INTRODUCTION TO

CORPORATE FINANCE
Laurence Booth • W. Sean Cleary

Chapter 22 – Dividend Policy

Prepared by
Ken Hartviksen
 CHAPTER 22
Dividend Policy
 Lecture Agenda
• Learning Objectives
• Important Terms
• Mechanics of Dividend Payments
• Cash Dividend Payments
• M&M’s Dividend Irrelevance Theorem
• The “Bird in the Hand” Argument
• Dividend Policy in Practice
• Relaxing the M&M Assumptions
• Stock Dividends and Stock Splits
• Share Repurchases
• Summary and Conclusions
– Concept Review Questions

CHAPTER 22 – Dividend Policy 22 - 3

 Learning Objectives

You should understand the following:

• The mechanics of dividend payments and why they are different from
interest payments
• The difference between a stock split and a stock dividend
• Under what assumptions a dividend payment is irrelevant and what a
homemade dividend is
• Why dividend payments generally reflect the business risk of the firm
• How transactions costs, taxes and information problems give value to
corporate dividend policies
• How stock dividends and stock splits differ
• How a share repurchase program can substitute for a dividend payout policy.

CHAPTER 22 – Dividend Policy 22 - 4

 Important Chapter Terms

• Agency theory • Free cash flow

• • Holder of record
Bird in the hand argument
• Homemade dividends
• Cash cow • Income stripping
• Declaration date • Odd lots
• Dividend reinvestment plans • Residual theory of dividends
• Dividend yield • Special dividend
• • Split shares
Equity market capitalization
• Stock dividend
• Ex-dividend date • Stock split
• Tax clienteles

CHAPTER 22 – Dividend Policy 22 - 5

What is Dividend Policy?

Dividend Policy
 Dividend Policy
What is It?

• Dividend Policy refers to the explicit or implicit decision

of the Board of Directors regarding the amount of
residual earnings (past or present) that should be
distributed to the shareholders of the corporation.
– This decision is considered a financing decision
because the profits of the corporation are an
important source of financing available to the firm.

CHAPTER 22 – Dividend Policy 22 - 7

Types of Dividends

Dividend Policy
 Types of Dividends

• Dividends are a permanent distribution of residual earnings/property

of the corporation to its owners.
• Dividends can be in the form of:
– Cash
– Additional Shares of Stock (stock dividend)
– Property
• If a firm is dissolved, at the end of the process, a final dividend of
any residual amount is made to the shareholders – this is known as a
liquidating dividend.

CHAPTER 22 – Dividend Policy 22 - 9

Dividends and Corporate Financing

Dividend Policy
 Dividends a Financing Decision
– In the absence of dividends, corporate earnings accrue to the benefit of
shareholders as retained earnings and are automatically reinvested in
the firm.
– When a cash dividend is declared, those funds leave the firm
permanently and irreversibly.
– Distribution of earnings as dividends may starve the company of funds
required for growth and expansion, and this may cause the firm to seek
additional external capital.

Retained Earnings
Corporate Profits After Tax
Dividends

CHAPTER 22 – Dividend Policy 22 - 11

 Dividends versus Interest Obligations

Interest
• Interest is a payment to lenders for the use of their funds for a given period of time
• Timely payment of the required amount of interest is a legal obligation
• Failure to pay interest (and fulfill other contractual commitments under the bond
indenture or loan contract) is an act of bankruptcy and the lender has recourse through
the courts to seek remedies
• Secured lenders (bondholders) have the first claim on the firm’s assets in the case of
dissolution or in the case of bankruptcy

Dividends
• A dividend is a discretionary payment made to shareholders
• The decision to distribute dividends is solely the responsibility of the board of directors
• Shareholders are residual claimants of the firm (they have the last, and residual claim on
assets on dissolution and on profits after all other claims have been fully satisfied)

CHAPTER 22 – Dividend Policy 22 - 12

The Mechanics of Dividend Payments

Dividend Policy
 Dividend Payments
Mechanics of Cash Dividend Payments

• Declaration Date
• Holder of Record Date
• Ex-dividend Date
• Payment Date

CHAPTER 22 – Dividend Policy 22 - 14

 Dividend Payments
Mechanics of Cash Dividend Payments

Declaration Date
– this is the date on which the Board of Directors meet and declare the dividend. In their
resolution the Board will set the date of record, the date of payment and the amount of the
dividend for each share class.
– when CARRIED, this resolution makes the dividend a current liability for the firm.

