16/05/2021

FIN222 Lecture 10
Dividend Policy
Chapter 17

Recording 1: Dividend and Share Repurchase

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Week 12 Homework is Due.

• Week 12 Homework is due by the start time of
your tutorial in Week 12.

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Lecture 10 Chapters Lecture 11 Chapters

• 17.1 Chapter 20
• 17.2 • 20.1
Alternative 1 • 20.2
Alternative 2 Chapter 21
• 17.3
• 17.5
• 17.6
• 17.7
Valuation and franking
credits: The theory
Adjusting cost of capital
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Learning Outcome 6
• Explain capital structure and dividend policy
and their impact on the value of a company.
What did you learn last week?
MM I MMI with tax Real world
v V -Trade-off theory
V
=D*Tc

D/V D/V Optimum

MM2 D/V
r rE VL=VU+D*Tc
- Pecking Order Theory
rU rWACC Internal funds > debt > equity

D/E

Notations
• Pcum Cum-dividend share price
• Pex Ex-dividend share price
• Prep Share price with share repurchase
• FF divs Fully franked dividends
• PF divs Partially franked dividends
• UF divs Unfranked dividends
• Tc Corporate tax rate
• T Effective corporate tax rate
•𝛾 the proportion of franking credits shareholders can
utilise
• DPS Dividend Per Share
• DRP Dividend Reinvestment Plan

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CASH DISTRIBUTIONS TO SHAREHOLDERS

• Payout policy
– The way a firm chooses between the alternative ways to pay cash
out to shareholders.

Net Profit After Tax

% determined by
Payout ratio which is
% determined by
DPS/EPS
Retention rate =
1- Payout ratio

Dividends
• Regular cash dividends
– Dividends are paid twice a year in Australia
• Interim dividend & Final dividend
• Special dividend
– A one-off dividend payment a firm makes that
is usually much larger than a regular dividend
Eg) distribute excess cash from operation, sale
of a major asset or business
Eg) as a way to alter a company’s capital
structure Return of capital
• Liquidating dividend (= ___________)
– The final dividend that is paid to stockholders
when a firm is liquidated

Dividends – Important dates

WOW 2020 dividend dates The last date you can purchase a share
With dividends.
Board
Vote Declaration
date
The first date on which a stock
Cum-dividend period Trades without dividends

Record date _______

Ex-dividend date
:One business day before Ex-dividend period
the record date
Payable
date
• Investors who purchase shares during cum-dividend
period will be entitled to receive the dividend
• Record date (=Books closing date)
A company closes its share register to determine which shareholders
are entitled to receive the current dividends.

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Share Repurchases (=buyback)

• An alternative way to pay cash to investors
• The firm uses cash to buy some of its outstanding
shares.
Open market repurchase
• Most common way a firm repurchase shares
• A firm announces its intention to buy its own shares
on the open market
Off-market buyback
• A firm invites its shareholders to offer to sell their
shares back to the firm by way of a tender process.
– Equal-access buy-backs: A firm offers to buy the same
proportion of each shareholder’s shares.
– Selective buyback: A firm offers to repurchase shares
directly from only one or some of its shareholders.

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SHARE REPURCHASES
1. Does not represent a pro-rata distribution of
value to the shareholders because not all
shareholders participate
2. When a company repurchases its own shares,
it removes them from circulation.
 __________ number of shares outstanding by
the number of shares repurchased.
3. Share repurchases are taxed differently than
dividends.
More to come…

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DIVIDENDS VS SHARE REPURCHASES

IN A PERFECT MARKET
• Assume FIN222 Ltd has $20 million in excess cash.
• The firm has no debt and 10 million shares outstanding with a
current market price of $42.
IMPACT ON Dividends Share Repurchase
DPS = Number of shares to be
repurchased=
(20 mil) / $42 = 476,190.48
Market Value
of the firm
Number of Reduced by 476,190.48to
shares
10mil – 476,190.48=9,523,809.52
_____________________
Price Price to decrease by _______ Prep = 400𝑚𝑖𝑙
= $42
Pex=_____________ 9,523,809.52

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DIVIDENDS VS SHARE REPURCHASES

IN A PERFECT MARKET
• Would you prefer FIN222 Ltd to pay a dividend
or repurchase its stock?
– Assume you hold 2000 shares of FIN222 stock.
– The investor’s holdings after a dividend or share
repurchase are:

Dividend Repurchase
In Cash $2*2000=$4,000
0
In Shares
$40*2000=$80,000 $42*2000=$84,000

