In Week 1, we discussed three important decisions managers make. They are investment, financing and dividend/payout decisions. Payout decision/policy is one of the 3 important decisions that managers make. It is an important decision because it can affect the financing decision of the firm and firm value. When a firm makes a profit, it can be used to fund new projects. If so, it can reduce the amount of debt in the capital structure of the firm. Hence, it could potentially affect the financing decision of the firm. Does dividend payout affect share price? Yes, it does. If you remember, in Week 5 you used different dividend discount models to value firms. They are constant, constant growth and supernormal growth dividend model. Thus, payout policy can affect firm value.

In this topic, we will discuss five concepts related to payout policy. They are as follows:

Concept 1: Articulate why cash payments to shareholders are important.

Concept 2: Explain the institutional features of dividends.

Concept 3: Dividend imputation

Concept 4: Share repurchase

Concept 5: Discuss different theories of payout policy.

Concept 1: Articulate why cash payments to shareholders are important.

Dividend policy is one of the major areas of corporate decision-making. It involves deciding the company’s overall policy regarding distributions of value to shareholders:

• Whether a dividend is going to be paid in a particular year?
• How much dividend is going to be paid?
• Are there better ways to distribute wealth than paying dividends?
• Should the company pay a dividend or repurchase the shares? Or give shareholders the option of reinvesting in shares or Issue bonus shares?

When a company earns profit what does it do with it? There are 3 options:

• The company can reinvest the profit in the business.
• The company can distribute it to the shareholders as dividends.
• The company can hold it as loose cash.

From the above, option 2 is payout and you will learn about payout policy in this topic. Is it important to distribute profits to the shareholders as dividends? There are two reasons for why it is important for firms to pay dividends. First of all, by paying regular dividends, firms can signal their financial well-being. If the firm is not in good health, it cannot pay regular dividends. Secondly, shareholders provide capital to the firm with the expectation that they will receive a return from the company in the form of a payout or capital gain.

Dividends are a distribution of company’s profit to shareholders in the form of cash. Apart from dividends, there are a few other ways companies can distribute profit to shareholders. They are share buyback, special dividends and bonus issues. Companies repurchase shares from existing shareholders, and hence reduce the number of shares outstanding. In April 2019, Woolworths announced a plan to return $1.7 billion to shareholders via a share buyback programme, to be completed by 30 May 2019. A company pays a special dividend when it generates high profit in a specific period. For example, Woolworths paid a special dividend of $0.45 to its shareholders in 2021 fiscal year. There are instances where firms instead of paying cash dividends, companies may choose to pay dividends by issuing bonus shares.

Cash Dividends: Regular Cash Dividend

The most common form of dividend is the regular cash dividend, which is a cash dividend that is paid on a regular basis.

In Australia, dividends are generally paid semi-annually and are a common means by which companies return some of their profits to shareholders.

The size of a company’s regular semi-annual cash dividend is typically set at a level that management expects the company to be able to maintain in the long run, barring some major change in the fortunes of the company.

Cash Dividends: Special Dividend

Management does not like to reduce the dividend because it can send a bad signal to the shareholders regarding the future prospect of the company

Management can afford to make mistake on the side of setting the regular cash dividend low because it always has the option of paying a special dividend if earnings are higher than expected.

Firm Life Cycle and Dividend Policy

The below table depicts the relation between firm life cycle and its dividend policy.

Stages of firm life cycle	External financing need	Internal financing need	Capacity to pay dividends
Introductory/start-up	High but constrained because of infrastructure	Negative or low	None since the cash flow is negative.
Growth	High	Negative	None. The investment need will be high compared to the cash flow generation.
High growth	High	Low	Very low. Firms in a stage of high growth are not likely to pay dividends since cash can be used to fund potential investments.
Mature growth	Moderate as low investment opportunities	High	High since firm will have cash flows realising from investments
Decline	Moderate as low investment opportunities	High	High since firm will continue to have cash flows realising from investments

What are the different determinants of payout?

