Dividend PolicyROOZBEH HOJABRI -1082200038

DBA PROGRAMFACULTY OF MANAGEMENTMULTIMEDIA UNIVERSITY

Contents : • Introduction • Type of dividend • Dividend and corporate finance• Divided VS Interests • Dividend payments• Dividend Policy• Dividend Reinvestment Plans (DRIPs)• Dividend Payments

• Implications• Effect on the Company• Effect on Shareholders

• Stock Dividends versus Stock Splits• Modigliani and Miller’s Dividend Irrelevance theory

• Assumptions• Residual Theory of Dividends• Homemade Dividends

• The “Bird-in-the-Hand” Argument • Assumption • M&M versus Gordon’s Bird in the Hand Theory

• Dividend Policy in Practice– Lintner’s Work on Dividend Adjustment– Welcome to the Real World!

• Transactions Costs• Dividends and Signaling• Agency theory• The Excess Cash

• Share Repurchases• Borrowing to Pay Dividends• Overall framework• Intra-industry conformity in dividend policy

• Use Dividends to Signal or Not: An Examination of the UK Dividend Pay out Patterns

Dividend PolicyWhat 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.

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.

Dividends and Corporate Financing– 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.

Corporate Profits After Tax Retained Earnings

Dividends

Dividends versus Interest ObligationsInterest

• 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 firm’s 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)

Dividend Payments• Declaration Date• Holder of Record Date• Ex-dividend Date• Payment Date

Dividend PaymentsDeclaration 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 firm’s 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 Payments

• Declaration Date

• Date of• Record

• Date of• Payment

• 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 opening…compared• to the previous day’s close.

• The Board Meets• and passes the• motion to create• the dividend

• 2 business days prior to the Date of Record

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 post-trade 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.

Dividend PolicyDividends, 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 BOD’s 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

Dividend PaymentsDividend 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 on-going relationship with shareholders

Dividend PaymentsDividend Reinvestment Plans (DRIPs)

• 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 firm’s ability to pay dividends in the future.

Dividend PaymentsStock Dividends

Implications– reduction in the R/E account– reduced capacity to pay future dividends– proportionate share ownership remains unchanged– shareholder’s wealth (theoretically) is unaffected

Effect on the Company– conserves cash– serves to lower the market value of firm’s 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

Effect on Shareholders– proportion of ownership remains unchanged– total value of holdings remains unchanged– if former DPS is maintained, this really represents an increased dividend payout

Stock Dividends versus Stock Splits• Stock Dividends Stock Splits

- lowers stock price slightly - large drop in stock price- little psychological appeal - much stronger potential signalling effect- recapitalization of earnings - no recapitalization- no change in proportional - same

ownership- odd lots created - odd lots rare- theoretically, no value to - same

the investor

Modigliani and Miller’s Dividend Irrelevance theory

Modigliani and Miller’s Dividend Irrelevance

• The value of M&M’s Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.

M&M’s Dividend Irrelevance 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

M&M’s Dividend Irrelevance 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.

M&M’s Dividend Irrelevance Residual Theory of Dividends - Implication

The implication of the Residual Theory of Dividends are:

Investment decisions are independent of the firm’s 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 can’t 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

M&M’s Dividend Irrelevance Homemade Dividends

• Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern.– They don’t need management declare a cash

dividend, they can create their own.

Conclusion: under the assumptions of M&M’s model, the investor is indifferent to the firm’s dividend policy.

The “Bird-in-the-Hand” Argument

The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed

• Risk is a real world factor.• Firm’s that reinvest free cash flow, put

that money at risk – there is no certainty of investment outcome – those forfeit dividends that are reinvested…could be lost

The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed

• 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

0

1

P

D

Gordon

OPTIMAL INVESTMENT

M&M

0

01

P

PP

The “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand Theory

Conclusions:– Firms cannot change underlying operational

characteristics by changing the dividend– The dividend should reflect the firm’s

operations through the residual value of dividends

Dividend Policy in Practice

Dividend Policy in Practice• 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

• Dividend Policy in Practice (Lintner’s 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

Dividend Policy in Practice Lintner’s Work on Dividend Adjustment

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&M’s irrelevance arguments because the real world does not match the assumptions

used

Relaxing the M&M AssumptionsWelcome 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

Relaxing the M&M AssumptionsWelcome to the Real World!

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 changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)

Relaxing the M&M AssumptionsWelcome to the Real World!

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.

Relaxing the M&M AssumptionsWelcome to the Real World!

– 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 investment…remember only ‘realized’ capital gains are subject to tax

• Low income earners tend to prefer dividends

Conclusion – firm’s should not change dividend policy drastically since it upsets the existing ownership base.

The Excess Cash

• The excess cash that a firm has in any period should be paid out as dividends in that period.– Argument: The firm has (temporary) excess

cash on its hands this year, no investment projects this year and wants to give the money back to stockholders.

