Dividend policy

INTRODUCTION TOINTRODUCTION TO
CORPORATE FINANCECORPORATE FINANCE
Chapter 22 – Dividend PolicyChapter 22 – Dividend Policy

CHAPTER 22CHAPTER 22
Dividend PolicyDividend Policy

CHAPTER 22 – Dividend Policy 22 - 3
Lecture AgendaLecture Agenda
• Learning ObjectivesLearning Objectives
• Important TermsImportant Terms
• Mechanics of Dividend PaymentsMechanics of Dividend Payments
• Cash Dividend PaymentsCash Dividend Payments
• M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance Theorem
• The “Bird in the Hand” ArgumentThe “Bird in the Hand” Argument
• Dividend Policy in PracticeDividend Policy in Practice
• Relaxing the M&M AssumptionsRelaxing the M&M Assumptions
• Stock Dividends and Stock SplitsStock Dividends and Stock Splits
• Share RepurchasesShare Repurchases
• Summary and ConclusionsSummary and Conclusions
– Concept Review QuestionsConcept Review Questions

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

Important Chapter TermsImportant Chapter Terms
• Agency theoryAgency theory
• Bird in the hand argumentBird in the hand argument
• Cash cowCash cow
• Declaration dateDeclaration date
• Dividend reinvestment plansDividend reinvestment plans
• Dividend yieldDividend yield
• Equity market capitalizationEquity market capitalization
• Ex-dividend dateEx-dividend date
• Free cash flowFree cash flow
• Holder of recordHolder of record
• Homemade dividendsHomemade dividends
• Income strippingIncome stripping
• Odd lotsOdd lots
• Residual theory of dividendsResidual theory of dividends
• Special dividendSpecial dividend
• Split sharesSplit shares
• Stock dividendStock dividend
• Stock splitStock split
• Tax clientelesTax clienteles

What is Dividend Policy?What is Dividend Policy?

What is It?What is It?
• Dividend Policy refers to the explicit or implicitDividend Policy refers to the explicit or implicit
decision of the Board of Directors regarding thedecision of the Board of Directors regarding the
amount of residual earnings (past or present)amount of residual earnings (past or present)
that should be distributed to the shareholdersthat should be distributed to the shareholders
of the corporation.of the corporation.
– This decision is considered aThis decision is considered a financing decisionfinancing decision
because the profits of the corporation are anbecause the profits of the corporation are an
important source of financing available to the firm.important source of financing available to the firm.

Types of DividendsTypes of Dividends

Types of DividendsTypes of Dividends
• Dividends are a permanent distribution of residualDividends are a permanent distribution of residual
earnings/property of the corporation to its owners.earnings/property of the corporation to its owners.
• Dividends can be in the form of:Dividends can be in the form of:
– CashCash
– Additional Shares of Stock (stock dividend)Additional Shares of Stock (stock dividend)
– PropertyProperty
• If a firm is dissolved, at the end of the process, a finalIf a firm is dissolved, at the end of the process, a final
dividend of any residual amount is made to thedividend of any residual amount is made to the
shareholders – this is known as ashareholders – this is known as a liquidating dividendliquidating dividend..

Dividends and Corporate FinancingDividends and Corporate Financing

– In the absence of dividends, corporate earnings accrue to the benefit ofIn the absence of dividends, corporate earnings accrue to the benefit of
shareholders as retained earnings and are automatically reinvested inshareholders as retained earnings and are automatically reinvested in
the firm.the firm.
– When a cash dividend is declared, those funds leave the firmWhen a cash dividend is declared, those funds leave the firm
permanently and irreversibly.permanently and irreversibly.
– Distribution of earnings as dividends may starve the company of fundsDistribution of earnings as dividends may starve the company of funds
required for growth and expansion, and this may cause the firm to seekrequired for growth and expansion, and this may cause the firm to seek
additional external capital.additional external capital.
Corporate Profits After Tax
Retained Earnings
Dividends
Dividends a Financing DecisionDividends a Financing Decision

Dividends versus Interest ObligationsDividends versus Interest Obligations
InterestInterest
• Interest is a payment to lenders for the use of their funds for a givenInterest is a payment to lenders for the use of their funds for a given
period of timeperiod of time
• Timely payment of the required amount of interest is a legal obligationTimely payment of the required amount of interest is a legal obligation
• Failure to pay interest (and fulfill other contractual commitments underFailure to pay interest (and fulfill other contractual commitments under
the bond indenture or loan contract) is an act of bankruptcy and thethe bond indenture or loan contract) is an act of bankruptcy and the
lender has recourse through the courts to seek remedieslender has recourse through the courts to seek remedies
• Secured lenders (bondholders) have the first claim on the firm’s assets inSecured lenders (bondholders) have the first claim on the firm’s assets in
the case of dissolution or in the case of bankruptcythe case of dissolution or in the case of bankruptcy
DividendsDividends
• A dividend is a discretionary payment made to shareholdersA dividend is a discretionary payment made to shareholders
• The decision to distribute dividends is solely the responsibility of theThe decision to distribute dividends is solely the responsibility of the
board of directorsboard of directors
• Shareholders are residual claimants of the firm (they have the last, andShareholders are residual claimants of the firm (they have the last, and
residual claim on assets on dissolution and on profits after all otherresidual claim on assets on dissolution and on profits after all other
claims have been fully satisfied)claims have been fully satisfied)

