Dividends

Concept of Dividends and Dividend Policies

Dividend classifications:

• Cash dividend: Distribute cash to shareholders
  • Regular dividends
  • Special/Extra dividends: When price is overvalued
  • Liquidating dividends: When bankruptcy
• Stock dividend
• Stock split (e.g. 2-for-1 splict)
  • Reverse stock split (e.g. 1-for-20 reverse stock split)

Effects of dividends on shareholders' wealth

• Cash: Stock price will drop by dividend amount, but wealth of shareholder will not change
• Stock: Only change number, will not influnence the wealth

Effects of dividends on financial ratios

• Cash:
  • Reduces A and E in B/S
  • Reduces Liquidity ratio since cash reduces
  • Financial leverage ratio will increase (D/A, D/E)
• Stock:
  • No effect on A and E, volume increase
  • Price and EPS will decline

	After cash dividends	After stock dividends / split
Assets (cash)	Lower	The same
Equity	Lower	The same
Price	Lower	Lower
EPS	The same	Lower
P/E	Lower	The same
Liquidity ratios	Lower	The same
Financial leverage ratios	Higher	The same

Dividend Policy

MM theory proposes dividend does not matter. Bird-in-hand argument, Tax argument, Information signaling, and Agency costs theory proposes dividend matters.

• Information signaling: Dividend convey information about the company (positive or negative)
• Agency Cost:
  • Dividend reduces FCF for managers to overinvest and run out of control
  • Dividend increase default risk on its debt

Tax Considerations

Double Taxation System

Corporate pretax earnings are taxed at the corporate level and then taxed again at shareholder level if they are distributed to taxable shareholders as dividends.

$$Div=EBT\times \text{payout\%}(1-t_{corporate})(1-t_{individualdiv})$$

Then Effective tax rate = $t_{corporate}+(1-t_{corporate})t_{individualdiv}$.

Dividend Imputation Tax System

Ensure that profit distributed as dividends are taxed just once, at the shareholder's tax rate.

$$Div=EBT\times \text{payout\%}(1-t_{individualdiv})$$

The Effective tax rate is just $t_{indiviauldiv}$

Split-rate Tax System

Corporate earnings that are distributed as dividends are taxed at a lower rate at corporate level than earnings retained.

$$Div=EBT\times \text{payout\%}(1-t_{corporate})(1-t_{individualdiv})$$

Then Effective tax rate = $t_{corporate}+(1-t_{corporate})t_{individualdiv}$.

Dividend Payout Policy

Stable Dividend Policy

$$E(Div)=Di{v}_{t-1}+(E(NI)\times r_{div}-Di{v}_{t-1})\times \text{Adjustment Factor}$$

where Adjustment factor is $\frac{1}{N}$, $N$ is the number of years over which the adjustment in dividends should take place.

Constant Dividend Payout Ratio Policy

Always pay dividend at a constant payout ratio

$$Div=r_{div}\times NI$$

This method is infrequently used because dividend fluctuates with earnings.

Share Repurchase and Effects

Share repurchase: A transaction in which a company buys back its own shares. Repurchased stock are called Treasury Shares. They are not considered for dividends, voting or computing EPS.

There are 3 repurchase methods:

• Buy in the market: Flexible in time and amount
• Tender offer
  • Fixed price tender offer: Buy a fixed number of shares at a fixed price, typically at a premium to market
  • Dutch auction: Use auction to determine the lowest price
• Direct negotiation: Typically at premium to market

Effect on EPS:

• Repurcahsed with excess cash
  • A and E will decline, leverage ratio (D/A, D/E) will increase
  • EPS will increase
• Repurchase with debt
  • D increase and E decline, leverage ratio increase (more than repurchase with cash)
  • If Earning Yield (E/P) > after-tax cost of debt, EPS will increase, decrease otherwise

Epffect on Book Value Per Share:

NOTE

BVPS = Book value of equity/ shares outstanding

• Decrease if the repurchase price > original BVPS
• Same if repurchase price = BVPS
• Increase else

NOTE

Some ratios

• Dividend payout ratio = $\frac{div}{NI}$.
• Dividend coverage ratio = $\frac{NI}{div}$
• FCFE coverage ratio = $\frac{FCFE}{div+\text{shares repurchase}}$
• Warning signals for dividend cut:
  • Negative external stock market indicators
  • Extremely high dividend yields.