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# INTRODUCTION TO

CORPORATE FINANCE
Chapter 22 Dividend Policy

CHAPTER 22
Dividend Policy

Lecture Agenda

Learning Objectives
Important Terms
Mechanics of Dividend Payments
Cash Dividend Payments
M&Ms Dividend Irrelevance Theorem
The Bird in the Hand Argument
Dividend Policy in Practice
Relaxing the M&M Assumptions
Stock Dividends and Stock Splits
Share Repurchases
Summary and Conclusions
Concept Review Questions
CHAPTER 22 Dividend Policy

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Learning Objectives
You should understand the following:
The mechanics of dividend payments and why they are different
from interest payments
The difference between a stock split and a stock dividend
Under what assumptions a dividend payment is irrelevant and
Why dividend payments generally reflect the business risk of the
firm
How transactions costs, taxes and information problems give value
to corporate dividend policies
How stock dividends and stock splits differ
How a share repurchase program can substitute for a dividend
payout policy.

22 - 4

## Important Chapter Terms

Agency theory
Bird in the hand argument
Cash cow
Declaration date
Dividend reinvestment
plans
Dividend yield
Equity market
capitalization
Ex-dividend date

## Free cash flow

Holder of record
Income stripping
Odd lots
Residual theory of
dividends
Special dividend
Split shares
Stock dividend
Stock split
Tax clienteles

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Dividend Policy

Dividend Policy
What is It?

## Dividend Policy refers to the explicit or

implicit decision of the Board of Directors
regarding the amount of residual earnings
(past or present) that should be distributed to
the shareholders of the corporation.
This decision is considered a financing decision
because the profits of the corporation are an
important source of financing available to the firm.

## CHAPTER 22 Dividend Policy

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Types of Dividends
Dividend Policy

Types of Dividends
Dividends are a permanent distribution of residual
earnings/property of the corporation to its owners.
Dividends can be in the form of:
Cash
Additional Shares of Stock (stock dividend)
Property

## If a firm is dissolved, at the end of the process, a final

dividend of any residual amount is made to the
shareholders this is known as a liquidating dividend.

22 - 9

Dividend Policy

## Dividends a Financing Decision

In the absence of dividends, corporate earnings accrue to the benefit of
shareholders as retained earnings and are automatically reinvested in
the firm.
When a cash dividend is declared, those funds leave the firm
permanently and irreversibly.
Distribution of earnings as dividends may starve the company of funds
required for growth and expansion, and this may cause the firm to seek

Retained Earnings
Corporate Profits After Tax
Dividends

22 - 11

## Dividends versus Interest Obligations

Interest
Interest is a payment to lenders for the use of their funds for a given
period of time
Timely payment of the required amount of interest is a legal obligation
Failure to pay interest (and fulfill other contractual commitments
under the bond indenture or loan contract) is an act of bankruptcy and
the lender has recourse through the courts to seek remedies
Secured lenders (bondholders) have the first claim on the firms assets
in the case of dissolution or in the case of bankruptcy
Dividends
A dividend is a discretionary payment made to shareholders
The decision to distribute dividends is solely the responsibility of the
board of directors
Shareholders are residual claimants of the firm (they have the last,
and residual claim on assets on dissolution and on profits after all
other claims have been fully satisfied)
CHAPTER 22 Dividend Policy

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## The Mechanics of Dividend Payments

Dividend Policy

Dividend Payments
Mechanics of Cash Dividend Payments

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

## CHAPTER 22 Dividend Policy

22 - 14

Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date

this is the date on which the Board of Directors meet and declare the dividend. In their
resolution the Board will set the date of record, the date of payment and the amount of the
dividend for each share class.
when CARRIED, this resolution makes the dividend a current liability for the firm.

Date of Record

is the date on which the shareholders register is closed after the trading day and all those
who are listed will receive the dividend.

Ex dividend Date

is the date that the value of the firms common shares will reflect the dividend payment (ie.
fall in value)
ex means without.
At the start of trading on the ex-dividend date, the share price will normally open for trading
at the previous days close, less the value of the dividend per share. This reflects the fact
that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the
declared dividend.