Date of Record
– is the date on which the shareholders register is closed after the trading day and all those
who are listed will receive the dividend.

Ex dividend Date
– is the date that the value of the firm’s common shares will reflect the dividend payment (ie.
fall in value)
– ‘ex’ means without.
– At the start of trading on the ex-dividend date, the share price will normally open for trading
at the previous days close, less the value of the dividend per share. This reflects the fact
that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the
declared dividend.

Date of Payment
– is the date the cheques for the dividend are mailed out to the shareholders.

CHAPTER 22 – Dividend Policy 22 - 15

 Dividend Declaration Time Line

2 business days prior to the Date of Record

Date of Date of
Record Payment
Declaration Date

Ex Dividend Date is determined

The Board Meets by the Date of Record.
and passes the The market value of the shares
motion to create drops by the value of the dividend
the dividend per share on market opening…compared
to the previous day’s close.

CHAPTER 22 – Dividend Policy 22 - 16

 Trade Settlement and the Ex Dividend
Date
Changes in the Settlement Cycle
• In June 1995 the settlement cycle for all non-money-market Canadian and U.S. securities
was reduced from five business days (T + 5) to three business days (T + 3).
• The rationale for the change stems from the 1987 stock market crash when it was realized
that a securities market failure could result in a credit market failure. The gridlock created in
1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S. broker, increased the need
to minimize the risks involved in the clearing and settlement of securities.
• The shortened settlement cycle requires that the payment of funds and the delivery of
securities take place on the third business day after the trade date. This will reduce credit,
market and liquidity risks by decreasing post-trade settlement exposure.

Ex Dividend Date
• The date is not chosen by the board of directors, rather it is determined as a result of the
exchanges settlement practices and is a function of the date of record.

CHAPTER 22 – Dividend Policy 22 - 17

Dividend Decision and the Board of
Directors

Dividend Policy
 Dividend Policy
Dividends, Shareholders and the Board of Directors

• There is no legal obligation for firms to pay dividends to common

shareholders
• Shareholders cannot force a Board of Directors to declare a
dividend, and courts will not interfere with the BOD’s right to make
the dividend decision because:
– Board members are jointly and severally liable for any damages
they may cause
– Board members are constrained by legal rules affecting
dividends including:
• Not paying dividends out of capital
• Not paying dividends when that decision could cause the firm to
become insolvent
• Not paying dividends in contravention of contractual commitments
(such as debt covenant agreements)

CHAPTER 22 – Dividend Policy 22 - 19

Dividend Payments

Dividend Policy
 Dividend Payments
Dividend Reinvestment Plans (DRIPs)

• Involve shareholders deciding to use the cash dividend

proceeds to buy more shares of the firm
– DRIPs will buy as many shares as the cash dividend allows with
the residual deposited as cash
– Leads to shareholders owning odd lots (less than 100 shares)

• Firms are able to raise additional common stock capital

continuously at no cost and fosters an on-going relationship
with shareholders.

CHAPTER 22 – Dividend Policy 22 - 21

 Dividend Payments
Stock Dividends

• Stock dividends simply amount to distribution of additional

shares to existing shareholders

• They represent nothing more than recapitalization of earnings

of the company. (that is, the amount of the stock dividend is
transferred from the R/E account to the common share
account.

• Because of the capital impairment rule stock dividends reduce

the firm’s ability to pay dividends in the future.

CHAPTER 22 – Dividend Policy 22 - 22

 Dividend Payments
Stock Dividends

Implications
– reduction in the R/E account
– reduced capacity to pay future dividends
– proportionate share ownership remains unchanged
– shareholder’s wealth (theoretically) is unaffected

Effect on the Company

– conserves cash
– serves to lower the market value of firm’s stock modestly
– promotes wider distribution of shares to the extent that current owners divest themselves of
shares...because they have more
– adjusts the capital accounts
– dilutes EPS

Effect on Shareholders
– proportion of ownership remains unchanged
– total value of holdings remains unchanged
– if former DPS is maintained, this really represents an increased dividend payout

CHAPTER 22 – Dividend Policy 22 - 23

 Dividend Payments
Stock Dividend Example

ABC Company
Equity Accounts
as at February xx, 20x9
Common stock (215,000) $5,000,000
Retained earnings 20,000,000
Net Worth $25,000,000

The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for
the stock is $40.00 per share.

