lecture 9 : dividends & policy
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Lecture 9 : Dividends & Policy. C. L. Mattoli. Learning outcomes (Chp. 14). On successful completion of this module you should be able to: outline the dividend types and explain how dividends are paid discuss the issues surrounding dividend policy decisions. Learning outcomes (Chp. 14). - PowerPoint PPT PresentationTRANSCRIPT
Lecture 9 : Dividends & Policy
C. L. Mattoli
1(C) 2009 Red Hill Capital Corp.,
Delaware USA
Learning outcomes (Chp. 14)
On successful completion of this module you should be able to:
outline the dividend types and explain how dividends are paid
discuss the issues surrounding dividend policy decisions
2(C) 2009 Red Hill Capital Corp.,
Delaware USA
Learning outcomes (Chp. 14)
discuss the types of dividend policy that a firm can pursue
explain the difference between cash and shares dividends
explain why share repurchases are an alternative to cash dividends.
3(C) 2009 Red Hill Capital Corp.,
Delaware USA
Intro So, now the company is in business. It has taken in capital and spent it on
projects. Then, the cash flow is rolling in. What should it do with that cash flow? Of course, some money will need to be
continually invested in the company for maintenance.
4(C) 2009 Red Hill Capital Corp.,
Delaware USA
Intro More money will need to be invested for the
company to grow. Of course, we can raise additional capital,
but we should first look at that internally-generated cash flow and decide what to do with it.
We can retain some or all of these cash flows to invest in new projects or otherwise (many technology companies, for example, invest in stocks of fledgling technology companies).
5(C) 2009 Red Hill Capital Corp.,
Delaware USA
Intro We can also distribute some cash to
shareholders as cash dividends. People like to get cash; capital gains, on
paper (not realized because to realize gains you have to sell out your investment) are nice, but cash is even nicer.
However, should not the corporation be able to better invest the shareholder’s money than the shareholders themselves?
6(C) 2009 Red Hill Capital Corp.,
Delaware USA
Intro Cannot the shareholders create their
own cash flows by selling some shares and realizing the capital gains that have resulted from the corporation retaining and reinvesting its money.
The corporation can also do the same thing in a share repurchase, buying shares in the market, paying cash to those who want to sell shares, instead of paying dividends.
7(C) 2009 Red Hill Capital Corp.,
Delaware USA
Intro Just like in the case of capital structure, there is
no current comprehensive theory of dividend decisions. There are only simplified theories and some suggestions.
In this lecture, we shall take a closer look at dividends and how they can be paid, and we study what goes in the dividend payout-retention decision process.
We shall explore some of the theories and considerations that go into the dividend decision.
8(C) 2009 Red Hill Capital Corp.,
Delaware USA
Dividend Example
9
Capital Sturcture number ordinary shares 1,000,000pfd shares 100,000 $100 par value 4% pfddebt 1,000 $1000 FV 3% coupon bonds
Revenue 50,000,000-COGS 30,000,000-depreciation 1,000,000=EBIT 19,000,000- Interest 30,000= Income BT 18,970,000-tax (30%) 5,691,000=At income 13,279,000-pfd dividend 400,000
=Earnings available for common shareholders 12,879,000EPS 12.879Dividend to common 5,000,000Payout Ratio 38.82%RE 7,879,000DPS 5.00
(C) 2009 Red Hill Capital Corp., Delaware USA
The Corporate Machine
Investors in
securities
CashDebt Equity
SecuritiesIssued
CashFunding
Securities Markets
Cash &PhysicalAssets
Debt Equity
Businesses
BusinessProjectsMarkets
Reinvestment
InventoryPP&E Return on
Corporate Investment
Dividends
10
EPS
(C) 2009 Red Hill Capital Corp., Delaware USA
Paying Dividends
11(C) 2009 Red Hill Capital Corp.,
Delaware USA
What is a Cash Dividend First, we must deal with language issues, in
talking about dividends. A cash dividend usually refers to a cash
payment by a company to its shareholders (SH) out of current after-tax earnings.
On the other hand, if a cash payment is made to SH from other than current of retained earnings, it is called a distribution or liquidating dividend.
12(C) 2009 Red Hill Capital Corp.,
Delaware USA
What is a Cash Dividend Liquidating dividends are usually the result
of liquidating some or all of a business. Dividends can also be classified as:
regular, extra, special dividends. To SH, they are all dividends. Typically, companies, in Australia, pay
regular dividends twice a year: an interim and a final year’s dividend, approved at the company’s annual meeting after the end of a year.
