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Chapter 9: Dividend Policy
Chapter Review Solutions 1.
Shareholders make returns from shares in two ways: Through dividends Through capital gains If funds are re-invested into the company rather than distributed in dividends this may result in increased profits which may increase the share price leading to capital gains for investors. Conversely if dividends are increased this may lower capital gains but increase dividend income. Thus there is a trade-off when attempting to maximise shareholder wealth between dividends and capital gains.
2.
Steady Growth Dividend Policy A steady growth dividend policy means that the dividend will grow by a fixed percentage each year and as such shareholders are aware of what they are likely to receive by way of dividend. Constant Dividend Payout Ratio A constant dividend payout ratio means that the company will distribute a fixed proportion of profits. This dividend policy will fluctuate more as profits in each period tend to be variable.
3.
Factors that should be taken into account: Type of investors – do investors prefer high dividends or capital gains? Life cycle stage of the company – newer companies are likely to be growing faster than mature companies and need to retain a greater percentage of profits and thus pay a smaller dividend. Mature companies tend to pay higher dividends. Can the company earn a higher return by reinvesting profits than the investor could? Financial situation of the company – in times of financial stress the dividend should be reduced. Public perception of the company – reducing dividends can be damaging to a company’s reputation as it is an indicator of poor performance. Stability of earnings
4.
Some investors like to have a constant payment (dividend) to use as income from their investments. As large proportions of the wealth are tied up in shares they need dividends to use for their day to day expenses. This is one reason companies insist on paying dividends. Additionally, under the imputation tax system investors get a tax break from dividends, and so may prefer dividends to capital gains. Finally paying a stable or constant dividend, rather than one that changes significantly from period to period means that shareholders are aware of what
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they are likely to receive by way of dividend and can plan for it. A stable dividend also projects financial safety and stability and there is a positive psychological effect on shareholders from the payment of a dividend. 5.
Investors are only concerned with the overall total return from an investment. This includes both dividend yield and capital gains. In a perfect capital market in which there are no taxes, cost-free information, rational behaviour and no transaction costs, investors will be able to borrow and invest at the same rate as the company, and as a result, will earn the same rate of return on dividends as the company would retaining profits. Therefore, there will be no difference between capital gains and dividends and as such dividend policy is irrelevant. The reasons that this theory does not have application in the current Australian financial environment are:
In Australia dividends are taxed differently to capitals gains. Dividends attract franking credits which can lower an investors tax, whereas capital gains are subject to capital gains tax. Companies can usually borrow at cheaper rates than investors because they have access to wholesale credit markets, can use bargaining power due to their size etc. Dividends signal to the public that the company is performing well. There is a positive psychological effect on shareholders from receiving dividends. Some investors require dividends to use as income. There are transaction costs, information asymmetry and imperfect capital markets in the real world.
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6.
(a)
(b)
A Share Buy Back is where a company makes the decision to buy back its own shares. This can be done either on market or off market and must be approved by shareholders. Overall growth is not nearly as important as growth per share. That is, the company will achieve a greater Earnings per Share ratio ( EPS ) even if growth remains the same because there will be less shares on issue. When a company reduces the amount of shares outstanding by declaring a stock buy back program, each of your shares becomes more valuable and represents a greater percentage of equity in the company. As an alternative to paying a dividend. The company may think that buying back its own shares is more beneficial than paying a dividend. In this case management think that the shares are undervalued and the outlook for the company is positive.
(c)
7.
Equal access buy-backs
Selective buy-backs
Other types of buy-backs ( See text ).
(a)
Key factors are: Amount of net profit after tax in relation to paid up capital Liquidity - the availability of cash resources to pay out Accessibility to capital markets - borrowing facilities Stability of net profit - or alternatively - fluctuations Growth rate and asset expansion Investment opportunities and needs Future certainty or uncertainty The proximity of new capital requirements Take over possibilities Life cycle stage of the company young or mature, growing quickly or slowly. Level of retained earnings Nature of the company’s shareholders Restriction in a trust deed or loan agreement/covenants
( b ) Dividend policy often has a direct effect on share price. Companies usually opt for a steady growth dividend policy to project a solid image and therefore maintain share price. For example, a company would not increase the dividend rate unless there was an expectation that the rate can be maintained. This may influence judgments made by investors about the future prospects of the company and thus affect share prices in the short term. Shareholder wealth is made up of both dividends and the value of the share. To maximise shareholder wealth management must attempt to maximise the sum of the share price and the dividend.