This stock dividend will increase the number of shares outstanding by 10 percent. This will mean
issuing 21,500 shares. The value of the shares is:

$40.00 (21,500) = $860,000

This stock dividend will result in $860,000 being transferred from the retained earnings account to the
common stock account:

next page...

CHAPTER 22 – Dividend Policy 22 - 24

 Dividend Payments
Stock Dividend Example

After the stock dividend:

ABC Company
Equity Accounts
as at March 1, 20x9

Common stock (236,500) $5,860,000

Retained earnings 19,140,000
Net worth $25,000,000

The market price of the stock will be affected by the stock dividend:

New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36

The individual shareholder’s wealth will remain unchanged.

CHAPTER 22 – Dividend Policy 22 - 25

 Dividend Payments
Stock Splits

• Although there is no theoretical proof, there is some who believe

that an optimal price range exists for a company’s common shares.
• It is generally felt that there is greater demand for shares of
companies that are traded in the $40 - $80 dollar range.
• The purpose of a stock split is to decrease share price.
• The result is:
– increase in the number of share outstanding
– theoretically, no change in shareholder wealth
• Reasons for use:
– better share price trading range
– psychological appeal (signalling affect)

CHAPTER 22 – Dividend Policy 22 - 26

 Dividend Payments
Stock Split Example

The Board of Directors of XYZ Company is considering using a stock split to put its
shares into a better trading range. They are confident that the firm’s stock price will
continue to rise given the firm’s outstanding financial performance. Currently, the
company’s shares are trading for $150 and the company’s shareholders equity accounts
are as follows:
Commons shares (100,000 outstanding) $1,500,000
Retained earnings 15,000,000
Net Worth $16,500,000

A 2 for 1 Stock Split:

New Share Price = P0[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00

The firm’s equity accounts:
Commons shares (200,000 outstanding) $1,500,000
Retained earnings 15,000,000
Net Worth $16,500,000

CHAPTER 22 – Dividend Policy 22 - 27

 Dividend Payments
Further Stock Split Examples

A 4 for 3 Stock Split:

New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50
The firm’s equity accounts:
Commons shares (133,333 outstanding) $1,500,000
Retained earnings 15,000,000
Net Worth $16,500,000

A 3 for 4 Reverse Stock Split:

New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00
The firm’s equity accounts:
Commons shares (75,000 outstanding) $1,500,000
Retained earnings 15,000,000
Net Worth $16,500,000

Clearly the Board can use stock splits and reverse stock splits to place the firm’s stock in a particular
trading range.

CHAPTER 22 – Dividend Policy 22 - 28

 Dividend Payments
Stock Split Effects

• shareholders wealth should remain unaffected:

Original Holdings: (100 shares @ $150/share) = $15,000
After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000

• the above will hold true if there is no psychological appeal to

the stock split.
• There is some evidence that the share price of companies
which split stock is more bouyant because of a positive signal
being transferred to the market by this action.

CHAPTER 22 – Dividend Policy 22 - 29

 Stock Dividends versus Stock Splits

Stock Dividends Stock Splits

- lowers stock price slightly - large drop in stock price

- little psychological appeal - much stronger potential
signalling effect
- recapitalization of earnings - no recapitalization
- no change in proportional - same
ownership
- odd lots created - odd lots rare
- theoretically, no value to - same
the investor

CHAPTER 22 – Dividend Policy 22 - 30

 Cash Dividend Payments
The Macro Perspective

• Figure 22 -1 illustrates:
– Aggregate after-tax profits run at approximately 6% of GDP but
are highly variable
– Aggregate dividends are relatively stable when compared to
after-tax profits.
• They are sustained in the face of drops in profit during recessions
• They are held reasonably constant in the face of peaks in aggregate
profits.