13(C) 2009 Red Hill Capital Corp.,
Delaware USA
What is a Cash Dividend In the US, for example, and some other
countries, dividends are paid quarterly instead of semiannually.
Extra dividends are so named as to psychologically distinguish them as above what will be usual for dividend payments.
Special dividends are so named as to even farther distance them is SH’s minds from usual expectations.
14(C) 2009 Red Hill Capital Corp.,
Delaware USA
Declaration & Payment The dividend decision resides in the board
of directors of the company who, at a board meeting, will decide to declare a dividend.
The declaration will announce the per share payment amount and the date that the dividend will be paid to shareholders of record.
From declaration to distribution there are several steps and some technical details, as shown in the next few slides.
15(C) 2009 Red Hill Capital Corp.,
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Steps in cash dividends
1. First, the distribution of a dividend must be decided on by the board of directors and then declared. The announcement date is the date of directors’ meeting where the dividend is recommended : on this date the total amount of dividends to be paid is transferred from the retained earnings account to the dividends payable account.
16(C) 2009 Red Hill Capital Corp.,
Delaware USA
Steps in cash dividends
2. The record date is used to identify all shareholders on the Register of Members who are holders-of-record of shares on the proper date, so they can receive a dividend
3. The ex-dividend date is 4 days prior to the record date in a system where share transfer and settlement, once shares are sold in the secondary market, is 5 days.
17(C) 2009 Red Hill Capital Corp.,
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Steps in cash dividends4. Payment date: The actual date of
payment of the dividend is usually several weeks after the date of record. On the payment date, the total amount of dividends paid is debited from the dividend payable account and the cash account.
It is expected that the market price of a share will drop by approximately the declared dividend amount on the ex-dividend date.
18(C) 2009 Red Hill Capital Corp.,
Delaware USA
Stock Drop on Dividend X-date That the price of the stock should
drop on the ex-date is because it will be worth one cash flow less.
That it will drop by a number that might not exactly equal the amount of the dividend is due to taxes: what the dividend is really worth to people after tax.
19(C) 2009 Red Hill Capital Corp.,
Delaware USA
Record dates
There are a number of reasons that companies rely on record dates on which holders of record are included in corporate events.
We saw it earlier in rights and ex-rights dates.
It is also relied on for voting at shareholder meetings.
20(C) 2009 Red Hill Capital Corp.,
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Record dates In all events, there is a certain date, the
record date, on which the holders of record will be the ones who are included, and after that date, even if a person owns the shares, he will not be included.
First, for every type of these events, there is an announcement. In the announcement, a record date will be given.
21(C) 2009 Red Hill Capital Corp.,
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Record dates Then, a person has to be on the record
books of the company on that one date, in order to be eligible for whatever event is occurring.
The key to all of these events is that it takes several days between the time that shares are bought and when the new owner is recorded on the books of the company.
If there are T days for settlement, then, on T – 1 days before that record date, a buyer will not be included on the books in time to receive the benefit, whatever it is.
22(C) 2009 Red Hill Capital Corp.,
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Ex-dividend Date It is Monday June 10, and the record
date for a dividend is Friday June 14. I sell my shares on Monday, on an
exchange where it takes 5 business days for trades on the stock exchange to settle, i.e., the share transfer to be effected, and registration of the shares to change on the books of the corporation.
23(C) 2009 Red Hill Capital Corp.,
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Ex-dividend Date Then, my name will still be in the corporate
records on Friday June 14, it will only be changed on Monday June 17, and I will receive the dividend.
Based on that analysis, in order for someone to buy the stock with the right to the dividend (cum-dividend) a purchase must be made at least 5 (business) days before the dividend record date.
24(C) 2009 Red Hill Capital Corp.,
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Ex-dividend Date In this case, they purchased my shares 1
day too late. They purchased from me on the ex-date, so they did not buy shares with the right to get the dividend still attached to my shares.
Had they bought shares on Friday June 7, they would have been on the record books on Friday June 14, and they would have been the one to receive the dividend.
25(C) 2009 Red Hill Capital Corp.,
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Cum- and ex-dividend shares
Cum-dividend shares are those that have a current entitlement to receive a dividend Investors who own shares (and don’t sell
them) before the ex-dividend day are entitled to a dividend
As we saw in the above example, if they sell shares on or after the ex- date, they will still receive that dividend check in the mail.
