11-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides prepared by Farida Akhtar and Barry Oliver, Australian National University

Chapter 11:

Payout Policy

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Learning Objectives• Understand the significance of cash payment to

shareholders and some institutional features of dividends and share repurchases.

• Explain why dividend policy is irrelevant to shareholders’ wealth in a perfect capital market with no taxes.

• Define full payout policy and its importance to companies.

• Explain cost and factors that may affect payout policy.

• Outline the imputation and capital gains tax systems and explain their effects on returns to investors.

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Learning Objectives (cont.)• Understand the argument that payout decision

could give signals to investors.

• Explain how agency cost can be related to payout decision.

• Identify the factors that may cause dividend policy to be important.

• Be familiar with the nature of share buybacks, dividend reinvestment plans and dividend election schemes.

• Explain how payout policy may change as a firm moves through its life cycle.

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The Importance of Payout Policy to Shareholders

• A company’s business decisions involve investment, financing and payout policies.

• Directors of companies must decide how much cash, if any, to pay to shareholders and whether the payment should be in the form of dividends or repurchase shares.

• The amount of money involved in payment suggests payout decision is a significant issue in many companies operation.

• It is evident from empirical studies that investors supply capital to business only because they have the reasonable expectation of eventually receiving payouts from company in one form or another. (De Anglo & De Anglo, 2007)

• The decision on the company’s payout policy should be consistent with the overall financial objective of maximising shareholders’ wealth.

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Is There an Optimal Dividend Policy?• In practice, companies payout decision should not be

made in isolation. When determining level and form of payout, company needs to consider whether:

– Dividend decision is related to other financial decisions.

– Effects of changing dividends and whether to adopt a dividend reinvestment plan.

• Companies that pay dividends usually make two dividend payments each year.

• It is important for these companies to review their payout policy regularly.

• Hence, the payout decision can involve several factors, and the optimal policy may be far from obvious.

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Institutional Features of Dividends• Dividend declaration procedures

– Interim and final:

In Australia, if dividends are paid, we typically find two types:

• A final dividend is paid after the end of the accounting or reporting year.

• An interim dividend can be paid any time before the final report is released, usually after the half-yearly accounts are released.

– Cum-dividend period:

Period during which the share holder is qualified to receive a previously announced dividend.

– Ex-dividend date:

Shares purchased on or after the ex-dividend date do not include a right to the forthcoming dividend payment.

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• Types of dividends:– Dividends are normally paid in cash, but many Australian

companies have adopted dividend reinvestment plans — this gives shareholders the option of reinvesting all or part of their dividend back in the company.

• Example of cum-dividend and ex-dividend date: Cum-Dividend Period 4 days

time 0 Book Closing

Date announcement Ex-dividend

Payment date date date

Institutional Features of Dividends (cont.)

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• Declaration date

– Date Board of Directors pass a resolution to pay a dividend.

• Record (books closing) date

– The date on which shareholders listed in the register of shareholders are designated to receive a dividend.

– This is 4 days after the ex-dividend date.

– The idea is that if shares are traded cum-dividend, brokers have time to notify the share register to ensure the new shareholder receives the dividend.

• Date of payment

– Date dividend cheques are mailed or dividends are paid electronically.

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• Legal considerations:

– Dividends can only be paid out of profit and are not to be paid out of capital.

– A dividend cannot be paid if it would make the company insolvent.

– Dividend restrictions may exist in covenants, trust deeds and loan agreements.

– Under imputation, if a company has the capacity to pay a franked dividend then, as a general rule, it must do so.

– Franked dividend carries credits for tax paid by the company.

– New Zealand also operates an imputation system for dividends.

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• Dividend Imputation

– Franked dividend:

Carries a credit for income tax paid by the company.

– Franking credit:

Credit for Australian company tax paid which, when distributed to shareholders, can be offset against their tax liability.

– Withholding tax:

Tax deducted by a company from the dividend payable to a non-resident shareholder.

– Franking account:

Account that records Australian tax paid on company profits. This identifies the total amount of franking credits that can be distributed to shareholders in the form of franked dividends.

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Repurchasing Shares • Over the past decade, the popularity of Australian

companies buying back their own shares has grown as a means of returning excess capital to shareholders.

• Types of share buyback:

– Equal access buyback — pro-rata to all shareholders.

– Selective buyback — repurchase from specific, limited number of shareholders.

– On-market buyback — repurchase through normal stock exchange trading.

– Employee share scheme buyback.

– Minimum loading buyback — buy back small parcels of shares (transaction costs).

