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Lecture 9 : Dividends & Policy. C. L. Mattoli. Learning outcomes (Chp. 14). On successful completion of this module you should be able to: outline the dividend types and explain how dividends are paid discuss the issues surrounding dividend policy decisions. Learning outcomes (Chp. 14).

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lecture 9 dividends policy

Lecture 9 : Dividends & Policy

C. L. Mattoli

(C) 2009 Red Hill Capital Corp., Delaware USA

learning outcomes chp 14
Learning outcomes (Chp. 14)

On successful completion of this module you should be able to:

  • outline the dividend types and explain how dividends are paid
  • discuss the issues surrounding dividend policy decisions

(C) 2009 Red Hill Capital Corp., Delaware USA

learning outcomes chp 143
Learning outcomes (Chp. 14)
  • discuss the types of dividend policy that a firm can pursue
  • explain the difference between cash and shares dividends
  • explain why share repurchases are an alternative to cash dividends.

(C) 2009 Red Hill Capital Corp., Delaware USA

intro
Intro
  • So, now the company is in business.
  • It has taken in capital and spent it on projects.
  • Then, the cash flow is rolling in.
  • What should it do with that cash flow?
  • Of course, some money will need to be continually invested in the company for maintenance.

(C) 2009 Red Hill Capital Corp., Delaware USA

intro5
Intro
  • More money will need to be invested for the company to grow.
  • Of course, we can raise additional capital, but we should first look at that internally-generated cash flow and decide what to do with it.
  • We can retain some or all of these cash flows to invest in new projects or otherwise (many technology companies, for example, invest in stocks of fledgling technology companies).

(C) 2009 Red Hill Capital Corp., Delaware USA

intro6
Intro
  • We can also distribute some cash to shareholders as cash dividends.
  • People like to get cash; capital gains, on paper (not realized because to realize gains you have to sell out your investment) are nice, but cash is even nicer.
  • However, should not the corporation be able to better invest the shareholder’s money than the shareholders themselves?

(C) 2009 Red Hill Capital Corp., Delaware USA

intro7
Intro
  • Cannot the shareholders create their own cash flows by selling some shares and realizing the capital gains that have resulted from the corporation retaining and reinvesting its money.
  • The corporation can also do the same thing in a share repurchase, buying shares in the market, paying cash to those who want to sell shares, instead of paying dividends.

(C) 2009 Red Hill Capital Corp., Delaware USA

intro8
Intro
  • Just like in the case of capital structure, there is no current comprehensive theory of dividend decisions. There are only simplified theories and some suggestions.
  • In this lecture, we shall take a closer look at dividends and how they can be paid, and we study what goes in the dividend payout-retention decision process.
  • We shall explore some of the theories and considerations that go into the dividend decision.

(C) 2009 Red Hill Capital Corp., Delaware USA

dividend example
Dividend Example

(C) 2009 Red Hill Capital Corp., Delaware USA

the corporate machine
The Corporate Machine

Business

Projects

Markets

Securities

Markets

Investors

in

securities

Businesses

Reinvestment

Dividends

EPS

Inventory

PP&E

Cash

Funding

Securities

Issued

Return on

Corporate

Investment

Cash &

Physical

Assets

Debt

Equity

Debt

Equity

Cash

(C) 2009 Red Hill Capital Corp., Delaware USA

paying dividends

Paying Dividends

(C) 2009 Red Hill Capital Corp., Delaware USA

what is a cash dividend
What is a Cash Dividend
  • First, we must deal with language issues, in talking about dividends.
  • A cash dividend usually refers to a cash payment by a company to its shareholders (SH) out of current after-tax earnings.
  • On the other hand, if a cash payment is made to SH from other than current of retained earnings, it is called a distribution or liquidating dividend.

