Chapter 11

Payout policy
Solutions to questions

1. (a) Ex-dividend date: the date on which shares are first quoted on an ex-dividend basis
that is, buyers on and after that date will not be entitled to receive the coming
dividend.
(b) Franked dividend: a dividend that carries a credit for income tax paid by the
company.
(c) Dividend reinvestment plan: a plan that allows shareholders to use their cash
dividends to purchase additional newly-issued shares.
(d) Dividend drop-off ratio: the ratio of the change in share price (price drop-off) on
the ex-dividend date to the amount of the dividend (which could include any franking
credit associated with the dividend).
(e) Overseas dividend plan: a plan that allows non-resident shareholders to receive their
dividend in one or more forms other than the cash dividend paid to resident
shareholders.
(f) Franking account: an account kept by each company that contains details of the
income tax paid by a company, and of the franking credits it has distributed.
(g) Free cash flow: cash flow in excess of that needed to fund all available projects that
have positive net present values.
(h) Full payout policy: a policy of distributing the full present value of free cash flows to
shareholders.
(i) Progressive dividend policy: a policy where the aim is to steadily increase dividends
over time as profits increase. In the event of a fall in profit the dividend would be
maintained rather than reduced.

2. A full payout policy is advocated by De Angelo and De Angelo, because shareholders

wealth will be reduced if part of a companys free cash flow is retained.

3. We agree with the statement (which is fundamental to the De Angelo and De Angelo
argument that companies should adopt a full payout policy). Any financial asset is valuable
only because of the future cash flows that it is expected to generate. In the case of shares,
the cash flows to shareholders consist of dividends, plus any cash paid out to repurchase
shares. As discussed in Section 11.1, there are some successful companies whose shares
have been valued highly, often for periods of several years, despite the absence of
dividends or other cash payments to shareholders. These companies are typically fast-
growing, and retain cash to invest in assets that are expected to generate more cash in the
future. However, De Angelo and De Angelo argue that in such cases, there must be an
expectation that eventually growth will slow and excess cash will be paid out.
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4. A companys investment value is defined as the present value of the free cash flows to
the company generated by the companys investments. Its distribution value is the
present value of the free cash flow paid out to shareholders. The distribution value
concept is important, because shareholders wealth can be reduced if all of the free cash
flow generated by a companys investments is not paid out to shareholders.

5. Dividend clienteles are likely to develop because a companys payout policy suits the tax
position and/or consumption needs of particular investors. The evidence on dividend
clienteles is mixed, but on balance, the evidence seems to support their existence. It is
suggested in the chapter that there are no long-term benefits attributable to the existence
of dividend clienteles.

6. (a) False
(b) False (Short-term capital gains are taxed at income tax rates, but long-term capital
gains are taxed at much lower rates.)
(c) False
(d) True
(e) True
(f) True

7. The validity of the statement depends critically on whether dividends are franked or
unfranked, whether investors realise capital gains before or after 12 months, and whether
investors are residents or non-residents. If dividends are franked, it is true that most
resident investors will pay a lower rate of tax on dividends than on capital gains.
However, if dividends are unfranked they will be taxed at the same rate as short-term
capital gains, while long-term capital gains will be taxed at much lower rates. This
suggests that resident investors will prefer that companies pay dividends only to the extent
they can be franked. If a company has additional cash to distribute, resident investors will
generally prefer that it be distributed via share buy-backs that allow investors to receive
returns as capital gains. Non-resident investors do not benefit directly from the dividend
imputation system, and they would generally prefer capital gains to dividends, even if
dividends were franked. This suggests a preference for low-dividend payout companies.
As a result, the existence of tax-induced clienteles, and hence a demand for shares in
companies with various dividend policies, is suggested.

8. (a) The demand for dividends would fall, and dividend payout ratios could be expected
to fall.
(b) As in part (a), dividend payout ratios should fall.
(c) Retention of profits would become more attractive and dividend payout ratios should
fall.
(d) Profits would be expected to fall, but dividends are likely to be maintained so that
payout ratios would increase.
(e) Dividends are likely to be increased, but the rate of increase would generally be lower
than the rate of increase in profits. Therefore, dividend payout ratios would fall.
(f) The higher costs of raising capital by issuing shares would make retention of profits
more attractive. Therefore, dividend payout ratios would be expected to fall.
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9. Simply maximising the payout of franked dividends may not be an optimal dividend policy
for all Australian companies. Companies should also pay attention to non-resident
investors who do not benefit directly from tax credits. The possibility of distributing
additional cash through buying back shares should also be considered. For other
companies, the amount of cash available for dividends may serve as a constraint on
payment of cash dividends, but any such constraint may be addressed by introducing a
dividend reinvestment plan.