Other financial decisions (investment and financing): If the company decides to finance its expenses and investments from its earnings, then it will have to pay less dividends to shareholders.

Signalling effect of dividends (eg what does a higher dividend signal?): If a company pays dividends then this indicates a positive future performance of the company’s share. If the company is profitable, it should generate positive cash flow, and have enough funds to pay out as dividends.

Dividend clientele (characteristics of shareholders): When shareholders have a preference for current dividend income over capital gains, the company may be required to pay dividends regularly.

Future economic indications: The future economic condition of the company is one of the important factors influencing the dividend policy. If future sales are high, the earnings of the company are relatively stable. Therefore, the company is more likely to pay out a higher percentage of its earnings in dividends than another company that has unpredictable earnings.

Firm life cycle: A company in the introductory stage of its life cycle may require much of its earnings for financing investments or growth requirements. Therefore, it may not pay any dividends. On the other hand, a company in a mature stage of its life cycle can afford a more consistent dividend policy since cash flows remain stable.

How do we measure dividend distribution?

There are two ways we can measure dividend distribution. They are dividend payout and dividend yield.

• Dividend payout = Dividend/Net income
  • Measures the % of earnings company pays in dividends
• What if net income is negative?
• Dividend yield = Dividend per share / share price
  • Measures the return that an investor can make from dividends alone.

Concept 2: Explain the institutional features of dividends.

Now let’s look at the dividend declaration procedure. The process starts with the dividend announcement date. On this date the board of directors pass a resolution to pay dividend. Then comes the ex-dividend date. This is the date before which investors should own the share to get the dividend. The next is record date. On this date shareholders are listed in the register of shareholders to receive dividend and finally the payment date on which dividends are paid.

The announcement date: The date on which this announcement is made is known as the declaration date or announcement date. The announcement includes amount of dividend per share and other dates associated with the dividend payment process. Share price often changes when a dividend is announced because it sends a signal to the market about the future performance of the company.

The ex-dividend date: The ex-dividend date is 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, while an investor who buys the share on or after the ex-dividend date will not.

Before the ex-dividend date, a share is said to be trading cum dividend, or with dividend. The share price usually drops on ex-dividend date to reflect the amount of dividend (plus franking credits) that shareholders are to receive.

The record date: The record date is the date on which an investor must be a shareholder of record (that is, officially listed as a shareholder) in order to receive the dividend. The record date typically follows the ex-dividend date by three days. The reason that the ex-dividend day precedes the record date is that it takes time to update the shareholder list (normally 3 working days) when someone purchases shares during the cum-div period.

The payment date: The final date in the dividend payment process is the payable (payment) date, when the shareholders of record actually receive the dividend (by cheque or direct transfer to the nominated bank account).

Concept 3: Dividend Imputation

Australia has moved from a classical tax system to an imputation tax system (from July 1987). Classical Tax System – profits were taxed at company tax rate and dividends paid were taxed again at the investor’s marginal personal tax rate. This system resulted in double taxation.

Imputation Tax System – company tax paid is used as a franking credit to offset the tax liability of shareholders. Now dividends are effectively taxed only once at the personal tax rate.

• Franked dividend: a dividend paid out of Australian company profits on which company tax has been paid and which carries a franking credit for the income tax paid by the company.
• Franking credit: a credit for Australian company tax paid which, when distributed to shareholders, can be offset against their personal tax liability. When a dividend is declared, the company must state the extent to which the dividend is franked.

Concept 4: Share repurchase

So far, we have looked at cash dividends, but a number of alternatives to dividends are available to companies. All of these alternatives, like dividends, can be used to distribute cash/earnings (wealth) to shareholders. These alternatives include: Dividend reinvestment plans (DRPs), Share repurchase and Bonus shares.

