Overview #
Steps to payout policy: The cashflows generated are distributed to certain policies, and payout policy queues at the last line - Just as shareholders standing at the last line of receiving return
- Cashflow from Operations
- Financing decision: How much did you borrow? - cashflows to debt
- Investment decision: How good are your investment choices? Do we put money back into business?
- What is a reasonable cash balance? - cash held back by the company
- What do your stock holders prefer? - stock buybacks or dividends
Dividends #
Concepts #
- Usually a cash dividend, sometimes a stock
- Level of dividends are not fixed and can be changed any time by the firm
- Dividend restrictions may exist to protect creditor(debtholders)
- Companies distinguish between regular dividends and special dividends
- Measurements
- Dividends per share(DPS)
- Dividend yield: DPS/Share price
- Dividend payout ratio: DPS/EPS
Keypoints
- Dividends tend to be sticky
- Dividends follow earnings
- Frank dividends carries franking credit for tax paid by the company
Solvency test
- Asset must exceed liabilities and excess is sufficient for the payment of the dividend
- The payment of the dividends is fair and reasonable
- The payment of the dividend does not materially prejudice the firm’s ability to pay its creditors
Dividend with taxes #
Dividend drop-off ratio #
Keypoints
- The price change on ex-dividend day will be determined by the difference between tax-rate on dividends and the tax rate on capital gains for the typical investor in the stock.
- If dividends and capital gains are taxed equally, then the price change is equal to the dividend
- If dividends are taxed lower than capital gains, then the price change will be greater than the dividend - and vice versa
Formula for drop ratio
$$ R = \frac{P_{cum} - P_{ex}}{D} = \frac{1 - T_d}{1 - T_g} $$Where:
- $R$ = Dividend drop-off ratio
- $P_{cum}$ = Cum-dividend share price
- $P_{ex}$ = Ex-dividend share price
- $D$ = Dividend per share
- $T_d$ = Effective personal tax rate on dividends
- $T_g$ = Effective personal tax rate on capital gains
Derivation: This formula arises from the principle that, in equilibrium, an investor should be indifferent between selling the stock just before it goes ex-dividend (cum-dividend) and selling it just after (ex-dividend), considering the taxes paid in each scenario.
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Cash flow from selling cum-dividend:
- Receive $P_{cum}$.
- Pay capital gains tax: $(P_{cum} - P_0) T_g$, where $P_0$ is the purchase price.
- Net cash flow = $P_{cum} - (P_{cum} - P_0) T_g$.
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Cash flow from selling ex-dividend:
- Receive dividend $D$.
- Pay dividend tax: $D \times T_d$. Net dividend = $D(1 - T_d)$.
- Sell share for $P_{ex}$.
- Pay capital gains tax: $(P_{ex} - P_0) T_g$.
- Net cash flow = $D(1 - T_d) + P_{ex} - (P_{ex} - P_0) T_g$.
Equating the net cash flows from both scenarios:
$P_{cum} - P_{cum} T_g + P_0 T_g = D(1 - T_d) + P_{ex} - P_{ex} T_g + P_0 T_g$
$P_{cum} (1 - T_g) = D(1 - T_d) + P_{ex} (1 - T_g)$
$(P_{cum} - P_{ex}) (1 - T_g) = D(1 - T_d)$
$\frac{P_{cum} - P_{ex}}{D} = \frac{1 - T_d}{1 - T_g}$
Determinants of dividend policy #
Flaws of MM’s view #
- Uncertainty of future dividends
- Can be resolved through selling shares immediately
- Issurance and transaction costs
- High dividends may imply more frequent capital raising, which incurr high transaction costs
- The higher the costs associated with raising capital, the lower the expected level of dividends
- Information asymmetry and signaling
- Dividends can be signals to the market that managers believe that firms have good cash flow prospects in the future
- There is a strong positive price reaction to dividend announcements
- Agency costs
- Managers may waste money on perks
- Higher dividend payout implies that less money is available for managerial perk consumption and overinvestment, and that more money needs to be raised externally
- Taxes
- In classical tax systems, capital gain tax is less than individual dividend tax, so investors prefer capital
- In imputation tax system, the effective tax rate on dividends can be much lower because of franking credits - investors prefer dividends than capital gains
Keypoints #
- Only investment policy can change firm’s value
- Retention of profits can involve double taxation as imputation credits cannot be transferred to shareholders through capital gains in imputation tax systems
Modigliani-Miller’s Dividend Irrelevance Theorem #
In perfect capital markets the value of a firm is independent of its payout policy
Underlying assumptions #
- There are no tax differences to investors between dividends and capital gains
- If companies pay too much in cash, they can issue new stock, with no flotation costs or signaling consequences, to replace this cash
- If companies pay too little in dividends, the excess cash will not be put into bad projects or acquisitions
Implications to real-world scenarios: tax differences, information asymmetric, flotation costs, resolution of uncertainty and agency costs need to be considered.