26(C) 2009 Red Hill Capital Corp.,
Delaware USA
Price on X The day before an ex-date, the stock trades
with a right to receive a dividend. The next day it will no longer contain that
right. Thus, the price should drop from one day to
the next to reflect the loss of value of the dividend.
So, if the stock was $50 on the day before ex-D, and D = $2, then, the price on the ex-date should be around $2 less, or $48.
27(C) 2009 Red Hill Capital Corp.,
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Dividend Policy
28(C) 2009 Red Hill Capital Corp.,
Delaware USA
Intro As an investor, we look for future cash for
present outlay of funds. Cash dividends are one thing that we can get
as SH’s. Dividend policy is, then, really the decision to
pay out cash from earnings, now, or reinvest and pay out cash later.
Arguments can be made on both sides, depending on assumptions.
29(C) 2009 Red Hill Capital Corp.,
Delaware USA
Irrelevance MM showed that, under a number of
specific assumptions, dividend policy affects neither the price of a firm’s shares nor a firm’s cost of capital, i.e. dividend policy is irrelevant.
It is based on the assumptions that: If there are no taxes, then, shareholders
will be focused on total return: capital gains plus dividend yield
30(C) 2009 Red Hill Capital Corp.,
Delaware USA
Irrelevance A dividend decision is separable from an
investment decision, which it really is not, since a company has a choice of paying out a cash dividend and letting investors invest that cash as they like or making a higher return for the investors by retaining earnings and investing in high return projects, whose return is higher than the investor could achieve on her own.
capital markets are perfect (i.e., no taxes, transaction costs and free and complete information)
31(C) 2009 Red Hill Capital Corp.,
Delaware USA
Homemade dividends Assume either no taxes or taxes that are the
same for both capital gains and dividends. Assume that there are no transaction costs
for buying or selling shares. Then, SH can make their own ‘dividends’
by selling shares (alternative means of cash inflow for investors).
They can neutralize dividends by purchasing more shares if dividends are paid by the company
32(C) 2009 Red Hill Capital Corp.,
Delaware USA
Homemade dividends Irrelevance relies on the basic premise
that the market value of a firm depends on the PV of future cash
flows from its assets which in turn depends on investment
decisions not on dividend decisions. Both investors and managers have the
same information regarding future investment opportunities
33(C) 2009 Red Hill Capital Corp.,
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Example: Irrelevant
Firm has an annual FCF (free cash flow) of $150 million.
1. Free cash flow is after investment.
2. Shares outstanding are 110 million.
3. If the growth rate of FCF is 10% per year, and the required rate of return (RRR) is 15% what is the value of the firm?
34(C) 2009 Red Hill Capital Corp.,
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Example: Irrelevant
Look at 3 cases: Case 1 (100% payout) - it pays a dividend
of $150 million today: all FCF Case 2 (New issue + high dividend) -
issues $50m of shares and pays dividend of $200m: more than actual FCF
Case 3 (Total retention)- pays no dividend: retains all
35(C) 2009 Red Hill Capital Corp.,
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case 1 – moderate dividends
million3300$10.015.0
)10.1(150$
30$000,000,110
000,000,300,3$P 36.1$
000,000,110
000,000,150$DPS
gk
gFCFValue
)1(
36.31$36.130 SV
The value represented by a share of stock is the discounted Future CF value Plus the value of the dividend paid now (at present)
36(C) 2009 Red Hill Capital Corp.,
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case 2 – high dividends
million3300$10.015.0
)10.1(150$
55.29$000,000,110
000,000,250,3$P 82.1$
000,000,110
000,000,200$DPS
gk
gFCFValue
)1(
37.31$818.1545.29 SV
However, since it is issuing new shares, and the market value of the Firm has not really changed since there has been no event to cause revaluation in the market, the original shareholders will have a total value of $3.3 billion – $50 million, so that
37(C) 2009 Red Hill Capital Corp.,
Delaware USA
case 3 – no dividends
million3450$
15010.015.0
)10.1(150$
36.31$000,000,110
000,000,450,3$P
gk
gFCFValue
)1(
36.31$036.31 SVSince this year’s (present) FCF has been retained, it is part of the PV of the firm. Value of a share is DFCF of the company plus the additional right-now FCF.
38(C) 2009 Red Hill Capital Corp.,
Delaware USA
Conclusion
In all three cases, payout of all FCF, payout of more than FCF or no payout at all we get the same value of the firm.
