Tuesday, 4 June 2013


Firm has 2 choices
n  Pay dividend
n  Reinvest funds instead of paying out
Dividend policy is the time pattern of dividend payout
Should the firm pay out a large percentage or small percentage of profits and when?

Life Cycle of Dividend Policy

Investors only care about total returns…

n  Not how they are divided between dividends and capital gains

n  Dividends are merely a financing decision

n  Only important driver of value is future earnings power
Some investors prefer low dividend payouts and will buy shares in those companies that offer low dividend payouts

Some investors prefer high dividend payouts and will buy shares in those companies that offer high dividend payouts
Implications of Clientele Effect
What do you think will happen if a firm changes its policy from a high payout to a low payout?

What do you think will happen if a firm changes its policy from a low payout to a high payout?

If this is the case, does dividend POLICY matter?
STC = 12.5%                   CGT = 10%

retentions lead to capital gains à lower tax

if no +ve NPV projects = free cash flow
(a) pay dividend
if personal < corporate tax rate
(b) invest in short term instruments
 if personal > corporate tax rate
Desire for current income
§  ‘Widows and orphans’
§  Shares with relatively high degree of safety and dividend income

Uncertainty resolution
§  ‘Bird in hand’ theory
§  Dividends are less risky than capital gains

n   Asymmetric information – managers have more information about the health of the company than investors

n   Changes in dividends convey information
n  Dividend increases
n Management believes it can be sustained
n Signal of a healthy, growing firm

n  Dividend decreases
n Management believes it can no longer sustain the current level of dividends
n Signal of a firm that is having financial difficulties
1.         Firms set target dividend payout ratios.

2.         They change dividends to match long-term sustainable shifts in earnings.

3.         Managers increase dividends only if they feel they can be maintained.

4.         Managers are more concerned about dividend changes than about levels of dividends. WHY?
Academic Thinking on Dividend Policy
Dividend payout ratio should primarily reflect

n  Expected capital requirements
n (above expected operating cash flow)

n  Riskiness of the business
n (variability of cash flow)

n  Target capital structure
n (also partly related to risk)

n  Availability and cost of outside capital
How does theory measure up to reality?
§  Models versus Perceptions.

§  Academia makes provision for broad range of dividend theories.

§  Problem is no single theory has been proven to hold up in the market over extended periods.

§  Current prevailing view is that signalling (information content) and clientele effects are observable but true driver is market sentiment vis-à-vis growth and safety.
Alternative: Share Buybacks
§  Buyback shares
v  Tender offer – company states a purchase price and a desired number of shares
v  Open market – buys shares in the open market
§  Reduces cash and equity
§  Simple method for changing capital structure
§  Value of the firm will be the same regardless of whether dividend paid or shares repurchased

Common Rationales
n  Deploy excess cash
n (shortage of viable investments)
n  To increase share price
n (management believes shares underpriced)
n  Replace cash dividends
n (possible tax advantages)
n  Prevent dilution of earnings
n (enhance EPS, or prevent reduction in EPS caused by exercise of share options)
n  Rationalize capital structure
n (Higher D/E can be sustained)

Current US Situation
§  Historically, dividend paying stocks favoured. (Quarterly payments expected from “good” companies)

§  WHY?

§  Move to growth stocks in last two decades, especially with advent of technology and IT sector.

§  IT firms actually penalised for paying good dividends to shareholders.

§  After bull markets of last few years, companies sitting on large cash reserves (if no profitable opportunities exist, pay out to shareholders?)

Current issues favouring payout?
§  Bush regime pushing through tax cuts (lower tax rates to apply to 2010 and divs not taxed in hands of shareholders)

§  Scepticism concerning accounting profits. (Enron, et al)

§  Current volatility in markets means share holders desire safety, which can be accomplished by paying certain stream of dividends versus uncertainty of future share prices.

Current issues against payout?
§  Emergence of more small-cap firms, high on growth but low on cash. (Fama and French, 2001)

§  Buybacks preferred over dividends. (discretionary versus compulsory)

§  Academic theory – irrelevance of dividends

§  Future uncertainty (war, oil prices, etc.)

So are academic views upheld?
§  Given the above there is little evidence for signalling and the clientele effect.

§  Indeed, the prevalent driver of dividend policy in the US seems to be sentiment as proposed by Baker and Wurgler (2002).

What is the South African situation?
§  Bhana (1991) finds indications that announcements of dividends have significant impact on share pricing in the ‘direction’ of the announcement. [positive (negative) announcement – increase (decrease)]

§  Therefore strong proof that information content holds for SA.

§  Importantly, overreaction hypothesis also holds – market reacts ‘correctly’ for positive announcement but overreacts for negative announcements.