What are the mechanics of dividend payments?

Questions to be Considered:

• What are the mechanics of dividend payments?
• What is dividend policy?
• In what circumstances would dividend policy be irrelevant?
• In what circumstances would dividend policy be important?
• What are the effects of dividend imputation on returns to investors?
• What are the factors influencing dividend policy in Australia?

1. The Payment of Cash Dividends

As we have noted previously, in theory the value of a share at a point in time is simply the sum of the discounted expected future dividends associated with the share.

Under current Australian law, companies can pay out cash dividends up to the value of their net assets, i.e. up to the excess of assets over liabilities. (Previously cash dividends could only be paid out of current or retained earnings) Companies commonly pay dividends semi-annually.
With respect to the payment of a dividend, there are several important dates:

• Date the dividend is declared by the firm directors: on this date the total amount of dividends to be paid is transferred from the retained earnings account to the dividends payable account.

• Date of record: Only listed shareholders on the register of shareholders on the date of record (set by directors) are entitled to receive a declared dividend.

• Ex-dividend date: The ex-dividend date is usually four business days before the date of record. On this date the share register is closed and the shares start trading ex-dividend, i.e. purchasers of shares on or after the ex-dividend date are not entitled to the currently declared dividend payment.

• 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.

Empirically this seems to be true.
On 7 June 2013 the directors of the Rainforest Woodchip Company declare a dividend of $1 per share to be paid on Friday 19 July 2013, with a date of record of Friday 21 June 2013. Just before the date of declaration of the dividend, the firm had 60,000 shares on issue, a cash balance of $300,000, retained earnings of $500,000 and no dividends payable. Determine the ex-dividend date and show the changes in the firms accounts associated with declaration and payment of the dividend. (Ex-dividend date: Monday 17 June 2013)

Counting back four business days prior to Friday 21 June, or 5 business days before the date of record, including the date of record, we find an ex-dividend date of Monday 17 June. (This should be illustrated on a timeline)

Just before declaration of the dividend:

Cash 300,000 Dividends Payable
Retained Earnings 0

After declaration of the dividend:

Cash 300,000 Dividends Payable
Retained Earnings 60,000

After payment of the dividend:

Cash 240,000 Dividends Payable
Retained Earnings 0

Thus the final effect of the dividend payment is to reduce total assets and retained earnings (shareholders equity) by $60,000.

2. Dividend Reinvestment Plans

Under these plans, shareholders can choose to receive newly issued shares instead of the declared cash dividend, usually at a favourable price compared to the current market price.

A dividend reinvestment plan effectively acts as a system of retaining earnings, but instead of the retained earnings account balance increasing, the value of outstanding shares increases by the value of the dividends reinvested.

These are now popular in Australia since they reduce issue costs and also allow shareholders to benefit from imputation tax credits (covered later).

But there are some disadvantages to DRP’s, e.g. the possibility of excessive capital raising.

3. Forms of Dividend Policy

Dividend policy refers to the decision as to how much of a company’s profit should be paid out as dividends and, consequently, how much should be retained.

This essentially boils down to whether investors prefer dividends to capital gains.
Consider the constant growth share valuation model:

If is increased, this by itself increases , but at the same time an increase in leaves less money for reinvestment (assuming the firm faces some capital rationing), thus decreasing g, i.e. there are two opposing effects. The aim would be to balance these effects to maximize .

The text lists a number of legal, contractural and firm specific factors that should be considered when formulating dividend policy. Students should familiarize themselves with these factors.

A major consideration is that shareholders seem to dislike volatility in dividends. Indeed it has been observed that companies tend to ‘smooth’ dividends relative to profit.

Managers seem to prefer stability in dividend payouts in the face of fluctuations in profits that are considered temporary.

So it seems managers certainly think dividend policy is important.

Various types of dividend policy have been identified.

(i) A residual dividend policy is followed if a firm pays out as dividends any profit that management believes cannot be reinvested profitably.

The idea is that the firm should pay out as dividends any earnings that cannot be retained and invested in projects that would yield a return for shareholders at least as great as the return they could obtain on similar risk investments elsewhere.