The Mechanics of Dividend PaymentsThe Mechanics of Dividend Payments

Dividend PaymentsDividend Payments
Mechanics of Cash Dividend PaymentsMechanics of Cash Dividend Payments
• Declaration DateDeclaration Date
• Holder of Record DateHolder of Record Date
• Ex-dividend DateEx-dividend Date
• Payment DatePayment Date

Mechanics of Cash Dividend PaymentsMechanics of Cash Dividend Payments
Declaration DateDeclaration Date
– this is the date on which the Board of Directors meet and declare the dividend. In theirthis is the date on which the Board of Directors meet and declare the dividend. In their
resolution the Board will set theresolution the Board will set the date of recorddate of record, the, the date of paymentdate of payment and theand the amount of theamount of the
dividenddividend for each share class.for each share class.
– when CARRIED, this resolution makes the dividend a current liability for the firm.when CARRIED, this resolution makes the dividend a current liability for the firm.
Date of RecordDate of Record
– is the date on which the shareholders register is closed after the trading day and all thoseis the date on which the shareholders register is closed after the trading day and all those
who are listed will receive the dividend.who are listed will receive the dividend.
Ex dividend DateEx dividend Date
– is the date that the value of the firm’s common shares will reflect the dividend payment (ie.is the date that the value of the firm’s common shares will reflect the dividend payment (ie.
fall in value)fall in value)
– ‘‘ex’ means without.ex’ means without.
– At the start of trading on the ex-dividend date, the share price will normally open for tradingAt 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 factat 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 thethat purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the
declared dividend.declared dividend.
Date of PaymentDate of Payment
– is the date the cheques for the dividend are mailed out to the shareholders.is the date the cheques for the dividend are mailed out to the shareholders.

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
Dividend Declaration Time LineDividend Declaration Time Line

Changes in the Settlement CycleChanges in the Settlement Cycle
• In June 1995 the settlement cycle for all non-money-market Canadian andIn June 1995 the settlement cycle for all non-money-market Canadian and
U.S. securities was reduced from five business days (T + 5) toU.S. securities was reduced from five business days (T + 5) to three businessthree business
daysdays (T + 3).(T + 3).
• The rationale for the change stems from the 1987 stock market crash when itThe 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 marketwas realized that a securities market failure could result in a credit market
failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnhamfailure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham
Lambert, a large U.S. broker, increased the need to minimize the risksLambert, a large U.S. broker, increased the need to minimize the risks
involved in the clearing and settlement of securities.involved in the clearing and settlement of securities.
• The shortened settlement cycle requires that the payment of funds and theThe shortened settlement cycle requires that the payment of funds and the
delivery of securities take place on thedelivery of securities take place on the third business daythird business day after the tradeafter the trade
date. This will reduce credit, market and liquidity risks by decreasing post-date. This will reduce credit, market and liquidity risks by decreasing post-
trade settlement exposure.trade settlement exposure.
Ex Dividend DateEx Dividend Date
• The date is not chosen by the board of directors, rather it is determined as aThe 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 ofresult of the exchanges settlement practices and is a function of the date of
record.record.
Trade Settlement and the Ex DividendTrade Settlement and the Ex Dividend
DateDate

Dividend Decision and the Board ofDividend Decision and the Board of
DirectorsDirectors

Dividends, Shareholders and the Board of DirectorsDividends, Shareholders and the Board of Directors
• There is no legal obligation for firms to pay dividends toThere is no legal obligation for firms to pay dividends to
common shareholderscommon shareholders
• Shareholders cannot force a Board of Directors toShareholders cannot force a Board of Directors to
declare a dividend, and courts will not interfere with thedeclare a dividend, and courts will not interfere with the
BOD’s right to make the dividend decision because:BOD’s right to make the dividend decision because:
– Board members are jointly and severally liable for any damagesBoard members are jointly and severally liable for any damages
they may causethey may cause
– Board members are constrained by legal rules affectingBoard members are constrained by legal rules affecting
dividends including:dividends including:
• Not paying dividends out of capitalNot paying dividends out of capital
• Not paying dividends when that decision could cause the firm toNot paying dividends when that decision could cause the firm to
become insolventbecome insolvent
• Not paying dividends in contravention of contractual commitmentsNot paying dividends in contravention of contractual commitments
(such as debt covenant agreements)(such as debt covenant agreements)

Dividend Reinvestment Plans (DRIPs)Dividend Reinvestment Plans (DRIPs)
• Involve shareholders deciding to use the cashInvolve shareholders deciding to use the cash
dividend proceeds to buy more shares of the firmdividend proceeds to buy more shares of the firm
– DRIPs will buy as many shares as the cash dividend allows withDRIPs will buy as many shares as the cash dividend allows with
the residual deposited as cashthe residual deposited as cash
– Leads to shareholders owning odd lots (less than 100 shares)Leads to shareholders owning odd lots (less than 100 shares)
• Firms are able to raise additional common stockFirms are able to raise additional common stock
capital continuously at no cost and fosters an on-capital continuously at no cost and fosters an on-
going relationship with shareholders.going relationship with shareholders.

Stock DividendsStock Dividends
• Stock dividends simply amount to distribution ofStock dividends simply amount to distribution of
additional shares to existing shareholdersadditional shares to existing shareholders
• They represent nothing more than recapitalizationThey represent nothing more than recapitalization
of earnings of the company. (that is, the amount ofof earnings of the company. (that is, the amount of
the stock dividend is transferred from the R/Ethe stock dividend is transferred from the R/E
account to the common share account.account to the common share account.
• Because of theBecause of the capital impairment rulecapital impairment rule stockstock
dividends reduce the firm’s ability to pay dividendsdividends reduce the firm’s ability to pay dividends
in the future.in the future.