(C) 2009 Red Hill Capital Corp., Delaware USA

what is a cash dividend13
What is a Cash Dividend
  • Liquidating dividends are usually the result of liquidating some or all of a business.
  • Dividends can also be classified as: regular, extra, special dividends.
  • To SH, they are all dividends.
  • Typically, companies, in Australia, pay regular dividends twice a year: an interim and a final year’s dividend, approved at the company’s annual meeting after the end of a year.

(C) 2009 Red Hill Capital Corp., Delaware USA

what is a cash dividend14
What is a Cash Dividend
  • In the US, for example, and some other countries, dividends are paid quarterly instead of semiannually.
  • Extra dividends are so named as to psychologically distinguish them as above what will be usual for dividend payments.
  • Special dividends are so named as to even farther distance them is SH’s minds from usual expectations.

(C) 2009 Red Hill Capital Corp., Delaware USA

declaration payment
Declaration & Payment
  • The dividend decision resides in the board of directors of the company who, at a board meeting, will decide to declare a dividend.
  • The declaration will announce the per share payment amount and the date that the dividend will be paid to shareholders of record.
  • From declaration to distribution there are several steps and some technical details, as shown in the next few slides.

(C) 2009 Red Hill Capital Corp., Delaware USA

steps in cash dividends
Steps in cash dividends
  • First, the distribution of a dividend must be decided on by the board of directors and then declared. The announcement date is the date of directors’ meeting where the dividend is recommended : on this date the total amount of dividends to be paid is transferred from the retained earnings account to the dividends payable account.

(C) 2009 Red Hill Capital Corp., Delaware USA

steps in cash dividends17
Steps in cash dividends
  • The record date is used to identify all shareholders on the Register of Members who are holders-of-record of shares on the proper date, so they can receive a dividend
  • The ex-dividend date is 4 days prior to the record date in a system where share transfer and settlement, once shares are sold in the secondary market, is 5 days.

(C) 2009 Red Hill Capital Corp., Delaware USA

steps in cash dividends18
Steps in cash dividends
  • Payment date: The actual date of payment of the dividend is usually several weeks after the date of record. On the payment date, the total amount of dividends paid is debited from the dividend payable account and the cash account.
  • It is expected that the market price of a share will drop by approximately the declared dividend amount on the ex-dividend date.

(C) 2009 Red Hill Capital Corp., Delaware USA

stock drop on dividend x date
Stock Drop on Dividend X-date
  • That the price of the stock should drop on the ex-date is because it will be worth one cash flow less.
  • That it will drop by a number that might not exactly equal the amount of the dividend is due to taxes: what the dividend is really worth to people after tax.

(C) 2009 Red Hill Capital Corp., Delaware USA

record dates
Record dates
  • There are a number of reasons that companies rely on record dates on which holders of record are included in corporate events.
  • We saw it earlier in rights and ex-rights dates.
  • It is also relied on for voting at shareholder meetings.

(C) 2009 Red Hill Capital Corp., Delaware USA

record dates21
Record dates
  • In all events, there is a certain date, the record date, on which the holders of record will be the ones who are included, and after that date, even if a person owns the shares, he will not be included.
  • First, for every type of these events, there is an announcement. In the announcement, a record date will be given.

(C) 2009 Red Hill Capital Corp., Delaware USA

record dates22
Record dates
  • Then, a person has to be on the record books of the company on that one date, in order to be eligible for whatever event is occurring.
  • The key to all of these events is that it takes several days between the time that shares are bought and when the new owner is recorded on the books of the company.
  • If there are T days for settlement, then, on T – 1 days before that record date, a buyer will not be included on the books in time to receive the benefit, whatever it is.

(C) 2009 Red Hill Capital Corp., Delaware USA

ex dividend date
Ex-dividend Date
  • It is Monday June 10, and the record date for a dividend is Friday June 14.
  • I sell my shares on Monday, on an exchange where it takes 5 business days for trades on the stock exchange to settle, i.e., the share transfer to be effected, and registration of the shares to change on the books of the corporation.