Date of Payment

is the date the cheques for the dividend are mailed out to the shareholders.
CHAPTER 22 Dividend Policy

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## Dividend Declaration Time Line

2 business days prior to the Date of Record

Declaration Date

and passes the
motion to create
the dividend

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 openingcompared
to the previous days close.
CHAPTER 22 Dividend Policy

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## 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

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
Ex Dividend Date

## The date is not chosen by the board of directors, rather it is determined as

a result of the exchanges settlement practices and is a function of the
date of record.

22 - 17

## Dividend Decision and the Board of

Directors
Dividend Policy

Dividend Policy
Dividends, Shareholders and the Board of Directors

## There is no legal obligation for firms to pay dividends to

common shareholders
Shareholders cannot force a Board of Directors to
declare a dividend, and courts will not interfere with
the BODs right to make the dividend decision because:
Board members are jointly and severally liable for any damages
they may cause
Board members are constrained by legal rules affecting dividends
including:
Not paying dividends out of capital
Not paying dividends when that decision could cause the firm to
become insolvent
Not paying dividends in contravention of contractual commitments
(such as debt covenant agreements)
CHAPTER 22 Dividend Policy

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Dividend Payments
Dividend Policy

Dividend Payments
Dividend Reinvestment Plans (DRIPs)

## Involve shareholders deciding to use the cash

dividend proceeds to buy more shares of the firm
DRIPs will buy as many shares as the cash dividend allows with
the residual deposited as cash
Leads to shareholders owning odd lots (less than 100 shares)

## Firms are able to raise additional common stock

capital continuously at no cost and fosters an ongoing relationship with shareholders.

## CHAPTER 22 Dividend Policy

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Dividend Payments
Stock Dividends

## Stock dividends simply amount to distribution of

They represent nothing more than recapitalization
of earnings of the company. (that is, the amount
of the stock dividend is transferred from the R/E
account to the common share account.
Because of the capital impairment rule stock
dividends reduce the firms ability to pay
dividends in the future.
CHAPTER 22 Dividend Policy

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Dividend Payments
Stock Dividends

Implications

## reduction in the R/E account

reduced capacity to pay future dividends
proportionate share ownership remains unchanged
shareholders wealth (theoretically) is unaffected

## Effect on the Company

conserves cash
serves to lower the market value of firms stock modestly
promotes wider distribution of shares to the extent that current owners divest themselves of
shares...because they have more
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

## CHAPTER 22 Dividend Policy

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Dividend Payments
Stock Dividend Example
ABC Company
Equity Accounts
as at February xx, 20x9
Common stock (215,000)
\$5,000,000
Retained earnings
20,000,000
Net Worth
\$25,000,000
The company, on March 1, 20x9 declares a 10 percent stock dividend when the
current market price for the stock is \$40.00 per share.
This stock dividend will increase the number of shares outstanding by 10 percent.
This will mean issuing 21,500 shares. The value of the shares is:
\$40.00 (21,500) = \$860,000
This stock dividend will result in \$860,000 being transferred from the retained
earnings account to the common stock account:

next page...
CHAPTER 22 Dividend Policy

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Dividend Payments
Stock Dividend Example
After the stock dividend:

ABC Company
Equity Accounts
as at March 1, 20x9
Common stock (236,500)
Retained earnings
Net worth

\$5,860,000
19,140,000
\$25,000,000

The market price of the stock will be affected by the stock dividend:
New Share Price = Old Price/ (1.1) = \$40.00/1.1 = \$36.36
The individual shareholders wealth will remain unchanged.

## CHAPTER 22 Dividend Policy

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Dividend Payments
Stock Splits

## Although there is no theoretical proof, there is some

who believe that an optimal price range exists for a
companys common shares.
It is generally felt that there is greater demand for
shares of companies that are traded in the \$40 - \$80
dollar range.
The purpose of a stock split is to decrease share price.
The result is:
increase in the number of share outstanding
theoretically, no change in shareholder wealth

## Reasons for use:

psychological appeal (signalling affect)
CHAPTER 22 Dividend Policy

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

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

## A 2 for 1 Stock Split:

New Share Price = P0[1/(2/1)] = \$150[1/(2/1)] = \$150[.5] = \$75.00

## The firms equity accounts:

Commons shares (200,000 outstanding)
Retained earnings
Net Worth
CHAPTER 22 Dividend Policy