Stock DividendsStock Dividends
ImplicationsImplications
– reduction in the R/E accountreduction in the R/E account
– reduced capacity to pay future dividendsreduced capacity to pay future dividends
– proportionate share ownership remains unchangedproportionate share ownership remains unchanged
– shareholder’s wealth (theoretically) is unaffectedshareholder’s wealth (theoretically) is unaffected
Effect on the CompanyEffect on the Company
– conserves cashconserves cash
– serves to lower the market value of firm’s stock modestlyserves to lower the market value of firm’s stock modestly
– promotes wider distribution of shares to the extent that current owners divest themselves ofpromotes wider distribution of shares to the extent that current owners divest themselves of
shares...because they have moreshares...because they have more
– adjusts the capital accountsadjusts the capital accounts
– dilutes EPSdilutes EPS
Effect on ShareholdersEffect on Shareholders
– proportion of ownership remains unchangedproportion of ownership remains unchanged
– total value of holdings remains unchangedtotal value of holdings remains unchanged
– if former DPS is maintained, this really represents an increased dividend payoutif former DPS is maintained, this really represents an increased dividend payout

Stock Dividend ExampleStock Dividend Example
ABC CompanyABC Company
Equity AccountsEquity Accounts
as at February xx, 20x9as at February xx, 20x9
Common stock (215,000)Common stock (215,000) $5,000,000$5,000,000
Retained earningsRetained earnings 20,000,00020,000,000
Net WorthNet Worth $25,000,000$25,000,000
The company, on March 1, 20x9 declares a 10 percent stock dividend when the currentThe company, on March 1, 20x9 declares a 10 percent stock dividend when the current
market price for the stock is $40.00 per share.market price for the stock is $40.00 per share.
This stock dividend will increase the number of shares outstanding by 10 percent. ThisThis 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:will mean issuing 21,500 shares. The value of the shares is:
$40.00 (21,500) = $860,000$40.00 (21,500) = $860,000
This stock dividend will result in $860,000 being transferred from the retained earningsThis stock dividend will result in $860,000 being transferred from the retained earnings
account to the common stock account:account to the common stock account:
next page...next page...

Stock Dividend ExampleStock Dividend Example
After the stock dividend:After the stock dividend:
ABC CompanyABC Company
Equity AccountsEquity Accounts
as at March 1, 20x9as at March 1, 20x9
Common stock (236,500)Common stock (236,500) $5,860,000$5,860,000
Net worthNet worth $25,000,000$25,000,000
The market price of the stock will be affected by the stock dividend:The market price of the stock will be affected by the stock dividend:
New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36
The individual shareholder’s wealth will remain unchanged.The individual shareholder’s wealth will remain unchanged.

Stock SplitsStock Splits
• Although there is no theoretical proof, there is some whoAlthough there is no theoretical proof, there is some who
believe that an optimal price range exists for abelieve that an optimal price range exists for a
company’s common shares.company’s common shares.
• It is generally felt that there is greater demand forIt is generally felt that there is greater demand for
shares of companies that are traded in the $40 - $80shares of companies that are traded in the $40 - $80
dollar range.dollar range.
• The purpose of a stock split is to decrease share price.The purpose of a stock split is to decrease share price.
• The result is:The result is:
– increase in the number of share outstandingincrease in the number of share outstanding
– theoretically, no change in shareholder wealththeoretically, no change in shareholder wealth
• Reasons for use:Reasons for use:
– better share price trading rangebetter share price trading range
– psychological appeal (signalling affect)psychological appeal (signalling affect)

Stock Split ExampleStock Split Example
The Board of Directors of XYZ Company is considering using a stock splitThe 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 theto put its shares into a better trading range. They are confident that the
firm’s stock price will continue to rise given the firm’s outstandingfirm’s stock price will continue to rise given the firm’s outstanding
financial performance. Currently, the company’s shares are trading forfinancial performance. Currently, the company’s shares are trading for
$150 and the company’s shareholders equity accounts are as follows:$150 and the company’s shareholders equity accounts are as follows:
Commons shares (100,000 outstanding)Commons shares (100,000 outstanding) $1,500,000$1,500,000
A 2 for 1 Stock Split:A 2 for 1 Stock Split:
New Share Price = PNew Share Price = P00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00
The firm’s equity accounts:The firm’s equity accounts:

Further Stock Split ExamplesFurther Stock Split Examples
A 4 for 3 Stock Split:A 4 for 3 Stock Split:
New Share Price = PNew Share Price = P00[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50
A 3 for 4 Reverse Stock Split:A 3 for 4 Reverse Stock Split:
New Share Price = PNew Share Price = P00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00
Clearly the Board can use stock splits and reverse stock splits to place the firm’s stockClearly the Board can use stock splits and reverse stock splits to place the firm’s stock
in a particular trading range.in a particular trading range.

Stock Split EffectsStock Split Effects
• shareholders wealth should remain unaffected:shareholders wealth should remain unaffected:
Original Holdings: (100 shares @ $150/share) = $15,000Original Holdings: (100 shares @ $150/share) = $15,000
After a 4 for 1 split: (400 shares @ $37.50/share) =After a 4 for 1 split: (400 shares @ $37.50/share) =
$15,000$15,000
• the above will hold true if there is no psychologicalthe above will hold true if there is no psychological
appeal to the stock split.appeal to the stock split.
• There is some evidence that the share price ofThere is some evidence that the share price of
companies which split stock is more bouyantcompanies which split stock is more bouyant
because of a positive signal being transferred to thebecause of a positive signal being transferred to the
market by this action.market by this action.