A dividend reinvestment plan (DRP) gives shareholders the option of receiving new shares at a small discount, instead of cash dividends. Under a DRP, shareholders:

• Are deemed to have received the cash dividend and are taxed on it
• Receive franking credits that can be used to offset all or part of their tax liability

See the below video that shows the power of dividend reinvestment.

https://www.youtube.com/watch?v=vffTJV0IzHM

In a share buy-back (or share repurchase), the company buys some of the issued shares back from shareholders. Share buy-backs differ from dividends in some ways.

• Shareholders can choose not to participate in buy-backs.
• It reduces the number of shares outstanding (In Australia, bought back shares have to be cancelled)
• Profit to the shareholders on share buybacks is considered capital gains and taxed accordingly.

(In Australia maximum allowed as buybacks per year is 10% of the issued capital. Bought back shares have to be cancelled. In USA the rules are different).

Methods of share buy-backs

• On market buy-backs :Company buys shares from the share market at the market price.
• Equal access buy-back: Buyback is offered to all shareholders on a pro-rata basis. Shareholders have to apply.
• Selective buy-back: Only offered to a select groups of shareholders (targeted buyback)
• Employees share scheme buy-back: Only offered to employees who are shareholders under an employee share scheme.
• Minimum holding buy-back: Firms buy back unmarketable small parcels of shares. To reduce administration costs.

Advantages of share buybacks

Buy-backs give shareholders the ability to choose when they want to receive the distribution, which may depend on the timing of the tax they must pay. Shareholders who sell shares back to a company pay tax only on the capital gains they realise, and historically these capital gains have been taxed at a lower rate than dividends. (Effectively at 50% (half) of income tax).

From management’s perspective, share buy-backs provide greater flexibility in distributing value and managing the capital structure. Management can always cut back or end the buy-backs at any time. On market, buybacks are also preferred by managers as they’re flexible.

Bonus share issues

One type of “dividend” that does not involve the distribution of cash (or value) is known as a bonus share issue. When a company issue bonus shares, it distributes new shares on a pro-rata basis to existing shareholders. The number of shares each shareholder owns increases but their value (price), in theory, should go down proportionately. Therefore, the shareholder is left with exactly the same total value (total wealth) as before.

Share splits

A share split is quite similar to a bonus share issue, but it involves the distribution of a larger multiple of the outstanding shares. Theoretically, just like bonus share issues, share splits do not add value (do not increase wealth).

Concept 5: Discuss different theories of payout policy.

Miller and Modigliani’s theorem says dividend policy does not matter if the market is perfect (no tax, no transaction cost and the company’s investment policy is fixed). If the above conditions (assumptions) are true, shareholders can “manufacture” any dividends he or she wants at no cost.

For example, shareholders can replicate a company’s dividend policy on their own by selling some of the shares for cash. Some shareholders prefer high dividend yields. For example, retirees (who depend on dividend income).

Irrelevance of Payout Policy

Modigliani & Miller (MM, 1961) argue that a company’s dividend payout policy has no effect on shareholder wealth, and that the value of firm is determined solely by the earning power of the firm’s assets. MM assume the following:

• The company has an investment plan and has determined how much of its assets to be acquired will be financed with borrowing.
• Perfectly competitive capital market – no taxes, transaction costs, flotations costs, or information costs.
• Investors are rational – they prefer more to less wealth, and are equally satisfied with a given increase in wealth, whether it is in the form of cash paid out (dividends) or an increase in the value of the shares that they hold.
• If a firm increases dividend payment; as investment and borrowing decisions are fixed, extra funds needed to pay higher dividends can only come from issuing new shares; alternatively, if dividend is reduced, surplus cash can only be used to repurchase shares. Hence dividend policy involves a trade-off between higher or lower dividends and issuing or repurchasing ordinary shares.

Therefore, dividend policy will not change shareholder wealth. And the value of a company depends only on the quality of its investments; net cash that can be paid out to investors is a residual – the difference between profits and investments. Companies can adjust payouts to any level by making corresponding adjustments to the number of shares on issue.

