Corporate Finance &

Financial
Markets
Week Seven
DIVIDEND POLICY

18/04/09 1
REVIEW

 Revisited the topic of Investment Appraisal

 Considered the problem on Sensitivity

 Discussed limitations of capital - rationing

 Introduced tools to help us deal with uncertainty

18/04/09 2
HOMEWORK
 Reading
– Organisations, stakeholders, financial objectives
– Stock, Capital and Money Markets
– Business Plans, Financing Businesses, New Shares
– Time value of Money
– Inflation & Taxes
– Marketable securities
– Capital Structure
– Required return both debt and equity
– WACC
– Investment Appraisal, non DCF / DCF techniques, taxes
– Sensitivity Analysis, Capital Rationing, risky decision making

 And, of course, your market

18/04/09 3
LECTURE OBJECTIVES
 Introduce Dividend Policy

 Theoretical viewpoint of Dividend Policy

 Dividends or other forms of shareholder compensation

 A few real world considerations about dividends

18/04/09 4
VALUATION RATIOS
 Comparative ratios
 Firm & Industry specific

 Usually reference share price

– Price to book
– Price to sales
– Price to earnings (P/E)

18/04/09 5
PRICE TO EARNINGS (P/E)
 Calculated as PricePerShare
PE =
EarningsPerShare
 Can be used to infer relative value

18/04/09 6
DIVIDEND POLICY
 Companies are run for the benefit of a single group

 Profitable companies have a welcome problem (re)

 If investment opportunities can’t be found …

 But how much of a dividend should be paid?

18/04/09 7
FREE CASH FLOW
 Free Cash Flow calculated as
Cash Flow from Operations

Minus

Finance Charges
Other Expenses
Changes in Net Working Capital
Changes in Investments
Taxes
Investments necessary to maintain business

 Money available to pay a dividend

 But what % of Free Cash Flow should be paid out?

18/04/09 8
FREE CASH FLOW
 Represents money left over after all bills are paid

 Can easily be negative - why?

 Many younger companies have negative free cash flow

 Required return for such firms?

18/04/09 9
FREE CASH FLOW
 What to do with free cash flow?
 Pay down debt (consider projects vs. financing cost)
 Investment
 “Core Business” or Diversification
 Goal of management is to increase shareholder value

18/04/09 10
FREE CASH FLOW
 What if a dividend is paid?

 Funds are no longer readily available

 Firm must approach markets for funds

 Introduces a level of uncertainty into Cost of Capital

18/04/09 11
DIVIDEND EXPECTATIONS
 Dividends represent management confidence

 Consistency, more than absolute level is key

 Changes are carefully evaluated for meaning

 Dividends attract specific class of investor

18/04/09 12
DIVIDEND EXPECTATIONS
 Low income shareholders - high dividend

 High income shareholders - low dividend

 Institutional investors - mixture of dividends

 Tradeoff between tax on current income / capital gains

18/04/09 13
DIVIDEND POLICY
 Every firm has a unique view on dividend payouts

 Key criteria is payout rate (%) of earnings

 Retained earnings is net profit kept by company

DividendGrowth = r * b
With
r the required (expected?) return on new projects
b the percentage of earnings retained

18/04/09 14
DIVIDEND IRRELEVANCE
 Modigliani & Miller 1958/1961

 Dividend policy has no impact on shareholder wealth (price)

 Assumptions
– No transaction costs
– Shares are fairly priced in the market
– All projects undertaken by the firm have same risk / reward profile
– Investment decisions not impacted by dividend policy

18/04/09 15
WHY FIRMS MAY NOT PAY
 Every firm is different

 Retained capital need not be borrowed

 Some firms prefer to buy back shares

 Share buy backs not taxed dividends

18/04/09 16
LEGAL ISSUES
 UK
– Dividends paid out of free cash flow
– Sometimes government has limited dividends
– Some firms pay in kind e.g., BA with discount airfare
– In kind far more tax efficient

 US
– REITS must pay 95% of free cash flow as a dividend
– FFO or Funds from Operations key for analysis
– Sustainability of dividend trivial for REITS

18/04/09 17
Corporate Finance &
Financial
Markets

18/04/09 18