MONASH

BUSINESS
SCHOOL

BFF5954
BUSINESS FINANCE

JOHN R. WATSON
 MONASH
BUSINESS
SCHOOL

Teaching Week Twelve

Dividend Policy

Readings
Chapter 17 (Sections 17.1-17.7 pages 636-666).
 MONASH
BUSINESS
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Learning Objectives

(1) Understand what dividends are; how they are paid;

and how companies decide on making dividend
payments;
(2) Understand whether (and when) investors might care

about dividends + what are alternatives; and

Understand how dividends are taxed.
Different types of payouts

 Many companies pay a regular cash dividend.

– Public companies often pay quarterly or six-monthly.
– Sometimes firms will pay an extra one-off special dividend.
– The extreme case would be a liquidating dividend.

 Companies will often declare stock dividends.

– No cash leaves the firm.
– The firm increases the number of shares outstanding.

 Some companies declare a dividend in kind.

– Wrigley’s Gum sends a box of chewing gum.

 Many companies use stock buybacks.

– Open market repurchase or off-market repurchase
Use of free cash flow
Procedure for Cash Dividend in Australia

19 May. 24 May. 25 May. 26 May. 9 June

…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date (5:00pm)

Declaration Date: The Board of Directors declares a payment of dividends. The amount
of dividend is usually a percentage of company earnings and is called the dividend
payout ratio

Cum-Dividend Date: Buyer of stock still receives the dividend.

Ex-Dividend Date: Seller of the stock retains the dividend.

Record Date: The corporation prepares a list of all individuals believed to be stockholders
as of 26 May.
Price Behavior after dividends

 In a perfect world, the stock price will fall by the amount of

the dividend on the ex-dividend date.

-t …
-2 -1 0
$P +1 +2 …

$P - div
The price drops Ex-
by the amount of dividend
the cash Date
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.
Example 12-1

30 June 15 July 30 July

…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date (5:00pm)

On 30 June the board of directors of Excel Corp, an ASX listed firm declared a dividend of $2 per
share. This dividend is payable on 30 July to all shareholders on record at 15 July.

(i) Identify the ex dividend and cum dividend date.

Now ignoring any tax effects and assuming no other new information:

(ii) On which date would you expect to see a change in share price?
(iii) In what direction would the change occur?
(iv) By how much do you expect the price to change?
Example 12-1

30 June 10 July 11 July 15 July 30 July

…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date (5:00pm)

On 30 June the board of directors of Excel Corp, an ASX listed firm declared a dividend of $2 per
share. This dividend is payable on 30 July to all shareholders on record at 15 July.

(i) Identify the ex dividend and cum dividend date.

We know that the Cum dividend date is five business days before the record date (Australian setting).

Now ignoring any tax effects and assuming no other new information:

(ii) On which date would you expect to see a change in share price? Ex Dividend Date, 11 July
(iii) In what direction would the change occur? The price will decrease
(iv) By how much do you expect the price to change? A decrease of $2
Dividends?

 Should the firm pay dividends?

 Modigliani and Miller: in perfect capital markets, this question is

irrelevant.
Homemade Dividends

 Example: Homemade dividends

 Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
 Bob Investor owns 80 shares and prefers a $3 dividend.
 Bob’s homemade dividend strategy: Sell 2 shares ex-dividend

$3 Dividend
homemade dividends
Cash from dividend $240$160
Cash from selling stock
$0 $80
Total Cash$240 $240
Value of Stock Holdings
$39 × 80
$40
= × 78 =
$3,120 $3,120
Repurchase of Stock

 Instead of declaring cash dividends, firms can rid themselves of

excess cash through buying shares of their own stock.

 Recently, share repurchase has become an important way of

distributing earnings to shareholders.

 Question: Dividends versus Share repurchase; which method is

better?
Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to its shareholders.

