FIN601 Lect Topic 6

Topic 6
1
Chapter 13: Dividend Policy
Reference: Beal, Goyen & Shamsuddin, 2008
2
Fundamental dividend concepts
The dividend policy involves the allocation of

profits between dividend payments to
shareholders and retention for reinvestment in
the company.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 13, Australia: Wiley. 3
The dividend payment process
Australian and New Zealand companies
generally pay cash dividends twice a year
(interim dividend and final dividend).
A final dividend is paid following the annual
general meeting and an interim dividend is paid
typically six months prior to the final dividend.
Whether to pay dividends in a publically listed
company, and how much to pay, are
recommendations made by the Board of
directors.
The directors take into account the last
periods financial performance and dividend
payment and future growth opportunities in
recommending the amount of dividend to pay.
The announcement date is the date of the
directors meeting when the dividend is
recommended.
The record date is used to identify all
shareholders on the register of members so
they can receive a dividend.
The ex-dividend date is certain working days
prior to the record date, to allow time for
registering changes in share ownership in the
Register of Members by the record date.
Cum-dividend shares are those that have a

current dividend entitlement.
On the ex-dividend date, the share price
normally drops because investors who
purchase shares on or after the ex-dividend
date do not receive a dividend.
Measures of dividend policy
A firms dividend policy is primarily reflected in

the:
dividend payout ratio
Dividend yield
Stability of dividends over time.
Dividend payout ratio

The dividend payout ratio measures the
amount of dividends paid per dollar of
earnings.
Example: if the BSPs dividend per share and
earnings per share were $1.66 and $2.52,
respectively. What was the dividend payout
ratio?
= 1.66/2.52
= 0.6587
=65.87%
The dividend payout ratio can be used to
estimate the firms future earnings growth
rates.
The retention ratio is the proportion of
earnings retained in the company, not
returned to shareholders as dividends.
Retention ratio = 1-payout ratio
A firm with a high retention ratio is normally
expected to have higher future growth in
earnings and share prices.
The expected growth rate of a firm depends on
the retention ratio and the rate of return on
retained profits (return on equity).
Return on equity, is the ratio of net profit to
equity.
Example: BSP increased its dividend payout
ratio from 65% in 2005 to 75.5% in 2006. Over
the same period the return on equity increased
from 16.45% to 18.18%. Calculate the estimated
growth rate under the two payout ratios.
High payout= (1-0.755) x 0.1818 =4.45%

Moderate payout = (1-0.65) x 0.1645 =5.76%
Dividend yield
Dividend yield is the ratio of dividend per share to the
share price.
Dividend yield
Example: BSP paid a dividend of 40 cents per
share and its share price was around $4.94 at
the end of the year. What is the dividend yield.
= 0.40/4.94
= 8.1%
Dividend stability
Dividend stability shows the volatility of
dividend yields or dividend per share over time.
Companies generally attempt to pay a stable
stream of dividends to shareholders despite
fluctuations in earnings.
In particular, companies are reluctant to reduce
dividend payout when earnings decline and
they increase dividends when a persistent
increase in earnings is anticipated.
Dividend stability
There is no standard measure of dividend
stability.
We focus on two alternative measures of
dividend stability:
standard deviation of dividend yields
and
the dividend instability indicator.
Dividend stability Standard deviation of yields
The standard deviation of dividend yields gives
an indicator of volatility of dividend yields
around the mean dividend yield.
Dividend stability Instability indicator
This measure is based on the incidence of
cuts to dividend payout.
Unlike the standard deviation, this measure
considers only downward movements in
dividends.
Dividend irrelevance theory
Theories of dividend policy are concerned with

the potential impact of a dividend decision on
share value of a company.
Broadly speaking, these theories can be
categorised into two groups: those proposing
that dividends are irrelevant to share value,
and those proposing that dividends are
relevant to share value.
Dividend irrelevance theory argues that
what a company pays in dividends has no
influence on its share value.
This theory was put forward by Miller and
Modigliani (M&M), and is based on the
notion that, if there are no taxes, investors will
only care about return, not the components of
total return dividend and capital gain.
Companies that pay lower dividends and retain
more earnings for reinvestment are likely to
provide higher future earnings growth and
capital gains than companies paying higher
dividends.
The M&M theory relies on this fundamental
trade-off between dividends and capital gain and
is based on the following assumptions:
The investment decisions of the company are
independent of its dividend policy. This
assumption is useful in isolating the impact of
dividend policy from the influence of
investment decisions.
Capital markets are perfect. This assumption
implies that there are no business or personal
taxes, investors can buy and sell with no
transaction costs and complete information
about companies is available to investors with
no costs.
Under these assumptions, it can be shown that

