H KUSPRCE

ti ~ ~ • 5 • ~ • * ~
HKU School of Professional and Continuing Education

Postgraduate Diploma in Professional Accounting

Module: Financial Management

Topic 3
Financial performance evaluation and
the dividend decision
Dr. Zenki Kwan, FRM, CPA (Aust.), CA/A, CB
[email protected]
 Dividend

• Dividends are the amounts of cash that a company distributes

to its shareholders as the servicing of that type of capital
• Dividends are the company's direct compensation to
shareholders for their investment
• Dividends, unlike interest and principal payments to
debtholders, are not a contractual right of shareholders
• No requirement that a company pay its shareholders any
particular amount of dividend at any particular time
• Since shareholders are the residual claimants of the
company's cash flows, a sense 'own' the amounts of cash that
the company produces net of all other contractual requirements
(other claims being the costs of operations, taxes, interest, and
so forth)
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Dividend

• Financial managers of a company must decide how much of

its residual cash should be paid as dividends to shareholders.
Since any residual cash not paid as dividends is still 'owned' by
shareholders', this retained cash is reinvested in the company
on behalf of shareholders
• The dividend decision is thus also, in mirror image, a cash
retention or reinvestment decision. Any reasonable discussion of
dividend policy questions must treat both aspects of this decision
• Dividend policy is the determination of the proportion of profits
paid out to shareholders

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 Dividend Investment Ratios

• Dividend Payout Ratio (DPR) is the amount of dividends

paid relative to the company's earnings = Dividend
/Distributable profit for the year, or DPS/EPS

• Dividend Yield = Dividend per share (DPS)/Market price

per share (MPS)

.....
Dividend Yield [email protected]¥ Dividend Yield
Dividend Dividends Per Share •100 Dividend $1.50
Yield Ratio Market Price Per Share $15,25 x100
Yield Ratio
' Babson Builders pays an annual dividend of Babson Builders pays an annual dividend of
S1.50 per share. The market price of the $1.50 per share. The market price of the
company's share was $15.25 at the end of company's share was $15.25
2015

This: ratio Identifies the retum, In

The yield rato is 9.84% .
terms of cash dividends, on the
current market price of the share.

Dividend Payout Ratio OOi1JBrel¥

Dividend Dividend Por Sharo xi
00
Payout Ratio Earnings Per Share

Babson Builders pays an annual dividend of

$1.50 per share. The EPS Is $1.96

$ l .s.,oo
$1.96 =76.53%
 Important Dates for Dividends
• Declaration Date
- The date on which the board of directors authorizes the payment of a
dividend

• Record Date
- When a firm pays a dividend, only shareholders on record on this date
receive the dividend

• Ex-dividend Date
- The first date on which the share will trade without rights to the Dividend
- An investor who buys shares before the ex-dividend date will receive
the dividend, whil e an investor who buys shares on or after the ex-
dividend date will not
- The shares price drops on the ex-dividend date reflects the difference in
the value of the cash flows that the shareholders are entitled to receive
before and after the ex-d ividend date

.....
 Dividend policy

• The rationale and conclusion of the ideas of Miller and

Modigliani's dividend irrelevancy hypothesis
• The concept of dividends as a residual
• The influence of particular dividend policies attracting
different 'clients' as shareholders
• The effect of taxation
• The importance of dividends as a signalling device
• Resolution of uncertainty
• The impact of agency theory on the dividend decision
• The role of scrip dividends and share repurchase

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Defining the problem

• Dividend policy is the determination of the proportion of

profits paid out to shareholders - usually periodically.
• Whether shareholder wealth can be enhanced by
altering the pattern of dividends not the size of dividends
overall.
• We will assume that:
- a the underlying investment opportunities and returns on
business investment are constant
- b the extra value that may be created by changing the capital
structure is constant.

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Miller and Modigliani's dividend irrelevancy proposition

• Dividend policy is irrelevant to share value

Assumptions for model:
- 1 There are no taxes
- 2 There are no transaction costs
- 3 All investors can borrow and lend at the same interest rate
(allowing access to external finance)
- 4 All investors have free access to all relevant information
- 5 Investors are indifferent between dividends and capital gains

• Any money paid out could quickly be replaced by having

a new issue of shares
• 'Homemade dividends'
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Dividend irrelevance example

• Belvoir pie, an all-equity company which has a policy of paying out

all annual net cash flow as dividend.
• Expected to generate a net cash flow of £1 m to an infinite horizon.
• Cost of equity capital is 12 per cent
d1 £1m
P0 = d0+-= £1m + - - = £9.333m
kE 0.12
• A new investment opportunity. Which will produce additional
cash flows of £180,000 per year starting in one year.
• The company will be required to invest £1 m now.
£180,000
NPV = -£1 m + - - - - = £500,000
0.12

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 Belvoir pie
The project is financed through the sacrifice of the present dividend
Year 0 1 2 3, etc.

