Stephen A.

Ross
FUNDAMENTALS of Corporate FINANCE Randolph W. Westerfield
ASIA GLOBAL EDITION Bradford D. Jordan
Corporate FINANCE Joseph Lim
ASIA GLOBAL EDITION Ruth Tan
Copyright © 2016 by McGraw-Hill Education. All rights reserved.
 TOPIC 8:
DIVIDENDS & PAYOUT POLICY

Copyright © 2016 by McGraw-Hill Education. All rights reserved.

 WHAT WILL BE COVERED IN THIS
TOPIC?
1. Dividend payment procedures

2. Dividend irrelevance concept

3. The Rightists

4. The Leftists

5. Factors affecting Dividends Decision Making

6. Stock Repurchase

7. Stock Split, Bonus Issue and Stock Dividends

4-3
Copyright © 2016 by McGraw-Hill Education. All rights reserved
 DIVIDEND PAYMENT PROCEDURES
1. Declaration date: board of directors declares a
payment of dividends.
2. Ex-dividend date:
a. The day the share is traded ex-dividends. If you buy
the stock before this date, you are entitled to the
dividend. If you buy on this date or after, the previous
owner will get the dividend.
b. Stock price will be officially adjusted down on the ex-
dividend date, theoretically by the amount of dividend
per share paid.
Example: If stock is traded at $2.00 per share before ex-
dividend date, the price will be adjusted to $1.90 on the
ex-dividend date if the dividend per share declared is
$0.10.
3. Record Date:
a. The record list of shareholders as of the record date
will receive the dividends. In other words, if your
name appears in the list, you are entitled for the
dividends.
b. Record date is usually 2 days after ex-dividend date.
4. Payment date: dividends checks are mailed to
shareholders
DIVIDEND IRRELEVANCE CONCEPT

• Proposed by MM – that in perfect world, how much

dividends paid is not relevant to shareholders.
• This is because shareholders can create their own
‘Homemade Dividends’.
• Example: A stock is selling at $42 per share and is
going to pay $2 dividend per share.
- So, on the ex-dividend date, stock price will be
adjusted to $40/share.
- Suppose an investor has 80 shares and he needs
$240 to spend on something.
• Alternative 1:
- Cash dividend from the firm $2 x 80 shares = $160
- Selling 2 shares $40 x 2 = $80 (homemade dividend)
- Total proceeds = $240
Value of his remaining stocks = 78 shares x $40 = $3120
• Alternative 2:
- If the firm pays $3 dividend per share, cash dividend
received by him = 80 x 3 = $240
- He doesn’t need to sell any stocks
Value of his stocks = 80 shares x $39 = $3120.
❖ Conclusion: He is not affected by whether the firm
pays $2 or $3 DPS.
 THE RIGHTISTS