(See Figure 22 - 1 on the following slide)

CHAPTER 22 – Dividend Policy 22 - 31

Cash Dividend Payments
Aggregate Dividends and Profits

FIGURE 22-2

CHAPTER 22 – Dividend Policy 22 - 32

 Cash Dividend Payments
The Macro Perspective

• Figure 22 -2 illustrates:
– Aggregate Dividend payouts further illustrates the
effects of relatively stable dividend payouts in the face
of profit volatility:
• The normal aggregate dividend payout rate is about 40% of
after-tax profit
• When profits drop and dividends are held constant, payout
rates rise to 100%

(See Figure 22 - 2 on the following slide)

CHAPTER 22 – Dividend Policy 22 - 33

Cash Dividend Payments
Aggregate Dividend Payouts

FIGURE 22-3

CHAPTER 22 – Dividend Policy 22 - 34

 Cash Dividend Payments
The Macro Perspective - Question

• Why are dividends smoothed and not matched to profits?

CHAPTER 22 – Dividend Policy 22 - 35

 Cash Dividend Payments
The Micro Perspective

• Table 22 -1 contains dividend yields for selected

companies.
– The companies chosen here illustrate the dramatic
differences between companies:
• Some pay no dividends
• Some pay consistent cash dividends representing substantial
yields on current shares prices
– The highest yields are found in the case of Income Trusts and
large stable ‘blue-chip’ financials and utilities

CHAPTER 22 – Dividend Policy 22 - 36

 Cash Dividend Payments
Dividend Yields

Table 22-1 S&P/TSX 60 Index Dividend Yields

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average
% % % % % % % % % %

BCE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31
Celestica Inc. 0 0 0 0 0 0 0 0 0 0 0.00
CIBC 3.67 3.07 2.85 3.37 3.17 2.9 3.48 3.28 3.31 3.57 3.27
Cott Corporation 0.23 0.53 0.54 0 0 0 0 0 0 0 0.13
Kinross Gold Corporation 0 0 0 0 0 0 0 0 0 0 0.00
TransAlta Corporation 6.22 5.16 4.52 5.35 5.59 4.06 4.92 5.73 5.88 4.51 5.19
Yellow Pages Income Fund 7.34 7.09 7.22

CHAPTER 22 – Dividend Policy 22 - 37

Modigliani and Miller’s Dividend
Irrelevance Theorem

M&M, Dividends and Firm Value

Modigliani and Miller’s Dividend Irrelevance
Theorem

The value of M&M’s Dividend Irrelevance argument is

that in the end, it shows where value can be created with
dividend policy and why.

CHAPTER 22 – Dividend Policy 22 - 39

 M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

Start with the single-period DDM:

D1  P1
[ 22-1] P0 
(1  Ke )

CHAPTER 22 – Dividend Policy 22 - 40

 M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

• Multiply by the number of shares outstanding (m) to

convert the single stock price model to a model to value
the whole firm:

m( D1  P1 )
[ 22-2] mP0  V0 
(1  Ke )

CHAPTER 22 – Dividend Policy 22 - 41

 M&M’s Dividend Irrelevance Theorem
Assumptions

• No Taxes
• Perfect capital markets
– large number of individual buyers and sellers
– costless information
– no transaction costs
• All firms maximize value
• There is no debt

CHAPTER 22 – Dividend Policy 22 - 42

 M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

• Without debt, sources and uses of funds identity (sources = uses)

can be expressed as:

[ 22-3] X 1  nP1  I1  mD1

• Where:
 X represents cash flow from operations
 I represents investment
 X–I is free cash flow
 mD1 is dividend to current shareholders at time 1

CHAPTER 22 – Dividend Policy 22 - 43

 M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

• Solving for dividends paid out (mD1 ):

mD1  X 1  nP1  I1

CHAPTER 22 – Dividend Policy 22 - 44

 M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

• If a firm pays out dividends that exceeds its free cash flow (X –I),
then it must issue new common shares to pay for these dividends.
• Substituting into Equation 22 – 2 we get:

X1  I1  [(m  n) P1  V1 ]
[ 22-4] V0 
(1  K )

• The value of the firm is the value of the next period’s free cash flow
(X1 –I1) plus the next period’s equity market value…

CHAPTER 22 – Dividend Policy 22 - 45

 M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

• The firm value is determined as the present value of the free cash
flows to the equity holders:

Value has
nothing

X t  It
[ 22-5] V0   to do with
t 1 (1  K ) t dividends

• The dividend is equal to the free cash flow each period, and
dividends are therefore a residual after the firm has taken care of all
of its investment requirements – this is the Residual Theory of
Dividends

CHAPTER 22 – Dividend Policy 22 - 46

 M&M’s Dividend Irrelevance Theorem
Residual Theory of Dividends

The Residual Theory of Dividends suggests that logically,

each year, management should:

– Identify free cash flow generated in the previous

period
– Identify investment projects that have positive NPVs
– Invest in all positive NPV projects
• If free cash flow is insufficient, then raise external capital – in
this case no dividend is paid
• If free cash flow exceeds investment requirements, the
residual amount is distributed in the form of cash dividends.

CHAPTER 22 – Dividend Policy 22 - 47

 M&M’s Dividend Irrelevance Theorem
Residual Theory of Dividends - Implication

The implication of the Residual Theory of Dividends are:

Investment decisions are independent of the firm’s dividend

policy
• No firm would pass on a positive NPV project because of the lack
of funds, because, by definition the incremental cost of those funds
is less than the IRR of the project, so the value of the firm is
maximized only if the project is undertaken.
• If the firm can’t make good use of free cash flow (ie. It has no
projects with IRRs > cost of capital) then those funds should be
distributed back to shareholders in the form of dividends for them
to invest on their own.
• The firm should operate where Marginal Cost equals Marginal
Revenue as seen in Figure 22 – 4 on the following slide:

CHAPTER 22 – Dividend Policy 22 - 48

M&M’s Dividend Irrelevance Theorem
Internal Funds, Investment, and Dividends

22 - 4 FIGURE

OPTIMAL INVESTMENT
Rate of
MC=MR
Return

IOS

WACC

Internal Funds Available

$11,976 $177,607
Million Million

CHAPTER 22 – Dividend Policy 22 - 49

 M&M’s Dividend Irrelevance Theorem
Homemade Dividends

• Shareholders can buy or sell shares in an underlying

company to create their own cash flow pattern.
– They don’t need management declare a cash
dividend, they can create their own.

Conclusion: under the assumptions of M&M’s model,

the investor is indifferent to the firm’s dividend policy.

CHAPTER 22 – Dividend Policy 22 - 50

The “Bird-in-the-Hand” Argument

Dividend Policy
 The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed

• Risk is a real world factor.

• Firm’s that reinvest free cash flow, put that money at risk
– there is no certainty of investment outcome – those
forfeit dividends that are reinvested…could be lost!
• Remember the two-stage DDM?

CHAPTER 22 – Dividend Policy 22 - 52

 The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed

• Remember the two-stage DDM?

ROE1  BVPS Inv ROE 2  K e

[ 22-6] P  ( )
Ke (1  K e ) Ke

– The first term is the present value of existing opportunities

(PVEO)
– The second term is the present value of growth opportunities
(PVGO)
– These forecast returns face risks of new market entrants to
compete for the excess profits forecast in emerging opportunities
making PVGO extremely vulnerable.

CHAPTER 22 – Dividend Policy 22 - 53

 The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed

• Myron Gordon suggests that dividends are more stable than capital
gains and are therefore more highly valued by investors.

• This implies that investors perceive non-dividend paying firms to be

riskier and apply a higher discount rate to value them causing the
share price to fall.

• The difference between the M&M and Gordon arguments are

illustrated in Figure 22 - 5 on the following slide:
– M&M argue that dividends and capital gains are perfect
substitutes

CHAPTER 22 – Dividend Policy 22 - 54

The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory

22 - 5 FIGURE

OPTIMAL INVESTMENT
D1
P0

Gordon
M&M
P1  P0
P0

CHAPTER 22 – Dividend Policy 22 - 55

 The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory

Conclusions:
– Firms cannot change underlying operational
characteristics by changing the dividend
– The dividend should reflect the firm’s operations
through the residual value of dividends

CHAPTER 22 – Dividend Policy 22 - 56

Dividend Policy in Practice

Dividend Policy
 Dividend Policy in Practice

• Firms smooth their dividends

– Firms tend to hold dividends constant, even in the
face of increasing after-tax profit
– Firms are very reluctant to cut dividends

