assignment1

Applications of dividend payment on the

firms

Contents

1. Introduction 4

2. Content 5

(1) Stable of dividend 5

(2)Dividend payout policy 6

(3) Different forms of dividend payments 9

(4) Share repurchases 11

3. Conclusion 14

4. Reference 16

Introduction:

As a global oil, gas and mining company in Australia, BHP Billiton releases a report on 11 April 2011 which says it completes AU$6 billion off-market buy-back of BHP Billiton limited shares recently. The managers choose using this method to increase the stock price. Managers expect share repurchases to influence BHP Billiton positively and benefit their shareholders. But it brings some controversies between analysts and other shareholders. This paper discusses how does the dividend policy work and how a company returns the excess cash to their shareholders using share buyback.

Dividend is one way of payments of corporation profits paid out to shareholders. When the corporation gets a profit, surplus can be used in two ways: if it’s regarded as retained earnings, it can be reinvested in the next or future business, or it can be allocated to stockholders as a dividend in proportion of how many shares they hold. However, what the year’s dividends shareholders can obtain have to see a company's business performance, as dividends are received from profits after taxes which are either the only resource of dividends and bonuses, or the limit of a company's dividend payout. In general, there are several forms to pay dividends: stock dividends, cash dividends, property dividends and other dividends. The stock dividend means a corporation sends to shareholders on a new stock as their dividends, and the latter is a company pays cash as dividends to their shareholders. This way is the simplest and most essential of dividend pay out.

Furthermore, allocating dividends must follow some principles. Firstly, profits after tax must be deducted in accordance with the necessary policy before they can be used for distribution of dividends. Secondly, they should carry out dividend policy which has been made by the company. Thirdly, a dividend payout must perform the same to the share with the principles. Lastly, when listed companies pay dividends following the above principles, they should pay

attention to the relevant legal restrictions also.

Sometimes dividends reflect whether this corporation has good performance in the whole year’s business. Dividends can provide an incentive to stocks even if companies are still not experiencing positive growth. At this time companies are not required to pay dividends. While, the companies that offer dividends are most often have potential to growth rapidly, and then cannot gain benefit effectively through reinvesting their profits. So they choose to pay these dividends out to shareholders.

Content:

1. Stable of dividend

Dividends are either a signal about a f irm’s future, or a tool of corporate governance to keep consistent of the manag ement’s interests with these of the shareholders. Dividends reflect the company’s earnings potential, so how much dividends the shareholders obtain demonstrates how confident the shareholders care about the firms’ prospects. Consistent dividend payments create a stable income for shareholders. For example, if you invest $100,000 in stocks and plan to buy some bonds with returns. But the stock you purchase is a non-dividend-paying stock, so you must sell a part of your stocks to get the returns. While, if you buy a $100 stock which pays a $5 dividend per share every year, you will receive $5,000 per year regardless of what happens in the future. Furthermore, dividends can provide income to the firms. However, this income is just a small part of its total return. The adjusted Miller and Modigliani (1961) model shows the dividends should change over time and across different firms. Firms tend to grow their dividend payouts over time and when they have growth of earnings, they often pay back to the investors using the form of high stock prices.

Sometimes, investors and firms both like getting high dividends. There are some

factors making them favor of high dividends: (1) Desire for current income. (2) Behavioral finance. It lets investors become disciplined. (3) Tax arbitrage. Investors can buy high dividend yield securities to avoid tax liabilities. (4) Agency costs. High dividends mean lower retaining funds. It reduces free cash flow. While, some firms will choose cut a dividend in their trade. Dividend cuts are nightmare for dividend investors. Investors will sell these stocks at a low price and then buy another company’s high yield stocks. The firm decreases its stock price and reduces the confidence of other shareholders. Hence, keep a stable level of the dividend is better for both shareholders and firms. The stability of dividends has some advantages. First is that the content of dividends can reflect the expectations of investors. A stable dividend shows the company except stable dividends in the future investment. Secondly, most investors desire a specific income will hope the company has a stable dividend rather than unstable dividend. Those are the reasons of the firm hope investors to see the dividend as an annuity. As we know, annuity is a contract between you and company which aims to obtain long-run and stable payment. When investors invest their money on stocks, most of them hope the stock is profitable and steady. All firms have their decisions about how to allocate dividends and how much dividends should they pay. They may cut or increase the dividend. Generally speaking, a flat or positive dividend is wished by investors. Dividend payments should maintain a stable position and increase when the firm has growth of earnings. The firm should try their best to reach this goal.