there is no relationship between a companys
dividend policy and its market value.
As noted earlier shareholders are concerned
about the total return.
It is important to remember that, in a perfect
capital market, investors are indifferent to
receiving dividends or share price appreciation.
Regardless of the firms dividend policy,

shareholders can create a dividend stream of
their choice.
The dividend irrelevance argument relies on
the fundamental premise that the value of a
company depends on its cash flows, which in
turn depend on investment decisions not
dividend decisions.
Dividend relevance theory
Arguments for dividend relevance theory are

based on the tax treatment of dividends as
compared to capital gains, riskiness of capital
gains, informativeness of dividend payouts,
agency costs, transaction costs and the
clientele effect.
Tax treatment of dividends and capital gains
Under a classical taxation system, dividends
are generally taxed more heavily than capital
gains.
Since investors are more concerned about
after-tax return, they would be willing to pay
less for shares of firms distributing a high
dividend at the expense of a capital gain.
This assertion is made under the classical tax
system where dividends are taxed at both
corporate and individual levels.
Taxation of dividends
Until 30 June 1987, Australia had a classical tax
system, featuring double taxation of dividends.
However, under the imputation taxation
system, dividends are taxed at the
shareholders personal tax rate and taxes paid
by a company on its taxable earnings are
deducted from the shareholders personal tax
bill under the Australian dividend imputation
system.
An imputation tax credit represents the
amount of tax on a dividend that has been paid
by the company on behalf of a shareholder.
A dividend containing an imputation credit is
known as a franked dividend.
Dividend franking is common practice at
Australian firms.
An imputation credit for a fully franked dividend is
calculated as follows:
where: = grossed up dividend
Example: Where Marginal personal tax
rate is higher than the corporate tax rate
(30%).
Tran received a fully franked dividend of $100.

He is in the 45% marginal tax bracket. His after
tax dividend income is :
Example contd:
Fully franked dividend = $100
Grossed up dividend = 100/(1-0.30) = $142.86
Tax at 45% = $142.86 x 0.45 = $64.29
Imputation credit = [100/(1-.030)] x 0.30 =
$42.86
Net tax liability = $64.29 - $42.86 = $21.43
After tax dividend = $100 - $21.43 = $78.57
Example: Where Marginal personal tax
rate is lower than the corporate tax rate
(30%).
Anita is currently in the 15% personal income

tax bracket. She received a fully franked
dividend of $100. Her after tax dividend
income is :
Example contd:
Fully franked dividend = $100
Grossed up dividend = 100/(1-0.30) = $142.86
Tax at 15% = $142.86 x 0.15 = $21.23
Imputation credit = [100/(1-.030)] x 0.30 =
$42.86
Net tax liability = $21.23 - $42.86 =-$21.43
After tax dividend = $100 - -$21.43 = $121.43
Example contd
Anitas tax on her grossed up dividend is less
that her imputation credit. She is entitled to a
refund of $21.43, the surplus imputation credit.
Therefore, her after-tax dividend income is more
than the fully franked dividend.
The after-tax dividend can be expressed as:
This expression can be further simplified as:
Where: Df = fully franked dividends

tp = investors marginal tax rate
tc = company tax rate
Verifying this formula with the previous

examples:
Tran received a fully franked dividend of $100.
he is in the 45% marginal tax bracket. His after
tax dividend income is :
= 100[(1-.45)/(1-.30)]
= $78.57
Anita is currently in the 15% personal income