CHAPTER 22 – Dividend Policy 22 - 58

 Dividend Policy in Practice
Lintner’s Work on Dividend Adjustment

• John Lintner suggested a partial adjustment model to

explain the smoothing of dividend behaviour illustrating
that firms slowly change dividends as they move toward a
new target level:

[ 22-7] ΔDt  β(Dt* -Dt-1 )

CHAPTER 22 – Dividend Policy 22 - 59

 Dividend Policy in Practice
Lintner’s Work on Dividend Adjustment

• The target dividend Dt* Lintner suggested is a function of the firm’s

optimal payout rate of the firm’s underlying earnings (Et) leading to
the following equation:

[ 22-8] Dt  a  (1  b) Dt-1  cE1

• The coefficient on lagged dividends was estimated at 0.70 indicating

an adjustment speed (b) coefficent of 0.30.
• The coefficient on current earnings (c) was estimated at 0.15

CHAPTER 22 – Dividend Policy 22 - 60

 Dividend Policy in Practice
Lintner’s Work on Dividend Adjustment

Implications
– The speed of dividend adjustment is only about 30
percent
– Firms are very reluctant to fully adjust
– Firms do not follow a policy of paying a constant
proportion of earnings out as dividends

Dividend policy in practice does not follow M&M’s

irrelevance arguments because the real world does
not match the assumptions used.

CHAPTER 22 – Dividend Policy 22 - 61

 Relaxing the M&M Assumptions
Welcome to the Real World!

Transactions Costs
– Underwriting costs are very high, providing a strong
incentive for firms to finance growth out of free cash
flow
– Facing these high underwriting costs firms:
• With high growth rates have little incentive to pay dividends
• With volatile earnings conserve cash from year to year to
finance projects and therefore pay very conservative
dividends

CHAPTER 22 – Dividend Policy 22 - 62

 Relaxing the M&M Assumptions
Welcome to the Real World!

Dividends and Signalling

– Under conditions of information asymmetry, shareholders and
the investing public watch for management signals (actions)
about what management knows.
– Management is therefore very cautious about dividend
changes…they don’t want to create high expectations (this is the
reason for extra or special dividends) that will lead to
disappointment, and they don’t want to have investors over react
to negative earnings surprises (the sticky dividend phenomenon)

(The Signalling Model is explained in Figure 22 – 6 found on the next slide.)

CHAPTER 22 – Dividend Policy 22 - 63

Relaxing the M&M Assumptions
The Signalling Model

22 - 6 FIGURE

et
$
et*
dt*
dt

1 2 3 Time

CHAPTER 22 – Dividend Policy 22 - 64

 Relaxing the M&M Assumptions
Welcome to the Real World!

Agency Theory
– Investors are wary of senior management so they seek to put
controls in place.
– There is a fear that managers may waste corporate resources by
over-investing in low or poor NPV projects.
– Gordon Donaldson argued this is the reason for the pecking
order managements tend to use when raising capital
• Shareholders would prefer to receive a dividend and then have
management file a prospectus, justifying investment in projects and
the need to raise the capital that was just distributed as a dividend.
• Shareholders are prepared to pay those additional underwriting
costs as an agency cost incurred to monitor and assess
management.

CHAPTER 22 – Dividend Policy 22 - 65

 Relaxing the M&M Assumptions
Welcome to the Real World!

Taxes and the Clientele Effect

– Table 22 -3 (on the following slide) illustrates that different
classes of investors face different tax brackets
– Preference for dividends versus capital gains income depends
on the province of residence and taxable income level leading to
tax clienteles.
• High income earners tend to prefer capital gains (there is an
additional tax incentive for such individuals in that they can choose
the timing of the sale of their investment…remember only ‘realized’
capital gains are subject to tax
• Low income earners tend to prefer dividends

Conclusion – firm’s should not change dividend policy drastically

since it upsets the existing ownership base.