-- lowers stock price slightlylowers stock price slightly -- large drop in stock pricelarge drop in stock price
-- little psychological appeallittle psychological appeal -- much stronger potentialmuch stronger potential
signalling effectsignalling effect
-- recapitalization of earningsrecapitalization of earnings -- no recapitalizationno recapitalization
-- no change in proportionalno change in proportional -- samesame
ownershipownership
-- odd lots createdodd lots created -- odd lots rareodd lots rare
-- theoretically, no value totheoretically, no value to -- samesame
the investorthe investor
Stock Dividends versus Stock SplitsStock Dividends versus Stock Splits
Stock Dividends Stock Splits

Cash Dividend PaymentsCash Dividend Payments
The Macro PerspectiveThe Macro Perspective
• Figure 22 -1 illustrates:Figure 22 -1 illustrates:
– Aggregate after-tax profits run at approximately 6% of GDP butAggregate after-tax profits run at approximately 6% of GDP but
are highly variableare highly variable
– Aggregate dividends are relatively stable when compared toAggregate dividends are relatively stable when compared to
after-tax profits.after-tax profits.
• They are sustained in the face of drops in profit during recessionsThey are sustained in the face of drops in profit during recessions
• They are held reasonably constant in the face of peaks in aggregateThey are held reasonably constant in the face of peaks in aggregate
profits.profits.
(See Figure 22 - 1 on the following slide)(See Figure 22 - 1 on the following slide)

Aggregate Dividends and ProfitsAggregate Dividends and Profits
FIGURE 22-2

The Macro PerspectiveThe Macro Perspective
• Figure 22 -2 illustrates:Figure 22 -2 illustrates:
– Aggregate Dividend payouts further illustrates theAggregate Dividend payouts further illustrates the
effects of relatively stable dividend payouts in the faceeffects of relatively stable dividend payouts in the face
of profit volatility:of profit volatility:
• The normal aggregate dividend payout rate is about 40% ofThe normal aggregate dividend payout rate is about 40% of
after-tax profitafter-tax profit
• When profits drop and dividends are held constant, payoutWhen profits drop and dividends are held constant, payout
rates rise to 100%rates rise to 100%
(See Figure 22 - 2 on the following slide)(See Figure 22 - 2 on the following slide)

Aggregate Dividend PayoutsAggregate Dividend Payouts
FIGURE 22-3

The Macro Perspective - QuestionThe Macro Perspective - Question
• Why are dividends smoothed and not matchedWhy are dividends smoothed and not matched
to profits?to profits?

The Micro PerspectiveThe Micro Perspective
• Table 22 -1 contains dividend yields forTable 22 -1 contains dividend yields for
selected companies.selected companies.
– The companies chosen here illustrate the dramaticThe companies chosen here illustrate the dramatic
differences between companies:differences between companies:
• Some pay no dividendsSome pay no dividends
• Some pay consistent cash dividends representing substantialSome pay consistent cash dividends representing substantial
yields on current shares pricesyields on current shares prices
– The highest yields are found in the case of Income Trusts andThe highest yields are found in the case of Income Trusts and
large stable ‘blue-chip’ financials and utilitieslarge stable ‘blue-chip’ financials and utilities

Dividend YieldsDividend Yields
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average
% % % % % % % % % %
BCE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31
Celestica Inc. 0 0 0 0 0 0 0 0 0 0 0.00
CIBC 3.67 3.07 2.85 3.37 3.17 2.9 3.48 3.28 3.31 3.57 3.27
Cott Corporation 0.23 0.53 0.54 0 0 0 0 0 0 0 0.13
Kinross Gold Corporation 0 0 0 0 0 0 0 0 0 0 0.00
TransAlta Corporation 6.22 5.16 4.52 5.35 5.59 4.06 4.92 5.73 5.88 4.51 5.19
Yellow Pages Income Fund 7.34 7.09 7.22
Table 22-1 S&P/TSX 60 Index Dividend Yields

Modigliani and Miller’s DividendModigliani and Miller’s Dividend
Irrelevance TheoremIrrelevance Theorem
M&M, Dividends and Firm ValueM&M, Dividends and Firm Value

Modigliani and Miller’s Dividend IrrelevanceModigliani and Miller’s Dividend Irrelevance
TheoremTheorem
The value of M&M’s Dividend IrrelevanceThe value of M&M’s Dividend Irrelevance
argument is that in the end, it shows whereargument is that in the end, it shows where
value can be created with dividend policy andvalue can be created with dividend policy and
why.why.