Note: in each case we consider the PV of cash flows as the value of a share.
39(C) 2009 Red Hill Capital Corp.,
Delaware USA
Conclusion
Those values, in each case, are the sum of future year cash flows, as given in the CG model plus the current year’s cash flow, which, in two cases, is a cash dividend and, in the last case, just FCF.
Thus, the conclusion is that dividends don’t matter, at least under the non-realistic conditions that underpin the MM theory.
40(C) 2009 Red Hill Capital Corp.,
Delaware USA
In the Real World
Reasons that dividends might be relevant are usually based on things like:
1. Tax differentials: div. vs. cap. gain
2. Psychology: money is nice
3. Agency costs: disclosure
4. Information: news We shall look at the effects in categories.
41(C) 2009 Red Hill Capital Corp.,
Delaware USA
Low Dividends.
In classical tax systems, there is usually a lower tax on capital gains than on income.
In the imputation system, that is not true for domestic SH but is still true for foreign SH’s.
In both systems, long term (more than a year of holding) cap gains tax is smaller than short term.
42(C) 2009 Red Hill Capital Corp.,
Delaware USA
Low Dividends. In addition, taxes on cap gains only
have to be paid when the shares are sold, while taxes on dividends must be paid once a year, franked or not.
Next, are issuance costs, which are quite high, to issue shares to grow instead of retaining earnings for growth.
Finally, there might be restrictive laws or covenants in debt.
43(C) 2009 Red Hill Capital Corp.,
Delaware USA
High Dividends It is psychologically more reassuring to
get cash than to wait for capital gains to materialize and be realized through sale (uncertainty resolution).
Some people, like retirees or trust funds either do not want to or cannot touch their principal investments, so rely on income.
Corporations get dividends from other corporations tax free.
Other investors are also tax exempt.
44(C) 2009 Red Hill Capital Corp.,
Delaware USA
Market value of franked dividendsWe can set out to determine the market value
of dividends by comparing the capital loss, the price decline of the stock, on the dividend ex date. Thus, the day before the ex-date, the share price included a dividend, after the ex-date the dividend is paid in cash, and the share value will reflect that loss. But how much should it be?
The capital loss is measured by the dividend drop-off ratio, which is the capital loss on ex-date divided by the dividend.
45(C) 2009 Red Hill Capital Corp.,
Delaware USA
Market value of franked dividends dividend drop-off ratio compares the
decline in the share price on the ex-dividend day to the cash dividend depends on the company tax rate and a typical shareholder’s marginal tax rates on
dividend income and capital gains
Let us look at the basic math of the situation………
46(C) 2009 Red Hill Capital Corp.,
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Alternative cash flows If an investor bought shares at price P(p),
and he sells them on the day before the ex-dividend date, his after-tax cash flow is:
CF(cd) = P(cd) – (P(cd) – P(p)) x T(cg)
Where cd=cum dividend, and T(cg) is capital gains tax.
Next, consider……………………..
47(C) 2009 Red Hill Capital Corp.,
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Alternative cash flows The same shareholder waits til the next day, after
the stock is trading ex-dividend, and gets the dividend and sells the stock. Then, the cash flow after tax is:
CF(xd) = P(xd) – (P(xd) – P(p)) x T(cg) +
These cash flows should be the same (they are less than a day apart), so by equating the two equations to each other, we get………..
c
p
t
tD
1
1
48(C) 2009 Red Hill Capital Corp.,
Delaware USA
Dividend drop-off
Which just says that after tax CG (loss due to price drop) = (1-tg)(PCD – PXD) on ex-date should be the same as after tax dividend = D(1 – tp)/(1 – tc).
This should be true because people care about what they actually get (AT inc)
)1)(1(
1
gc
p
f
DXCD
tt
t
D
PP
49(C) 2009 Red Hill Capital Corp.,
Delaware USA
Calculating the after-tax dividend In general, we use the PT dividend to
compute personal tax, then, we subtract off the franking tax credit (in the case of 100% franking, below). Then, we subtract personal tax due minus tax credit from franking to get AT dividend income, as:
tttt
tttt c
cpc
cc
pc
DDDDDD
1
)1(
11
50(C) 2009 Red Hill Capital Corp.,
Delaware USA
Calculating the after-tax dividend
Which shows that the only tax on pre-tax income of the corporation paid out as dividends is paid by the shareholder.