Assets Liabilities & Equity

A. Original balance sheet
Cash $150,000 Debt 0
Other Assets 850,000 Equity 1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share = $1,000,000 /100,000 = $10
Stock Repurchase versus Dividend

If they distribute the $100,000 as a cash dividend, the balance sheet will look like
this:

Assets Liabilities & Equity

B. After $1 per share cash dividend
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 100,000
Price per share = $900,000/100,000 = $9
Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase, the balance sheet will look
like this:

Assets Liabilities& Equity

C. After stock repurchase
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price pershare = $900,000 / 90,000 = $10
Dividends versus Repurchase

Investors’ wealth is the same in two cases:

Dividend Share repurchase

Number of shares = 100,000 shares Number of shares = 90,000 shares
Share price cum-dividend = $10 Share price = $10
Share price ex-dividend = $9
Number of shares sold = 0 Number of shares sold = 10,000 shares
Cash you have = $100,000 Cash you have = $100,000
Taxes on dividends

• Classical taxation system (Double tax):

Company level
Income earned $100
Company tax (30%) $30
Net profit after tax $70

Shareholder level
Dividend $70
Tax payable (47%) $33
Net income after tax $37

Total tax paid = $63

Taxes on dividends
• Australia operates under imputation tax system:
Company level
Net profit after tax (30%) $70

Shareholder level
Franked dividend $70
Imputation credit $30
Taxable income $100
Tax payable (47%) $47
Credit for company tax $30
Tax payable $17
Net income $53 = 70 – 17

Total tax paid = $47, not $63

Taxation on capital gains

 When an investor sells a share with a profit, the gain is subject to

tax.

 In Australia, it is a component of personal income tax.

 If shares were purchase after Sep 1999 and held for more than
one year, a discount method must be used:
 Capital gain is reduced by 50% before tax is applied.

 If the shares are held for less than one year, no adjustments apply
and gains are taxed at full personal tax rates.
Capital gains versus Dividends

For an investor who holds the stock for more than 12 months:

Capital gains A (47% tax rate) B (30% tax rate)

Gain on sale of share 70 70
Taxable component 35 35
Capital gains tax 16.45 10.5
Income after tax 53.55 59.5

Their wealth when the firm pays dividends instead:

Dividend A B
Income after tax 53 70
Dividend and capital gains tax
rates around the world
Optimal dividend policy with taxes

 Australian firms tend to pay higher dividends and increasingly

issuing equity rather than debt.

 Many Aussie firms face pressure of paying high dividends

 Taking advantage of imputation tax credits.

 As a consequence of high payout, many Australian firms have

low retained earnings.

 This is in contrast to the US, where the classical tax system

encourages share buyback.
Dividend Signaling

 Dividend smoothing: in practice firms tend to maintain

constant dividends.

Dividend signaling hypothesis

• What are the signals for dividend changes versus share
repurchase?
• Managers are much less committed to share repurchases than
to dividends.
• They do not need to smooth repurchases.
• Repurchases may suggest that stock price is undervalued.
 MONASH
BUSINESS
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FINAL EXAM DETAILS

and RECP
 MONASH
BUSINESS
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Exam Details
Please read all materials available under tab < week 13 > on Moodle
 Comprehensive Final Exam - 50% MONASH
BUSINESS
SCHOOL

BFF5954 Exam Time and Date: 5pm, Monday 3 June 2024

Weight Assigned: 50% of the final marks of the unit
Duration: 2 hours and 10 minutes (inclusive of reading time)
Exam Type: Closed-book, with permitted items.
Permitted Items: A physical calculator and/or a virtual calculator; Excel for calculations (only the
provided empty Excel file provided in the exam); Five empty working pages.
Access: eAssessment (https://eassessment.monash.edu/)
Hurdle requirement: None

The exam can only be undertaken during the designated time, unless you are granted a deferred exam.
Failure to undertake the exam at the scheduled time will result in a mark of 0 (fail).

The final exam will contain all the material covered in seminars, tutorials, the online learning activities
and the prescribed readings.
 MONASH
Final Exam Breakdown BUSINESS
SCHOOL

Question Type Marks Coverage

PART A
Multiple Choice Questions with response A-
E. Choose one correct answer ot of the 10 questions; 4 marks each for 40 marks in
Q1-Q10 Multiple Choice (Option A-E) options provided for each question. aggregate (40% of overall exam) Weeks 1 - 12
PART B
Q11 Market Efficiency and Dividend Policy Calculation and Short Answers. 15 marks Weeks 3-12
Q12 Capital Budgeting Calculation and Short Answers. 18 marks Weeks 5-7
Q13 Risk and Return and Portfolio Theory Calculation and Short Answers. 12 marks Weeks 8-9
Q14 Capital Structure and Cost of Capital Calculation and Short Answers. 15 marks Weeks 10-11

Note: the contents on the unit Moodle site for weeks 1-13 will be hidden approximately 2
hours before the scheduled time of the exam, i.e. 3pm on Monday 3 June 2024
 Final
Final Exam
Exam - FAQ
MONASH
BUSINESS
SCHOOL

What calculator is allowed in the exam?