10. This behaviour is consistent with the proposition that dividends are relevant. In particular,
the behaviour suggests that managers are reluctant to reduce dividends. Possible reasons
are the existence of dividend clienteles, the adverse information content of a reduction in
dividends, and the desire to transfer tax credits to shareholders as quickly as possible.

11. The existence of dividend clienteles and the information content of dividends provide
possible reasons for pursuing a stable dividend policy. If a companys dividends fluctuate
wildly, its shares may not appeal to any clientele of investors.

12. This statement points out that it would be less costly for a company to retain earnings
than to pay a dividend and then recover all or part of this amount by making a share issue.
There must, therefore, be some reason for such behaviour. The answer probably lies in a
perceived need by management to maintain a relatively stable dividend policy over time.
This perceived need may be explained by the existence of dividend clienteles and the
information content of dividends.

13. As explained in the chapter, the empirical evidence suggests that investors derive
information from an announcement of a change in dividends. In addition, a decrease in
dividends seems to have a greater effect on share price than an increase in dividends.
However, under the dividend imputation system, it is likely that the directors would adjust
the dividend per share in response to the balance available in the companys franking
account. Consequently, we might see greater fluctuations in dividend per share from year
to year. While the imputation system has been in operation for a considerable time, we are
not aware of any study that has provided evidence on whether the variability of dividends
has changed.

14. (a) The commitment to pay fully franked dividends on the preference shares may mean
that ordinary dividends will be partially franked or, possibly, unfranked.
(b) The company would probably pass the franking credits on to its own shareholders by
paying a higher franked dividend. Part of the dividend might be designated as
special to indicate that investors should not expect the higher dividend to be
permanent.
(c) Until the company returns to profitability, no more dividends should be paid because,
legally, dividends can be paid only from profits.
(d) A change in policy may be stimulated by the fact that the US investor will be unable
to use franking credits. To minimise the wasted tax credits, the company might issue
converting preference shares with an entitlement to fully franked dividends. The US
investor would be expected to sell their rights to the preference shares to Australian
resident investors.
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(e) The company could reduce its dividends to provide more internally generated funds
to finance the new mines. However, it is likely to be very difficult to convince
investors that the lower dividends do not reflect bad news. Therefore, dividends
might be maintained and funds raised by a share issue, and/or borrowing, to finance
the mines.

15. As discussed in Section 11.5, the findings of several studies including those by Watts
(1973), Benartzi, Michaely and Thaler (1997), De Angelo, De Angelo and Skinner (1996),
and Grullon, Michaely and Swaminathan (2002) support the conclusion reached by Allen
and Michaely that any signal conveyed by dividend decisions is not about future growth in
earnings or cash flows. Rather, changes in dividends appear to follow changes in profits
rather than providing new information about future profits. Other possible explanations
for the usual market responses to dividend announcements include:

Payment of dividends attracts institutional investors who will monitor a companys

performance and help to ensure that it remains well managed.

Increasing a companys dividend may signal that past increases in earnings are
expected to be maintained.

Increased cash payouts indicate that a company has become less risky, so investors will
discount expected future cash flows at a lower rate.

16. The maturity hypothesis discussed in Section 11.5 was put forward as an explanation for
the findings that changes in dividends are not significantly related to future profitability,
and that increases (decreases) in dividends are associated with decreases (increases) in
systematic risk. It proposes that higher dividends are often an important indicator of a
companys transition to a lower growth (mature) phase characterised by lower risk. The
reduction in risk can result in a significant decline in the companys cost of capital and,
therefore, an increase in share price despite the reduced growth prospects.

17. The ways in which the payment of dividends may reduce agency costs are discussed in
Section 11.6. Two main roles have been suggested. First, paying higher dividends will,
other things being equal, increase a companys need to raise capital externally, and the
capital-raising process provides the opportunity for investors and analysts to monitor a
companys use of resources at relatively low cost. Second, the payment of dividends can
reduce a companys free cash flows which might be wasted or invested unprofitably by
management.

18. As discussed in Section 11.6, the evidence from a study by Correia Da Silva, Goergen and
Renneboog (2004) is consistent with the view that control is a substitute for dividends as
a mechanism for monitoring management and reducing agency costs. For example, in
continental Europe, many companies are effectively controlled by a small number of
investors, each of which holds a large block of the companys shares. These blockholders
will closely monitor the actions of management, and the control they exercise should be
effective in ensuring that new investments by the company are expected to be profitable.
In other words, control by blockholders should prevent overinvestment. Conversely, when
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ownership is more diffuse and control by shareholders is limited, managers are likely to
find that a commitment to pay higher dividends is an effective way of avoiding
overinvestment.