TOTAL $84,000 $84,000

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Question arises…
• What if the firm repurchases shares but investor
wants cash?
– The investor could SELL shares to raise cash
(known as homemade dividend).
– To raise $2*2000 =$4000, how many shares
would you have to sell?
________________________
95
Repurchase + Sell ____Shares
In Cash $42 x 95= $3990
In Shares $42 x (2000-95)= $80,010
TOTAL $84,000

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Question arises…
• What if the firm pays a dividend and you do not want
cash?
– You could use the dividend to purchase additional
shares.
– How many shares can you buy with the total
dividend of $4000? ________________________

100
Dividend + Buy ____Shares
In Cash 0
In Shares $40 x (2000+100)= $84,000
TOTAL $84,000

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Question arises…
• In either case, your portfolio is worth $84,000.
• In perfect capital markets, investors are
indifferent between the firm distributing funds
via dividends or share repurchases.
• By reinvesting dividends or selling shares, they
can replicate either payout method on their
own.
• You’ve just learnt
MM dividend irrelevance:
In perfect capital market, holding fixed the investment
policy, the firm’s choice of dividend policy is irrelevant
and does not affect the initial share price.

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Recording 2: The impact of Tax on Dividends and

Share Repurchases

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DIVIDENDS AND TAXATIONS

• Australia moved from a classical tax system to
an imputation tax system on 1 July 1987.
• Under a classical tax system, a company’s profits
were first taxed at the company tax rate, and
dividends paid from the profits were taxed again
in the hands of the shareholders at the investor’s
marginal personal tax rate.
• The imputation tax system eliminated this
double taxation system.

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Corporate level Classsical Imputation Imputation

(45% personal tax) (45% personal tax) (19% personal tax)

Net Profit Before Tax $1.00 $1.00 $1.00

Corporate Tax (30%) 0.30 0.30 0.30

Net Profit After Tax 0.70 0.70 0.70

Shareholder
level
Cash dividends 0.70 0.70 0.70

Gross-up adjustment NA +0.30 +0.30

Grossed-up dividends NA 1.00 1.00

Personal tax 0.315 -0.45 -0.19

Franking credit NA +0.30 +0.30

Tax Payable 0.315 -0.15 +0.11 (Tax refund)

Dividends after taxes 0.385 0.55 0.81

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Under the Imputation Tax System

• The imputation tax system effectively eliminates the
double taxation for Australian recipient of franked
dividends.
The amount of corporate tax prepaid
– Franking credits (=________________________________)
attached to franked dividends can be used to reduce
investors’ personal tax liabilities
• Australian shareholders with a personal tax rate
above the corporate rate will only pay the difference
between their marginal tax rate and the corporate
tax rate.
• Australian shareholders with a personal tax rate
lower than the corporate rate will have a surplus
credit which can be used to offset their tax on other
income.
– If there is no other income against which surplus credits
can be offset, surplus credits will be refunded by the
Australia Taxation Office (ATO)

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FF, PF and UF
• Dividends can be fully franked (FF), partially
franked (PF) or unfranked (UF) depending on
whether dividends are paid from profits fully
taxed, partially taxed or untaxed.
1. FF divs: The franking proportion is 100% .
• Dividends are paid out of profits which have been
taxed at the full Australian corporate tax rate (Tc) of
30%.
2. UF divs: The franking proportion is 0%.
• Dividends are paid out of profits which have been
untaxed (i.e. profits not subject to the Australian
corporate tax rate such as foreign sourced income).
3. PF divs: The franking proportion is less than 100%.
When there is a mixture of fully franked dividends and
unfranked dividends.
• Companies may not need to pay tax at 30% due to
various tax deductions including losses made in all
previous years.
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Grossed-up dividend
& Franking credit calculation
Dividend
𝐺𝑟𝑜𝑠𝑠𝑒𝑑_𝑢𝑝 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 =
1 − Corporate tax rate
= 𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 + 𝑓𝑟𝑎𝑛𝑘𝑖𝑛𝑔 𝑐𝑟𝑒𝑑𝑖𝑡
= Face value of dividends

𝐹𝑟𝑎𝑛𝑘𝑖𝑛𝑔 𝐶𝑟𝑒𝑑𝑖𝑡(= 𝐼𝑚𝑝𝑢𝑡𝑎𝑡𝑖𝑜𝑛 𝐶𝑟𝑒𝑑𝑖𝑡)

= Grossed_up dividend X Corporate tax rate
= Grossed up dividend – cash dividend
In Australia, a $1 cash dividend is worth
$1 = $1 𝑐𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
= $1.4286
1 − 0.3 + $0.4286 franking credits
$ $
𝑁𝑜𝑡𝑒: $0.4286 = *0.3 or - $1
. .