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Is Payout Policy Important to Shareholders?• Payout policy involves two fundamental

questions:– Whether to pay cash to shareholders.

– The form of the payment.

• Three payout policies that might be adopted are:(1) Residual dividend policy:– Pay out as dividends any profit that management does not believe

can be invested profitably.

(2) Smoothed dividend policy:– Target proportion of annual profits to be paid out as dividend. Aim

for dividends to equal the long-run difference between expected profits and expected investment needs.

(3) Constant payout policy: – Where the dividend payout ratio stays the same every year.

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Managers and Payout Decisions

• Dividends are an active decision variable (Lintner). In a much larger study, some of the findings by Bray et. al. (2005) were consistent with those of Lintner:

– Maintaining current level of dividend per share is a high priority and is of similar importance to investment decisions.

– Managers see little reward for increasing dividends.

– Dividends are inflexible and smoothed relative to profits.

– Share repurchases are very flexible with no need for smoothing — repurchases are made using the residual cash flow after investment spending.

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Irrelevance Theory — Modigliani and Miller (1961)

• Value of firm is determined solely by the earning power of the firm’s assets and the manner in which the earnings stream is split between dividends; and retained earnings does not affect shareholders’ wealth.

• Modigliani and Miller (MM): Given the investment decision of the firm, the dividend payout ratio is a mere detail. It does not affect the wealth of shareholders.

• Assumptions

– Company has a fixed investment or capital budgeting program.

– No taxes, transaction costs, or other market imperfections.

– Investors are rational so always prefer more wealth to less wealth — investors are indifferent between receiving dividends or capital gains.

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MM’s Conclusion• Dividend policy is a trade-off between higher or

lower dividends, issuing or repurchasing ordinary shares to replace cash paid out.

• Pay dividend or issue new shares to replace cash:– Does not change the value of the company; and

– Does not change the wealth of the old shareholders because the value of their shares falls by an amount equal to the cash paid to them.

• If a company increases its dividends, it must replace the cash by making a share issue.

• Old shareholders receive a higher current dividend, but a proportion of future dividends must be diverted to the new shareholders.

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MM’s Conclusion (cont.)• The present value of these forgone future payments is equal to

the increase in current dividends.

• The MM dividend irrelevance proposition is valid in a perfect capital market with no taxes.

• Therefore, if the dividend policy is important in practice, the reasons for its importance must relate to factors that MM excluded from their analysis.

• Large body of research has examined whether the policies that companies adopt can be explained by an imperfect market.

• Recent studies by De Angelo & De Angelo (2006) (DD) argued that concept of full payout is a more logical starting point for discussion of payout policy — full present value of company’s free cash flow should be paid out to shareholders. Hence, MM irrelevance theorem is itself irrelevant but not wrong analysis!

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The Importance of Full Payout• MM’s assumption constrains a company to paying out all its

free cash flow (FCF) each year — optimal payout policy.

• DD argue that the MM approach does not prove that payout policy is irrelevant because company value can be changed if the company retains part of its FCF.

• DD distinguish between investment value and distribution value.

• In contrast to MM, DD conclude that both investment policy and payout policy are important. In summary, DD argue that managers are responsible for two important jobs:

– Selecting good investment projects.

– Ensuring that over the life of the enterprise, investors receive a distribution stream with the greatest possible present value.

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Payout policy in Practice• MM — any payout policy will do for shareholders.

• DD — support full payout policy.

• In a frictionless market — full payout means that the PV of FCF should be paid out over the life of the enterprise.

• Neither the DD analysis or MM analysis says anything about the form of payout.

• In a model, it is necessary to consider the effects of the frictions that may encourage or discourage payout of cash — therefore, we must consider factors that may influence the preferred form of payouts.

• Lease et. al. (2000) divide the factors into two groups — big three imperfections and little three frictions.

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Transaction Costs and Other Imperfections1. Transaction costs

– In practice, shareholders who buy and sell shares will incur transaction costs, so investors who require income may prefer to hold onto shares that pay dividends.

– Dividend clienteles effect may develop due to difference in preference among different classes of investors for current income.

2. Floatation costs – If a company pays dividends and its retailed profits are

insufficient to meet its investment needs, then one solution is to raise funds externally.

3. Behavioural factors and dividends– Investors are not always rational, and behavioural factors

may result in dividends being valued more highly than cash generated by selling shares.

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Dividends and Taxes• Differential tax treatment of dividend income vs

capital gains arising from retained profits can either favour or penalise payment of dividends.

• Despite the apparent tax disadvantage of paying dividends, many Australian companies did pay out a significant percentage of their profits as dividends.