2. Dividend payout policy

Different firms have their separate dividend policies. Some companies choose to cut dividends for retaining enough funds to do the reinvestment. Other firms do not cut dividends for enhancing the confidence of their shareholders to these companies. The decision to pay dividends or retaining funds to reinvest is determined by a firm’s dividend policy.

A corporation’s dividend policy is set by a firm’s board of directors, because they have the power of the senior management. How to determine an appropriate dividend policy is a hard work, as is has agency problem between shareholders and management. The final dividend decision should follow the investment decision and objective of the firm. With large amount of assumptions and calculations, Miller and Modigliani raised their Dividends Irrelevance Theory. The hypothesis shows that dividends do not affect the firm’s value. But if we want to get that hypothesis, it should satisfy three certain assumptions. First is there are no tax differences between dividends and capital gains. Second, there are no transaction costs. Last, it doesn’t have uncertainty items in the trade. Actually, in the real world the capital market is not always a perfect capital market, so the dividend policy is not irrelevant. Dividend payout decisions affect both shareholders’ profit and retain value of the firm. Hence, managers of the firm may consider more when choose the dividend policy (Baker Farrelly and Edelman, 1985; Baker and Powell, 1999).

Dividend payout provides the surface information for shareholders to understand the profits of this company in one year. Allen and Michaely (2003) and DeAngelo et al. (2009) present some facts about dividends. They are primary payout method for a company to give their profits to shareholders and the company should be stable, large enough for reducing management risk. Second, an increasing number of firms use share repurchases as their method of dividend payout instead of cash in recent years. Because dividends are related to stock prices and earnings, their volatility should be lower than the volatility of stock prices and earnings. If they fluctuate too fiercely, this means the company may have some management problems or other problems. Hence, from those facts we can see that the dividend payout is determined by firm characteristics such as its size, profitability etc. Apparently, it’s also related to the market characteristics what contains taxes, investment laws and market competition of the firm. Tax is a factor that should not be ignored when the firm doing dividend payout. Since

dividend payout policy is not irrelevant, taxes can affect a company’s dividend payout policy. If dividends are taxed heavily than capital gains, then the shareholder will prefer to receive more capital gains rather than dividends. On the contrary, when the tax rate on capital gains is greater than that on dividends, the stockholder should prefer to receive dividends than capital gains.

According to tax preference theory, investors prefer that the firm retain cash because the tax rate on dividends is higher than that on capital gains. If they want to maximize share price, they should keep payments of dividends low. When the firms do the dividend payout, there is another problem they should consider. Investors prefer stocks with lower dividend yields under high tax rate. While, investors in low tax rate prefer stocks with high dividend yields. This is called Clientele Effect (Pettit, 1977). Once the clienteles are satisfied, a company is unlikely to create value by changing its dividend policy. Overall, before the firms pay their dividends they should consider the relationship between taxation and dividend policy. Taxation can affect their stock price and dividend payout policy.

There are three common types of dividend policies, Constant Payout Ratio Policy, Constant Nominal Payments Policy and Low Regular and Extra Dividend Policy. In Constant Payout Ratio Policy, the payout ratio equals to the company’s cash dividend per share divided by the earnings per share. This ratio shows how much each dollar earned that is distributed to owners. The Constant Nominal Payments Policy is based on a fixed dollar dividend payment. Under this policy, firms nearly never cut dividend until they have problems in trading. The Low Regular and Extra Dividend policy represents that managers pay a low regular dividend and sometimes pay additional cash dividend.

3. Different forms of dividend payments

There are several different types of dividend payouts. Cash dividend is a normal

one. About returning money to shareholders we have two rules. If a company has surplus cash and few good project which means NPV>0, returning money to shareholders (no matter paying dividends or share repurchases) is good. However, if a company does not have excess cash and has few good projects, returning money to stockholders is bad. But when the firm has excess cash, sometimes they will not return dividends to shareholders. Hence, paying dividends is decided by the company's dividend policy. The companies pay money back to their shareholders as dividends in the form of cash and cash dividend often is out of firm’s current earnings or profits. Public companies always pay it quarterly. Once dividends are paid in the form of cash, it means those dividends are taxable. Tax is a considerable element that individuals show their preference to cash dividends. Investors and managers both aim to obtain more profit from company investment. So when the tax on cash dividends is higher than that on capital gains, the investors prefer to receive no dividends.

Secondly, when the company has no more cash left or wants to keep the excess cash to do the future reinvestment, managers will choose paying stock dividends. Stock dividend is a kind of payment of shares of stock to shareholders. After stock dividend payment, shareholders increase the amount of shares they hold, but total equity of shareholders remains the same. Therefore, we can say the surplus cash transfers out of retained earnings and into common stock from stock dividend payment. Furthermore, the firm does not change after paying stock dividend, the total value of the firm keeps the same. So actually the value of each share the shareholders get decreases.

