Slide 1

Dividend PolicyCHAPTER FIVEThe concept of dividend policyTypes of dividendsDividend payment procedureFactors affecting dividend payment procedureEffects of dividend paymentTheories of dividend policyFactors favouring a lower dividend payout policyOther consideration affecting dividend policyoutlineDividends refer to the cash paid out of earnings to shareholders.

Dividend policy: refers to the decision regarding the magnitude of dividend payout, i.e. the percentage of earnings paid out to stockholders in the form of dividend

Dividends are generally described in terms of dividend payout ratio, which indicates the amount of dividends paid relative to the companys earnings.

Concept of dividend policyIts the decision to pay out earnings versus retaining and reinvesting them. Includes these elements:1. High or low payout?2. Stable or irregular dividends?3. How frequent?4. Do we announce the policy?

What is dividend policy?How do Firms distribute Dividend to their Shareholders Cash dividendStock dividendBond dividendProperty dividendStock splitStock (share) repurchase

Types of dividendStock Repurchases (Stock Buyback)Stock repurchase is when a firm uses its cash to repurchase some of its own stock.

This results in a reduction in the firms cash balance as well as the number of shares of stock outstanding. Firms use one of three methods to purchase the shares: Open market repurchase, tender offer, and direct purchase.

How do Firms Repurchase Their Shares?Open Market Repurchase

Here the firm acquires the stock on the market, often buying a relatively small number of shares everyday. This will put upward pressure on share prices. This is the most widely used method for stock repurchase.How do Firms Repurchase Their Shares? (cont.)Tender Offer A company uses this method when it wants to buy a relatively large number of shares very quickly.The company makes a formal offer to buy a specified number of shares at a stated price.The price is set above the market price to attract sellers.How do Firms Repurchase Their Shares? (cont.)Direct Purchase from a large investor

Here the firm purchases the stock from one or more major stockholders on a negotiated basis. This method is not used frequently.With a share repurchase, a company uses cash to buy back its own shares from the market place, thereby reducing the number of outstanding shares.

For Cash and Share Repurchase, the impact on the Financial position / balance sheet will be as follows:

On the Assets side, cash will be reduced due to cash dividend or share repurchase.

On the Equity side, there will be a corresponding decrease.

Effect Of Share RepurchaseNon-Cash Distributions: Stock Dividends and Stock SplitsA stock dividend is a pro-rata distribution of additional shares of stock to the firms current stockholders. These distributions are generally defined in terms of a fraction paid per share.

For example, a firm might pay a stock dividend of .20 shares of stock per share or 2 shares for every 10 held.Non-Cash Distributions: Stock Dividends and Stock Splits (cont.)Stock split is essentially a very large stock dividend. For example, a 2-for-1 split would entail receiving two new shares for every old share currently held.

With a 2-for-1 split, the number of shares will double and the share price will drop in half.Rationale for a Stock Dividend or Stock SplitOne rationale for splits and stock dividends is that there is an optimal price range for the firms stock. Also, beyond a certain price range, there might be lower demand for shares from investors.If the price exceeds that optimal range, it can be brought back to the optimal range by doing a stock split or paying stock dividend.Dividend Payment ProceduresGenerally, companies pay dividends on a quarterly basis. There are several dates that are important with regard to dividend payment:

(a) Announcement date: It is the date on which dividend is formally declared by the board of directors.(b) Date of record: Investors who own stock on this date receive the dividend. However, this date was pushed forward two days to ex-dividend date.

Dividend Payment Procedures (cont.)(c) Ex-dividend date: This is two days before the date of record and any investor who buys shares after the ex-dividend date is not entitled to dividend.

(d) Payment date: This is the date on which dividend checks are mailed to the investors.

Dividend Payment Procedures (cont.)DateExplanationCalendar DateAnnouncement DateDividend is declared.March 15Ex-Dividend DateShares begin trading ex-dividend.May 17Record DateDividend will be paid to shareholders who own the stock on this date.May 19Payment DateDividends are distributed to the shareholders of record on the record date.May 27Factors affecting dividend policyEXTERNALINTERNALState of the EconomyState of the capital marketLegal RestrictionsContractual RestrictionDesire of shareholdersFinancial Needs of the companyStability of EarningsDesire for ControlLiquidity position

Residual Theory of DividendDividend Irrelevance ArgumentDividend Relevance ArgumentBird-in-hand TheoryProspect TheoryClientele effectSignaling TheoryDividend policy theories Why Some Firms Have Higher Payout Ratio Than OtherAgency CostTaxesTransaction CostsFactors favouring lower dividend policyAgency CostBird in handProspect TheoryFactors favouring higher dividend policyDoes Dividend Policy Matter?Modigiliani and Miller suggest that without taxes and transaction costs, cash dividends and share repurchases are equivalent and the timing of the distribution is unimportant.