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value
Start with the single-period DDM:Start with the single-period DDM:
1
11
0
)K(
PD
P
e+
+
=[ 22-1]

• Multiply by the number of shares outstandingMultiply by the number of shares outstanding
((mm) to convert the single stock price model to a) to convert the single stock price model to a
model to value the whole firm:model to value the whole firm:
1
)( 11
00
)K(
PDm
VmP
e+
+
==[ 22-2]

AssumptionsAssumptions
• No TaxesNo Taxes
• Perfect capital marketsPerfect capital markets
– large number of individual buyers and sellerslarge number of individual buyers and sellers
– costless informationcostless information
– no transaction costsno transaction costs
• All firms maximize valueAll firms maximize value
• There is no debtThere is no debt

• Without debt, sources and uses of funds identityWithout debt, sources and uses of funds identity
(sources = uses) can be expressed as:(sources = uses) can be expressed as:
• Where:Where:
 XX represents cash flow from operationsrepresents cash flow from operations
 II represents investmentrepresents investment
 X – IX – I is free cash flowis free cash flow
 mDmD11 is dividend to current shareholders at time 1is dividend to current shareholders at time 1
1111 mDInPX +=+[ 22-3]

• Solving for dividends paid out (Solving for dividends paid out (mDmD11 ):):
1111 InPXmD −+=

• If a firm pays out dividends that exceeds its free cashIf a firm pays out dividends that exceeds its free cash
flow (X –I), then it must issue new common shares to payflow (X –I), then it must issue new common shares to pay
for these dividends.for these dividends.
• Substituting into Equation 22 – 2 we get:Substituting into Equation 22 – 2 we get:
• The value of the firm is the value of the next period’s freeThe value of the firm is the value of the next period’s free
cash flow (cash flow (XX11 –I–I11) plus the next period’s equity market) plus the next period’s equity market
value…value…
)1(
])[(X 1111
0
K
VPnmI
V
+
=++−
=[ 22-4]

• The firm value is determined as the present value of theThe firm value is determined as the present value of the
free cash flows to the equity holders:free cash flows to the equity holders:
• The dividend is equal to the free cash flow each period,The dividend is equal to the free cash flow each period,
and dividends are therefore a residual after the firm hasand dividends are therefore a residual after the firm has
taken care of all of its investment requirements – this istaken care of all of its investment requirements – this is
thethe Residual Theory of DividendsResidual Theory of Dividends
)1(1
0 ∑= +
−
=
α
t
t
tt
K
IX
V[ 22-5]
Value has
nothing
to do with
dividends

Residual Theory of DividendsResidual Theory of Dividends
TheThe Residual Theory of DividendsResidual Theory of Dividends suggests thatsuggests that
logically, each year, management should:logically, each year, management should:
– Identify free cash flow generated in the previousIdentify free cash flow generated in the previous
periodperiod
– Identify investment projects that have positive NPVsIdentify investment projects that have positive NPVs
– Invest in all positive NPV projectsInvest in all positive NPV projects
• If free cash flow is insufficient, then raise external capital – inIf free cash flow is insufficient, then raise external capital – in
this case no dividend is paidthis case no dividend is paid
• If free cash flow exceeds investment requirements, theIf free cash flow exceeds investment requirements, the
residual amount is distributed in the form of cash dividends.residual amount is distributed in the form of cash dividends.

Residual Theory of Dividends - ImplicationResidual Theory of Dividends - Implication
The implication of theThe implication of the Residual Theory of DividendsResidual Theory of Dividends are:are:
Investment decisions are independent of the firm’s dividendInvestment decisions are independent of the firm’s dividend
policypolicy
• No firm would pass on a positive NPV project because of the lackNo firm would pass on a positive NPV project because of the lack
of funds, because, by definition the incremental cost of those fundsof funds, because, by definition the incremental cost of those funds
is less than the IRR of the project, so the value of the firm isis less than the IRR of the project, so the value of the firm is
maximized only if the project is undertaken.maximized only if the project is undertaken.
• If the firm can’t make good use of free cash flow (ie. It has noIf 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 beprojects with IRRs > cost of capital) then those funds should be
distributed back to shareholders in the form of dividends for themdistributed back to shareholders in the form of dividends for them
to invest on their own.to invest on their own.
• The firm should operate where Marginal Cost equals MarginalThe firm should operate where Marginal Cost equals Marginal
Revenue as seen in Figure 22 – 4 on the following slide:Revenue as seen in Figure 22 – 4 on the following slide:

Internal Funds, Investment, and DividendsInternal Funds, Investment, and Dividends
22 - 4 FIGURE
$11,976
Million
Rate of
Return
WACC
Internal Funds Available
OPTIMAL INVESTMENT
IOS
$177,607
Million
MC=MR

Homemade DividendsHomemade Dividends
• Shareholders can buy or sell shares in anShareholders can buy or sell shares in an
underlying company to create their own cashunderlying company to create their own cash
flow pattern.flow pattern.
– They don’t need management declare a cashThey don’t need management declare a cash
dividend, they can create their own.dividend, they can create their own.
Conclusion: under the assumptions of M&M’s model,Conclusion: under the assumptions of M&M’s model,
the investor is indifferent to the firm’s dividend policy.the investor is indifferent to the firm’s dividend policy.

The “Bird-in-the-Hand” ArgumentThe “Bird-in-the-Hand” Argument

M&M’s Assumptions RelaxedM&M’s Assumptions Relaxed
• Risk is a real world factor.Risk is a real world factor.
• Firm’s that reinvest free cash flow, put thatFirm’s that reinvest free cash flow, put that
money at risk – there is no certainty ofmoney at risk – there is no certainty of
investment outcome – those forfeit dividendsinvestment outcome – those forfeit dividends
that are reinvested…could be lost!that are reinvested…could be lost!
• Remember the two-stage DDM?Remember the two-stage DDM?