tax bracket. She received a fully franked
dividend of $100. Her after tax dividend
income is :
= 100[(1-.15)/(1-.30)]
= $121.43
Market value of franked dividends
Unfranked dividends have no tax advantage
over capital gains in Australia.
Franked dividends may have a tax advantage
over capital gains resulting from retention of
earnings.
The market value of this tax advantage should
be reflected in share prices and can be
measured by the dividend drop-off ratio.
The dividend drop-off ratio is the ratio of
the decline in the share price on the ex-
dividend day to the cash dividend.
An investor who holds shares for less than 12
months will not be entitled to a tax discount
on capital gains.
Thus a short term investor might be indifferent
between unfranked dividends and capital gains
because both are taxed at the investors
marginal tax rate with no discount for capital
gains and no imputation credits for dividends.
The drop-off ratio can be calculated according to the
following equation:
Example: Suppose the typical investor in New
England Biotech holds shares for less than 12
months and faces a personal tax rate of 45%.
The company is expected to pay a fully franked
dividend this year. Given the company tax rate
of 30%, estimate the expected price decline as
a percentage of dividend payout on the ex-
dividend day.
Example contd
Here tp=tg, because the typical investor is not
eligible for a capital gains tax discount.
= 1-0.45/[(1-.30)(1-0.45)]
= 1.43 or 143%
That is for each dollar of fully franked dividend, the
price decline would be $1.43 on the ex-dividend day.
Other dividend relevance arguments
Riskiness of capital gains
It has been argued that shareholders consider
dividends to be paid in the distant future more
unpredictable and riskier than dividends to be
paid in the near future.
Thus, dividends anticipated in the distant
future will be discounted at a higher rate to
reflect this differential risk.
Put differently, investors prefer a bird in the
hand over two in the bush.
Thus, share value might be increased by
increasing current dividends at the cost of
future growth in earnings and capital gains.
Investors prefer a dollar of current dividends
over capital gains anticipated from a dollar of
retained earnings because future cash flows
are riskier.
However, the fallacy of the bird in hand
reasoning can be recognised by focusing on
the basic valuation principle.
The risk of a company depends on the
riskiness of the cash flows from its assets, not
on the temporal pattern of dividend payout.
A change in dividend policy has no impact on
the expected cash flows or its volatility.
Thus, where shareholders are rational wealth
maximisers, high dividends are not expected to
increase the value of the company.
Signalling and asymmetric information
Corporate insiders know more about the firms
capacity to generate cash flows and earnings
than outsiders.
This asymmetric information is an important
source of market imperfection.
Insiders can convey their private information
to markets through announcing a change in
dividend payout.
Signalling and asymmetric information
An increase in dividend is costly to a firm and
generally viewed as a positive signal because it
reflects the firms ability to generate adequate
cash flow to meet its dividend payment and
debt obligations in the future.
Signalling theories suggest that an increase in
dividend gives a signal for a permanent
increase in earnings and increases shareholder
value.
Agency costs
Agency costs arise from the separation of
ownership and day-to-day management of
companies managers may make decisions to
maximise their own benefits rather than
shareholders wealth.
It has been argued that dividend payments
may reduce agency costs in two ways.
First, dividend payments may facilitate
external monitoring of a managers
performance.
Agency costs
This is because higher dividend payments can
lead a company to raise external capital by
issuing new shares or debt instruments.
This process involves publicising information
about the companys recent performance and
future growth prospects in a prospectus which
is scrutinized by market participants.
Thus, the capital raising process exposes a
managers performance to external monitoring
and encourages managers to act in the interest
of shareholders.
Agency costs
Second, dividend payments may restrain
managers from spending free cash flows on
unprofitable activities.
Managers may prefer to retain free cash flows
(rather than pay as dividends) and use the
funds to provide themselves with attractive
salary package or to spend on projects to
enhance their corporate powers.
Therefore, a high dividend policy can be
effective in reducing agency costs and
increasing share value of the firm.
Transactions costs and the clientele effect
If a company adopts a high dividend policy, it
may have to raise capital by issuing new shares,
which involves floatation costs.
Thus, floatation costs may induce a company
to adopt a low dividend policy and rely more
on retained earnings to meet investment
needs.
Transaction costs also constrain shareholders
from creating a homemade dividend stream.