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Shareholders preference for current income may attract a particular class of investor and therefore affect share prices in the short term. ( c ) Alternative dividend policies include: Special dividends One-off dividend payments to share holders in addition to the two ordinary dividend payments. Usually offered if the company has a oneoff windfall payment and the dividend returns to its normal growth plan in the next period.
Share buy-backs Where a company buys back its own shares.
(d) Non-cash methods of paying dividends: Bonus Share Issues A dividend paid in the form of shares. Dividend re-investment plans Shareholders can use their dividends to purchase new shares. As an incentive companies offer discounts on the new shares and may abolish transaction charges.
8.
( a ) Australia has an imputation system of income tax on dividends. A company which has paid income tax may pay a franked dividend to shareholders. Shareholders, who are resident individuals are entitled to a credit in their income tax returns in respect of the franked amount. The amount of the credit entitlement is specified on the dividend payment notice. (b)
Capital gains tax applies to assets acquired after 19 September 1985.
Capital gains tax is payable on realised capital gains. A capital gain or loss occurs whenever a capital gains tax event happens. Whenever an asset has been disposed a CGT event occurs. Capital losses can only be used to reduce capital gains, they cannot be deducted from income. Capital losses can be carried forward to reduce capital gains in future years. There is no time limit applied to carrying forward losses.
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(c) Cum-div If a share is referred to as cum-div it means that the buyer or holder os the share will receive the dividend. Ex-div If a share is referred to as ex-div it means that the buyer of the share will not receive the dividend. In this case the seller will receive the dividend. 9.
Assuming that all dividends are fully franked ( a ) Imputation credit = $3,500 x
(b)
(c)
30 70
=
$ 1,500
Taxable amount
=
$3,500 + $1,500
=
$ 5,000
Imputation credit
=
$21,000 x
=
$ 9,000
Taxable amount
=
$21,000 + $9,000
=
$30,000
Imputation credit
=
$49,000 x 30 70
=
$21,000
Taxable amount $70,000
=
$49,000 + $21,000
30 70
=
10. Marginal Tax Rate Dividend Received Imputation credit Taxable dividend income
15% $7,000 3,000 10,000
Tax on dividend income less credit Tax payable on dividend
1,500 3,000 ( 1,500 )
30% $10,500 4,500 15,000
40% $17,500 7,500 25,000
45% $28,000 12,000 40,000
4,500 4,500 0
10,000 7,500 2,500
18,000 12,000 6,000
11.
Thursday 16th August ( four days prior ) Any shareholder who acquires shares prior to the 16th August receives the dividend of 18 c per share.
12.
Assignment or class discussion.
13.
( a ) $3,800 as shares were held less than one year.
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( b ) $89,150 as shares were held more than one year. 14. 1.
Pre Tax Profit less: Tax paid at 30% (tax when paid is credited to the Franking A/c) Profit after Tax
2.
Dividend Received add: Imputed tax credit = 30 / 70 x $8,400 Taxable Income from dividend
$500,000 150,000 $350,000 8,400 3,600 12,000
Tax on additional Taxable Income ( 12,000 x 45% ) less Imputation Credits Additional tax payable (refundable) 15.
5,400 3,600 1,800
(a) Earnings before tax less Tax Earnings after tax
$1,000,000 300,000 700,000
Dividends paid
480,000
Retained Earnings External Finance Proposed Investment
220,000 180,000 400,000
(b) Amount credited to the franking Account ( when paid )
=
$ 300,000
(c) (i)
Fully Franked 30/70 x $480,000
=
205,714
( ii )
65% Franked ( 205,714 x 65% )
=
133,714
( iii )
Unfranked
=
0
(d) Balance is $300,000 - 205,714
=
$ 94,286 Cr Nil as account is in credit
16.
Fully franked $233,333 Unfranked
166,667
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NPAT
400,000
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