The text describes implementation of a residual dividend policy as a 3-step procedure:
• Step 1: Determine the desired total level of capital expenditure (i.e. for the next period).
• Step 2: Based on the firm’s desired mix of financing (or optimal capital structure) and capital expenditure, determine the required amount of equity financing.
• Step 3: As retained earnings are a lower cost form of equity financing than new equity issues, they should be used to meet the equity financing requirement determined in Step 2: any shortfall is made up by new equity issues, and any excess is paid out as dividends.

(See numerical example of residual dividend policy given in text)

(ii) A constant payout ratio policy involves paying a constant percentage of earnings each period as dividends.

In this case, if earnings are volatile, dividends will also be volatile.

(iii) A regular dividend policy involves payment of a fixed dollar amount of dividends each period, at least until increased earnings can be reliably predicted.

(iv) A low-regular-and-extra dividend policy involves payment of a relatively low dividend each period that is augmented by an extra dividend if higher temporary earnings are experienced.

Firms that experience significant swings in earnings over the business cycle are more likely to follow such a policy.

4. Other Forms of ‘Dividends’

(i) Share Dividends (Bonus Share Issues)

A share dividend involves the issue of new shares to shareholders instead of dividends. In theory a share dividend should not result in a change in the value of shares held by a shareholder, but merely a transfer from retained earnings to share capital.

Suppose the ABC Company’s shareholders’ equity account currently is as follows (in dollars):

Ordinary share capital
(50,000 shares at $50)

Retained earnings 2,500,000
Total shareholders’ equity 3,100,000
If the company declares a 5% share dividend (1 bonus ordinary share for every 20 shares held) and the current market price of the shares is $60, the resulting amount of retained earnings to be transferred to ordinary share capital will be

The resulting shareholders’ equity account will be (in dollars):

Ordinary share capital
(50,000 shares at $50 plus 2,500 shares at $60)

Retained earnings 2,650,000

Total shareholders’ equity 3,100,000

Q. After the bonus issue in the above example, what would the market price of ordinary shares be expected to change to (assuming no increase in earnings is expected)? ($57.14)

This is based on the assumption that the total market value of the firm’s ordinary shares does not change as a result of the bonus issue.

Share dividends, however, may serve as a signal of confidence in future growth of the firm.
(ii) Share Splits

A share split results in a greater number of shares being held by each existing shareholder, but in theory no change in the value of shares held need occur.

For example, a 2 for 1 share split results in each share holder receiving two new shares for each existing share held. In this case:
• The recorded par value of shares would be halved.
• The number of shares on issue would be doubled.

After a share split, the total market value of the firm’s shares could be unchanged, although sometimes it may increase if the share split is considered to signal good news.

(iii) Share Buybacks

Share buybacks involve a company repurchasing (and cancelling) its own shares: the repurchased shares cannot be reissued subsequently. (The text explains the various methods of buying back shares)

A share buyback can be viewed as an alternative way of paying cash dividends. It normally results in a change in the firm’s capital structure and an increase in earnings per share.

Share buybacks can act as:
• A signal that the managers of the firm believe the firm’s shares are undervalued.
• A strategy to discourage an unfriendly takeover.

5. Miller and Modigliani’s (1961) Dividend Irrelevance Theory

Miller and Modigliani (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.

MM showed dividend irrelevance under the following assumptions:
• neither personal nor company income taxes are levied
• no share issue/flotation costs or other transaction costs

These assumptions mean we have no capital market imperfections (if we also assume a perfectly competitive capital market).

• investors are indifferent between dividends and capital gains
• the firm has a fixed capital investment program that is independent from dividend policy
• both investors and managers have the same information regarding future investment opportunities

MM argued that a firm’s value depends on its earning power and risk class, not the split between dividends and retained earnings.

Under the above assumptions, MM showed that an increase in a dividend payout would necessitate the raising of additional new capital of the same amount to replace the cash paid out. This will not change the value of the company, and the wealth of existing shareholders will be unchanged because the value of their shares falls by an amount equal to the cash paid to them.