• Remember the two-stage DDM?Remember the two-stage DDM?
– The first term is the present value of existing opportunitiesThe first term is the present value of existing opportunities
(PVEO)(PVEO)
– The second term is the present value of growth opportunitiesThe second term is the present value of growth opportunities
(PVGO)(PVGO)
– These forecast returns face risks of new market entrants toThese forecast returns face risks of new market entrants to
compete for the excess profits forecast in emerging opportunitiescompete for the excess profits forecast in emerging opportunities
making PVGO extremely vulnerable.making PVGO extremely vulnerable.
)
ROE
(
)K(1
Inv 2
e
1
e
e
e K
K
K
BVPSROE
P
−
+
+
×
=[ 22-6]

• Myron Gordon suggests that dividends are more stableMyron Gordon suggests that dividends are more stable
than capital gains and are therefore more highly valuedthan capital gains and are therefore more highly valued
by investors.by investors.
• This implies that investors perceive non-dividend payingThis implies that investors perceive non-dividend paying
firms to be riskier and apply a higher discount rate tofirms to be riskier and apply a higher discount rate to
value them causing the share price to fall.value them causing the share price to fall.
• The difference between the M&M and Gordon argumentsThe difference between the M&M and Gordon arguments
are illustrated in Figure 22 - 5 on the following slide:are illustrated in Figure 22 - 5 on the following slide:
– M&M argue that dividends and capital gains are perfectM&M argue that dividends and capital gains are perfect
substitutessubstitutes

M&M versus Gordon’s Bird in the Hand TheoryM&M versus Gordon’s Bird in the Hand Theory
0
1
P
D
22 - 5 FIGURE
Gordon
OPTIMAL INVESTMENT
M&M
0
01
P
PP −

M&M versus Gordon’s Bird in the Hand TheoryM&M versus Gordon’s Bird in the Hand Theory
Conclusions:Conclusions:
– Firms cannot change underlying operationalFirms cannot change underlying operational
characteristics by changing the dividendcharacteristics by changing the dividend
– The dividend should reflect the firm’s operationsThe dividend should reflect the firm’s operations
through the residual value of dividendsthrough the residual value of dividends

Dividend Policy in PracticeDividend Policy in Practice

• Firms smooth their dividendsFirms smooth their dividends
– Firms tend to hold dividends constant, even in theFirms tend to hold dividends constant, even in the
face of increasing after-tax profitface of increasing after-tax profit
– Firms are very reluctant to cut dividendsFirms are very reluctant to cut dividends

Lintner’s Work on Dividend AdjustmentLintner’s Work on Dividend Adjustment
• John Lintner suggested a partial adjustmentJohn Lintner suggested a partial adjustment
model to explain the smoothing of dividendmodel to explain the smoothing of dividend
behaviour illustrating that firms slowly changebehaviour illustrating that firms slowly change
dividends as they move toward a new targetdividends as they move toward a new target
level:level:
1 )-Dβ(DΔD t-
*
tt =[ 22-7]

• The target dividendThe target dividend DDtt
**
Lintner suggested is a function ofLintner suggested is a function of
the firm’s optimal payout rate of the firm’s underlyingthe firm’s optimal payout rate of the firm’s underlying
earnings (earnings (EEtt) leading to the following equation:) leading to the following equation:
• The coefficient on lagged dividends was estimated atThe coefficient on lagged dividends was estimated at
0.70 indicating an adjustment speed (0.70 indicating an adjustment speed (bb) coefficent of) coefficent of
0.30.0.30.
• The coefficient on current earnings (The coefficient on current earnings (cc) was estimated at) was estimated at
0.150.15
)1( 11 cEDbaD t-t +−+=[ 22-8]

ImplicationsImplications
– The speed of dividend adjustment is only about 30The speed of dividend adjustment is only about 30
percentpercent
– Firms are very reluctant to fully adjustFirms are very reluctant to fully adjust
– Firms do not follow a policy of paying a constantFirms do not follow a policy of paying a constant
proportion of earnings out as dividendsproportion of earnings out as dividends
Dividend policy in practice does not follow M&M’sDividend policy in practice does not follow M&M’s
irrelevance arguments because the real world doesirrelevance arguments because the real world does
not match the assumptions used.not match the assumptions used.

Relaxing the M&M AssumptionsRelaxing the M&M Assumptions
Welcome to the Real World!Welcome to the Real World!
Transactions CostsTransactions Costs
– Underwriting costs are very high, providing a strongUnderwriting costs are very high, providing a strong
incentive for firms to finance growth out of free cashincentive for firms to finance growth out of free cash
flowflow
– Facing these high underwriting costs firms:Facing these high underwriting costs firms:
• With high growth rates have little incentive to pay dividendsWith high growth rates have little incentive to pay dividends
• With volatile earnings conserve cash from year to year toWith volatile earnings conserve cash from year to year to
finance projects and therefore pay very conservativefinance projects and therefore pay very conservative
dividendsdividends

Dividends and SignallingDividends and Signalling
– Under conditions of information asymmetry, shareholders andUnder conditions of information asymmetry, shareholders and
the investing public watch for management signals (actions)the investing public watch for management signals (actions)
about what management knows.about what management knows.
– Management is therefore very cautious about dividendManagement is therefore very cautious about dividend
changes…they don’t want to create high expectations (this is thechanges…they don’t want to create high expectations (this is the
reason for extra or special dividends) that will lead toreason for extra or special dividends) that will lead to
disappointment, and they don’t want to have investors over reactdisappointment, and they don’t want to have investors over react
to negative earnings surprises (the sticky dividend phenomenon)to negative earnings surprises (the sticky dividend phenomenon)
(The Signalling Model is explained in Figure 22 – 6 found on the next slide.)(The Signalling Model is explained in Figure 22 – 6 found on the next slide.)