If there is a mismatching between a
shareholders consumption needs and
dividend payments, the shareholder may buy
or sell shares to create a desired stream of cash
flows.
However, transactions costs of buying and
selling shares limit the shareholders ability to
achieve this goal.
Companies paying a regular stream of
dividends may attract investors, such as
pensioners, who need additional income to
meet their consumption needs.
While, companies paying low or no dividends
typically attract investors at the middle stage of
their life cycle who usually have adequate
income to meet their consumption needs.
Recognising this dividend clientele effect,
companies generally try to avoid any
significant changes to their dividend payout
ratios.
Alternatives to cash dividends
Share repurchase
A share repurchase refers to the company
buying back its own shares and is a substitute
for a cash dividend.
A share repurchase reduces the number of
outstanding shares and usually increases the
share price.
A share repurchase can be a perfect substitute
for a cash dividend under certain assumptions.
Share repurchase
Rationales for share repurchase
Buybacks lead to an increase in earnings per
share (EPS) and are often accompanied by a
share price appreciation or capital gain.
Share buybacks can perform a signalling
function. Buybacks provide positive signals
to investors about the companys future
earnings prospects.
Share buybacks are a more flexible way to
return cash to shareholders as, unlike with
dividends, investors do not expect a
company to repurchase its shares on a
regular basis.
Bonus shares
Bonus shares are dividends paid in the
form of additional shares.
There are four main motivations for
providing bonus shares.
First, a share dividend can be given without
cash, which is an attractive way of paying
dividends for cash-strapped companies.
Second, a company in a high-growth phase
of its life cycle may reinvest most of its
earnings on profitable investment projects
and offer a share dividend scheme to
supplement its low cash dividend policy.
Bonus shares
Third, a bonus issue increases the number of
shares outstanding and may reflect the
companys confidence in future earnings
growth and ability to pay dividends on an
augmented share base.
Fourth, some managers believe that market
liquidity for the companys shares can be
improved by making more shares available
to potential investors, at a lower price per
share, through a bonus issue.
Dividend reinvestment plan
A dividend reinvestment plan (DRP)
provides shareholders with an option to
invest their cash dividends in the companys
shares.
A DRP has several attractive properties.
First, a DRP allows existing shareholders to
acquire more shares in the company without
incurring transactions costs.
Second, many companies offer a discount of
about 5% of the prevailing market price,
making the DRP more rewarding to existing
shareholders.
Dividend reinvestment plan
Third, participation in a DRP is voluntary.
Thus, a DRP offers flexibility to shareholders
in making an investment decision.
Fourth, a DRP may be useful in conserving
the companys cash balance. It generally
allows a company to get back part of a cash
dividend by issuing additional shares.
Disadvantages of a DRP include an increase
in cost of capital for the company where
shares are issued at a substantial discount
and new shares may dilute EPS of the
company.
Optimal dividend policy
Alternative dividend policies
Residual dividend policy
Under this policy, dividends are paid from
residual earnings the part of earnings left
over after financing a firms investment
needs.
In a perfect capital market with no floatation
costs of issuing new shares, the firm would
be indifferent between capital raised
through the sale of new shares and retention
of earnings.
Residual dividend policy
However, the firm incurs floatation costs
and the cost of new shares is more than the
cost of retained earnings.
Therefore, the firm will first try to meet its
investment needs using internal equity, and
then pay a dividend if any earnings are left
over after financing all desired projects.
This argument relies on the presence of
transactions costs in issuing new shares and
gives priority to meeting investment needs
over shareholders dividend needs.
Constant payout ratio policy
Under this policy, dividend payment as a
percentage of earnings is constant. The
dollar amount of dividend can vary with
earnings fluctuations but the payout ratio is
fixed.
Generally, a firm cant maintain a constant
payout ratio over its entire life cycle.
Stable dividend policy
This policy is in favor of paying a fixed dollar
dividend per share.
Mature firms with a good earnings history
are likely to commit themselves to a stable
dividend policy.
A minor variation of the stable dividend
policy can be a low regular dividend and an
occasional extra dividend linked to the
companys performance.
Stable dividend policy
In general, managers have significant

discretion over dividend payouts and they
typically follow a more or less stable
dividend policy.
65

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Topic 6

Reference: Beal, Goyen & Shamsuddin, 2008

The dividend policy involves the allocation of

Cum-dividend shares are those that have a

A firms dividend policy is primarily reflected in

Dividend payout ratio

High payout= (1-0.755) x 0.1818 =4.45%

Theories of dividend policy are concerned with

Under these assumptions, it can be shown that

Regardless of the firms dividend policy,

Arguments for dividend relevance theory are

where: = grossed up dividend

Tran received a fully franked dividend of $100.

Anita is currently in the 15% personal income

This expression can be further simplified as:

Where: Df = fully franked dividends

Verifying this formula with the previous

Anita is currently in the 15% personal income

Transactions costs and the clientele effect

In general, managers have significant

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