51
c
pf t
tDtadiv
1
1).(
(C) 2009 Red Hill Capital Corp., Delaware USA
Standard Policies
52(C) 2009 Red Hill Capital Corp.,
Delaware USA
Residual Dividend Assume a company wants to maintain its
capital structure but wants to minimize its need to sell new equity.
Then, it will look to invest free cash flow in positive NPV projects and payout any leftovers.
This is called residual dividend policy. We would expect, then, young fast-growing
firms to have a low payout ratio and older mature firms with less opportunity to grow to have high payouts.
53(C) 2009 Red Hill Capital Corp.,
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Stable Dividend As opportunities wax and wane, a residual
dividend policy could have a very unpredictable pattern.
The definition of a stable dividend policy is one in which the firm pays a fixed payout ratio.
That will be effected either semi-annually, called cyclical policy or yearly.
Most firms try to at least not cut dividends because it can send a negative signal to the markets.
54(C) 2009 Red Hill Capital Corp.,
Delaware USA
Compromise Policy
5 Goals dominate real world policy:
1. Avoid cutting +NPV projects to pay D.
2. Avoid cuts in dividends.
3. Minimize need to sell equity.
4. Maintain target capital structure.
5. Maintain a target payout ratio. Companies can satisfy goals with regular and
extra dividends.
55(C) 2009 Red Hill Capital Corp.,
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Additional Policy Considerations The clientele effect refers to the fact that
certain groups of investors because of their needs will gravitate to high or low payout ratio stocks.
Thus, companies might design dividend policy to attract certain investors, and it must keep that in mind when administering policy on an ongoing basis.
56(C) 2009 Red Hill Capital Corp.,
Delaware USA
Additional Policy Considerations Firm’s must also be aware of changes in
the demand side of the market for dividends.
Investors take signals, i.e., infer information from dividend announcements.
That is due to the asymmetry of information between insiders of the firm and outsiders.
Outsiders don’t have all the info.
57(C) 2009 Red Hill Capital Corp.,
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Additional Policy Considerations Agency costs (external monitoring and
constraint on use of free cash flows). If you pay out a lot of your earnings in dividends, you have to raise more money externally, which requires information disclosure in prospectuses.
This keeps a rein on management by showing more internal information.
So, if they pay high dividends and need to raise more capital, their track record becomes more visible in additional disclosure
58(C) 2009 Red Hill Capital Corp.,
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Optimal dividend policy When making dividend policy, firms take into
account Internal: to payout earnings or to use them
for internal project financing. Institutional factors include legal restrictions
and the mix of shareholders with differing tax statuses
Market factors including transaction costs, agency costs, and the incompleteness of information that shareholders have versus managers.
59(C) 2009 Red Hill Capital Corp.,
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Internal factors and dividend policy profitability liquidity and capacity to attract external financing
Generally, these factors vary with the stage of a firm’s life-cycle and can vary with the business cycle in the shorter term..
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Institutional factors
inability to pay dividends from legal capital possible restrictive loan covenants taxation system – maximise after-tax return
for the majority of shareholders
61(C) 2009 Red Hill Capital Corp.,
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Market factors
asymmetric information transaction costs agency costs
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Alternatives to Cash Dividends
63(C) 2009 Red Hill Capital Corp.,
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Bonus Shares: Stock Dividends As an alternative to cash, dividends can
also be paid out in shares, e.g., stock dividend of 0.1 shares per share of outstanding stock.
These are called bonus shares in Australia. Even though there is no value paid for
shares, and the value of the firm has not changed, investors can take a bonus share issue as a positive signal from management.
Then, the market value will increase.
64(C) 2009 Red Hill Capital Corp.,
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Share Repurchases Another real alternative to cash
dividends is for the company to repurchase a portion of its shares.
That way, investors can get some cash.
Realistically, it should have no impact on value, if cash is paid to investors by dividend or by repurchasing shares.
65(C) 2009 Red Hill Capital Corp.,
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Share Repurchases Tax-wise, though, tax must be paid on
dividends, while tax is paid only by those who sell shares into the repurchase.
In addition, signals can be inferred from repurchasing.
If the company believes that its shares are a good buy, then, maybe they are undervalued because management knows something that investors do not.
66(C) 2009 Red Hill Capital Corp.,
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Share repurchase
When the company purchases its own shares, there are rules and restrictions:
Can buy up to 10% of shares in 12 months (10/12)
Legislation specifies 5 methods1. equal access purchase
67(C) 2009 Red Hill Capital Corp.,
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Share repurchase
2. on-market purchase3. selective purchase4. employee share plan5. odd lot purchase (odd lots are
shareholdings that are less than a standard exchange purchase lot, which is 100 shares).
