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The Dividend Decision
Will it Affect shareholder Value?
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Agenda
• The Theoretical Positions- Dividend irrelevance- Dividend relevance- Leftists and rightists
• The Possible Policies
• Practical Issues
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Theoretical Discussion
• Irrelevance of Dividend Decision, the residual argument- Company X has net assets of £3,000,000 at day1- 1,000,000 shares issued, share price = £3-00- Co X earns £ 300,000 in year- If no distribution net assets = £3,300,000 so share price
£3-30- If distributes, net assets £3,000,000 so share price £3-00
and each shareholder receives 30 pence div
• Shareholder total value £3-30 i.e. the same
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The Buts (Dividend Relevance)
• But what about shareholders that need income?
- No problem, sell shares and manufacture a dividend
• But what about tax?• But what about transaction costs?• But what about behavioural finance, the
information effect and the bird in the hand?
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Personal Tax Implications 1
• Tax payer – 40% income tax
30% capital Gains tax
Owns 100,000 (10%) shares of Co X
Co X earnings £300,000
Shareholder Dividend 30,000
Tax at 40% 12,000
Net Receipt 18,000
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Personal Tax Implications 2
• But if no dividend and needs income of £18,000 then• Share value £3-30• Capital gain = 30 pence, tax at 30% = 9 pence per share• Therefore sell 18,000/3.21 = 5607 shares• 5607 x 3-30 = £18,503• 5607 x 3-00 = £16,821• Capital Gain £ 1,682• Tax at 30% £ 504• Net receipt £17,999
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Personal Tax Implications 3
• Net Result is to raise £17,999 but Shareholder still has 94,393 shares worth £3-30 each.
• Total value left £311,497• Original value £300,000• Difference £ 11,497
• Income tax £ 12,000• Capital Gains tax £ 504 • Difference £ 11,496
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Tax EffectEx Dividend Day test
• Income Tax 40 %• Capital Gains Tax 25 %• Share Price at Yr start £1.00• Share Price ar Yr end £1.20 (cum div)
• Income Tax Payer• Receives 20 pence dividend• Tax 8• Net 12
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Tax EffectEx Dividend Day Test
• Capital Gains Tax Payer would be willing to pay £1.04 at the start of the period to obtain the same result
• Start Price £1.04• End Price £1.20• Capital Gain 16• Tax @ 25 % 4• Net 12
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The Buts (part deux)
• Transaction costs
• Divisibility
• Flotation costs
• Dilution
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Leftists and Rightists
• Leftists. Apart from a residual dividend policy dividends are harmful.
- costs of funding
- tax
• Rightists. A high payout ratio is a good thing for information effects,clientele effects and psychology
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‘Middle of the Roaders’
• Dividend policy does not matter except in so far as tax and transaction costs effect value
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Information Effect
John Lintner (American Economic Review, May 1956)
• Firms have long run target dividend pay out ratios• Focus is on changes rather than absolute levels• Changes in dividend follow shifts in long run
sustainable earnings (Healy and Palepu, J of Fin Ec 21, 1988)
• Managers are reluctant to reverse dividend decisions
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Clientele Effect
• Widows and orphans• Legal restrictions/dividend paying shares• Capital gains versus income
Behavioural Effect• Bird in the hand• Dilution• Management discipline
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Policies
• Argued that there is no right or wrong policy but- There should be one and
- It should be consistent
• Possible policies are- Residual
- Stable amount
- Constant percentage
- No dividend
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Practicalities 1
• Financial - Liquidity/ cash flow - Debt repayment - Asset expansion - Profit growth - Stability of earnings - Access to capital markets
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Practicalities 2
• Legal/ Technical
- Restrictive loan agreements
- Private limited Cos, only from realised profits
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Practicalities 3
- Timing Cum dividend – includes accrued dividend
when the share is sold Ex dividend – excludes the dividend when
the share is sold - Shareholder agreement at AGM Interim Final
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Other ways to return money to shareholders 1
– Bonus Issue (Scrip Issue) Example Bonus issue of 1share for every 4 owned 1 million new shares at 50p each (par) £000’s Before Scrip AfterNet A’s 5,000 5,000Called up CapOrdinary shares 2,000 +500 2,500P/L a/c 3,000 - 500 2,500Shldrs Funds 5,000 5,000
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Other ways to return money to shareholders 2
• Impact on share price• Assume pre bonus share price 200p• Individual holding of 1,000 shares = £2,000• Will receive 250 shares• Therefore owns 1,250 shares worth £2,000• Therefore each share now worth 160p• But may perform better• Why therefore? – reduce market price, distribute
reserves
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Other ways to return money to shareholders 3
• Share buy backs
• How
- by acquiring shares through the stock market
- agreements with specific shareholders
- tender offer
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Other ways to return money to shareholders 4
• Why
- Distribution of cash but no commitment
- EPS will rise
- Adjust capital base
- Tighten control
- Tax effect
- No better use
* Cancelled or held as Treasury Stock
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General Information
• Dividend Coverage Ratios Industry Ratio Construction 3Chemicals 2Engineering 2.25Telecoms 1.5Oil Exploration and 1 Production(From Peter Atrill original source, FT17-10- 98
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General Information
• Country Differences
• Dividend Payment, what it looks like!
• Dividend Reinvestment Plans