Payout Policy is Important – The Importance of Full Payout

De Angelo & De Angelo (DD) (2006) say MM’s theorem is inadequate for understanding payout policy. DD state that MM’s analysis is correct with the given assumptions. However, concept of ‘full payout’ is a more logical starting point for discussion of payout policy. The ‘full payout’ policy – full present value of a company’s free cash flow should be paid out to shareholders.

Free cash flows are cash flows in excess of those required to fund all available projects that have a positive NPV. Company value can be changed if the company retains part of its free cash flow. DD distinguish between investment value and distribution value. In contrast to MM, DD conclude that both investment policy and payout policy are important.

In summary, DD argue that managers are responsible for two important jobs:

• Selecting good investment projects (Investment value)
• Ensuring that, over the life of the enterprise, investors receive a distribution stream with the greatest possible present value. (Distribution value)

Under perfect capital market DD and MM support different payout policy. Now let’s understand what happens if we relax the assumption of a perfect capital market.

Transaction Costs & Other Market Imperfections

Transaction costs:

In theory (with perfect markets), shareholders can develop their own payout policy – if shareholder receives an unwanted dividend, they can use cash to buy more shares in a company, and if additional cash is needed, they can sell shares to create ‘homemade dividend’.

In reality, shareholders who buy and sell shares incur transaction costs, e.g. brokerage fees, so investors who require income may prefer to hold onto shares that pay regular dividends.

Imperfections in the capital market lead to ‘dividend clienteles’ – different classes of investors with different preferences for current income; a firm will attract a clientele of investors suited to its dividend policy.

For Example, a company with no/low dividends will attract investors with adequate income from other sources; these investors will reinvest any dividends they receive but can avoid transaction costs by investing in companies that retain profits.

Another example is a company with stable high dividends will attract investors requiring regular income from their share portfolio to meet consumption needs, e.g. retirees, who avoid transaction costs that would arise if co. had a residual dividend policy, i.e. dividends are only paid out if the company has profits that it cannot profitably invest, otherwise, they will have to purchase other shares and will incur transactions costs, e.g. brokerage fees.

Transaction costs may result in dividend clienteles due to the difference in preference among different classes of investors.

Some shareholders prefer low dividends for taxation reasons. These shareholders tend to have a high marginal tax rate and prefer to have capital gains. They can also delay paying tax on capital gains (by postponing the sale until it suits them)

Floatation costs:

If a company pays dividends and retained profits are insufficient to meet investment needs, then it must raise funds externally and this involves costs, which can be quite substantial, e.g. prospectus preparation costs, underwriter’s fees, loan establishment fees. Existence of flotation costs provides an incentive to preserve shareholder wealth by restricting dividends.

Behavioural factors:

Investors are not always rational, and behavioural factors may mean that sometimes investors prefer dividends being paid to increase the value of their shares. In contrast, other times, they may prefer increases in the value of their shares to dividends.

If investors are willing to pay more to invest in companies that pay higher dividends, then the arbitrage process will not prevent these companies from having higher share prices than those that don’t pay dividends.

Catering theory:

Managers cater to investor demand – pay dividends when investors place higher value on dividends; don’t pay dividends when investors place higher value on increases in value of shares. This leads to ‘catering theory’ – managers cater to changes in investor demand for dividends.

Taxes:

Differential tax treatment of dividend income versus capital gains arising from retained profits can either favour or penalise payment of dividends. Despite the apparent tax disadvantage of paying dividends, many Australian companies pay out a significant percentage of their profits as dividends. This could be explained by the dividend imputation system that exists in Australia as opposed to the classical system present in UK and US.