The Signalling ModelThe Signalling Model
22 - 6 FIGURE
et
$
1 2 3 Time
et
*
dt
*
dt

Agency TheoryAgency Theory
– Investors are wary of senior management so they seek to putInvestors are wary of senior management so they seek to put
controls in place.controls in place.
– There is a fear that managers may waste corporate resources byThere is a fear that managers may waste corporate resources by
over-investing in low or poor NPV projects.over-investing in low or poor NPV projects.
– Gordon Donaldson argued this is the reason for the peckingGordon Donaldson argued this is the reason for the pecking
order managements tend to use when raising capitalorder managements tend to use when raising capital
• Shareholders would prefer to receive a dividend and then haveShareholders would prefer to receive a dividend and then have
management file a prospectus, justifying investment in projects andmanagement file a prospectus, justifying investment in projects and
the need to raise the capital that was just distributed as a dividend.the need to raise the capital that was just distributed as a dividend.
• Shareholders are prepared to pay those additional underwritingShareholders are prepared to pay those additional underwriting
costs as an agency cost incurred to monitor and assesscosts as an agency cost incurred to monitor and assess
management.management.

Taxes and the Clientele EffectTaxes and the Clientele Effect
– Table 22 -3 (on the following slide) illustrates that differentTable 22 -3 (on the following slide) illustrates that different
classes of investors face different tax bracketsclasses of investors face different tax brackets
– Preference for dividends versus capital gains income dependsPreference for dividends versus capital gains income depends
on the province of residence and taxable income level leading toon the province of residence and taxable income level leading to
tax clienteles.tax clienteles.
• High income earners tend to prefer capital gains (there is anHigh income earners tend to prefer capital gains (there is an
additional tax incentive for such individuals in that they can chooseadditional tax incentive for such individuals in that they can choose
the timing of the sale of their investment…remember only ‘realized’the timing of the sale of their investment…remember only ‘realized’
capital gains are subject to taxcapital gains are subject to tax
• Low income earners tend to prefer dividendsLow income earners tend to prefer dividends
Conclusion – firm’s should not change dividend policy drasticallyConclusion – firm’s should not change dividend policy drastically
since it upsets the existing ownership base.since it upsets the existing ownership base.

TaxesTaxes
Income Level $25,000 $50,000 $75,000 $100,000
British Columbia Dividends 2.52 6.19 15.69 20.04
Capital gains 12.45 15.58 18.85 20.35
Alberta Dividends 3.63 8.03 13.83 13.83
Capital gains 12.63 16.00 18.00 18.00
Ontario Dividends 0.00 8.24 20.74 20.74
Capital gains 10.65 15.58 21.71 21.71
Quebec Dividends 5.95 15.42 26.06 26.06
Capital gains 14.37 19.19 22.86 22.86
Nova Scotia Dividends 0.00 8.75 17.05 19.06
Capital gains 12.02 18.48 21.34 22.63
Table 22-3 Individual Tax Rates (%) on Dividends and Capital Gains

Repackaging Dividend-Paying SecuritiesRepackaging Dividend-Paying Securities
• Tax clienteles help to explain the financialTax clienteles help to explain the financial
engineering whereby different parts of theengineering whereby different parts of the
return by the firm are stripped, repackaged andreturn by the firm are stripped, repackaged and
sold to different investors as illustrated insold to different investors as illustrated in
Figure 22 – 7. (See the following slide)Figure 22 – 7. (See the following slide)
• Split shares are shares sold as the dividendsSplit shares are shares sold as the dividends
and capital gains parts.and capital gains parts.

MYW’s B Corporation SharesMYW’s B Corporation Shares
)1()1(
6
1
6
0
0 ∑= +
+
+
=
t
t
t
k
P
k
d
P
MYW
)1(
)1,30min($
)1(
Pref
6
1
6
6
∑= +
−
+
+
=
t t
t
k
P
k
d
22 - 7 FIGURE
$143 million$330 million
$454 million
)1(
)1,30min($
IR 6
66
k
PP
+
−−
=

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

• allowed under the OBCA and CBCAallowed under the OBCA and CBCA
• reasons for use:reasons for use:
– Offsetting the exercise of executive stock optionsOffsetting the exercise of executive stock options
– Leveraged recapitalizationsLeveraged recapitalizations
– Information or signalling effectsInformation or signalling effects
– Repurchase dissident sharesRepurchase dissident shares
– Removing cash without generating expectations for futureRemoving cash without generating expectations for future
distributionsdistributions
– Take the firm private.Take the firm private.

• they are usually done on an irregular basis, so a shareholderthey are usually done on an irregular basis, so a shareholder
cannot depend on income from this source.cannot depend on income from this source.
• if regular repurchases are made, there is a good chance thatif regular repurchases are made, there is a good chance that
Revenue Canada will rule that the repurchases were simply aRevenue Canada will rule that the repurchases were simply a
tax avoidance scheme (to avoid tax on dividends) and willtax avoidance scheme (to avoid tax on dividends) and will
assess taxassess tax
• there may be some agency problems - if managers havethere may be some agency problems - if managers have
inside information, they are purchasing from shareholders atinside information, they are purchasing from shareholders at
a price less than the intrinsic value of the shares.a price less than the intrinsic value of the shares.
Disadvantages of Share RepurchasesDisadvantages of Share Repurchases