68(C) 2009 Red Hill Capital Corp.,
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Information Content of Repurchases Share repurchases sends a positive signal
that management believes that the current price is low and investing in its own shares is a good corporate investment.
Tender offers send a more positive signal than open market repurchases because the company is stating a specific price
The share price often increases when repurchases are announced because of those kinds of signals inferred.
69(C) 2009 Red Hill Capital Corp.,
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DRIP’s While some people like cash and, therefore,
cash dividends, other don’t like dividends and would prefer gains in principal.
Dividend reinvestment plans (DRIP’s) give shareholders a chance to not get dividends but to get growth in principal, instead.
For those signed up for the plan, the company takes their dividends and exchanges the cash for new share at a discount to market value with no transactions fees.
70(C) 2009 Red Hill Capital Corp.,
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Splits & Reverse Splits
Beyond bonus shares, companies can also do share splits, e.g., each old share becomes 2 new shares, or
Reverse splits, whereby each old share might become ½ a new share.
Companies do this, mainly to adjust the prices of their stocks for investors to purchase comfortably.
71(C) 2009 Red Hill Capital Corp.,
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Splits & Reverse Splits
The reason is that shares are normally sold in blocks of 100 shares on the markets; lower amounts are called odd-lots, and their purchase is more expensive in transaction costs.
So, many companies try to adjust the price of their stocks, in the market, so many, more, or certain investors can purchase them.
72(C) 2009 Red Hill Capital Corp.,
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Splits & Reverse Splits
Thus, a price of $25/share means $2,500/block.
Warren Buffet of Berkshire Hathaway has taken the other tact and has a share price for his company’s stock in the range of several hundred thousand US$/share, so that only the wealthy can own his shares.
Again, this is marketing and stock design.
73(C) 2009 Red Hill Capital Corp.,
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Trailer
74(C) 2009 Red Hill Capital Corp.,
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The accounting aspects If, as is entirely possible, you are an
accounting student, you might be interested in how the dividends are paid (from the accounting point of view).
When the dividend is announced, the firm transfers funds from the retained earnings account to the dividends payable account.
When the dividend is paid on the payment date, the dividends payable account reduces by the amount of the dividend and so too does the cash account:
75(C) 2009 Red Hill Capital Corp.,
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The accounting aspects
Time three: dividend paid
Cash $50 Dividends payable $0
Retained earnings $200
Time two: upon the announcement of a $50 dividend
Cash $100 Dividends payable $50
Retained earnings $200
Time one: before dividend declaration
Cash $100 Dividends payable $0
Retained earnings $250
76(C) 2009 Red Hill Capital Corp.,
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Residual theory: dividend policyfrom Study Book We mentioned in passing that the firm will (1)
determine how much it needs to spend on positive NPV projects; (2) estimate the amount of equity financing it will need (using its optimal debt-to-equity ratio); (3) use new share issues to top-up retained earnings if necessary; and (4) if the required investment amount is less than retained earnings, the difference may be paid out in dividends.
77(C) 2009 Red Hill Capital Corp.,
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Residual theory: dividend policy The question is: how is the debt-to-equity
ratio used in this particular situation? 1. Assume that the firm has $3 000 000 in
retained earnings. 2. Assume that the firm has determined that it
wants to spend $1 000 000 on new, positive NPV projects.
3. Assume that the firm has determined its debt-to-equity ratio should be around 35% (35% debt-to-65% equity).
78(C) 2009 Red Hill Capital Corp.,
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Residual theory: dividend policy 4. With this debt to equity ratio, the firm will finance
the $1 000 000 in investments with $350 000 debt and $650 000 equity.
5. Since the firm has $3 000 000 in retained earnings it will use $650 000 worth and pay out the rest in dividends.
This line of reasoning will work for various scenarios. Of course, if the firm wanted to invest in $5,000 000 of positive NPV projects, it would need to issue new shares to raise additional equity capital. This is because 65% of $5 000 000 comes to $3 250 000 and we only have $3 000 000 in retained earnings. In this case, there would be no dividend.
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Learning activity
Attempt all of the critical thinking and concepts review section.
From Chapter 14: questions and problems 1, 2, 3, 7, 8, 9, 11, 12, 14.
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END
81(C) 2009 Red Hill Capital Corp.,
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