This difference in tax treatment is understood by comparing a classical tax system with an imputation tax system. In a classical tax system:

Company profits are taxed at the corporate tax rate, t_c, leaving (1 – t_c) to be distributed as a dividend. Dividends received by shareholders are then taxed at the shareholder’s personal marginal tax rate, t_p. The consequence is that, from a dollar of company profit, the shareholder ends up with (1 – t_c) x (1 – t_p) dollars of after-tax dividend. Result is that profit paid as a dividend is effectively taxed twice. Also, under such a system, capital gains are either tax-free or are taxed at lower rates than dividends. From a taxation viewpoint, many investors were disadvantaged if they received a dividend and would have preferred that companies retained profits (to increase the share price). Classical tax system is still used in many countries, including the US.

In Australia, a classical tax system operated until 1 July 1987, when an imputation system was introduced.

Imputation tax system

Australian resident equity investors can use tax credits associated with franked dividends to offset their personal tax – eliminating double taxation of the classical tax system. Company tax is assessed on corporate profits in the normal way, at the corporate tax rate (t_c). As of 2014, t_c is 30%. For each dollar of franked dividends paid by company, resident shareholders are taxed at their marginal rate (t_p) on an imputed dividend of $D/(1 – t_c) — grossed-up dividend. The grossed-up dividend is equal to the dividend plus the franking credit.

This website below explains how the imputation tax system works in Australia:

www.stockwatch.com.au/articles/franking-credits.aspx

Franking credit is given by:

7.1

Franking Credit

[latex]Imputation\ credit=\frac{\left(franked\ dividend\ \times\ t_c\right)}{\left(1-t_c\right)}[/latex]

The shareholder receives a tax credit equal to the franking credit. Tax credit can be used to offset tax liabilities associated with any other form of income. Result is that franked dividends are effectively tax-free to Australian residents if the investor’s marginal tax rate is equal to the corporate tax rate.

If investor’s marginal tax rate is less than corporate rate, investor will have excess tax credits, which can be used to reduce tax on other income. If investor’s marginal tax rate is greater than corporate rate, some tax will be payable by the investor on the dividend. Shareholders are unable to use tax credits until franked dividends are paid. Profits earned and taxed by companies offshore do not have franking credits.

Example of dividends and imputation tax system:

To understand how the imputation tax system works, let’s consider an example. Suppose a company has a profit before tax of $100. The company tax rate is 30 per cent. After tax, profit for the company is $70. Now let’s say that there is only 1 shareholder in the company. If the company decides to pay all of its profit as dividend, then the dividend amount is $70 but it comes with a $30 tax credit which sits with the tax office. So the total dividend income is $100 which includes $70 dividend from the company + $30 tax credit from the tax office.

Now let’s see how the dividend income is affected if a different tax rate is applicable to the shareholder. Suppose the shareholder has a personal tax rate of 10 per cent then the shareholder should pay $10 as tax on the $100 dividend income but since the company has already paid $30 on the $100, the shareholder will get a $20 tax refund. Now suppose the shareholder has a personal tax rate of 30 per cent. Then he/she has to pay a tax of $30. Now since the company has already paid the $30, the shareholder does not have to pay anything or receive anything. Now suppose the shareholder has a personal tax rate of 50 per cent then his/her income tax is $50. However, since the company has already paid $30 tax, the shareholder only has to pay $20 more to the tax office.

The following table shows the company’s income statement

Company
Profit before tax	$100
Tax Rate	30%
Profit after Tax	$70
Dividend	$70
Tax Credit provided by ATO. This amount sits at the tax office.	$30
Dividend Income	$70+$30 = $100

The following table shows how dividend income is taxed for shareholders in a different tax bracket

Shareholder under different tax bracket
Tax Rate	Dividend Income	Income Tax	Franking Credit	Net effect
10%	$100	$10	$30	$20
30%	$100	$30	$30	0
50%	$100	$50	$30	-$20

Franking credit can be calculated as:

[latex]$Dividend\ast\frac{t_c}{1-t_c}[/latex]

Information Signalling Effects of Dividends

Managers usually have better information about company’s prospects than shareholders and if this affects their decisions about current dividend payments, then changes in dividends will convey management’s ‘inside’ information about future cash flows to the market. Thus, the announcement of change in dividends provides the occasion for a change in share price, but is not the cause of the change in share price.