● A physical calculator of any type

And/Or

A virtual calculator

1. Inbuilt Mac/Windows calculator

2. Website https://www.educalc.net/2336211.page
3. 10bii Financial Calculator for Mac by K2 Cashflow
https://apps.apple.com/au/app/10bii-financial-calculator/id473144920
 Final
Final Exam
Exam - FAQ
MONASH
BUSINESS
SCHOOL

Is excel permitted in the exam?

• You are provide a link to an excel spreadsheet for calculation purposes. Data analysis and
Solver are enabled should you desire use of this functionality.
 Final
Final Exam
Exam - FAQ
MONASH
BUSINESS
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Question 12: Capital Budgeting and Cash Flow Analysis Question

For the download/upload question the eAssessment platform for one question requires answers to be provided in an Excel template provided to you
through the platform. To answer this download/upload question, you need to download the template (file), complete your answer in the Excel file provided
and upload your completed file when you have finished answering the question. Note you must upload the file with your answers inserted prior to the end
of the exam time You will not be given extra time after the end of the exam to upload your Excel files. It is recommended that you upload your file before
you move on to the next question.

For the download/upload question please review the following instructions prior to sitting your eExam to limit any potential errors:

1. Read the question text and download the provided file.

2. Rename the file to ensure it includes:
o The unit code
o Question name
o Student ID number
For example, BFF5954_Q12_CAPITAL BUDGETING _STUDENT ID NUMBER
3. Open the file you just renamed.
4. Provide your answer in the Microsoft Excel file according to the question instructions. Make sure you save the file regularly (at least once every five
minutes).
5. Upload your renamed file to your e-exam before you move onto the next question.
The upload of files MUST be completed before your exam time ends as files CANNOT be uploaded once the exam has been submitted (when the time
expires).
 Final
Final Exam
Exam - FAQ
MONASH
BUSINESS
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Is a formula sheet available?

Yes. The formula sheet, which has been available on Moodle, is the formula sheet you will be able
to refer to and use during the exam. It will be included on the eAssessment platform. Note: you may
not be required to use all formulae in the exam.

Do I need to know any additional formula not provided on the formula sheet?

The more you know, the better you will perform. However, questions contained in the exam may be
attempted with the formulae provided on the formula sheet.
 Final
Final Exam
Exam - FAQ
MONASH
BUSINESS
SCHOOL

Semester one final assessments (3–21 Jun)

You’re expected to attend your on-campus eExam in person. You can

apply to change the location of your final assessment only if:

•you’re participating in a Monash-facilitated program overseas at the time of your scheduled final
assessment (e.g. GIG, Monash Global Campus Intensives)

•you are participating in mandatory military service at the time of your scheduled final assessment.
You won’t be able to sit your on-campus eExam remotely if you’re away on holiday or travelling,
so plan ahead and avoid booking a trip until after Friday 21 June

Link: On-campus eExams (Australia) - Current students (monash.edu)

 Final
Final Exam
Exam - FAQ
MONASH
BUSINESS
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Can I choose to sit my on-campus eExam from home?

No, if you've been scheduled for an on-campus eExam, you're expected to sit your exam on campus.

If you can’t sit your final assessment because you tested positive for COVID-19, you may be eligible
for a deferred one – take a look at the
defer or reschedule your scheduled final assessment (exam) page for all the details.

If you’re a close (household) contact but you’re not displaying symptoms, you’ll need to sit your
assessment on campus – just make sure you wear a mask and do a RAT test on the morning of your
exam.

link: Can I choose to sit my on-campus eExam from home? (monash.edu)

 Final ExamFinal
(whatExam
MONASH
should I study?) BUSINESS
SCHOOL

Covers lecture materials from week 1 to week 12.