CHAPTER 22 – Dividend Policy 22 - 66

 Relaxing the M&M Assumptions
Taxes

Table 22-3 Individual Tax Rates (% ) on Dividends and Capital Gains

Income Level $25,000 $50,000 $75,000 $100,000

British Columbia Dividends 2.52 6.19 15.69 20.04

Capital gains 12.45 15.58 18.85 20.35
Alberta Dividends 3.63 8.03 13.83 13.83
Capital gains 12.63 16.00 18.00 18.00
Ontario Dividends 0.00 8.24 20.74 20.74
Capital gains 10.65 15.58 21.71 21.71
Quebec Dividends 5.95 15.42 26.06 26.06
Capital gains 14.37 19.19 22.86 22.86
Nova Scotia Dividends 0.00 8.75 17.05 19.06
Capital gains 12.02 18.48 21.34 22.63

CHAPTER 22 – Dividend Policy 22 - 67

 Relaxing the M&M Assumptions
Repackaging Dividend-Paying Securities

• Tax clienteles help to explain the financial engineering

whereby different parts of the return by the firm are
stripped, repackaged and sold to different investors as
illustrated in Figure 22 – 7. (See the following slide)
• Split shares are shares sold as the dividends and capital
gains parts.

CHAPTER 22 – Dividend Policy 22 - 68

 Relaxing the M&M Assumptions
MYW’s B Corporation Shares

22 - 7 FIGURE

66
ddtt PP00
P00  
P 

1 kk))t ((11 kk)) 6
t 6
tt11 ((1

$454 million
MYW
$330 million $143 million
66
ddtt min($
min($3030,, PP66 11)) P66  min($30, P66  1)
Pref  
Pref  IR 
1 kk))tt
tt11 ((1 ((11 kk))66 (1  k ) 66

CHAPTER 22 – Dividend Policy 22 - 69

 Share Repurchases

• Simply another form of payout policy.

• An alternative to cash dividend where the objective is to
increase the price per share rather than paying a dividend.
• Since there are rules against improper accumulation of
funds, firms adopt a policy of large infrequent share
repurchase programs.

CHAPTER 22 – Dividend Policy 22 - 70

Share Repurchases

Dividend Policy
 Share Repurchases

• allowed under the OBCA and CBCA

• reasons for use:
– Offsetting the exercise of executive stock options
– Leveraged recapitalizations
– Information or signalling effects
– Repurchase dissident shares
– Removing cash without generating expectations for future
distributions
– Take the firm private.

CHAPTER 22 – Dividend Policy 22 - 72

 Disadvantages of Share Repurchases

• they are usually done on an irregular basis, so a shareholder cannot

depend on income from this source.
• if regular repurchases are made, there is a good chance that Revenue
Canada will rule that the repurchases were simply a tax avoidance scheme
(to avoid tax on dividends) and will assess tax
• there may be some agency problems - if managers have inside
information, they are purchasing from shareholders at a price less than the
intrinsic value of the shares.

CHAPTER 22 – Dividend Policy 22 - 73

 Methods of Share Repurchases

• tender offer:
– this is a formal offer to purchase a given number of shares at a
given price over current market price.
• open market purchase:
– the purchase of shares through an investment dealer like any
other investor
– this is not designed for large block purchases.
• private negotiation with major shareholders
In any repurchase program, the securities commission requires
disclosure of the event as well as all other material information
through a prospectus.

CHAPTER 22 – Dividend Policy 22 - 74

 Repurchased Shares

• called treasury stock (U.S.)

• non-voting (U.S.)
• may not receive dividends (U.S.)
• if not retired, can be resold (U.S.)
• unlike the U.S., repurchases in Canada do not involve
shares that can be placed into treasury stock - they are
canceled

CHAPTER 22 – Dividend Policy 22 - 75

 Repurchase Example

Current EPS
= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00
Current P/E ratio
= $20 / $4 = 5X

EPS after repurchase of 100,000 shares

= $4.4 m / 1.0 = $4.40
Expected market price after repurchase:
= [p/e][EPSnew] = [5][$4.40] = $22.00 per share

CHAPTER 22 – Dividend Policy 22 - 76

 Effects of A Share Repurchase

• EPS should increase following the repurchase if earnings

after-tax remains the same
• a higher market price per outstanding share of common
stock should result
• stockholders not selling their shares back to the firm will
enjoy a capital gain if the repurchase increases the stock
price.

CHAPTER 22 – Dividend Policy 22 - 77

 Advantages of Share Repurchases

• signal positive information about the firm’s future cash flows

• used to effect a large-scale change in the firm’s capital structure
• increase investor’s return without creating an expectation of higher
future cash dividends
• reduce future cash dividend requirements or increase cash dividends
per share on the remaining shares, without creating a continuing
incremental cash drain
• capital gains treated more favourably than cash dividends for tax
purposes.