\$1,500,000
15,000,000
\$16,500,000
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Dividend Payments
Further Stock Split Examples
A 4 for 3 Stock Split:

## The firms equity accounts:

Commons shares (133,333 outstanding)
Retained earnings
Net Worth

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

## The firms equity accounts:

Commons shares (75,000 outstanding)
Retained earnings
Net Worth

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

Clearly the Board can use stock splits and reverse stock splits to place the firms
stock in a particular trading range.
CHAPTER 22 Dividend Policy

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Dividend Payments
Stock Split Effects

## shareholders wealth should remain unaffected:

Original Holdings: (100 shares @ \$150/share) = \$15,000
After a 4 for 1 split: (400 shares @ \$37.50/share) = \$15,000

## the above will hold true if there is no psychological

appeal to the stock split.
There is some evidence that the share price of
companies which split stock is more bouyant
because of a positive signal being transferred to
the market by this action.
CHAPTER 22 Dividend Policy

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Stock Dividends

Stock Splits

## lowers stock price slightly

little psychological appeal

recapitalization of earnings
no change in proportional
ownership
odd lots created
theoretically, no value to
the investor

## large drop in stock price

much stronger potential
signalling effect
no recapitalization
same

same

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## Cash Dividend Payments

The Macro Perspective

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

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## Cash Dividend Payments

Aggregate Dividends and Profits
FIGURE 22-2

22 - 32

## Cash Dividend Payments

The Macro Perspective

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

## (See Figure 22 - 2 on the following slide)

CHAPTER 22 Dividend Policy

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## Cash Dividend Payments

Aggregate Dividend Payouts
FIGURE 22-3

22 - 34

## Cash Dividend Payments

The Macro Perspective - Question

## Why are dividends smoothed and not

matched to profits?

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## Cash Dividend Payments

The Micro Perspective

## Table 22 -1 contains dividend yields for

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

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Dividend Yields

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## Modigliani and Millers Dividend

Irrelevance Theorem
M&M, Dividends and Firm Value

## Modigliani and Millers Dividend Irrelevance

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

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## M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

[ 22-1]

D1 P1
P0
(1 Ke )

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## M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

## Multiply by the number of shares outstanding

(m) to convert the single stock price model to
a model to value the whole firm:

[ 22-2]

m( D1 P1 )
mP0 V0
(1 Ke )

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## M&Ms Dividend Irrelevance Theorem

Assumptions

No Taxes
Perfect capital markets
large number of individual buyers and sellers
costless information
no transaction costs

There is no debt

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## M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

## Without debt, sources and uses of funds identity

(sources = uses) can be expressed as:

[ 22-3]

X 1 nP1 I1 mD1

Where:

X
I
XI
mD1

## represents cash flow from operations

represents investment
is free cash flow
is dividend to current shareholders at time 1
CHAPTER 22 Dividend Policy

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## M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

mD1 X 1 nP1 I1

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## M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

## If a firm pays out dividends that exceeds its free cash

flow (X I), then it must issue new common shares to
pay for these dividends.
Substituting into Equation 22 2 we get:

[ 22-4]

X1 I1 [(m n) P1 V1 ]
V0
(1 K )

## The value of the firm is the value of the next periods

free cash flow (X1 I1) plus the next periods equity
market value
CHAPTER 22 Dividend Policy

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## M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

## The firm value is determined as the present value of

the free cash flows to the equity holders:

X t It
V0
t
(
1

K
)
t 1

[ 22-5]

Value has
nothing
to do with
dividends

## The dividend is equal to the free cash flow each period,

and dividends are therefore a residual after the firm
has taken care of all of its investment requirements
this is the Residual Theory of Dividends
CHAPTER 22 Dividend Policy

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## M&Ms Dividend Irrelevance Theorem

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.