Cash flow to
shareholders 0 1,180,000 1,180,000 1,180,000

Shareholders' wealth= l ,l SO,OOO = £9.833m

0.12
If the project is financed through a rights issue while leaving the
dividend pattern intact
Year a 1 2 3, etc.

Cash flow to shareholders

Receipt of dividend + £1,000,000
Rights issue - £1,000,000
0 1,180,000 1,180,000 1,180,000

Shareholders' wealth= l ,l SO,OOO £9.833m

0.12

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Dividends as a residual

• Imagine that the raising of external finance is so expensive that to all

intents and purposes it is impossible.
• In this world dividends should only be paid when the firm has
financed all its positive NPV projects.
• In these circumstances dividend policy becomes an important
determinant of shareholder wealth:
- 1 If cash flow is retained and invested within the firm at less
than kE, shareholder wealth is destroyed; therefore it is better to
raise the dividend payout rate.
- 2 If retained earnings are insufficient to fund all positive NPV
projects, shareholder value is lost, and it would be beneficial to
lower the dividend.

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 Dividend as signals

• Another capital market imperfection that bears on the dividend

decision concerns the need for information
• Capital markets are imperfect in that information is neither costless
nor universally available, and so decisions have often to be made on
the basis of imperfect and incomplete information
• Thus a company's dividend declaration - which is free and
universally available - is often thought to signal information about its
future performance
• If the stock market places such an informational content on the
dividend declaration, then a company cannot ignore this fact. Hence
dividend decisions becomes relevant

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What about the world in which we live?

• Transaction costs
• Taxes further complicate the issue
• Dividend policy makes some difference to shareholder
wealth
• Young rapidly growing firms with a need for investment
finance have a very low dividend (or zero) payouts,
whereas mature 'cash cow' type firms choose a high
payout rate

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 Some influences on dividend policy

• Cl ientele effects
- Pressure on the management to produce a stable and
consistent dividend policy
- Most firms seem to have a consistent dividend policy
based on a medium- or long-term view of earnings and
investment capital needs. The shortfalls and surpluses in
particular years are adjusted through other sources of
finance

• Taxation
• Dividends as conveyors of information

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Tax Considerations
• Other shareholders may prefer company-distributed dividends
because their marginal tax rate results in less tax being paid than the
combined effect of capital gains tax and transaction costs incurred in
the process of providing home-made dividends, say it TCG < TD,
investors indicate a preference for dividends, some institutional
investors may only invest in companies which distribute dividends
• Once again, we must conclude by saying that if a company follows a
widely recognized, consistent dividend policy, then it can be expected
to attract that class of shareholders on whom the particular dividend
policy chosen has the most favourable taxation effects
• Dividend trading strategies
If TCG = TD , share drops = dividend
If TCG < TD , share drops < dividend
If TCG > TD , share drops > dividend

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 Resolution of uncertainty

• Myron Gordon (1963) argued that investors perceive that a company, by

retaining and reinvesting a part of its current cash flow, is replacing a certain
dividend flow to shareholders now with an uncertain more distant flow in the
future.
• The market places a greater value on shares offering higher near-term
dividends.

Po= - - - + - - - - + ... + - - - - + ...

where:
kE1 < kE2 < kE3 .. •
• Perceived risk
• Take a company which pays out all its earnings in the hope of raising
its share price because shareholders have supposedly had resolution
of uncertainty chat row needs to invest.
• 'Bird-in-the-hand fallacy'

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Bird in the hand fallacy

• The traditional view of the dividend decision is that at any particular

point of time £1 of dividends is somehow more valuable than £1 of
retained cash flow - even though the cash flow may have been
retained for investment in a project yielding a substantial positive
NPV
• This is sometimes referred to as the 'bird in the hand' argument (or
the 'bird in the hand fallacy')
• The early payment of dividends may not actually change a
company's business risk level, but it can favourably alter an
investor's perception of the level of risk. Thus current dividends
are viewed as more valuable than retained earnings because the
investor's perception of risk is imperfect and this may lead him to
under-value the future dividend stream that the retained earnings will
generate

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 Bird in the hand fallacy

• As a result, the more generous a company's dividend

policy , the greater the impact on shareholder value
• Myron Gordon (1963) believed that dividend is relevant
in dividend decision making and it does affect
shareholder value
• His basic valuation model is based on the following
assumptions
- The firm is an all equity firm
- No external financing is available or used. Retained earnings
represent the only source of financing investment programs
- Share price is the combination of dividend yield+ capital gains

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Bird in the hand fallacy

• Bird-in-the-hand fallacy: The mistaken belief that

dividends paid early in the future are worth more than
dividends expected in later time periods, simply because
they are nearer in time and viewed as less risky

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 Owner control (agency theory)

• Many firms seem to have a policy of paying high

dividends, and then, shortly afterwards, issuing new
shares to raise cash for investment
• One possible answer is signalling
• A second potential explanation lies with agency cost
• Owners insist on relatively high payout ratios. Then, if
managers need funds for investment they have to ask

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A possible practical dividend policy

• Forecast fixed capital expenditure and additional investment in

working capital as well as sales, profits, etc. Allowing an estimation
of medium- to long-term cash flows
• Determine dividend level that will leave sufficient retained earnings to
meet the financing needs of investment projects without having to
resort to selling shares-a maintainable regular dividend
• Dividends may be set at a level low enough that, if poorer trading
conditions do occur, the firm is not forced to cut the dividend
• In years of plenty cash flows, directors can pay out surplus cash in
the form of special dividends or share repurchases
• Make a gradual adjustment
• Provide as much information to investors as possible

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