The Dividends Controversy: Should firms pay more or

less dividends in the real world?
Rightists proposed that high dividend would increase
the value for the firm:
1. Information content/Signaling effect of dividend:
a. Because high dividends send positive signaling
about strong cash flow/earnings prospect of the firm
that the firm can maintain in the future. Sometimes, a
well-managed company will purposely pay higher
dividend than its competitors to differentiate itself from
the competitors because as a well-managed firm, it
has the ability to pay higher dividend compared to an
average firm.
b. Higher than expected dividends (actual dividend
> anticipated by market) send stronger positive signal
that the firm’s prospect and performance are better
than the one expected by the market. Vice versa.
c. Some argue that the change in dividends carry
more info content than the level of dividends.
d. Positive signaling from dividend can be reinforced
by a stable growth in dividend over long term. This
can differentiate from other average firms (Example:
Maybank, Carlsberg Malaysia).
e. Dividend is considered as quite an effective
signaling tools because it involves “action of paying
actual cash” – Talk is cheap.
• Counter-argument: Sometimes dividend may fail as
an effective tool if firms try to maintain their
dividend even when their earnings have declined
or even loss over the years.
• Dividend cut – unpopular - send negative signal.
• Firms contemplating for dividend cut must prepare
for it several months before its announcement.
• Firms who need to cut dividend to retain more
earnings must have evidence to convince the
shareholders/market that the cut has got nothing to
do with the performance.
Example: IBM managed to convince its shareholders
when it decided to cut dividends in 1993 by 50% in
order to retain more earnings to go into PC business!
2. Clientele Effect:
• Different shareholders have differing needs and
preferences.
• Therefore some shareholders prefer high dividends but
some prefer that firms don’t pay dividends to them.
• Example: Many institutional investors such as pension
funds will prefer high dividend not only because they
have special tax advantage but also because their
investment policies do not allow them to spend from
their principal.
• Rightists also believe that attracting these investors
can help to monitor the firm and reduce the agency
problems.
• Counter argument:
- Middle-of-the-roaders/MM argue that even though
there is such a clientele effect, but it should not affect
the firm value.
- This is because the capital market is assumed to be
large enough to accommodate all investors who prefer
low dividends are able to satisfy their objective since
there will be sufficient stocks in the Stock Exchange that
pay zero/low dividends and vice versa.
- So, changing from one dividend policy to another one
(for instance from low dividend policy to high dividend
policy) will attract a new group of investors but will also
result in the existing shareholders to withdraw.
3. Reducing Agency Costs: (Jensen’s FCF Hypothesis)
• Some managers treat retained earnings as “free
money” they can use for any purpose.
• Paying high dividend can force the manager to go
to the external capital market to raise fund to
finance any projects and subject the manager to
the explicit costs of capital.
• So firms will be more careful in choosing only the
most potential project (for example with highest
NPV).
• Counter argue – reducing cash in the hand of
managers can only reduce agency costs, not solve.
4. Bird-in-the-hand Argument:
• Lintner and Gordon believed that dividends are
preferred to capital gains because dividend is safer
(less uncertain) compared to capital gain which is
uncertain.
• So, the required return of investors, k, will be lower if
the dividend payout is increased → higher share price.
• Capital gain depends on whether the retained
earnings can generate higher return to the firm or not -
-- so it is more uncertain, but for dividend, once paid, it
is in the hand.
• “One bird in the hand is better than two birds in the
bush”.
• Counter argument: risk for shareholders should not
depends on how the earnings are split between
dividends & retained earnings. (total size of a
birthday cake is the same no matter how you slice it
into two pieces)
• Risk should depend on the business activities/projects
that generate the earnings. If the earnings are
generated from high risk project or business, then risk
of shareholders will be high and vice versa.
• Besides risk, the Dividend Irrelevance school also
believes that shareholder value depends on the
investment project implemented (whether +ve or –
ve), not dividends.
5. Behavioral Finance view: (Shefrin and Statman,1984)
• Many investors lack self-control.
• Example: suppose a retiree needs to spend $20,000 a
year from savings. On one hand, she could buy stocks
with a dividend yield high enough to generate $20,000
in dividends. On the other hand, she could place her
savings in zero-dividend stocks, selling off some stocks
for $20,000 each year for consumption. Though these
two approaches seem equivalent, the second method
may allow for too much leeway as she might sell off
too much, leaving little for her later years.
• Regret aversion argument: consumption from
dividends may be preferable than consumption from
capital for people who are averse to regret. If
consumption made from selling some of the stocks
and later the stock price increases, he will feel regret
over this.
 THE LEFTISTS

• Dividends received – to pay personal income tax

• Lower dividend (some leftists propose zero dividend
policy) is better because the personal income tax
rate, on average, is higher than the tax rate on
capital gain. (On average, percentage of share
ownership for individual investors is dominated by
high net worth investors, so their income tax is at the
highest income tax bracket).
• Therefore, minimizing dividend payment means
minimizing tax payment by these individual
investors.
• Also, tax on capital gain can be postponed, tax on
dividend cannot be postponed.
• Counter-arguments:
(a) The leftists argument is less convincing in countries
with imputation tax system. This is because under the
system, the impact of tax on dividend will be less due
to the fact that shareholders may not have to pay
the tax on dividend if the corporation already paid
the corporate tax ‘on their behalf’ and they can
even have claim back on the amount that was
overpaid by the corporation.
(b) For many institutional investors, tax is not an issue
for them since they are given special tax treatment
such as tax-exemption for the dividend they
received. So there is no reason for them to prefer
capital gain to dividend.

(c) In many circumstances, investors can find

loopholes in the tax system to avoid paying the tax.
Therefore, high tax rate on dividend may not be as
serious as suggested by the leftists.