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## M&Ms Dividend Irrelevance Theorem

Residual Theory of Dividends - Implication

## The implication of the Residual Theory of Dividends are:

Investment decisions are independent of the firms dividend policy

## No firm would pass on a positive NPV project because of the lack of

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

22 - 48

## M&Ms Dividend Irrelevance Theorem

Internal Funds, Investment, and Dividends
22 - 4 FIGURE
OPTIMAL INVESTMENT

Rate of
Return

MC=MR
IOS

WACC

\$11,976
Million

\$177,607
Million

22 - 49

## Shareholders can buy or sell shares in an

underlying company to create their own cash
flow pattern.
They dont need management declare a cash
dividend, they can create their own.
Conclusion: under the assumptions of M&Ms model,
the investor is indifferent to the firms dividend policy.

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Dividend Policy

## The Bird-in-the-Hand Argument

M&Ms Assumptions Relaxed

## Risk is a real world factor.

Firms that reinvest free cash flow, put that
money at risk there is no certainty of
investment outcome those forfeit dividends
that are reinvestedcould be lost!
Remember the two-stage DDM?

22 - 52

## The Bird-in-the-Hand Argument

M&Ms Assumptions Relaxed

[ 22-6]

ROE1 BVPS
Inv
ROE 2 K e

(
)
Ke
(1 K e )
Ke

## The first term is the present value of existing opportunities

(PVEO)
The second term is the present value of growth opportunities
(PVGO)
These forecast returns face risks of new market entrants to
compete for the excess profits forecast in emerging opportunities
making PVGO extremely vulnerable.
CHAPTER 22 Dividend Policy

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## The Bird-in-the-Hand Argument

M&Ms 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

22 - 54

## The Bird-in-the-Hand Argument

M&M versus Gordons Bird in the Hand Theory
22 - 5 FIGURE
OPTIMAL INVESTMENT

D1
P0

Gordon

P1 P0
P0

M&M

22 - 55

## The Bird-in-the-Hand Argument

M&M versus Gordons Bird in the Hand Theory

Conclusions:
Firms cannot change underlying operational
characteristics by changing the dividend
The dividend should reflect the firms operations
through the residual value of dividends

22 - 56

Dividend Policy

## 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

22 - 58

## John Lintner suggested a partial adjustment

model to explain the smoothing of dividend
behaviour illustrating that firms slowly change
dividends as they move toward a new target
level:
[ 22-7]

Dt (Dt* -Dt-1 )

22 - 59

## The target dividend Dt* Lintner suggested is a function

of the firms optimal payout rate of the firms underlying
earnings (Et) leading to the following equation:

[ 22-8]

Dt a (1 b) Dt-1 cE1

## The coefficient on lagged dividends was estimated at

0.70 indicating an adjustment speed (b) coefficent of
0.30.
The coefficient on current earnings (c) was estimated at
0.15
CHAPTER 22 Dividend Policy

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## Dividend Policy in Practice

Implications
percent
Firms are very reluctant to fully adjust
Firms do not follow a policy of paying a constant
proportion of earnings out as dividends
Dividend policy in practice does not follow M&Ms
irrelevance arguments because the real world does
not match the assumptions used.
CHAPTER 22 Dividend Policy

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## Relaxing the M&M Assumptions

Welcome to the Real World!

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

22 - 62

## Relaxing the M&M Assumptions

Welcome to the Real World!

## Dividends and Signalling

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

22 - 63

## Relaxing the M&M Assumptions

The Signalling Model
22 - 6 FIGURE

et

et*
dt*
dt

Time

22 - 64

## Relaxing the M&M Assumptions

Welcome 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.
CHAPTER 22 Dividend Policy

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## Relaxing the M&M Assumptions

Welcome to the Real World!

## Taxes and the Clientele Effect

Table 22 -3 (on the following slide) illustrates that different
classes of investors face different tax brackets
Preference for dividends versus capital gains income depends
on the province of residence and taxable income level leading to
tax clienteles.
High income earners tend to prefer capital gains (there is an
additional tax incentive for such individuals in that they can choose
the timing of the sale of their investmentremember only realized
capital gains are subject to tax
Low income earners tend to prefer dividends

## Conclusion firms should not change dividend policy drastically

since it upsets the existing ownership base.
CHAPTER 22 Dividend Policy

22 - 66

Taxes

22 - 67

## Relaxing the M&M Assumptions

Repackaging Dividend-Paying Securities

## Tax clienteles help to explain the financial

engineering whereby different parts of the
return by the firm are stripped, repackaged
and sold to different investors as illustrated in
Figure 22 7. (See the following slide)
Split shares are shares sold as the dividends
and capital gains parts.