(C) 2009 Red Hill Capital Corp., Delaware USA

ex dividend date24
Ex-dividend Date
  • Then, my name will still be in the corporate records on Friday June 14, it will only be changed on Monday June 17, and I will receive the dividend.
  • Based on that analysis, in order for someone to buy the stock with the right to the dividend (cum-dividend) a purchase must be made at least 5 (business) days before the dividend record date.

(C) 2009 Red Hill Capital Corp., Delaware USA

ex dividend date25
Ex-dividend Date
  • In this case, they purchased my shares 1 day too late. They purchased from me on the ex-date, so they did not buy shares with the right to get the dividend still attached to my shares.
  • Had they bought shares on Friday June 7, they would have been on the record books on Friday June 14, and they would have been the one to receive the dividend.

(C) 2009 Red Hill Capital Corp., Delaware USA

cum and ex dividend shares
Cum- and ex-dividend shares
  • Cum-dividend shares are those that have a current entitlement to receive a dividend
    • Investors who own shares (and don’t sell them) before the ex-dividend day are entitled to a dividend
    • As we saw in the above example, if they sell shares on or after the ex- date, they will still receive that dividend check in the mail.

(C) 2009 Red Hill Capital Corp., Delaware USA

price on x
Price on X
  • The day before an ex-date, the stock trades with a right to receive a dividend.
  • The next day it will no longer contain that right.
  • Thus, the price should drop from one day to the next to reflect the loss of value of the dividend.
  • So, if the stock was $50 on the day before ex-D, and D = $2, then, the price on the ex-date should be around $2 less, or $48.

(C) 2009 Red Hill Capital Corp., Delaware USA

dividend policy

Dividend Policy

(C) 2009 Red Hill Capital Corp., Delaware USA

intro29
Intro
  • As an investor, we look for future cash for present outlay of funds.
  • Cash dividends are one thing that we can get as SH’s.
  • Dividend policy is, then, really the decision to pay out cash from earnings, now, or reinvest and pay out cash later.
  • Arguments can be made on both sides, depending on assumptions.

(C) 2009 Red Hill Capital Corp., Delaware USA

irrelevance
Irrelevance
  • MM showed that, under a number of specific assumptions, dividend policy affects neither the price of a firm’s shares nor a firm’s cost of capital, i.e. dividend policy is irrelevant.
  • It is based on the assumptions that:
  • If there are no taxes, then, shareholders will be focused on total return: capital gains plus dividend yield

(C) 2009 Red Hill Capital Corp., Delaware USA

irrelevance31
Irrelevance
  • A dividend decision is separable from an investment decision, which it really is not, since a company has a choice of paying out a cash dividend and letting investors invest that cash as they like or making a higher return for the investors by retaining earnings and investing in high return projects, whose return is higher than the investor could achieve on her own.
  • capital markets are perfect (i.e., no taxes, transaction costs and free and complete information)

(C) 2009 Red Hill Capital Corp., Delaware USA

homemade dividends
Homemade dividends
  • Assume either no taxes or taxes that are the same for both capital gains and dividends.
  • Assume that there are no transaction costs for buying or selling shares.
  • Then, SHcan make their own ‘dividends’ by selling shares (alternative means of cash inflow for investors).
  • They can neutralize dividendsby purchasingmore shares if dividends are paid by the company

(C) 2009 Red Hill Capital Corp., Delaware USA

homemade dividends33
Homemade dividends
  • Irrelevance relies on the basic premise that the market value of a firm
    • depends on the PV of future cash flows from its assets
    • which in turn depends on investment decisions not on dividend decisions.
    • Both investors and managers have the same information regarding future investment opportunities

(C) 2009 Red Hill Capital Corp., Delaware USA

example irrelevant
Example: Irrelevant

Firm has an annualFCF (free cash flow) of $150 million.

  • Free cash flow is after investment.
  • Shares outstanding are 110 million.
  • If the growth rate of FCF is 10% per year, and the required rate of return (RRR) is 15% what is the value of the firm?