19. In the Wall Street Journal article mentioned in the question, Liam Denning noted that a
letter signed by 31 members of the US Congress called for BP to suspend its dividends.
Presumably this call was based on the argument that continuing to pay dividends could
impair the companys capacity to meet the cost of cleaning up the oil spill and restoring
affected areas in the Gulf of Mexico. It may also have reflected the view that BPs
shareholders should forego dividends in order to contribute to the clean-up costs.

Denning pointed out that based on consensus estimates of BPs operating cash flow, the
company had the capacity to borrow to meet capital expenditure requirements, dividends
and estimated first-year clean-up costs without taking its gearing above the companys
target. He argued that cutting dividends would cause BPs share price to fall harming
shareholders and having real effects on the companys ability to fund its operations and
hence pay for the clean-up. Denning concluded that government interference in BPs
dividend policy was unnecessary and could be counterproductive.

In preparing an answer, students could use the MM dividend irrelevance theorem as a

starting point and recognise that, with the MM assumptions being violated, this question
raises many payout policy issues, namely:

Dividend clienteles. As one of the largest companies in the world with its shares
listed on the London and New York stock exchanges, BP has many shareholders
who are retirees and rely on its dividends as a source of income.

Transaction costs. If shareholders sell some of their BP shares to create

homemade dividends, they will incur transaction costs.

Free cash flow. De Angelo and De Angelo argue that if free cash flow is not paid
out a companys share price will be lower than it would be if the full payout
policy were followed.

Agency costs. If omitting dividends results in retention of free cash flow, resources
may be squandered by making unprofitable investments and/or allowing
inefficiencies to develop.

Signalling. Cutting dividends usually signals bad news, but is probably not
relevant in this case as the oil spill had already occurred, the company was under
intense scrutiny and any decision to cut dividends would probably be a response to
political pressure rather than reflecting managements assessment of the companys
prospects.

Claim dilution. To maintain its dividend payments while meeting its clean up
obligations, BP would need to increase its borrowing and/or sell assets. Higher
gearing will increase the companys default risk and the interest cost of debt so the

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value of existing debt will tend to fall unless the existing lenders are adequately
protected by covenants.

Taxation. Taxation is complex, with US and UK shareholders being subject to

different tax systems. The US uses the classical tax system and while the UK no
longer uses the imputation system, dividends in the UK still carry a 10 per cent tax
credit. Shareholders who sell shares to create homemade dividends may incur
capital gains tax.

20. Catering theory suggests that managers cater to changes over time in investor demand for
dividends. This theory has three foundations. First, it is assumed that not all investors are
rational and that sometimes investors prefer dividends to increases in the value of their
shares, and sometimes they prefer increases in the value of their shares to dividends.
Second, it is assumed that if investors are sometimes willing to pay more to invest in
companies that pay higher dividends that the process of arbitrage, as discussed in Section
1.5.7, will fail to prevent these companies having higher prices than those that do not pay
dividends. Third, managers cater to this investor demand by paying dividends when
investors place higher value on dividends, and not paying dividends when investors place
higher value on increases in the value of their shares.

To test this theory, Baker and Wurgler (2004a) examine whether the market-wide rate of
companies initiating or omitting to pay dividends depends on the presence of a so-called
dividend premium in share prices. A companys dividend premium is measured as a ratio,
given by the market value of its shares divided by the book value of its shares. The
market-wide dividend premium is the difference between the average of this ratio for
companies paying dividends and those not paying dividends. Baker and Wurgler argue that
this market-wide dividend premium is due to investors being willing to pay more to hold
payers than non-payers. They also argue that if a dividend premium is present it will lead
to a difference between the future share returns of dividend-paying and non-dividend-
paying companies. Specifically, they argue that if demand for dividends is high this will
lead to the share prices of dividend-paying companies being overpriced, and hence their
future returns to be relatively low.

Using US data from 1963 to 2000 they found that market-wide dividend initiations were
higher in years following years in which the market-to-book ratio for dividend-paying
companies was higher than for non-dividend paying companies. They also found that
increases in market-wide dividend initiations were followed by years in which shares in
dividend-paying companies underperformed shares in non-dividend-paying companies.
Similarly they found that market-wide dividend omissions were high in years following
those years when the market-to-book ratio for dividend-paying companies was low
relative to that for non-dividend-paying companies. Further, they found that increases in
market-wide dividend omissions were followed by years in which shares in dividend-
paying companies outperformed shares in non-dividend-paying companies. These results
suggest that dividends are relevant to share prices, and that managers cater to changes
over time in investor demand in order to maximise the current share price.