Suppose that in a given year a large company’s capital budget requires $50 million of equity financing and that earnings of $70 million are expected. Assume the MM assumptions hold and that the firm has no retained earnings from previous periods.

(i) How much can the company pay out in dividends without having to issue new shares? ($20 million)

Simply, million

(ii) By how much will existing shareholders’ wealth increase if the maximum amount of dividends is paid out without having to issue new capital? ($70 million)

Dividend + capital gain million

Here the capital gain represents an increase in the value of the firm’s assets of the same amount as the internal equity financing.

(iii) By how much will existing shareholders’ wealth increase if all earnings are paid out as dividends and the equity financing needed is met by issuing new shares? ($70 million)

In this case, there is no capital gain for the existing shareholders, but they simply receive $70 million in dividends.

The value of the firm’s assets financed by equity again increases by $50 million, but this represents wealth of the new shareholders.

Similarly, if the firm pays out $40 million in dividends, retains $30 million and raises $20 million from a new share issue, the wealth of old shareholders will again increase by $70 million ($40 million in dividends +$30 million in capital gains).

In essence, if new shares are issued to meet capital budgeting requirements, future dividends going to the new shareholders will be equal in PV to the increase in dividends to existing shareholders ($20m in the above example).

A residual dividend payout policy is consistent with dividend policy irrelevance, as in this case dividends are not viewed as a decision variable that can affect firm value.

Dividend Irrelevance Theory can also be Consistent with:

• Share price changes associated with the ‘signaling’ effects of dividend changes.

There is some empirical evidence that dividend changes tend to be associated with changes in share price. Miller and Modigliani suggested this was due to the information (‘signaling’) effects of dividends, not a causal relationship between dividend payout ratios and share value.

For example, an increased dividend payout ratio can be used to signal future prospects, leading to an increase in share price. If the market were aware of the future profits, the share price would increase anyway.

• The existence of dividend clienteles

(Of course this contradicts the assumption of shareholder indifference between dividends and capital gains, although overall there may be no particular preference one way or the other)

Companies may tend to attract investors (clienteles) that prefer their particular dividend policies: for example, higher dividends to investors requiring high current income. However, provided ‘supply’ and ‘demand’ for particular dividend policies are equal, dividend policy need not affect share value, in so far as investors simply get what they expect.

But, in this case, changes to dividend policy will annoy some investors, who in turn will face transaction costs if they wish to switch investments.

If there were an undersupply of high dividend policy firms, those offering a higher dividend payout rate would command a premium for their shares.

This is an argument for stable dividend policy.

6. Dividend Relevance Theory

The dividend irrelevance result will not hold if any of the specific assumptions are not satisfied. Two major possibilities are that (1) investors (as a whole) are not indifferent between dividends and capital gains, and (2) there may by capital market imperfections, in particular there are usually taxes.

Various rationales for dividend relevance are considered below.

(i) The ‘bird in the hand’ argument

This states that the required return on shares increases (and the value of the firm decreases) as the dividend payout is reduced because investors consider expected future capital gains more risky than dividends in the near future.

(Can omit the following if desired)
Using the constant growth share valuation model:
The bird-in-the-hand argument is that is considered less risky by shareholders than g.

The bird-in-the-hand argument is considered by many to be fallacious since, given that a firm’s investment decisions are unchanged by dividend policy, the risk of a firm (and hence its value) is determined by the riskiness of future cash flows from its assets, not by its dividend payout policy.

(ii) Preference for retained earnings under a classical tax system

Differences in the taxation of dividends and capital gains can lead to a shareholder preference for retained profits over payment of dividends, in particular in a classical tax system where there is no dividend imputation.

Thus under a classical tax system the payment of dividends is penalized relative to capital gains because company profits and dividends are taxed separately. Thus any profits are taxed twice.

Suppose an investor pays a marginal tax rate of 45% and taxes on capital gains are 30%. In this case, the investor benefits in two ways from higher retained profits:
• The investor pays less tax on capital gains stemming from retained profits.
• Since tax on a capital gain is only paid when the gain is realized, the investor can defer realization of the gain to defer payment of the tax. Given the time value of money, this provides a further gain to the shareholder.