CHAPTER 22 – Dividend Policy 22 - 78

 Disadvantages of Share Repurchases

• signal negative information about the firm’s future

growth and investment opportunities
• the provincial securities commission may raise questions
about the intention
• share repurchase may not qualify the investor for a capital
gain

CHAPTER 22 – Dividend Policy 22 - 79

Borrowing to Pay Dividends

Signalling
 Borrowing to Pay Dividends

• Is this legal? is it possible to do?

• Yes
– the firm must have the ability and capacity to borrow
– the firm must have sufficient retained earnings to allow it
to pay the dividend
– the firm must have sufficient cash on hand to pay the
cash dividend
– the firm must NOT have agreed to any limitations on the
payment of dividends under the bond indenture.
• Why?
– A possible answer is to signal to the market that the
board is confident about the firm’s ability to sustain cash
dividends into the future.
CHAPTER 22 – Dividend Policy 22 - 81
 Borrowing to Pay Dividends
An Example

Before Borrowing:
Assets: Liabilities: 0% Debt
Cash 10 Long-term Debt 0
Fixed Assets 140 Common Stock 50
Retained Earnings 100
Total Assets $150 Total Claims $150

After Borrowing…before cash dividend: 25% Debt

Assets: Liabilities:
Cash 60 Long-term Debt 50
Fixed Assets 140 Common Stock 50
Retained Earnings 100
Total Assets $200 Total Claims $200
CHAPTER 22 – Dividend Policy 22 - 82
 Borrowing to Pay Dividends
An Example …

After Dividend Declaration…before date of payment.

Assets: Liabilities:
50% Debt
Cash 60 Current liabilities 50
Fixed Assets 140 Long-term Debt 50
Common Shares 50
Retained earnings 50
Total Assets $200 Total Claims $200

After Cash Dividend payment of $50

33% Debt
Assets: Liabilities:
Cash 10 Long-term Debt 50
Fixed Assets 140 Common Stock 50
Retained earnings 50
Total Assets $150 CHAPTER 22Total Claims
– Dividend Policy $150 22 - 83
 Borrowing to Pay Dividends
An Example

• The foregoing example illustrates:

– it is possible for a firm with ‘borrowing capacity’ to borrow funds to
pay cash dividends.
– this is not possible if the lenders insist on restrictive covenants that
limit or prevent this from occurring.
– the cash for the dividend must be present in the cash account.
– payment of dividends reduces both the cash account on the asset
side of the balance sheet as well as the retained earnings account
on the ‘claims’ side of the balance sheet.
– in the absence of restrictions, it is possible to transfer wealth from
the bondholders to the stockholders. (Bondholders in this example
may have thought their firm would have only a 25% debt ratio….after the
dividend the debt ratio rose to 33% and the equity cusion dropped from
75% to 66%.)

CHAPTER 22 – Dividend Policy 22 - 84

 Summary and Conclusions

In this chapter you have learned:

– About the different types of dividends including, regular and

special cash dividends, stock dividends, stock splits as well as
share repurchases.
– M&M’s dividend irrelevance argument and the real world factors
such as transactions costs, taxes, clientele effects and
signalling tend to favour real-world dividend relevance
– Tax motives and other reasons explain why firms might want to
repurchase their shares.

CHAPTER 22 – Dividend Policy 22 - 85

Concept Review Questions

Dividend Policy
 Concept Review Question 1
Important Dates and Dividends

Define four important dates that arise with respect to

dividend payments.

CHAPTER 22 – Dividend Policy 22 - 87

 Copyright
Copyright © 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this work
beyond that permitted by Access Copyright
(the Canadian copyright licensing agency) is
unlawful. Requests for further information
should be addressed to the Permissions
Department, John Wiley & Sons Canada, Ltd.
The purchaser may make back-up copies for
his or her own use only and not for
distribution or resale. The author and the
publisher assume no responsibility for errors,
omissions, or damages caused by the use of
these files or programs or from the use of the
information contained herein.

CHAPTER 22 – Dividend Policy 22 - 88