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How do we incorporate the value of franking credits into firm

valuation?
• The two main components of the model are
free cash flows and the weighted average cost
of capital (WACC).
• To capture the impact of dividend imputation
on firm value, we should adjust the WACC
down or free cash flow up in the present value
calculation.

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Adjusting the cost of capital

• In a 1994 study, Officer shows that for valuation

purposes the cost of equity (rE) should be
adjusted by a factor equal to

where T represents the effective corporate tax

rate and gamma (𝛾) represents the proportion of
tax collected from the firm that will be rebated
against personal tax in the hands of shareholders

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Adjusting the cost of capital

• 𝛾 = 0,
𝑟 = 𝑟 𝐸% + 𝑟 1 − 𝑇 𝐷%
• 𝛾 = 1,
𝑟 = 𝑟 (1 − 𝑇)𝐸% + 𝑟 1 − 𝑇 𝐷%

• The impact of imputation - a reduction in cost of equity

– Shareholders willing to accept a lower cost of equity in
recognition of the benefit of franking credits or
– The return required by shareholders remain unchanged. Rather
the government funds a portion reducing the cost of equity to
the firm.

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Adjusting the cost of capital

FIN222 Ltd
• Debt, MV=BV=200mil
• FCF = 114 mil perpetuity
• No growth expected
• Expected dividend to shareholders = 100 mil
• Pre-tax rD=10%
• rE=15%
• Tc=30%
Under a classical tax system,
$100 𝑚𝑖𝑙
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝐸 = = $667 𝑚𝑖𝑙𝑙𝑜𝑛
0.15

𝑉 = 𝐷 + 𝐸 = 200𝑚𝑖𝑙 + 667 𝑚𝑖𝑙 = 867 𝑚𝑖𝑙

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Adjusting the cost of capital

𝑟 = 𝑟 𝐸% + 𝑟 1 − 𝑇 𝐷%

• Now consider the value of FIN222 Ltd under an

imputation tax system where all of its shareholders can
fully utilize the franking credits to offset their personal
tax.
• In this case, 𝛾 = 1, so that cost of equity is reduced by

• The adjusted cost of equity is 15%*0.7 = 10.5%

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Adjusting the cost of capital

𝑉 = 𝐷 + 𝐸 = 200𝑚𝑖𝑙 + 952 𝑚𝑖𝑙 = 1152 𝑚𝑖𝑙

𝐹𝐶𝐹 $114 𝑚𝑖𝑙

𝑉= = = $1152 𝑚𝑖𝑙𝑙𝑜𝑛
𝑊𝐴𝐶𝐶 0.0989

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SHARE REPURCHASE AND TAXATION

Taxation of Capital Gains
• When a shareholder sells a share at a higher
price than that at which they purchased the
share, the gain is subject to tax.
• If shares were purchased after September 1999
and held for one year or more
– Shareholders can reduce their capital gain by 50%
before tax is applied.
• If held for less than one year
– No adjustments apply.
– The full capital gains are to be taxed.

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SHARE REPURCHASE AND TAXATION

Taxation of Capital Gains

=50% of Gain on sale of share

=Taxable component* tax rate
=Gain on sale – Capital gains tax

=Taxable component* tax rate

=Gain on sale – Capital gains tax

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Share repurchase structured as dividends

• In Australia, off-market equal access share
buybacks can be structured such that some
portion of the repurchase price is designated as
a dividend and the remainder a capital
component.
o Dividend component subject to income tax
o Capital component subject to capital gains tax
o Dividend component can be franked therefore
making distribution of franking credits possible.
• On-market buybacks
- The price cannot include a dividend component.
- The whole amount paid to shareholders is treated as
proceeds from the sale of shares.
- Therefore shareholders are subject to capital gains tax

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Recording 3: Signalling, DRP and Bonus Issues

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SIGNALLING WITH PAYOUT POLICY

• What would be the impact of dividend policy on firm
value under the presence of asymmetric information?
– When managers have better information than
investors regarding the future prospects of the firm,
their payout decisions may signal this information.
– How would this affect the behaviour of dividend
payment?
Dividend Smoothing
• The practice of maintaining relatively
constant dividends.
• Firms raise their dividends only when they
perceive a long-term sustainable increase in the
expected level of future earnings, and cut them
only as a last resort.