Important:

 Seminar and all illustrations provided throughout the semester

 Tutorial Questions/Solutions
 Online learning activities
 Relevant Chapters in the textbook and additional assigned readings
 Other related materials

Any of this material is assessable

 Final(consultation)
Final Exam Exam MONASH
BUSINESS
SCHOOL

Refer to week 13 tab < Swot Vac - Exam Consultation and Exam Information >
 MONASH
BUSINESS
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RECAP
Financial Mathematics
Financial Mathematics

• Simple vs. Compounding interest

• Nominal vs. Effective interest rate

• Applications with TVM

– Solving for number of periods
– Solving for unknown interest rates
– Solving for future and present values
– Loan amortisation
Financial Mathematics
Future Values

• Single Sum

• Mixed Stream

• Annuity Ordinary
Financial Mathematics
Present Values

• Single Sum

• Mixed Stream
C
PV 
r
• Perpetuity C
PVA n  1 
1 
N 
r  (1  i) 
Valuation of Bonds and Shares
41

• Intrinsic Value vs. Price

Valuation approach is one of determining a security’s
intrinsic value, i.e. , what it ought to be worth based on
objective evidence - this value is PV of CF stream,
discounted at a required rate of return appropriate for risk
involved

Bond Value (B0) = PV(Coupons) + PV(Face Value)

CPN  1  FV
PB  1  
y  1  y n  1  y 
n
Valuation of Bonds and Shares
42

1. Bond prices and market interest rates move in opposite directions.

2. When coupon rate = YTM, price = par value.

When coupon rate > YTM, price > par value (premium bond)
When coupon rate < YTM, price < par value (discount bond)

3. A bond with longer maturity has a higher relative (%) price change than
one with shorter maturity when the interest rate (YTM) changes. All
other features are identical.

4. A lower coupon bond has a higher relative price change than a higher
coupon bond when the YTM changes. All other features are identical.
Valuation of Bonds and Shares
43

• Share Price vs. Intrinsic Value

• Zero Growth Model

D1
P0 
R
Valuation of Bonds and Shares
44

• Constant Growth Model

D0  (1  g ) D1
P0  
kg kg
• Variable Growth Model

D1 D2 Dt Pt
P0    ...  
(1  k)1 (1  k) 2 (1  k) t (1  k) t
Efficient Market Hypothesis

• An efficient market is one in which the prices of securities fully reflect

all available information, requiring instantaneous and unbiased
adjustment to new information

• Three forms of market efficiency have been proposed:

– Weak-form: relates to the historical information on price and
volume: also called random walk hypothesis
– Semi-strong form: relates to all public information
– Strong-form: relates to all information including insider information

• Strong-form encompasses other two forms

• Conclusion: generally markets are efficient (what form)?
Capital Budgeting Techniques
46

NPV technique (accept NPV >0, reject NPV<0)

MAXIM: Maximise shareholder wealth

n NC Ft
NPV  
t
t  0 (1  k)

NPV Profile (Understand how to construct/interpret)

Independent vs. mutually exclusive projects
Conventional vs. Non conventional cash flow projects
Hard Capital rationing vs. Soft Capital Rationing
Capital Budgeting Techniques
47

IRR Technique (accept k<IRR, reject k>IRR)

n NCFt
IRR  NPV   0
t
t 0 (1  irr)

Pitfalls of IRR
1) Borrowing and Lending
2) Multiple rates of return (non conventional CF)
3) Zero rates of return
4) Mutually exclusive projects (conflict between NPV/IRR)
Capital Budgeting Techniques
48

Payback Period technique

Decision Rule: Accept a project if the project Payback Period is

less than some prescribed value (cut-off period)

Strengths vs. weaknesses

Profitability Index

Decision Rule: Accept a project if the profitability index is greater than 0

Strengths vs. weaknesses

Capital Budgeting - Cash Flow Analysis
49

a standard cash flow consists of 3 components:

Part 1) The initial investment

Part 2) The operating cash flows

• Ignore Sunk Costs
• Include Opportunity Costs
• Beware of allocated overheads
• Do not forget Net Working Capital
• Interest costs should NOT be included as an explicit cash flow.
• Be consistent with treatment of inflation

Part 3) The terminal cash flow

Risk and Return for an individual
security (time series)
50

Return

Variance

Standard deviation is the square root of the variance

Risk and Return
for an individual security (CV)
51

The CV is a standardized measure of dispersion about

The expected return.
 Ri
CV 
E ( Ri )

The CV tells us how much risk we face per unit of

return.

IMPORTANT
Understand the difference between: coefficient of Variation;
the covariance; and the correlation.
Risk Diversification – a portfolio of shares

Total Risk (s)

Most unsystematic can be removed by holding a portfolio of some 12 to 16 shares (Fama 1976).
Portfolio Return

• The portfolio weights must add up to 1.00 or 100%.

• The expected return of a portfolio is the weighted average of the
expected returns of the investments within it.

• Portfolio risk is NOT a weighted average

 Portfolio risk is NOT a weighted average. Why?