• This difference in tax treatment is understood by comparing a classical tax system with an imputation tax system.

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Classical Tax System• In a classical tax system:

– Company profits are taxed at the corporate tax rate, tc, leaving (1 – tc) to be distributed as a dividend.

– Dividends received by shareholders are then taxed at the shareholder’s personal marginal tax rate, tp.

– The consequence is that, from a dollar of company profit, the shareholder ends up with (1 – tc) x (1 – tp) dollars of after-tax dividend in a classical tax system.

– The result is that profit paid as a dividend is effectively taxed twice.

• In Australia, a classical tax system operated until 1 July 1987, when an imputation system was introduced.

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Imputation Tax System• A system under which Australian resident equity

investors can use tax credits associated with franked dividends to offset their personal tax.

• This eliminates the double taxation inherent under the classical tax system.

• Company tax is assessed on the corporate profits in the normal way, at the corporate tax rate (tc). As of 2008, tc is 30%.

• For each dollar of franked dividends paid by the company, resident shareholders will be taxed at their marginal rate (tp) on an imputed dividend of $D / (1 – tc) — grossed-up dividend.

• The grossed-up dividend is equal to the dividend plus the franking credit.

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Imputation Tax System (cont.)

• Franking credit is given by:

• The shareholder receives a tax credit equal to the franking credit.

• The credit can be used to offset tax liabilities associated with any other form of income.

• The result is that franked dividends are effectively tax-free to Australian residents — if the investor’s marginal tax rate is equal to the corporate tax rate.

( )( )c

c

t

t

−

×=

1

dividendcredit Imputation

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Imputation Tax System (cont.)• If the investor’s marginal tax rate is less than the corporate

rate, then the investor will have excess tax credits, which can be used to reduce tax on other income, or refunded if they cannot be used.

• If the investor’s marginal tax rate is greater than the corporate rate, some tax will be payable by the investor on the dividend.

• Investors pay tax, at their marginal rate, on any unfranked dividends received.

• Under the imputation system — shareholders are unable to use tax credits until franked dividends are paid.

• Since 1 October 2003, Australian and New Zealand companies have been able to distribute all franking credits to Australian and New Zealand resident shareholders.

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Imputation and Capital Gains Tax (CGT)• If companies retain profits, their share price is likely to rise

relative to companies that distribute profits, giving rise to capital gains tax liabilities for shareholders if and when the shares are sold.

• Capital gains receive preferential tax treatment compared to ordinary income

• Capital gains tax (CGT) applies only to short-term gains and to long-term real capital gains on assets acquired on or after 20 September 1985, and is payable only when gains have been realised. As of 21 September 1999, capital gains earned over 12 months or longer are subject to CGT discounting.

• For individuals, maximum rate of CGT will be half their marginal tax rate on ‘ordinary’ income. For superannuation funds, the maximum rate of CGT on long-term gains is 10% compared with their normal income tax rate of 15%.

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Dividend Policy with Imputation and CGT• If all company shares were held by resident investors with

marginal tax rates less than company tax rates, then the optimal dividend policy for an Australian company is one that at least pays dividends to the limit of its franking account balance.

• This policy will benefit resident investors in two ways:

– The franking credits attached to franked dividends can be used to reduce investors’ personal tax liabilities.

– Since the alternative to dividends is capital gains, which are subject to company tax and CGT, higher dividends will mean that less CGT is payable by investors.

• If all franking credits are not paid out, the credits that are retained are potentially wasted as they have no value except when accompanying dividend payments. (At best, their value is discounted if they are used to offer franking credits on future dividends.)

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Dividend Policy with Imputation and CGT (cont.)

• Complicating factors for optimal dividend policy:– Shares are held by both resident and non-resident

individuals.

– Many individuals have personal marginal tax rates that are greater than the company tax rate and may have a tax-based preference for retention of profits.

– Since July 2000, resident investors that are tax-exempt have excess franking credits refunded.

• Overall, the interaction of CGT and the imputation system means that shareholders with low (high) marginal tax rates prefer profits to be paid out as dividends (retained, leading to capital gains).

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Value of Franking Credits• The argument that investors will prefer tax credits to be

distributed rather than retained assumes that tax credits are valuable to investors.

• Supporting evidence from the dividend drop-off ratio:

– Drop-off ratio: ratio of the decline in the share price on the ex-dividend day to the dividend per share.

• Walker and Partington (1999) study drop-off ratios:

– 1 January 1995 to 1 March 1997, when ASX allowed trading in cum-dividend shares after the ex-dividend date.