Evidence suggests share price changes around the time of the announcement of dividend changes are positively related to the change in the dividend.

DD argue that this supports the importance of payout policy—investors value securities only for the payouts they are expected to provide. Therefore, it is logical that a higher share price follows the announcement of higher payouts.

Agency Costs & Corporate Governance

Agency costs can be reduced by paying higher dividends because there is:

• Greater accountability – higher dividend force the company to raise capital externally, which requires the provision of information to investors, potential investors, underwriters, and others, who are allowed to scrutinise the company at a relatively low cost, so it increases the provision of information, increases accountability to the market, increases monitoring of managers. Managers are more likely to act in the interests of shareholders.
• Avoid overinvestment – where firms have free cash flows (FCF) managers may retain cash and overinvest to increase the size of the company and, hence, increase their power and remuneration. New projects may have negative NPVs, thus, reducing shareholder wealth. This argument is particularly relevant to mature firms with fewer investment opportunities; shareholders are better off if management pays out the FCFs as dividends.

Lie (2000) and Grullon, Michaely and Swaminathan (2002) provide empirical evidence that increased payouts signal a reduced opportunity to overinvest, and that firms with excess cash relative to industry norms who do pay out have positive excess returns – the market welcomes payouts because of the belief that managers cannot be relied upon to invest retained funds profitably, and firms with limited investment opportunities exhibit a bigger abnormal return to the announcement of such initiatives.

Types of Payout Policies

Three payout policies that might be adopted are:

• Residual dividend policy – pay out as dividends any profit that management does not believe can be invested profitably (no fixed pay out percentage is set)
• Stable (Progressive) dividend policy – a target proportion of annual profit to be paid out as dividends, e.g. if profit in Yr 1 is $10m & target is 10%, dividends paid = $1m, if profit in Yr 2 is $20m (and this is a sustainable increase in profit) and target is 10%, dividends paid = $2m, if profit in Yr 2 is $20m but this is not sustainable, then target may drop to 5%, dividends paid = $1m; dividends are related to the long-run difference between expected profits and expected investment needs; dividend per share will increase if an increase in profits is sustainable, but not if increase in profit is temporary; if profits fall, generally, dividend per share is maintained.
• Constant payout policy – dividend payout ratio remains constant (so in the example above the dividend paid in Yr 2 would always be $2m, regardless of whether the increase in profits is permanent or temporary).

Dividends Are Sticky

Empirical evidence (e.g. Lintner (1956), Brav, Graham, Harvey, & Michaely (2005)) finds that most managers are reluctant to make changes in dividends that are likely to have to be reversed in the future.

Sticky – maintaining current level of dividend per share (DPS) is of high priority, as is not cutting DPS (external funds will be raised to finance investments rather than cutting DPS).

Inflexible – managers do not see much reward in increasing DPS; it does happen, but only after investment and liquidity needs are met.

Smoothed – target proportion of annual profit to be paid out as dividends.

Managers prefer not to pay dividends – they would prefer share repurchases as a way of rewarding shareholders as repurchases are more flexible with no need for smoothing, and repurchase decisions are made after investment decisions, so use residual cash flows.

References

• Peirson, G., Brown, R., Easton, S. A., Howard, P., & Pinder, S. (2015). Business finance (Twelfth edition). McGraw-Hill Education.
• Ross, S. A., Trayler, R., Hambusch, G., Koh, C., Glover, K., Westerfield, R., & Jordan, B. (2021). Fundamentals of corporate finance (Eighth edition.). McGraw-Hill Education (Australia) Pty Limited.
• Parrino, R., Au Yong, H. H., Dempsey, M. J., Ekanayake, S., Kidwell, D. S., Kofoed, J., Morkel-Kingsbury, N., & Murray, J. (2014). Fundamentals of corporate finance (Second edition.). John Wiley and Sons Australia, Ltd.