• tender offer:tender offer:
– this is a formal offer to purchase a given number of shares at athis is a formal offer to purchase a given number of shares at a
given price over current market price.given price over current market price.
• open market purchase:open market purchase:
– the purchase of shares through an investment dealer like anythe purchase of shares through an investment dealer like any
other investorother investor
– this is not designed for large block purchases.this is not designed for large block purchases.
• private negotiation with major shareholdersprivate negotiation with major shareholders
In any repurchase program, the securities commissionIn any repurchase program, the securities commission
requires disclosure of the event as well as all otherrequires disclosure of the event as well as all other
material information through a prospectus.material information through a prospectus.
Methods of Share RepurchasesMethods of Share Repurchases

• called treasury stock (U.S.)called treasury stock (U.S.)
• non-voting (U.S.)non-voting (U.S.)
• may not receive dividends (U.S.)may not receive dividends (U.S.)
• if not retired, can be resold (U.S.)if not retired, can be resold (U.S.)
• unlike the U.S., repurchases in Canada do notunlike the U.S., repurchases in Canada do not
involve shares that can be placed into treasuryinvolve shares that can be placed into treasury
stock - they are canceledstock - they are canceled
Repurchased SharesRepurchased Shares

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

• EPS should increase following the repurchase ifEPS should increase following the repurchase if
earnings after-tax remains the sameearnings after-tax remains the same
• a higher market price per outstanding share ofa higher market price per outstanding share of
common stock should resultcommon stock should result
• stockholders not selling their shares back tostockholders not selling their shares back to
the firm will enjoy a capital gain if thethe firm will enjoy a capital gain if the
repurchase increases the stock price.repurchase increases the stock price.
Effects of A Share RepurchaseEffects of A Share Repurchase

• signal positive information about the firm’s future cashsignal positive information about the firm’s future cash
flowsflows
• used to effect a large-scale change in the firm’s capitalused to effect a large-scale change in the firm’s capital
structurestructure
• increase investor’s return without creating anincrease investor’s return without creating an
expectation of higher future cash dividendsexpectation of higher future cash dividends
• reduce future cash dividend requirements or increasereduce future cash dividend requirements or increase
cash dividends per share on the remaining shares,cash dividends per share on the remaining shares,
without creating a continuing incremental cash drainwithout creating a continuing incremental cash drain
• capital gains treated more favourably than cashcapital gains treated more favourably than cash
dividends for tax purposes.dividends for tax purposes.
Advantages of Share RepurchasesAdvantages of Share Repurchases

• signal negative information about the firm’ssignal negative information about the firm’s
future growth and investment opportunitiesfuture growth and investment opportunities
• the provincial securities commission may raisethe provincial securities commission may raise
questions about the intentionquestions about the intention
• share repurchase may not qualify the investorshare repurchase may not qualify the investor
for a capital gainfor a capital gain
Disadvantages of Share RepurchasesDisadvantages of Share Repurchases

Borrowing to Pay DividendsBorrowing to Pay Dividends
SignallingSignalling

• Is this legal? is it possible to do?Is this legal? is it possible to do?
• YesYes
– the firm must have the ability and capacity to borrowthe firm must have the ability and capacity to borrow
– the firm must have sufficient retained earnings to allow itthe firm must have sufficient retained earnings to allow it
to pay the dividendto pay the dividend
– the firm must have sufficient cash on hand to pay thethe firm must have sufficient cash on hand to pay the
cash dividendcash dividend
– the firm must NOT have agreed to any limitations on thethe firm must NOT have agreed to any limitations on the
payment of dividends under the bond indenture.payment of dividends under the bond indenture.
• Why?Why?
– A possible answer is to signal to the market that theA possible answer is to signal to the market that the
board is confident about the firm’s ability to sustain cashboard is confident about the firm’s ability to sustain cash
dividends into the future.dividends into the future.

Assets: Liabilities:
Cash 10 Long-term Debt 0
Fixed Assets 140 Common Stock 50
Retained Earnings 100
Total Assets $150 Total Claims $150
After Borrowing…before cash dividend:
Retained Earnings 100
Before Borrowing:
0% Debt
25% Debt
An ExampleAn Example

Cash 60 Current liabilities 50
Fixed Assets 140 Long-term Debt 50
Common Shares 50
Retained earnings 50
After Cash Dividend payment of $50
Retained earnings 50
After Dividend Declaration…before date of payment.
50% Debt
33% Debt
An Example …An Example …

• The foregoing example illustrates:The foregoing example illustrates:
– it is possible for a firm with ‘borrowing capacity’ to borrow funds toit is possible for a firm with ‘borrowing capacity’ to borrow funds to
pay cash dividends.pay cash dividends.
– this is not possible if the lenders insist on restrictive covenants thatthis is not possible if the lenders insist on restrictive covenants that
limit or prevent this from occurring.limit or prevent this from occurring.
– the cash for the dividend must be present in the cash account.the cash for the dividend must be present in the cash account.
– payment of dividends reduces both the cash account on the assetpayment of dividends reduces both the cash account on the asset
side of the balance sheet as well as the retained earnings accountside of the balance sheet as well as the retained earnings account
on the ‘claims’ side of the balance sheet.on the ‘claims’ side of the balance sheet.
– in the absence of restrictions, it is possible to transfer wealth fromin the absence of restrictions, it is possible to transfer wealth from
the bondholders to the stockholders.the bondholders to the stockholders. (Bondholders in this example(Bondholders in this example
may have thought their firm would have only a 25% debt ratio….after themay 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 fromdividend the debt ratio rose to 33% and the equity cusion dropped from
75% to 66%.)75% to 66%.)
An ExampleAn Example

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

Dividend policy

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