(C) 2009 Red Hill Capital Corp., Delaware USA

example irrelevant35
Example: Irrelevant

Look at 3 cases:

  • Case 1(100% payout) - it pays a dividend of $150 million today: all FCF
  • Case 2 (New issue + high dividend) - issues $50m of shares and pays dividend of $200m: more than actual FCF
  • Case 3 (Total retention)- pays no dividend: retains all

(C) 2009 Red Hill Capital Corp., Delaware USA

case 1 moderate dividends
case 1 – moderate dividends

The value represented by a share of stock is the discounted

Future CF value Plus the value of the dividend paid now (at present)

(C) 2009 Red Hill Capital Corp., Delaware USA

case 2 high dividends
case 2 – high dividends

However, since it is issuing new shares, and the market value of the Firm has not really changed since there has been no event to cause revaluation in the market, the original shareholders will have a total value of $3.3 billion – $50 million, so that

(C) 2009 Red Hill Capital Corp., Delaware USA

case 3 no dividends
case 3 – no dividends

Since this year’s (present) FCF has been retained, it is part of the PV of the firm. Value of a share is DFCF of the company plus the additional right-now FCF.

(C) 2009 Red Hill Capital Corp., Delaware USA

conclusion
Conclusion
  • In all three cases, payout of all FCF, payout of more than FCF or no payout at all we get the same value of the firm.
  • Note: in each case we consider the PV of cash flows as the value of a share.

(C) 2009 Red Hill Capital Corp., Delaware USA

conclusion40
Conclusion
  • Those values, in each case, are the sum of future year cash flows, as given in the CG model plus the current year’s cash flow, which, in two cases, is a cash dividend and, in the last case, just FCF.
  • Thus, the conclusion is that dividends don’t matter, at least under the non-realistic conditions that underpin the MM theory.

(C) 2009 Red Hill Capital Corp., Delaware USA

in the real world
In the Real World
  • Reasons that dividends might be relevant are usually based on things like:
  • Tax differentials: div. vs. cap. gain
  • Psychology: money is nice
  • Agency costs: disclosure
  • Information: news
  • We shall look at the effects in categories.

(C) 2009 Red Hill Capital Corp., Delaware USA

low dividends
Low Dividends.
  • In classical tax systems, there is usually a lower tax on capital gains than on income.
  • In the imputation system, that is not true for domestic SH but is still true for foreign SH’s.
  • In both systems, long term (more than a year of holding) cap gains tax is smaller than short term.

(C) 2009 Red Hill Capital Corp., Delaware USA

low dividends43
Low Dividends.
  • In addition, taxes on cap gains only have to be paid when the shares are sold, while taxes on dividends must be paid once a year, franked or not.
  • Next, are issuance costs, which are quite high, to issue shares to grow instead of retaining earnings for growth.
  • Finally, there might be restrictive laws or covenants in debt.

(C) 2009 Red Hill Capital Corp., Delaware USA

high dividends
High Dividends
  • It is psychologically more reassuring to get cash than to wait for capital gains to materialize and be realized through sale (uncertainty resolution).
  • Some people, like retirees or trust funds either do not want to or cannot touch their principal investments, so rely on income.
  • Corporations get dividends from other corporations tax free.
  • Other investors are also tax exempt.

(C) 2009 Red Hill Capital Corp., Delaware USA

market value of franked dividends
Market value of franked dividends

We can set out to determine the market value of dividends by comparing the capital loss, the price decline of the stock, on the dividend ex date. Thus, the day before the ex-date, the share price included a dividend, after the ex-date the dividend is paid in cash, and the share value will reflect that loss. But how much should it be?

  • The capital loss is measured by the dividend drop-off ratio, which is the capital loss on ex-date divided by the dividend.