The third payment way is stock split. It is a way of increase the number of outstanding shares by reducing the par value of the stock. The difference between stock dividend and stock split is the stock split always expressed as a ratio and stock dividend is expressed as a percentage. For instance, a 2 for 1 stock split is the same as a 100% stock dividend. It is used to move the stock

price to a more popular trading range. Managers pay dividends using stock split when they believe the stock price can be reduced by stock splits. A stock split also has no effect on a firm’s capital structure.

Last one is reverse stock split. It is a stock split where the number of shares decreased by increasing par value of stocks. In these three methods of dividend payment, the total shareh olders’ equity does not change. Although these actions change the number that shareholders hold, the shareholders still keep the same proportion of ownership of the firm. On the other hand, these actions change the price of an individual share, so the market should react to this change. Cash dividend is related to cash while other three payments affect the number of outstanding shares. When the share price increases, shareholders will incline to receive more stock dividends. If the price of stock goes down, they should hope the company can pay them cash dividend. To the firms, pay cash dividend will reduce their retaining funds. Therefore, they prefer paying stock as dividends to those stockholders. Sometimes, managers buy those shares back to do the future reinvestment. In the BHP Billiton, managers increase their share price through share buyback instead of paying cash dividends. It is good for maintain shareholders’ wealth and in the same time the company has more money to reinvest some positive projects.

Today more than 2,000 firms choose to offer Dividend Reinvestment Plans (DRIPs) directly or through agents to shareholders (Baker, Kent (ed.). 2009). Dividend Reinvestment Plan is an optional plan for shareholders to reinvest their dividend payments by p urchasing shares of the company’s stock. Many small investors are attracted by this plan because this plan is no transaction fee and sometimes allows a discount to investors when they buy additional shares of the firm. Before joining this plan, investors should own at least one share of this firm’s stock. Due to different sources of shares, DRIPs can be divided into three types: (1) open-market DRIPs, where the investors buy their outstanding shares

using reinvest dividends in the open market. (2) new-issue DRIPs, where the company increases its capital through selling new issue shares to shareholders. (3) a combination of open-market and new-issue DRIPs (Baker, Kent (ed.). 2009). Although DRIPs have some advantages, they also have drawbacks. Different with regular investors, the investors join the DRIPs do not have control of the purchase prices. Investors should pay tax when they participant the DRIPs, so they do not have tax advantages. However, the discount and transaction fee still can offset the tax payment. Thus, DRIPs are good for shareholders to reinvest their dividend payments. Both corporations and investors can benefit from DRIPs. Investors use them to get another investment option and firms use them to finance equity .But DRIPs always are popular by small investors. Big investors often choose other reinvestment forms.

4. Share repurchases

The newest report shows that BHP Billiton Ltd has finished its share buyback program, nearly purchasing $6 billion worth of its shares. From large number of share buybacks, BHP Billiton can carry out a capital return to shareholders and then aims to boost its share price.

As we know, companies have several ways to distribute capital to their shareholders. They can pay cash dividends or through share repurchases or the combination of both. In the before, the firms often use dividends as private way of payout. Recently, share buyback has become an important method of paying earnings to shareholders for the firms. Firms can use their excess cash repurchasing shares of their stocks instead of cash dividends. There are five common methods of share buyback that firms use: (1) fixed-price tender offer, it is an offer by a firm to repurchase its own shares usually at a fixed price. This price is often higher than market price. (2) Dutch auction tender offer, this offer is similar with fixed-price tender offer, but the firm provides a specified price range for repurchasing stocks instead of a fixed price. Shares with the price at or

below the final price will be bought back while if the price of shares is higher than the final price will be paid to their owners. (3) open-market share repurchase, the firm buy shares back on the open market in two or three years. However, firms using this method do not need responsible for buying any shares back within a period of time. (4) Targeted share repurchases. (5) Transferable put-rights distributions, in this way the company issues put options to shareholders followed the proportion of shares they owned. The first three methods are primary way of share repurchases.