(d) Leftists cannot explain why in real world still many

companies pay high dividends.
 FACTORS AFFECTING DIVIDENDS
DECISION MAKING
• In the real world, mgmt should consider these factors:
a) Legal Constraints from bond indentures, and possibility of
the authority (some countries and many states in the US) to
impose the impairment of capital rule (prohibited from
paying a higher dividends than retained earnings)
b) Investment and growth opportunities of the firm –
depends on life cycle of the firm. Many firms still prefer to
retain more earnings and pay low dividends in Malaysia due
to higher growth opportunities during their growth stage of
life cycle. Also using retained earning may reduce interest
burden of debt and expensive cost of new equity.
c) Control - Reluctant to sell new equity to avoid the dilution
of control ownership. As such, more earnings will be retained
and pay less dividends.
d) Liquidity situation of firms – Firms with plenty of free
cash flows are able to pay more dividends, such as
the cash cows (beers and tobacco companies).
e) Availability of other sources of financing such as
bonds, syndicated loans and preferred stocks. For
instance, historically, firms rely on retained earnings. Syndicated
loan from banks is also another preferred way of raising capital
for many Malaysian corporations due to the less developed
bond mkt. However, since the two past decade, due to the
effort of the government to develop the Islamic bonds (Sukuk),
more and more corporations in Malaysia have been able to
raise capital from the bond market and do not solely rely on
retained earnings and loans. As a result, firms may have higher
capability to pay dividends.
f) Flotation costs of issuing new equity versus costs of
retained earnings.
g) Use of dividends as a signaling tool for the firm.
However, the fact that many corporations in
Malaysia pay relatively low dividends (between 0% to
2% dividend yield) makes signaling tool of dividend
difficult. Generally Malaysian retail investors also may
not be as dividends-sensitive as the US investors (they
focus more on capital gain). As a result, dividend
may not be a good signaling tool for many Malaysian
corporations.
h) Investors’ preference for dividends versus capital
gain and possibility of clientele effect from dividends.
i) Taxes and taxation system – taxes on dividends versus
taxes on capital gain. Various tax systems on dividends:
Double taxation system, Imputation tax system, Single
Tier Tax System.
At the moment, since 2008, Malaysia is practicing the
Single Tier Tax System (STS) (a.k.a. One-tier) whereby
shareholders will not be paying any taxes on the
dividends they received nor will they receive any tax
returns from the dividends.
• Under this STS, corporate income is taxed at
corporate level and is a final tax. No tax is being
deducted from dividend paid, credited or
distributed to shareholders.
• Negative impact to lower income individual
shareholders whose income tax bracket is less than
the company tax rate, as they no longer eligible to
claim for tax credits refund under the new STS.
 STOCK REPURCHASE
There are two principal types of repurchases:
• (1) situation where the firm has cash available for
distribution to its stockholders, and it distributes this cash
by repurchasing shares rather than by paying cash
dividends.
• Sometimes, share repurchase complements the
dividends so that firms can reduce the risk of cutting
dividends in the future.
• (2) situation where the firm concludes that its capital
structure is too heavily weighted with equity, and then it
issue and sells debt and uses the proceeds to buy back
its stock.
• Stock that has been repurchased by a firm is called
treasury stock.
• Comparing Share Repurchase and Cash Dividend:
Example:
• Suppose Scientax Berhad has 20 million shares
outstanding with a current market price of $50 per
share. Scientax made $100 million in profits for the
recent quarter, and since only 70% of these profits
will be reinvested back into the company,
Scientax’s Board of Directors is considering two
alternatives for distributing the remaining 30% to
shareholders:
(1) Pay a cash dividend of $30m/20m shares = $1.50 per
share.
(2) Repurchase $30m worth of common stock.
• Assume: i) dividends are received when the shares go
ex-dividend, ii) the stock can be repurchased at the
market price of $50 per share, and iii) there are no
differences in the tax treatment between the two
alternatives.
a) How would the wealth of a Scientax shareholder be
affected by the board’s decision on the method of
distribution?
b) How would the wealth of the remaining shareholders
be affected if the repurchase is done at $52 per share?
Answer:

• Under alternative (1): Cash Dividends

Ex-dividend stock price = 50-1.5 = 48.5
20m $50 −$30𝑚
Or = 48.5
20𝑚
Total wealth = 48.5 + 1.5 = $50