(C) 2009 Red Hill Capital Corp., Delaware USA

market value of franked dividends46
Market value of franked dividends
  • dividend drop-off ratio compares the decline in the share price on the ex-dividend day to the cash dividend
    • depends on the company tax rate and
    • a typical shareholder’s marginal tax rates on dividend income and capital gains
  • Let us look at the basic math of the situation………

(C) 2009 Red Hill Capital Corp., Delaware USA

alternative cash flows
Alternative cash flows
  • If an investor bought shares at price P(p), and he sells them on the day before the ex-dividend date, his after-tax cash flow is:

CF(cd) = P(cd) – (P(cd) – P(p)) x T(cg)

Where cd=cum dividend, and T(cg) is capital gains tax.

Next, consider……………………..

(C) 2009 Red Hill Capital Corp., Delaware USA

alternative cash flows48
Alternative cash flows
  • The same shareholder waits til the next day, after the stock is trading ex-dividend, and gets the dividend and sells the stock. Then, the cash flow after tax is:

CF(xd) = P(xd) – (P(xd) – P(p)) x T(cg) +

These cash flows should be the same (they are less than a day apart), so by equating the two equations to each other, we get………..

(C) 2009 Red Hill Capital Corp., Delaware USA

dividend drop off
Dividend drop-off
  • Which just says that after tax CG (loss due to price drop) = (1-tg)(PCD – PXD) on ex-date should be the same as after tax dividend = D(1 – tp)/(1 – tc).
  • This should be true because people care about what they actually get (AT inc)

(C) 2009 Red Hill Capital Corp., Delaware USA

calculating the after tax dividend
Calculating the after-tax dividend
  • In general,we use the PT dividend to compute personal tax, then, we subtract off the franking tax credit (in the case of 100% franking, below). Then, we subtract personal tax due minus tax credit from franking to get AT dividend income, as:

(C) 2009 Red Hill Capital Corp., Delaware USA

calculating the after tax dividend51
Calculating the after-tax dividend
  • Which shows that the only tax on pre-tax income of the corporation paid out as dividends is paid by the shareholder.

(C) 2009 Red Hill Capital Corp., Delaware USA

standard policies

Standard Policies

(C) 2009 Red Hill Capital Corp., Delaware USA

residual dividend
Residual Dividend
  • Assume a company wants to maintain its capital structure but wants to minimize its need to sell new equity.
  • Then, it will look to invest free cash flow in positive NPV projects and payout any leftovers.
  • This is called residual dividend policy.
  • We would expect, then, young fast-growing firms to have a low payout ratio and older mature firms with less opportunity to grow to have high payouts.

(C) 2009 Red Hill Capital Corp., Delaware USA

stable dividend
Stable Dividend
  • As opportunities wax and wane, a residual dividend policy could have a very unpredictable pattern.
  • The definition of a stable dividend policy is one in which the firm pays a fixed payout ratio.
  • That will be effected either semi-annually, called cyclical policy or yearly.
  • Most firms try to at least not cut dividends because it can send a negative signal to the markets.

(C) 2009 Red Hill Capital Corp., Delaware USA

compromise policy
Compromise Policy
  • 5 Goals dominate real world policy:
  • Avoid cutting +NPV projects to pay D.
  • Avoid cuts in dividends.
  • Minimize need to sell equity.
  • Maintain target capital structure.
  • Maintain a target payout ratio.
  • Companies can satisfy goals with regular and extra dividends.

(C) 2009 Red Hill Capital Corp., Delaware USA

additional policy considerations
Additional Policy Considerations
  • The clientele effect refers to the fact that certain groups of investors because of their needs will gravitate to high or low payout ratio stocks.
  • Thus, companies might design dividend policy to attract certain investors, and it must keep that in mind when administering policy on an ongoing basis.

(C) 2009 Red Hill Capital Corp., Delaware USA

additional policy considerations57
Additional Policy Considerations
  • Firm’s must also be aware of changes in the demand side of the market for dividends.
  • Investors take signals, i.e., infer information from dividend announcements.
  • That is due to the asymmetry of information between insiders of the firm and outsiders.
  • Outsiders don’t have all the info.

