE
P0 =
t =1
dt P0 + (1 + k )t (1 + k ) 6
$454 million
MYW
$330 million $143 million
dt min($30, P6 1) Pref = + (1 + k ) 6 t =1 (1 + k ) t
6
P6 min($30, P6 1) IR = (1 + k ) 6
22 - 69
Share Repurchases
Simply another form of payout policy. An alternative to cash dividend where the objective is to increase the price per share rather than paying a dividend. Since there are rules against improper accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.
22 - 70
Share Repurchases
Dividend Policy
Share Repurchases
allowed under the OBCA and CBCA reasons for use:
Offsetting the exercise of executive stock options Leveraged recapitalizations Information or signalling effects Repurchase dissident shares Removing cash without generating expectations for future distributions Take the firm private.
22 - 72
Disadvantages of Share Repurchases

they are usually done on an irregular basis, so a shareholder cannot depend on income from this source. if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax there may be some agency problems - if managers have inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.
22 - 73
Methods of Share Repurchases

tender offer:
this is a formal offer to purchase a given number of shares at a given price over current market price. the purchase of shares through an investment dealer like any other investor this is not designed for large block purchases.
open market purchase:

private negotiation with major shareholders In any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus.
22 - 74
Repurchased Shares
called treasury stock (U.S.) non-voting (U.S.) may not receive dividends (U.S.) if not retired, can be resold (U.S.) unlike the U.S., repurchases in Canada do not involve shares that can be placed into treasury stock - they are canceled
22 - 75
Repurchase Example
Current EPS = [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00 Current P/E ratio = $20 / $4 = 5X EPS after repurchase of 100,000 shares = $4.4 m / 1.0 = $4.40 Expected market price after repurchase: = [p/e][EPSnew] = [5][$4.40] = $22.00 per share
22 - 76
Effects of A Share Repurchase

EPS should increase following the repurchase if earnings after-tax remains the same a higher market price per outstanding share of common stock should result stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price.
22 - 77
Advantages of Share Repurchases

signal positive information about the firms future cash flows used to effect a large-scale change in the firms capital structure increase investors return without creating an expectation of higher future cash dividends reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, without creating a continuing incremental cash drain capital gains treated more favourably than cash dividends for tax purposes.
22 - 78
Disadvantages of Share Repurchases

signal negative information about the firms future growth and investment opportunities the provincial securities commission may raise questions about the intention share repurchase may not qualify the investor for a capital gain
22 - 79
Borrowing to Pay Dividends

Signalling

Is this legal? is it possible to do? Yes
the firm must have the ability and capacity to borrow the firm must have sufficient retained earnings to allow it to pay the dividend the firm must have sufficient cash on hand to pay the cash dividend the firm must NOT have agreed to any limitations on the payment of dividends under the bond indenture. A possible answer is to signal to the market that the board is confident about the firms ability to sustain cash dividends into the future.
Why?

An Example
Before Borrowing:
Assets: Cash 10 Fixed Assets 140 Total Assets $150 Liabilities: Long-term Debt 0 Common Stock 50 Retained Earnings 100 Total Claims $150 0% Debt
After Borrowingbefore cash dividend:

Assets: Cash 60 Fixed Assets 140 Total Assets $200 Liabilities: Long-term Debt 50 Common Stock 50 Retained Earnings 100 Total Claims
25% Debt
$200
22 - 82

An Example
After Dividend Declarationbefore date of payment.

Assets: Cash 60 Fixed Assets 140 Liabilities: Current liabilities Long-term Debt Common Shares Retained earnings Total Claims 50 50 50 50 $200 50% Debt
Total Assets
$200
After Cash Dividend payment of $50

Assets: Cash 10 Fixed Assets 140 Total Assets $150 Liabilities: Long-term Debt Common Stock Retained earnings
CHAPTER 22 Total Claims Dividend Policy
33% Debt 50 50 50 $150

22 - 83

An Example The foregoing example illustrates:
it is possible for a firm with borrowing capacity to borrow funds to pay cash dividends. this is not possible if the lenders insist on restrictive covenants that limit or prevent this from occurring. the cash for the dividend must be present in the cash account. payment of dividends reduces both the cash account on the asset side of the balance sheet as well as the retained earnings account on the claims side of the balance sheet. in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. (Bondholders in this example
may have thought their firm would have only a 25% debt ratio.after the dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.)
22 - 84
Summary and Conclusions

In this chapter you have learned:
About the different types of dividends including, regular and special cash dividends, stock dividends, stock splits as well as share repurchases. M&Ms dividend irrelevance argument and the real world factors such as transactions costs, taxes, clientele effects and signalling tend to favour real-world dividend relevance Tax motives and other reasons explain why firms might want to repurchase their shares.
22 - 85
Concept Review Questions

Dividend Policy
Concept Review Question 1

Important Dates and Dividends
Define four important dates that arise with respect to dividend payments.
22 - 87
Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

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INTRODUCTION TO

Prepared by Ken Hartviksen

CHAPTER 22 Dividend Policy

Important Chapter Terms

CHAPTER 22 Dividend Policy

What is Dividend Policy?

CHAPTER 22 Dividend Policy

CHAPTER 22 Dividend Policy

Dividends and Corporate Financing

Dividends a Financing Decision

Retained Earnings Corporate Profits After Tax Dividends

CHAPTER 22 Dividend Policy

Dividends versus Interest Obligations

The Mechanics of Dividend Payments

Declaration Date Holder of Record Date Ex-dividend Date Payment Date

CHAPTER 22 Dividend Policy

Dividend Declaration Time Line

Trade Settlement and the Ex Dividend Date

CHAPTER 22 Dividend Policy

Dividend Decision and the Board of Directors

CHAPTER 22 Dividend Policy

Effect on the Company

CHAPTER 22 Dividend Policy

CHAPTER 22 Dividend Policy

Reasons for use:

A 2 for 1 Stock Split:

The firms equity accounts:

$1,500,000 15,000,000 $16,500,000

The firms equity accounts:

A 3 for 4 Reverse Stock Split:

New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00

The firms equity accounts:

shareholders wealth should remain unaffected:

Stock Dividends versus Stock Splits

CHAPTER 22 Dividend Policy

Cash Dividend Payments

(See Figure 22 - 1 on the following slide)

CHAPTER 22 Dividend Policy

Cash Dividend Payments

CHAPTER 22 Dividend Policy

Cash Dividend Payments

(See Figure 22 - 2 on the following slide)

CHAPTER 22 Dividend Policy

Cash Dividend Payments

CHAPTER 22 Dividend Policy

Cash Dividend Payments

Why are dividends smoothed and not matched to profits?

CHAPTER 22 Dividend Policy

Cash Dividend Payments

Table 22 -1 contains dividend yields for selected companies.

CHAPTER 22 Dividend Policy

Cash Dividend Payments

Table 22-1 S&P/TSX 60 Index Dividend Yields

3.31 0.00 3.27 0.13 0.00 5.19 7.22

CHAPTER 22 Dividend Policy

Modigliani and Millers Dividend Irrelevance Theorem

Modigliani and Millers Dividend Irrelevance Theorem

CHAPTER 22 Dividend Policy

M&Ms Dividend Irrelevance Theorem