22 - 68

## Relaxing the M&M Assumptions

MYWs B Corporation Shares
22 - 7 FIGURE

dt
P0

t
(1 k ) 6
t 1 (1 k )

P0

\$454 million

MYW
\$143 million

\$330 million

dt
min(\$30, P6 1)
Pref

(1 k ) 6
t 1 (1 k ) t
6

P6 min(\$30, P6 1)
IR
(1 k ) 6

## CHAPTER 22 Dividend Policy

22 - 69

Share Repurchases
Simply another form of payout policy.
An alternative to cash dividend where the
objective is to increase the price per share
rather than paying a dividend.
Since there are rules against improper
accumulation of funds, firms adopt a policy of
large infrequent share repurchase programs.

## CHAPTER 22 Dividend Policy

22 - 70

Share Repurchases
Dividend Policy

Share Repurchases
allowed under the OBCA and CBCA
reasons for use:

## Offsetting the exercise of executive stock options

Leveraged recapitalizations
Information or signalling effects
Repurchase dissident shares
Removing cash without generating expectations for future
distributions
Take the firm private.

22 - 72

## they are usually done on an irregular basis, so a

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

22 - 73

tender offer:

## this is a formal offer to purchase a given number of shares at a

given price over current market price.
the purchase of shares through an investment dealer like any
other investor
this is not designed for large block purchases.

## 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.

## CHAPTER 22 Dividend Policy

22 - 74

Repurchased Shares

## called treasury stock (U.S.)

non-voting (U.S.)
if not retired, can be resold (U.S.)
unlike the U.S., repurchases in Canada do not
involve shares that can be placed into
treasury stock - they are canceled

## CHAPTER 22 Dividend Policy

22 - 75

Repurchase Example
Current EPS
= [total earnings] / [# of shares] = \$4.4 m / 1.1 m =
\$4.00
Current P/E ratio
= \$20 / \$4 = 5X
EPS after repurchase of 100,000 shares
= \$4.4 m / 1.0 = \$4.40
Expected market price after repurchase:
= [p/e][EPSnew] = [5][\$4.40] = \$22.00 per share

22 - 76

## Effects of A Share Repurchase

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

22 - 77

## signal positive information about the firms future cash

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

## CHAPTER 22 Dividend Policy

22 - 78

signal negative information about the firms
future growth and investment opportunities
the provincial securities commission may
share repurchase may not qualify the investor
for a capital gain

22 - 79

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 firms ability to sustain cash
dividends into the future.
CHAPTER 22 Dividend Policy

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## Borrowing to Pay Dividends

An Example

Before Borrowing:
Assets:
Cash
Fixed Assets
Total Assets

Liabilities:
10
140
\$150

0% Debt

Long-term Debt
0
Common Stock
50
Retained Earnings 100
Total Claims

\$150

## After Borrowingbefore cash dividend:

Assets:
Cash
Fixed Assets
Total Assets

25% Debt

Liabilities:
60
140
\$200

Long-term Debt
50
Common Stock
50
Retained Earnings 100
Total Claims
CHAPTER 22 Dividend Policy

\$200
22 - 82

An Example

## After Dividend Declarationbefore date of payment.

Assets:
Cash
Fixed Assets

Total Assets

Liabilities:
60
140

\$200

Current liabilities
Long-term Debt
Common Shares
Retained earnings
Total Claims

50
50
50
50
\$200

## After Cash Dividend payment of \$50

Assets:
Cash
Fixed Assets
Total Assets

33% Debt

Liabilities:
10
140
\$150

Long-term Debt
Common Stock
Retained earnings
Claims
CHAPTER 22 Total
Dividend
Policy

50% Debt

50
50
50
\$150

22 - 83

An Example

## it is possible for a firm with borrowing capacity to borrow funds to

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

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## Summary and Conclusions

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

22 - 85