– Counter: So why not just repurchase stock? If this is a one-time phenomenon, the firm has to consider future financing needs. • Consider the cost of issuing new stock• If it initiates dividends, it may need to raise capital

through a stock issue just to pay dividends in the future

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

Share Repurchases• 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.

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.

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.

• open market purchase:– the purchase of shares through an investment dealer like

any other investor– this is not designed for large block purchases.

• 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.

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

Advantages of Share Repurchases• signal positive information about the firm’s future

cash flows• used to effect a large-scale change in the firm’s

capital structure• increase investor’s 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.

Disadvantages of Share Repurchases• signal negative information about the

firm’s 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

Borrowing to Pay Dividends

SIGNALLING

Borrowing to Pay Dividends• 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.• Why?

– A possible answer is to signal to the market that the board is confident about the firm’s ability to sustain cash dividends into the future.

Overall framework

Dividend Policy

The Excess Cash The excess cash that a firm has in any period should be paid out as dividends in that period.•Consider the cost of issuing new stock

•If it initiates dividends, it may need to raise capital through a stock issue just to pay dividends in the future

M & M• Dividends do not affect value• (a) There are no tax differences between dividends and capital gains.

• (b) If companies pay too much in cash, they can issue new stock, with no flotation costs or signaling consequences, to replace this cash.

• (c) If companies pay too little in dividends, they do not use the excess cash for bad projects or acquisitions.

The bird in the hand•Dividends are better than capital gains because dividends are certain and capital gains are not.

•Risk is a real world factor.•Firm’s that reinvest free cash flow,

• there is no certainty of investment outcome – those forfeit dividends that are reinvested…could be lost

Lintner’spartial adjustment model to

explain the smoothing of dividend behavior illustrating

that firms slowly change dividends as they move toward a new target .

* Firms are very reluctant to fully adjust

* Firms do not follow a policy of paying a constant

proportion of earnings out as dividends

Signaling theory•Dividend changes act as signals to financial markets about the future sustainable earnings of the firm

•Under conditions of information asymmetry, shareholders and the investing public watch for management signals (actions) about what management knows.

Wealth Transfer :•By returning more cash to stockholders, there might be a transfer of wealth from the bondholders to the stockholders

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 projectsShare repurchasing

•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

•

Intra-industry conformityin dividend policy

TOM VAN CANEGHEM

HOGESCHOOL-UNIVERSITEIT BRUSSEL, BRUSSELS, BELGIUM AND

ANTWERP MANAGEMENT SCHOOL,

UNIVERSITEIT ANTWERPEN, ANTWERPEN, BELGIUM, AND

WALTER AERTS

UNIVERSITY OF ANTWERPEN, ANTWERPEN, BELGIUM

• Purpose – The purpose of this paper is to study the impact of intra-industry conformity tendencies• on dividend policy among a large sample of US firms.

• Design/methodology/approach – The paper explores mimetic influences on dividend policy.• Consistent with prior institutional research, the paper measures mimetic pressures as institutional• prevalence or the pervasiveness of a feature of dividend policy within a firm’s relevant environment.

• Findings – The results reveal a significantly positive relationship between the lagged density of• firms in the industry that pay a dividend and the probability of a focal firm paying a dividend.• Moreover, for firms paying a dividend, results indicate that higher similarity in dividend payout• among firms in the same industry induces more conformity between a focal firm and average industry• practice. Overall, results are consistent with imitation in dividend policy.

• Research limitations/implications – The results support the view that future research on• dividend policy should value social and behavioral factors more explicitly in order to arrive at a more• overall and consistent explanation of firms’ dividend policy. Moreover, the results also illustrate the• relevance of alternative theories in explaining dividend policy.

• Practical implications – The results show that intra-industry benchmarking of dividend policy• plays a significant role in the USA.

• Originality/value – This study documents the relevance of social imitation mechanisms behind• dividend payout behavior and therefore adds to the current knowledge of the impact of behavioral• processes on dividend policy.

• Conformity tendencies in dividend policy– Institutional templates of appropriate behavior– Industry effect on dividend payout behavior

Hypothesizes :• H1. The density of other firms in the industry paying a

dividend is positively related to the likelihood that the focal firm will pay a dividend.

• H2 .Greater dividend payout similarity within the industry increases conformity between the focal firm’s dividend payout and the industry practice.

Conclusion • First, consistent with H1, the density or relative number of

other firms in the industry paying a dividend in a prior year is positively related to the likelihood that the focal firm will pay a dividend in the current year.

• Second, consistent with H2, greater dividend payout similarity within the industry in a prior year drives the extent to which a focal firm’s dividend payout conforms to the average industry practice in the current year.