Implications of MM’s theorem #
- If a firm’s investment policies (and hence cashflows) do not change, the value of the firm cannot change as it changes dividends
- Paying dividends is a zero NPV transaction - so MV before = MV after + value of the dividends
- Investors can implement their own dividend policy in perfect markets
Payout #
Payout ratio #
Issues with High Payout Ratios
- Can lead to fluctuating dividend
- Solution: special dividends
- May result in the firm running short of cash
- Solution: DRPs allow high dividend without loss of cash
Share-buybacks #
Keypoints
- There are on-market and off-market
- On-market: common in the US
Motivations to buybacks #
- Improved performance measures
- Increase EPS - but the cash comes from debt, so not really
- Signalling and undervaluation
- If manager believes that the stock is undervalued
- A buyback announcement could be accompanied by new information
- Stock market response to a share repurchase seems roughly similar to that a dividend payment for similar amount of cash involved
- Financial flexibility
- Payment of dividend is a long-term commitment as major changes in dividend policy are unappreciated by the market
- Buybacks offer an alternative way to make distributions that may not be permanent - expectation management
- Employee share options
- Managers are frequently granted stock call options as part of their compensation package which is set at a set strike price.
- Unlike paying dividends, repurchases does not lead to a price drop like the ex-dividend price drop-off
- Often the share price will rise at buyback announcement
- So, stock call option holders (e.g. managers) prefer a share repurchase
Comparisions #
Dividends and repurchases #
Keypoints
- Dividends are paid with higher permanent operating cashflows
- Repurchases are used with higher temporary non-operating cashflows
- Firms repurchasing shares also have much more volatile cash flows and distributions
- Firms repurchase stock following poor stock market performance & increase dividends following good performance
On- and off-market buybacks #
Keypoints
- Managers prefer off-market buybacks to distribute franking credits
- Off-market buybacks consist of two parts in tax - franked dividend component and return on capital component, where franked dividend component carries franking credit that offsets personal tax rate
- However, on-market buybacks consist of only one component - return on capital component, suggesting returns will be taxed twice when delivered to shareholders
- Off-market buybacks were larger and firms were generating more cashflows
- On-market buybacks are commonly used to signal that the firm is undervalued.
Insights from tutorial #
Payout Policy
- Any change in value is really caused by investment policy but not payout policy.
- If the manager were to payout the dividend now but raise funds for negative NPV projects, the value of the firm will decrease instead of increase, suggesting a dividend now does not really better than capital gains later
- So as to realize return via capital gains and resolve uncertainty, investors could sell the shares immediately and buy the shares back ex-dividend
Excess cash
- Excess cash may be a temporary phenomenon, and that managers should consider future fundraising to determine whether to save cash for future investments.
- Keeping cash can ensure financial flexibility and not to lose opportunity.
- Future fundraising can be costly, and that not keeping cash but to payout may incurr higher cost when there is investment opportunity
Tax for non-resident investors
- Non-resident investors receive the dividends that have deducted tax - known as withhold tax, so that they will not receive franking credit that they cannot claim
- The company pay tax on gross amount - that is, amount that has deducted the corporate tax
- Then, the company send the taxed amount to investor’s account
- The off-market buybacks comprises two components, dividend component and return on equity component
- For dividend component, the tax rate will be the withhold tax rate
- For return on equity component, the tax rate will be the captial gain tax rate
- Capital gain tax rate may be lower than withhold tax rate, which will benefit non-residents
- Firms can adjust the proportion of the two components, so as to save more tax for non-resident investors