This is known as the Modigiliani and Miller dividend irrelevancy proposition.The Irrelevance of the Distribution ChoiceThe distribution choice is irrelevant under the following assumptions:There are no taxes.No transaction costs are incurred in either buying or selling shares of stock.The firms operating and investment policies are fixed.The Irrelevance of the Distribution Choice (cont.)The dividend irrelevancy proposition can be illustrated in two ways:

Timing of dividend distributions does not affect firm value.In the absence of taxes and transaction costs, a cash dividend is equivalent to a share repurchase.The Timing of Dividend is Irrelevant

The Timing of Dividend is Irrelevant (cont.)Figure 16-2 considers two alternatives:

Pay $35 million now and $135 million in one yearPay $52.5 million now and $114.875 million in one year

In both cases, the value of share remains the same at $15.24 per share.Why Dividend Policy is Important?Transactions are costly Since taxes are incurred when dividends are received and transactions costs are incurred when buying and selling shares, investors will prefer to select companies whose dividend policy match up with their own preferences. Because firms with different dividends attract different dividend clienteles, it is important that dividend policy remain somewhat stable.Why Dividend Policy is Important? (cont.)The Information Conveyed by Dividend and Share Repurchase AnnouncementInvestors and stock market are constantly trying to decipher the information released by firms to better understand what they imply about firm values.Firms tend to increase their dividends when dividends can be sustained in the future. In such cases, dividend increase is clearly good news.

Why Dividend Policy is Important? (cont.)Share repurchases are also viewed very favorably as it reveals that the firm has generated more money than it currently needs.

Share repurchases may also reveal that the equity is currently underpriced.

The empirical evidence indicates that dividends and share repurchases do in fact convey favorable information to investors.Why Dividend Policy is Important? (cont.)The Information Conveyed by Stock Dividends and Stock SplitsThe announcement of stock dividends and stock splits also tend to generate positive stock returns. This increase is harder to explain as stock dividends and stock splits do not affect firms cash flows.Some researchers have suggested that firms have a preferred trading range and stock splits help bring stock prices to that trading range.

Why Dividend Policy is Important? (cont.)A second possibility is that stock splits and stock dividends tend to attract attention. Naturally, firm would like to attract attention only when the prospects are favorable.

Thus even though there is no direct effect on cash flows, the market reacts favorably.Capital structureChapter 6The concept of capital structureGearing or LeverageTypes of LeverageTheories of capital structureRisks faced by equity investors with regards to capital structureDeterminants of capital structure

OutlineCapital structure is the particular mix or combination of debt, equity a other sources of finance that a company uses to fund its long term investment.

The sources of funds include;Debt Preference sharesEquity capitalThe concept of capital structureCapital structure is normally used interchangeably with others like gearing or leverage.

Gearing or leverage normally refer to the proportion of Debt financing.

The concept of capital structureDoes capital structure decision matter?Does capital structure decision affect the value (Debt + Equity) of a firm?Does capital structure decision affect the WACC?Does capital structure affect the NPV of a proposed project?

The opinions on the relevance of capital structure is mixed across different schools of thought.Theories of capital structureNet income theoryNet Operating income theoryTraditional view of capital structureModigliani and Miller propositions I and II (M&M I & II)

Theories of capital structureNet Operating Income TheoryBy David DurandAdvocates for the relevance of capital structure decisionsCapital structure decision will change the cost of capital and thereby alter the value of the firm.Example 1: A company expects its annual EBIT to be 50,000 cedis. The company has 200,000 in 10% bonds and the cost of equity is 12.5%. ( There are no taxes).What is the value of the firm given the above scenario.

Net income theoryAssume that the firm decides to retire 100,000 cedis worth of equity by using the proceeds of new debt issue worth the same amount. What is the new value of the firm? Has it increased or decreased?

17-Mar-15Net income theoryBy David Durand; Also Known as the Capital Structure Irrelevance Theory

Conclusion: CS decisions of a firm is irrelevant and that the market value of the firm is not affected by the CS decisions.Assumptions:No taxesDebt usage does not affect the business risk of the firmDebt usage increases the cost of equity.Net Operating Income theoryExample:Assume that a firm has an ebit level of 50000 ghana cedis, cost of debt 10%, the total value of debt 200000 cedis and the WACC is 12.5%. Let us find out the total value of the firm and the cost of equity

SolutionEbit = 50,000WACC = 12.5%Value of firm = 50,000/0.125 = 400,000 Market value of equity = 400,000-200,000 = 200,000Cost of Equity = [50000-(10%*200,000)]/200,000 = 15%

Net Operating Income theoryEffect of change in capital structureNow assume that the leverage increases from 200,000 to 300,000 cedis. The proceeds of the loan was used to repurchase the stock of the company.

Solution:Ebit = 50,000MV of firm = 50,000/0.125 = 400,000Market value of equity = 400000-300000=100,000Cost of equity = [50000-(10%*300000)]/100000 = 20%The cost of equity adjusts upwards due to the increase in debt usage. This causes the WACC to be unchangedNet Operating Income theoryBy Ezta Solomon and Fred Weston.The theory states that a firms value increases to a certain level of debt capital usage after which it tends to remain constant and then eventually begins to decrease.In other words cost of capital is U-shaped.Value of the firm is maximized at the minimum point of the cost of capital (WACC)

Traditional theory of capital structureM&M proposition I (no taxes, bankruptcy cost, and transaction cost)

M&M proposition II (with taxes, transaction cost, and bankruptcy cost)

Other theoriesFactors affecting capital structureInternal factorsExternal factorsRisk Flexibility Cash flowsRetaining controlPurpose of financeAsset structureAgency costs growth and stabilityFinancial leverageCompany characteristicsInflationTaxation policyLegal requirementLevel of interest rateAvailability of fundsSeasonal variationsTax benefits of debtSize of the firm Degree of competitionRequirements of investors Etc.