Furthermore, firms conduct share repurchase program have three reasons. First is considerations of regulatory and tax. Since tax influences the dividend payout policy, in a real world dividends and repurchases are taxable. The dividends also taxed as income while repurchases are taxed as capital gains. Hence, repurchases have an advantage in taxation relative to dividends. As the tax rates advantage on capital gains, investors prefer share repurchases rather than cash dividends. The government taxes cash dividends usually higher than share repurchases. Second reason is the firms want to adjust agency cost of free cash flow from share repurchases. Managers could put excess cash in investing some negative NPV projects which will incur agency costs of free cash flow. Therefore, the firms with high excess cash flows should repurchase shares which can help them increasing growth opportunities. The final reason is signaling or undervaluation. Based on signaling hypothesis, some researchers think that managers could use share repurchases to reveal the companies’ private information(Baker, Kent (ed.). 2009). These three reasons are important for us to understand why investors and managers prefer share repurchases. For different types of investors (clientele effect), share repurchases have lower tax rate is attractable. To corporations, paying dividends or repurchase shares can ease the agency problem between managers and shareholders. On the other hand, firms use share repurchases as a signal to their undervaluation or earnings under the signaling hypothesis. Because of those reasons, open-market repurchases have

become the main form of dividend payout instead of cash dividends.

Before dividend payout, managers should consider some factors about determining the trade-off between repurchasing shares and dividends. Share repurchases show the tax benefits to shareholders. Repurchases are taxed at a low rate than dividends as they are taxed on capital gain rate. Thus, investors can hold their shares without much cash and obtain profit associated with share repurchases ignoring tax payment. The second factor managers should consider is the flexibility to shareholders. For firms they hate to cut dividends and investors also don’t like cutti ng dividends. Dividends increase maybe not a very good news, but cutting dividends are bad news. Hence, the managers trust that it is hard for them to manage dividend. This means they have little flexibility on dividend payment. For this reason managers should a fixed level of dividends during good or bad times. Compared with that, share repurchases have more flexible than dividends. The firm can increase dividends during good times and buy dividends back when the firm cut the dividends. Next factor is the influence of earnings per share. Managers always reduce shares of outstanding to increase EPS. This can be considered as a component of the repurchases. Nonetheless, about repurchase as a tool for managing EPS, managers still have many controversies. The repurchase can only make EPS going up if this decision does not influence the cost of capital (Baker, Kent (ed.). 2009). Considering those factors managers often incline to choose to repurchase shares for getting tax advantage and increase flexibility of dividend payment and EPS. But few investors may prefer cash dividends, so the final decision of dividend payment should be decided by the board of directors.

Generally speaking, the share repurchases hold the main advantage for shareholders is that they can boost the firm’s share price and then return capital gains to shareholders than income. To both the investors and corporations, share buyback have many specific merits. After share buyback, the number of shares

the firms should pay dividends reduces which means companies have higher earnings per share. Theoretically, higher EPS should consistent with a high stock price. What this means that higher stock price can make more money for the company. Managers are happy to see that happen. Companies possess rich cash are always attracted by some positive projects. Share buybacks can bring better return for the firms on excess cash instead of these projects. The third advantage of share buyback is paying extra cash to shareholders without increasing the dividend. Investors can gain capital with low taxation as the tax rate of dividends is smaller than that of share buybacks. Since the main reason managers choose repurchasing stock is undervaluation, if those undervalued shares are repurchased this may be good for the company. Hence, buying shares back can increase the return on equity (Tyler Texas, 2007). As those reasons, investors and managers prefer to share buybacks rather than raising the dividends.

Conclusion

This paper provides the evidences to discuss why BHP Billiton Ltd chooses share repurchases to increase its share price relative to dividend payments and dividend policy.

When the companies get the profits they will pay them out to shareholders. Surplus cash usually can be used in two ways: regarding the surplus as retained earnings, it can be reinvested in the next or future investment, or it can be paid to stockholders as a dividend followed the proportion of how many shares they hold. Dividends can be divided into several forms: stock dividends, cash dividends, property dividends and other dividends. Stock dividends and cash dividends are two simple forms. Dividends are a signal of a company’s prospect, so the firm and investors always hate to cut dividends. Cutting dividends will reduce the confidence of shareholders to the company. Thus, the stability of dividend payment is very important to both firms and shareholders. A stable dividend can bring stable income for shareholders.

The detail of paying dividends the firm should follow its dividend policy. The decision on paying dividends directly to shareholders or retaining funds to reinvest is a company’s dividend policy. It is set by a firm’s board of directors. And, it is affected by some factors, tax is an important one. If the tax rate on capital gains is higher than dividends, shareholders will prefer receiving dividends. Investors should keep payments of dividend low, when they want to maximize the share price. According to tax preference theory and clientele effect, it can be seen that taxation can affect stock price and dividend policy.

The most important part of dividend payment is share repurchases. Share repurchases has many advantages. Buying shares back shows tax benefit and increases the flexibility of dividend payment. On the other hand, share buyback also reduces the number of undervalued shares from repurchasing these shares which makes the firm obtain better return on excess cash. Using this program the firms can increase their share price effectively as increase EPS and return on equity. Hence, now share repurchase is becoming more popular way of reinvestment for many firms.

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