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However, Hoberg and Prabhala (2009) cast doubt on these findings by showing that the
relationship between the so-called dividend premium and companies paying dividends may
be due to riska factor that Baker and Wurgler ignored. Hoberg and Prabhala argue that
riskier companies adopt more conservative payout policies to avoid the potential of
needing to cut dividends. And as was discussed in Section 7.7, some studies suggest that
companies with lower market-to-book ratios may be riskier. Therefore, they argue that the
difference between the market-to-book ratios of dividend-paying and non-dividend-paying
companies may be due to risk differences and that this in turn leads to differences in future
returns. As economy-wide risk varies over time so does this relationship between risk and
return. When Hoberg and Prabhala controlled for this risk factor they found no residual
relationship between the so-called dividend premium and companies propensity to pay
dividends.

21. The problem of running short of cash can be overcome by introducing a dividend
reinvestment plan and by paying dividends in the form of shares. In these ways, the twin
objectives of distributing franking credits to resident shareholders and retaining cash in the
company are achieved.

22. We agree with the statement. The relationship between investment opportunities and
dividend decisions is discussed in Section 11.6. The related influence of the companys life
cycle is discussed in Section 11.10.

23. The life-cycle theory of payout policy is discussed in Section 11.10. Essentially, the theory
proposes that (i) payouts will be influenced by a trade-off between the benefits and costs
of retaining cash, and (ii) this trade-off will evolve as a company moves through its life
cycle.

Solutions to problems

1. (a) Over the 2002 to 2009 period, the dividend payout ratio is very similar each year. The
average payout ratio is 67.8 per cent and all the results are within the narrow range
66.7 to 68.9. These results are consistent with a constant payout policy.

(b) The global financial crisis at least temporarily suspended the constant payout policy.
While in 2010 the company maintained its dividend per share even though its profit
fell, in 2011 it was forced to cut dividends per share.

2. A policy of increasing retention in 2015 in order to help finance the investment project,
only to increase the dividend payout in a couple of years time, will result in a
discontinuous dividend pattern which may have an adverse effect on the price of the
companys shares. It may be suggested, therefore, that the company maintain the 22 cent
dividend payout and finance the proposed investment by an issue of shares.

3. An investor who buys Dribnor shares just before they go ex-dividend will pay a price that
reflects the value of the company based on its expected future cash flows, plus the current
dividend. An investor who buys immediately after the shares trade ex-dividend will obtain
a share that provides the same expected future cash flows, but not the current dividend.
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Therefore, the price fall on the ex-dividend date should be equal to the value of the
current dividend. The dividend is $1 and the franking credit is:

$1 0.30
1 0.30
$0.42857

Therefore:
(a) if franking credits are of no value, the share price should fall by $1 on the ex-dividend
date
(b) if franking credits are fully valuedthat is, $1 of tax credits is worth $1the share
price should fall by $1.43 on the ex-dividend date.

It should be noted that Australian empirical evidence shows that, in practice, the average
dividend drop-off ratio is less than 100 per cent. However, this does not invalidate the
point of the questionthat is, for franked dividends, the drop-off will be larger if franking
credits are valuable.

4. Factors such as legal considerations, the cash requirements of the company, and the
information content of dividends, may have an important effect. It could be argued that
the companys shareholders will benefit from a higher rate of retention if this lowers the
transaction costs of raising external finance. The role of dividends in transferring franking
credits to shareholders should also be considered.

5. The object of this problem is to provide data on the behaviour of a companys share price
around the date of a dividend announcement and, in particular, to see if the evidence is
consistent with dividend announcements being a source of information.

$2 000 000
6. (a) Earnings per share =
4 000 000
= $0.50
$5
Priceearnings ratio =
$0.50
= 10

(b) (i) If the observer is correct, the price will be: $0.55 10 = $5.50.
(ii) The observer may be correct that the share price will increase after the buyback,
but the argument, as stated, has two weaknesses. First, it does not necessarily
follow that total earnings will remain unchanged and that EPS will increase in
line with the lower number of shares. To buy the shares, Falcon will have to
outlay cash that could have been invested to earn some profit. Therefore, total
earnings may fall after the buyback. Second, if the buyback results in higher
financial leverage, the shares will be more risky, in which case the P/E ratio
should fall.

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