Under alternative (2): Share repurchase

Repurchase = $30m/$50 = 600,000 shares
20m $50 −$30𝑚
Ex-repurchase stock price = = $50
20𝑚 −0.6𝑚
Total wealth = $50
(c) What will happen to the ex-repurchase stock
price if the stocks are repurchased at $52 per share
instead of $50?
#shares repurchased = $30m/$52 = 576,923 shares
20m $50 −$30𝑚
Ex-repurchase stock price = =
20𝑚 −0.576923𝑚
970m/19,423,077 = $49.94
Conclusion: Shareholders who surrender the shares
are better off and shareholders who continue to hold
the shares become worse off.
 ADVANTAGES AND DISADVANTAGES
OF SHARE REPURCHASE

• Advantages of Stock repurchase:

1. Repurchase can be interpreted as the firm invests
in its own stocks. Repurchase announcements
may be viewed as positive signals by investors
because the repurchase may be motivated by
management’s belief that the firm’s shares are
undervalued.
2. The stockholders have a choice when the firm
distributes cash by repurchasing stock – they can
sell or not sell. With a cash dividend, on the other
hand, stockholders must accept a dividend
payment and pay the tax.
3. A third advantage is that a repurchase can remove
a large block of stock that is “overhanging” the market
and keeping the price per share down.
4. The company has more flexibility in adjusting the
total distribution than it would if the entire distribution
were in the form of cash dividends, because
repurchases can be varied from year to year without
giving off adverse signals.
5. Repurchases can be used to produce large scale
changes in capital structures.
6. S.R. can prevent EPS dilution after the ESOP
(Employee Stock Ownership Programme).
• Disadvantages of Stock Repurchase:
1. Stockholders may not be indifferent between
dividends and capital gains, and the price of the
stock might benefit more from cash dividends than
from repurchases. Cash dividends are generally
dependable, but repurchases are not.
2. The selling stockholders may not be fully aware of all
the implications of a repurchase, or they may not
have all pertinent information about the
corporation’s present and future activities.
3. The corporation may pay too high a price for the
repurchased stock, to the disadvantage of
remaining stockholders.
STOCK SPLIT, BONUS ISSUE AND STOCK
DIVIDENDS
• Stock split and Scrip issue (Bonus issue)
• They are both ways in which a company can
increase the number of shares without raising any
additional funds.
• A bonus issue is a conversion of existing retained
earnings into additional shares, with the new shares
proportionally given to the shareholders.
• A share split involves reducing the nominal value of
each share and increasing the number of shares in
issue. For example, a ‘2-for-1 split’ – means if you are
holding 1 share, you will be given another share, so
it is like a share is split into two. In this case, the
nominal or par value of the stock will be halved.
• Example:

Same with 5-for-4 split

$100000/125000 shares = 0.80

• When the share price of a company has increased to
a level considered by the company as ‘too high’
(outside the popular trading range) to attract retail
investors, it will be the time to consider share split or
bonus issue.
• Reverse splits: opposite of share splits (1-for-10 reverse)
• Stock Dividends = Scrip dividends → Instead of paying
cash dividend, firms pay shareholders with new shares.
• Normally, firms that have lack of cash may consider
paying stock dividends instead of cash dividend.
• Stock dividends are almost similar to bonus issue except
that in the case of stock dividends, sometimes firms may
provide it as an option to cash dividends for shareholders
to choose. In bonus issue, no such option.
• Normally stated in percentage. Example: A firm
pays a stock dividend of 25% (like 5-for-4 share split).
Stock dividend effect is similar to stock split – result in
price per share being adjusted down because
there is additional number of shares without new
additional capital added.
• Both stock split and stock dividends may send
positive signal that the firm is confident about its
future prospects. This is particularly so if the firm
decides not to fully adjust down its dividends per
share after the event.
• Example: If the firm decides to maintain its DPS after a
2-for-1 split, it indirectly means that the firm has
DPS
increased its dividend yield! ( ) ↑(DPS
𝑃↓
unchanged/price per share = Div yield) (signals that
it has confidence on future).
• Assuming an initial stock price of $10 before the 2-for-1
stock split, if the firm decides to maintain the DPS at $1
before and after the split, it means that the dividend
yield has increased from 10% ($1/$10) before stock
split to 20% ($1/$5) after the 2-for-1 split.
• With a higher dividend yield and assuming
unaffected expected growth, the stock price could
be valued and traded higher than $5, say $5.20
because investors are willing to pay more due to the
confident of higher future performance portrayed
by the firm from the higher dividend yield! (the stock price is
supposed to be valued and traded at $5 without any positive signaling of the stock split).
END OF CHAPTER
END OF CHAPTER

4-42
Copyright © 2016 by McGraw-Hill Education. All rights reserved