We can compare the dividend irrelevance and relevance theories diagrammatically.

Share Price


MM Irrelevance
Tax preference: e.g. classical system

0 50 100
Dividend payout ratio (%)

Cost of equity

Tax preference: e.g. classical system

MM Irrelevance

0 50 100
Dividend payout ratio (%)

(iii) The dividend imputation tax system

This system has operated in Australia since 1987.

Under this system, Australian resident shareholders (including superannuation funds) can receive franked dividends to which tax (imputation) credits are associated.

The tax credits represent company tax payments (on income taxed in Australia) made before distribution of the dividends.

The amount of the imputation tax credit available to a resident shareholder is in general given by

Tax credit

• cash dividend = total cash dividends received
• corporate tax rate
• franking ratio = proportion of dividends that are franked

(Partially franked dividends arise from company income from foreign sources that has not been subject to Australian tax)

To derive the tax credit formula note firstly that the before company tax dividend satisfies

Multiplying this by gives the imputation tax credit if dividends are fully franked.

If the franking ratio is less than one, the imputation tax credit is then given by

The shareholder’s taxable income from receiving franked dividends is then given by (the ‘grossed up’ dividend), i.e.

(If the franking ratio is 1, the grossed up dividend reduces to )
The tax assessed is then found by multiplying this by the shareholder’s applicable marginal rate of income tax. The tax payable is found by subtracting the imputation tax credit from the tax assessed.

The imputation credit can be used to offset other tax liabilities, otherwise it is refunded.

• If shareholder’s marginal tax rate , fully franked (not grossed up) dividends to an Australian resident investor are effectively tax free
• If shareholder’s marginal tax rate , excess tax credits will be available to the shareholder to reduce tax on other income or be refunded
• If shareholder’s marginal tax rate , the investor will have to pay some tax out of the franked dividend received

(Unfranked dividends are taxed at the investor’s marginal rate)

Suppose a company pays out fully franked dividends of $70 each to investors with marginal tax rates of 19%, 32.5% and 45%. The statutory company tax rate is 30%. How much tax will each investor pay on his/her franked dividend? (-$11, $2.50, $15)

The imputation credit for each investor

Therefore, grossed up dividend

• For 19% marginal tax rate

Gross tax on grossed-up dividend income

Net tax payable on dividend income

This negative net tax can be used to offset other tax payable by the individual or be refunded.

In effect the investor would not pay any tax out of the franked dividend and would still have some tax credit left over.

• For 32.5% marginal tax rate

Gross tax on grossed-up dividend income

Net tax payable on dividend income

This will always be the case if the investor’s marginal tax rate equals the company tax rate.

• For 45% marginal tax rate

Net tax payable on dividend income

The particular tax circumstances of individuals will determine whether shareholders prefer franked dividends to retained earnings, however dividend imputation is felt to largely remove the bias towards retained earnings that exists in a classical tax system.

In particular, superannuation funds in Australia, which pay an earnings tax of only 15%, tend to prefer pay out of the maximum franked dividend possible.

However, only about 20% of shares listed on the ASX are owned by resident individuals or superannuation funds that can take advantage of imputation credits.

We can also note that intercompany dividend payments are tax free in Australia, and this was the case even before dividend imputation was introduced.

Q.: Give one tax-related reason why the shareholder could prefer retention of profits to dividends in the context of dividend imputation.

A.: Capital gains tax can be deferred till sale of the shares, thus there could still be an advantage in terms of the time value of money.

• Purchasers of shares on or after the ex-dividend date are not entitled to receive the currently declared dividend.
• There are several forms of dividend policy: residual, constant payout ratio, regular, and low-regular-and-extra dividend policies.
• Dividend policy irrelevance can be demonstrated under a number of restrictive assumptions that are not satisfied in reality (e.g. no taxes).
• Under a classical tax system there is a tendency for shareholders to prefer retained earnings to dividend distribution: it is believed this bias towards retained earnings is largely removed under a system of dividend imputation.
• Under dividend imputation, resident shareholders in domestic companies can benefit from tax credits representing company tax paid before distribution of dividends.

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