(C) 2009 Red Hill Capital Corp., Delaware USA

additional policy considerations58
Additional Policy Considerations
  • Agency costs (external monitoring and constraint on use of free cash flows). If you pay out a lot of your earnings in dividends, you have to raise more money externally, which requires information disclosure in prospectuses.
  • This keeps a rein on management by showing more internal information.
  • So, if they pay high dividends and need to raise more capital, their track record becomes more visible in additional disclosure

(C) 2009 Red Hill Capital Corp., Delaware USA

optimal dividend policy
Optimal dividend policy
  • When making dividend policy, firms take into account
  • Internal: to payout earnings or to use them for internal project financing.
  • Institutional factors include legal restrictions and the mix of shareholders with differing tax statuses
  • Market factors including transaction costs, agency costs, and the incompleteness of information that shareholders have versus managers.

(C) 2009 Red Hill Capital Corp., Delaware USA

internal factors and dividend policy
Internal factors and dividend policy
  • profitability
  • liquidity and
  • capacity to attract external financing
  • Generally, these factors vary with the stage of a firm’s life-cycle and can vary with the business cycle in the shorter term..

(C) 2009 Red Hill Capital Corp., Delaware USA

institutional factors
Institutional factors
  • inability to pay dividends from legal capital
  • possible restrictive loan covenants
  • taxation system – maximise after-tax return for the majority of shareholders

(C) 2009 Red Hill Capital Corp., Delaware USA

market factors
Market factors
  • asymmetric information
  • transaction costs
  • agency costs

(C) 2009 Red Hill Capital Corp., Delaware USA

alternatives to cash dividends

Alternatives to Cash Dividends

(C) 2009 Red Hill Capital Corp., Delaware USA

bonus shares stock dividends
Bonus Shares: Stock Dividends
  • As an alternative to cash, dividends can also be paid out in shares, e.g., stock dividend of 0.1 shares per share of outstanding stock.
  • These are called bonus shares in Australia.
  • Even though there is no value paid for shares, and the value of the firm has not changed, investors can take a bonus share issue as a positive signal from management.
  • Then, the market value will increase.

(C) 2009 Red Hill Capital Corp., Delaware USA

share repurchases
Share Repurchases
  • Another real alternative to cash dividends is for the company to repurchase a portion of its shares.
  • That way, investors can get some cash.
  • Realistically, it should have no impact on value, if cash is paid to investors by dividend or by repurchasing shares.

(C) 2009 Red Hill Capital Corp., Delaware USA

share repurchases66
Share Repurchases
  • Tax-wise, though, tax must be paid on dividends, while tax is paid only by those who sell shares into the repurchase.
  • In addition, signals can be inferred from repurchasing.
  • If the company believes that its shares are a good buy, then, maybe they are undervalued because management knows something that investors do not.

(C) 2009 Red Hill Capital Corp., Delaware USA

share repurchase
Share repurchase
  • When the company purchases its own shares, there are rules and restrictions:
  • Can buy up to 10% of shares in 12 months (10/12)
  • Legislation specifies 5 methods
    • equal access purchase

(C) 2009 Red Hill Capital Corp., Delaware USA

share repurchase68
Share repurchase
  • on-market purchase
  • selective purchase
  • employee share plan
  • odd lot purchase (odd lots are shareholdings that are less than a standard exchange purchase lot, which is 100 shares).

(C) 2009 Red Hill Capital Corp., Delaware USA

information content of repurchases
Information Content of Repurchases
  • Share repurchases sends a positive signal that management believes that the current price is low and investing in its own shares is a good corporate investment.
  • Tender offers send a more positive signal than open market repurchases because the company is stating a specific price
  • The share price often increases when repurchases are announced because of those kinds of signals inferred.

(C) 2009 Red Hill Capital Corp., Delaware USA

drip s
DRIP’s
  • While some people like cash and, therefore, cash dividends, other don’t like dividends and would prefer gains in principal.
  • Dividend reinvestment plans (DRIP’s) give shareholders a chance to not get dividends but to get growth in principal, instead.
  • For those signed up for the plan, the company takes their dividends and exchanges the cash for new share at a discount to market value with no transactions fees.