– Find a drop-off ratio of 1.23, implying that $1 of fully-franked dividends is worth more than $1.

– Some variability because of different individual marginal tax rates.

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Value of Franking Credits (cont.)• Cannavan, Finn and Gray (2004) also study

drop-off ratios:

– Use futures contracts on dividend paying shares to compare with actual shares.

– Futures contracts do not entitle holder to dividends so difference should reflect market value of dividend and associated franking credit.

– Tax rules change requiring shares to be held 45 days in order to claim franking credits.

Prior to introduction of this rule, franking credits had some value — franking credits were easily transferable from those that could not use them to those that could.

After this rule, franking credits appear to be worthless.

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Information Effects and Signalling to Investors• Evidence suggests share price changes around the time of the

announcement of dividend changes are positively related to the change in the dividend.

• MM claim that this does not invalidate irrelevance theory.

• DD argue this approach and instead support the importance of payout policy — investors value securities only for the payouts they are expected to provide. Therefore, it is logical that higher share price follows the announcement of higher payouts.

• There has been a large body of empirical evidence on the information signalling arguments. (p. 337–40)

• Many studies holds the view of Grullon et. al. (2002) approach known as maturity hypothesis — i.e. companies typically increase dividends when they are more mature and less risky.

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Agency Costs and Corporate Governance

– Agency costs can be reduced by paying higher dividends.

– Increased capital-raising required:

Accountability to market.

Increases provision of information.

Increases monitoring of managers.

Managers more likely to act in interests of shareholders.

– Lie (2000) and Grullon, Michaely and Swaminathan (2002) provide empirical evidence that increased payouts — either as special dividends, increased ordinary dividends, or a share repurchase program — signal reduced opportunity to over invest, free cash flow hypothesis.

– Firms with limited investment opportunities exhibit a bigger abnormal return to the announcement of such initiatives.

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Agency Costs and Corporate Governance (cont.)

– In Australia, Telstra’s announcement in June 2004 that they intend to focus on a higher dividend payout rate of 80% and to initiate $1.5b worth of capital management programs (special dividends and/or repurchases) was greeted with a 4.6% increase in share price.

– La Porta, Lopez-De-Silanes, Shleifer and Vishny (2000) provide empirical evidence that in countries where investors’ interests are relatively well protected, dividends are less likely to be a mechanism to reduce agency costs.

– Well-protected investors are willing to forgo dividends now in return for growth.

– High-growth companies pay lower dividends in economies where investors are relatively well-protected legally.

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Agency Costs and Corporate Governance (cont.)

– Correia Da Silva, Goeregen and Renneboog (2004) argue that dividend policy may be influenced by corporate governance regimes.

– Market-based and block-holder based regimes of corporate governance.

– The presence of large (block) shareholders reduces the impetus to pay out dividends (consider News Corp. in Australia, large block holder, low dividends).

– Controlling interest is a substitute for dividends as a monitoring mechanism, while agency costs are less of an issue as shareholder is potentially an insider or even a manager.

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Share Buy-Backs• A share buy-back is when a company purchases its

own shares on the stock market and then proceeds to either cancel them (Australia) or retain them as treasury stock (US).

• There are legal requirements associated with buybacks, but generally companies can repurchase up to 10% of their ordinary shares in a 12-month period.

• Rapid growth in repurchases in Australia, $770m in the 1995 financial year, up to $9.4b in the 12 months to June 2007.

• In 1999 and 2000, US industrial companies distributed more cash to shareholders through share repurchases than dividends.

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Why Companies Repurchase Shares? • Dividend substitution

– If capital gains are taxed more favourably than dividends.– Some supporting evidence from the US, where dividend

payout ratios have been falling in the 1980s and 1990s.

• Improved performance measures– EPS may rise, but if cash is returned rather than used to

retire debt, financial risk is increased and P/E ratio along with share price may fall.

– Return of funds that cannot be profitably used will raise share price.

• Signalling and undervaluation– Managers buying back company stock indicates that

they believe the stock is undervalued by the market.– Alternatively, a buy-back announcement could be

accompanied by some new information, e.g. sale of unprofitable asset/division.

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Why Companies Repurchase Shares? (cont.) • Resource allocation and agency costs

– Share repurchase returns capital to shareholders, who can reallocate funds into profitable activities through the capital market.

– Reduces the potential for managers to inefficiently use free cash (i.e. reduces agency costs).

• Financial flexibility– Payment of dividends is a long-term commitment, and sudden major

changes (especially decreases) in dividend policy are unappreciated by market.

