PowerPoint to accompanyChapter 11Dividend policyFrino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaOverview When a company generates free cash flows, it can: Retain all or part of this cash for future use Pay a dividend to its shareholders In this lecture we will discuss: What dividend policy is How companies pay dividends Alternatives to dividends How companies decide on the amount of dividends paid Impact of dividend policy on shareholder wealthFrino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaWhat is dividend policy? Companies typically pay dividends twice a year They may also elect to pay “special” dividends Additional one-off dividends to shareholders Dividend policy refers to the decision by companies to pay out net profits as dividends or to retain the profits The dividend payout ratio quantifies the dividend policy decision by measuring the proportion of profits after tax paid out as dividendsFrino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaExampleEarnings per share, dividend per share and dividend payout ratio of Qantas Airways LtdWhat is dividend policy? (cont) What were the decision-making processes that led Qantas to pay a dividend of 30 cents in 2007?TABLE 11.1Frino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaHow companies pay dividends Once a dividend is declared at the AGM, the companys shares trade cum-dividend This means that the shares trade with the promise of a dividend attached to them After the ex-dividend date: New purchasers of the shares are no longer entitled to the dividend payment In effect, the promise of a payment detaches from the shares The last person to own the shares prior to the ex-dividend date is entitled to the dividendFrino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaHow companies pay dividends (cont) The price of the shares typically falls by the value of the dividend on the ex-dividend date Share price around the ex-dividend date of the Westfield group on 11 Feb 2008FIGURE 11.1Frino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaAlternatives to dividends So far we have looked at cash dividends, but there are a number of alternatives to dividends available to companies All of these alternatives can be considered part of dividend policy These include: Share buybacks Dividend reinvestment plans (DRPs)Frino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaShare buybacks Share buyback Occurs when a company buys back its own shares from shareholders in return for cash May occur on-market (in the course of trading on the ASX) or off-market (via a written offer sent to all shareholders) Is similar to a cash dividend, in that the company gives cash to shareholders, however only shareholders offering their shares for sale receive cash in a buyback Has been legal on the ASX since 1989Frino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaShare buybacks (cont) In theory, a share buyback should have no effect on the share price if the shares are bought back for their fair value Example: A company with assets worth $20 billion and 20 billion shares on issue undertakes to buyback 1 billion shares The shares would be worth $1 each After the buyback the company will have $19 billion in assets and19 billion shares on issue Each share will be worth $1 before and after the repurchase However, most companies outperform the market following the buyback announcement (why?)Frino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaDividend reinvestment plans A dividend reinvestment plan (DRP) gives shareholders the option of receiving new shares instead of dividends Under a DRP, shareholders: Avoid brokerage and other transaction costs associated with acquiring shares 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 Do not typically know the number of shares they will receiveFrino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaDividend reinvestment plans (cont) DRPs have become a popular way to raise equity capital Value of shares issued under a DRP for the year ended 31/12/07 by the 5 largest listed companies During the 2006/2007 financial year, $8.79b was raised by ASX listed companies using DRPs representing 13.3% of total equity capital issued over this periodTABLE 11.2Frino, Hill, Chen: Introduction to Corporate Finance, 4e 2009 Pearson AustraliaHow companies decide the amount of dividends paid Lintner (1956) established that, in setting dividends, executives: Set long-run target payout ratios Focus on the change in dividends Base dividends on long-run forecast profits and are consequently re