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SIGNALLING WITH PAYOUT POLICY

Dividend signalling
• The idea that dividend changes reflect managers’
views about a firm’s future earnings prospects.
– When a firm _____ its dividend, it sends a positive signal
to investors that management expects to be able to
afford the higher dividend for the foreseeable future.
– When managers cut the dividend, it may signal that
they have given up hope that earnings will rebound in
the near term and so need to reduce the dividend to
save cash.
– Changes in dividends should be viewed in the context of
the type of new information managers are likely to have:
• An increase of a firm’s dividend may be signal of lack of
profitable investment opportunities.
• A firm might cut its dividend to exploit new positive-NPV
investment opportunities.  taken as positive news

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SIGNALLING WITH PAYOUT POLICY

Signalling and share repurchases
• Share repurchases are a credible signal that
the shares are _____________, because if they
are over-priced a share repurchase is costly
for current shareholders.
• If investors believe that managers have better
information regarding the firm’s prospects
and act on behalf of current shareholders,
then investors will react _____________to share
repurchase announcements.

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DIVIDEND REINVESTMENT PLANS

• Shareholders receiving dividends often have to pay
transaction costs if they want to reinvest the dividends.
• To eliminate this cost, some companies offer Dividend
Reinvestment Plan (DRP). What is it?
• Shareholders choose to reinvest their dividends. Firms
issue new shares instead as a form of payment.
• Shareholders receive new shares without paying
brokerage and other transaction costs.
• Shares often issued at a price discount to the market
price.
• BUT shareholders still be liable for income tax in the
same way that they would have if they had received
dividends
• Allows companies to retain cash to fund investments.
• Allows companies to distribute franking credits.

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BONUS ISSUES
• The issue of free shares to existing shareholders,
usually in proportion to the number of shares held
by a shareholder.
• The value of the assets in a company does not
change with a bonus issue.
• After Bonus issues?
Price ______, number of shares outstanding _______
MVasset=$11,000 MVasset=$11,000
10% bonus issue
10,000 shares 11,000 shares
Vshare=$1.1 Vshare=$1
VFirm=10,000X1.1 VFirm =11,000X1
=11,000 =11,000
• Lower share price can improve the affordability,
therefore ________demand.
• Bonus issue can signal better prospects ahead.

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Recording 4: Capital Market Efficiency

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Page 305
Capital Market Efficiency
Capital Market
maximise MV of shares
information

WCM decision Investors

-How to manage WC

Investment decision
-Where to invest $PSHARE
Financing decision
-How to finance
Distribution decision
-How to distribute

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Capital Market Efficiency

• In an efficient capital market,
– Security prices fully reflect the knowledge and
expectations of all investors at a particular point in
time
– The more efficient a security market, the more likely
securities are to be priced at or near their true value
• True value: PV of CFs an investor can expect to
receive in the future
• PV in turn reflects all available information about
the size, timing and riskiness of the cash flows

PV = C
(1+r)n

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Efficient Market Hypothesis

• Weak-form Efficiency
– All PAST information is reflected in current prices.
– If market is “weak-form” efficient, it would be
impossible to earn abnormally high returns by
analysing past return
• Semi-Strong-form Efficiency
– All publicly available information is reflected in
security prices
– If market is “semi-strong-form” efficient, as soon as
information becomes public, it should be quickly
reflected in stock prices through trading activity.
– AND it would be impossible to earn abnormally high
returns based on publicly available information

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Efficient Market Hypothesis

• Strong-form Efficiency
– All information, whether public or private, is reflected
in security prices
– If market is “strong-form efficient”, it would not be
possible to earn abnormally high returns by trading
on private (inside) information about a company
– In real world, insiders do make a profit by trading on
private information.
– Concept of strong-form-market efficiency is rather
ideal.

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Summary
• Can you define the following terms?
– Cum-dividend period
– Ex-dividend date
– Record date
– Franking credits
– Fully franked dividends
– Partially franked dividends
– Unfranked dividends
– Dividend reinvestment plan
– Dividend smoothing
– Dividend signalling hypothesis
– Bonus issue

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Summary
• Can you describe the difference between classical
tax system and imputation tax system using a
numerical example?
• Can you calculate grossed-up dividends and the
amount of franking credits?
• What is a share repurchase(=buyback)?
• Can you explain the differences between dividends
and share buy-backs using measures such as price,
number of shares?
• How are dividends and capital gains taxed in
Australia?
• Can you explain the difference between off-market
share repurchase and on-market share repurchase
in terms of
– The composition of a company’s purchase price
– Participating investors’ tax treatment

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Summary
• Can you describe MM dividend irrelevance
proposition?
• Can you discuss signalling hypothesis associated
with dividends and share repurchase?
• Why do companies practice dividend
reinvestment plan or bonus issues?
• Can you calculate the WACC and firm value
under the imputation tax system?

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