• We know the answer: Co-movement and Correlation

Portfolio risk is calculated considering the relationships

among returns of securities that make up the portfolio (not a
simple weighted average of individual risks).
Do not confuse CML with SML
55
Capital Structure

• Understand the effects of financial leverage

• Distinguish between business risk and financial risk

• Understand the “capital structure irrelevance” theory of Modigliani

and Miller – 1958
– Know the propositions

• Explain the role of corporate taxes MM (1963) that may influence

capital structure decisions

• Understand the impact of bankruptcy costs on capital structure

decisions
MM 1958 – No Tax World

• 1958 (World Without tax)

Assumptions
• Homogeneous Expectations
• Homogeneous Business Risk Classes
• Perpetual Cash Flows
• Firms do not retain any earnings; earnings are all paid out as
dividends and/or interest
• Perfect Capital Markets:
– Perfect competition
– Firms and investors can borrow/lend at the same rate (risk free)
– Equal access to all relevant information
– No transaction costs
MM 1958 – No Tax World

• 1958 (World Without tax)

• Implications of MM (1958) Proposition I – Capital structure do not

affect the value of the firm

• Implications of MM (1958) Proposition II – Increase in leverage

increase the cost of equity capital of the firm. The cost of equity to a
levered firm is equal to (a) the cost of equity of unlevered firm in the
same risk class plus (b) a risk premium to compensate financial risk.

• Implications of MM (1958) Proposition III– Increase in leverage do not

affect the discount rate used for a project.
The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital:
MM Proposition II with No Corporate Taxes
Cost of capital: r (%)

rE = rU + (D / E) (rU - rd)
PROP. 2 1958 FRAMEWORK

D E
rE rWACC   rD   rE
V V
PROP. 3 1958 FRAMEWORK

rd

D
Debt-to-equity Ratio
E
MM 1963 – Tax World

• 1963 (World with Tax)

Assumptions
• Homogeneous Expectations
• Homogeneous Business Risk Classes
• Perpetual Cash Flows
• Firms do not retain any earnings; earnings are all paid out as
dividends and/or interest
• Perfect Capital Markets:
– Perfect competition
– Firms and investors can borrow/lend at the same rate (risk free)
– Equal access to all relevant information
– No transaction costs
– Companies pay tax
 MM 1963 – Tax World
• 1963 (World With Tax)

• Implications of MM (1963) Proposition I – Increase in leverage increase

the value of the firm. The value of the levered firm is equal to (a) the value
of an unlevered firm in the same risk class plus (b) the gain from leverage,
which is the present value of tax savings and which equals the corporate
tax rate times the amount of debt the firm uses.

• Implications of MM (1963) Proposition II– Increase in leverage increase

the cost of equity capital of the firm. The cost of equity to a levered firm is
equal to (a) the cost of equity of unlevered firm in the same risk class plus
(b) a risk premium to compensate financial risk. Premium will be less in
tax world due to tax savings than no tax world.

• Implications of MM (1963) Proposition III – With the introduction of

Tax, there is now an additional advantage to gearing-up: the tax relief
obtained on the debt interest. The more highly geared company becomes,
the more tax relief it obtains and the smaller its tax liability becomes. In a
world where there was a tax relief on debt interest, we would expect a
company’s after-tax WACC to be progressively lowered as it increased its
level of gearing.
MM 1963 – PROPOSITION II & III

Cost of capital: rE (%) rE = rU + (D / E) (rU – rd)

PROP. 2 1958 FRAMEWORK

rE = rU + (D / E) (rsU - rd)(1-T)

PROP. 2 1963 FRAMEWORK

rE

rWACC  ( D / V )(rD )(1  T )  ( E / V )rE

PROP. 3 1963 FRAMEWORK

Debt-to-equity ratio (D/E)

 Integration of Tax Effects and Financial Distress
Costs

Value of firm (V) Value of firm under

MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TD

Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (D)
D*
Optimal amount of debt
It is difficult to express the optimal level of debt with a precise and rigorous formula.
Cost of Capital

• Determine a firm’s cost of equity capital

– CAPM/SML or Dividend growth model

• Determine a firm’s cost of debt

– YTM on a bond

• Determine a firm’s overall cost of capital

– Remember the 4 steps:
• 1) Calculate the weights of equity and debt
• 2) Calculate the cost of equity
• 3) Calculate the cost of debt
• 4) Calculate WACC
R
E E
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