(C) 2009 Red Hill Capital Corp., Delaware USA

splits reverse splits
Splits & Reverse Splits
  • Beyond bonus shares, companies can also do share splits, e.g., each old share becomes 2 new shares, or
  • Reverse splits, whereby each old share might become ½ a new share.
  • Companies do this, mainly to adjust the prices of their stocks for investors to purchase comfortably.

(C) 2009 Red Hill Capital Corp., Delaware USA

splits reverse splits72
Splits & Reverse Splits
  • The reason is that shares are normally sold in blocks of 100 shares on the markets; lower amounts are called odd-lots, and their purchase is more expensive in transaction costs.
  • So, many companies try to adjust the price of their stocks, in the market, so many, more, or certain investors can purchase them.

(C) 2009 Red Hill Capital Corp., Delaware USA

splits reverse splits73
Splits & Reverse Splits
  • Thus, a price of $25/share means $2,500/block.
  • Warren Buffet of Berkshire Hathaway has taken the other tact and has a share price for his company’s stock in the range of several hundred thousand US$/share, so that only the wealthy can own his shares.
  • Again, this is marketing and stock design.

(C) 2009 Red Hill Capital Corp., Delaware USA

trailer

Trailer

(C) 2009 Red Hill Capital Corp., Delaware USA

the accounting aspects
The accounting aspects
  • If, as is entirely possible, you are an accounting student, you might be interested in how the dividends are paid (from the accounting point of view).
  • When the dividend is announced, the firm transfers funds from the retained earnings account to the dividends payable account.
  • When the dividend is paid on the payment date, the dividends payable account reduces by the amount of the dividend and so too does the cash account:

(C) 2009 Red Hill Capital Corp., Delaware USA

the accounting aspects76
The accounting aspects

(C) 2009 Red Hill Capital Corp., Delaware USA

residual theory dividend policy from study book
Residual theory: dividend policyfrom Study Book
  • We mentioned in passing that the firm will (1) determine how much it needs to spend on positive NPV projects; (2) estimate the amount of equity financing it will need (using its optimal debt-to-equity ratio); (3) use new share issues to top-up retained earnings if necessary; and (4) if the required investment amount is less than retained earnings, the difference may be paid out in dividends.

(C) 2009 Red Hill Capital Corp., Delaware USA

residual theory dividend policy
Residual theory: dividend policy
  • The question is: how is the debt-to-equity ratio used in this particular situation?
  • 1. Assume that the firm has $3 000 000 in retained earnings.
  • 2. Assume that the firm has determined that it wants to spend $1 000 000 on new, positive NPV projects.
  • 3. Assume that the firm has determined its debt-to-equity ratio should be around 35% (35% debt-to-65% equity).

(C) 2009 Red Hill Capital Corp., Delaware USA

residual theory dividend policy79
Residual theory: dividend policy
  • 4. With this debt to equity ratio, the firm will finance the $1 000 000 in investments with $350 000 debt and $650 000 equity.
  • 5. Since the firm has $3 000 000 in retained earnings it will use $650 000 worth and pay out the rest in dividends.
  • This line of reasoning will work for various scenarios. Of course, if the firm wanted to invest in $5,000 000 of positive NPV projects, it would need to issue new shares to raise additional equity capital. This is because 65% of $5 000 000 comes to $3 250 000 and we only have $3 000 000 in retained earnings. In this case, there would be no dividend.

(C) 2009 Red Hill Capital Corp., Delaware USA

learning activity
Learning activity
  • Attempt all of the critical thinking and concepts review section.
  •  From Chapter 14: questions and problems 1, 2, 3, 7, 8, 9, 11, 12, 14.

(C) 2009 Red Hill Capital Corp., Delaware USA

slide81

END

(C) 2009 Red Hill Capital Corp., Delaware USA