• This is consistent with neo-institutional predictions, stating that institutional prevalence or higher shared agreement on a common industry dividend payout template engenders significant institutional pressure on firms to imitate industry recipes.

Cont.• The results obtained in this study suggest that dividend payout

decisions are affected by actions and processes at the level of organizational fields (in casu shared agreement on dividend payout templates and competition at the industry level) and not only by

technical, firm-level characteristics.• The finding that intra-industry similarity enhances conformity is

consistent with arguments emphasizing cognitive and normative legitimacy concerns as engines for dividend payout decisions.

• Overall, the results show that the behavior of firms at the industry level can be significant predictors of dividend payout practices at firm level.

• results support the view that future research on dividend policy should value social and behavioral factors more explicitly in order to arrive at a more overall and consistent explanation of firms’ dividend policy.

Use Dividends to Signal or Not: An Examination of

the UK Dividend Pay out Patterns

BY CHIN- BUN TSE, MANAGEMENT CENTRE, UNIVERSITY OF LEICESTER

Abstract• Author examine the dividend pay out pat terns for all UK

listed industrial companies featured in the FTSE All Share Index for the period 1992- 1998.

• Then match the pay out patterns to different dividend policies. From author empirical observations, argue that dividend signalling does not universally apply to all firms.

• also reports evidence that there is no industry norm for dividend policy, particularly when firms have decided whether to use dividends to signal or not.

• In addition, we found that the percent age of insiders’ share holdings, market capitalization and as set book values are statistically significant for determining whether firms use dividends to signal or not.

Introduction • In their discussion of dividend signalling models and

theories, Cope land and Wes ton (1992, p. 567) raise an unanswered is sue. They claim that

“al though they ex plain how an optimal dividend policy may arise, none of them can successfully explain cross- sectional

• differences in dividend pay outs across firms”. • In this paper, author apply a new approach to investigate UK

listed firms’ pay out patterns from a signalling frame work. • Specifically, author want to examine whether alternative

pay out patterns observed in practice are consistent with a dividend signalling hypothesis.

• also investigate what special characteristics would make firms more likely to use dividends to signal.

• Review of Dividend Signal ling Literature– Price- dividend type

• This is the usual method to test the dividend signalling hypothesis. Essentially, researchers use OLS regression to regress standardized share price or share re turns on dividends, along with other explanatory variables.

• Recently, standardized total market value has also been used as the de pendent variable in the regression analysis [Fama and French (1998)].

• Event studies are also common in this group of research to look at the market re actions following dividends changes. Some researchers refer to this relationship as the pricing of dividends [see: Hand and Lands man (1999)].

– Dividend- earnings studies• In these studies, researchers investigate the relationship between dividends

and firms’ earnings. Different researchers use different earnings as explanatory variables. The impacts of past earnings, current earnings and future earnings on dividends have all been considered in this type of empirical test.

• need to identify the alternative pay out pat terns of the sample firms. Then ,author link up the pay out patterns to different models of dividend behavior to see whether pay out pat terns are con sis tent with the dividend signalling hypothesis. author use three stages to establish firms’ dividend pay out pat terns:– Initial stage: identifying alternative patterns

• John son & Wichern (1998)

• identified five distinct groups of dividend pay out pat terns. They are Always- increase, Smooth, Pay- nothing, Irregular and Follow- earnings

– Second stage: allocation• dividends per share and earnings per share (EPS).

• All per share data has been adjusted for capital changes– Third stage: fine tuning

• need to look at the actual earnings and dividends time series raw data and cal cu late their correlation coefficient to differentiate

Results • Results for the initial identifying stage

– Smooth– Follow earnings– Always- increase– Irregular– Pay- nothing

• Results for the allocation and fine- tuning stages– identified 35 potentially mis- classified companies that

could be either Always- increase or Follow- earnings– one company could be ei ther Follow- earnings or

Smooth. – no confidence to make a distinction between them

• Always- increase (32.48%)• Irregular (31.57%)• Follow- earnings type with 23%• 9.12% of firms smooth• Pay- nothing firms are a mi nor ity with

just 3.83%.

Concluding Remarks• differences in dividend pay outs across firms”. Our

analysis provides a partial solution to this• puzzle.• The answer is that not all firms are dividend

signallers: some do, some do not. Signallers will exhibit pay out pat terns that are con sis tent with dividend signal ling hypothesis.

• The pay out patterns of many non- signallers are in consistent with dividend signalling theory.

• As pay out patterns are direct results of firms’ dividend policy, there fore not all pay out pat terns will be con sis tent with dividend signaling hypothesis.

• that dividend policy is very much set at in firm levels. Industry norm is not a major determinant for firms’ dividend policy. Our result also shows that the IH(insider holdings), MC (market capitalisation )and AB values(asset book value) are the major factors to determine whether firms to use dividends to signal or not.

Thank you