– Buy-backs offer an alternative way to make distributions that may not be permanent.

• Employee share options– Unlike paying dividends, share repurchases do not lead to the ex-

dividend price drop-off.

– Option holders (typically management) prefer a share repurchase to a dividend payout as a means of distributing profits to shareholders.

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Share Repurchases in Australia• Off-market buy-backs can be structured to provide

significant tax advantages with a large dividend and franking component. (see Finance in Action: CBA’s 2004 Off-market Share Buy-back.)

• Key point is that receipt of such a dividend is at the discretion of the shareholder who sells the shares back to the company.

• ASX requires companies to justify buy-back — many on-market buy-backs are justified on the basis that the market undervalues the company’s shares.

• Otchere and Ross (2002) find positive abnormal returns for companies, citing undervaluation as justification of a buy-back.

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Dividend Reinvestment Plans (DRPs) and Dividend Election Schemes• Definition

– DRPs offer shareholders the option to apply all or part of their cash dividends to the purchase of additional shares in the company (in some cases at a discount price).

– The number of listed companies that operate dividend reinvestment plans increased from just five in late 1982 to 14% of all listed companies by 1999.

– In 2005–06, $7.3b of total $38.7b of dividends declared by listed companies were reinvested through DRPs.

– The imputation system has played a large part in this increased popularity, providing an incentive to increase payouts.

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DRPs and Dividend Election Schemes (cont.)• Benefits to the company:

– Cheap/effective means of raising capital and conserving cash.

– Promotes good shareholder relations and stability of ownership.

• Disadvantages to the company:– Administration costs.– Promotion of the plan.– Excessive capital raising.– Dilution of EPS.

• Benefits to investors:– Taxation benefits.– Flexibility and Savings program.– Shares are generally issued at a discount to market

price and are free from brokerage and stamp duty.

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DRPs and Dividend Election Schemes (cont.)• Disadvantages to investors:

– Need to keep substantive and comprehensive records throughout the period of ownership of assets affected by capital gains tax.

– Familiarisation with plan and its tax consequences.

– No control over the reinvestment price.

– Discount disadvantages shareholders who do not participate in the DRP.

• Dividend Election Schemes allow shareholders the option of receiving their dividends in one or more of a number of forms.

• For example, as bonus shares (deferring tax), or as dividends from overseas subsidiaries (foreign tax credits).

• Tax effectiveness of dividend streaming via such schemes has been restricted.

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Payout Policy and Firm Life Cycle• Payout decision can be influenced by many factors;

therefore, if a model is to be used it should be able to explain important empirical findings, including the following:– Aggregate payouts are massive and have increased steadily

over the years.

– Dividends tend to be paid by mature firms.

– Firms pay dividends on an ongoing basis and avoid accumulating large cash balances.

– Individuals with large dividends pay huge taxes on dividends.

– Market reacts positively to announcements of repurchase and dividends increase.

– Unexpected dividend changes are of little help in forecasting future earnings surprise.

– Once regular dividends are initiated — managers are reluctant to cut or omit them.

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Payout Policy and Firm Life Cycle• DD argue that their full payout approach is a more

promising foundation for a model of payout policy than MM dividend irrelevance theorem.

• In reality, dividends are mostly paid by mature and profitable companies that have less information asymmetry than smaller growth companies.

• DD propose that:– A theory of payout policy should be based on the

principles that shares have value only for the payout to their holders.

– Time profile of a company will depend on trade-off between the advantages of internal capital and disadvantage of retaining cash.

• In summary, DD’s full payout approach leads naturally to a life-cycle theory of payout policy.

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Summary • Dividend policy is about the trade-off between

retaining profit and paying out dividends.

• Does not affect shareholders’ wealth in a perfect capital market (MM).

• Dividend policy becomes important when we consider taxes and agency costs (DD).

• Imputation system does eliminate double taxing of dividend income and encourages higher dividend payout ratios.

• Dividend policy environment has been changed by recent alteration to capital gains tax laws, favouring capital gains over dividends.

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Summary (cont.)• Share buybacks have become an increasingly popular

way to distribute cash to shareholders.

• Profits earned overseas can be distributed more tax-effectively to shareholders through share buybacks.

• Dividends and share repurchases have a role in reducing agency costs.

• Share repurchase and dividend announcements have significant effects on share prices.

• The full payout approach leads to a life-cycle theory of payout policy, which proposes that payouts will be determined by a trade-off between the benefits and costs of retaining cash. This trade-off will evolve as a firm moves through its life cycle.

Documents

11-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian