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Dividend Policy and Return of Capital

Corporations often ask investment bankers – “What should we do with our dividend?”

Theoretically, dividend policy does not change the value of the firm – implementing a dividend or adding to a dividend should not change the share price1. However outside of academia, it does for reasons including:

Tax on Dividends versus Tax on Capital Gains

From a tax perspective, dividends are immediately taxed while share price increases are not a tax event for shareholders that continue to hold the stock – gains can be compounded and the tax event can be deferred. Also, dividends may be taxed as income at a higher rate whereas capital gains may be taxed at a lower rate (often 50% of the marginal income tax). To a shareholder, the present value of their cash flows is therefore different, affecting the valuation.

In certain jurisdictions, there may not be any incentive to defer capital gains (stamp duty regimes like Hong Kong), which may change the attractiveness of a dividend from a tax perspective.

Investor Preferences and Dividend Fund Mandates

Depending on whether the investor base for a stock is institutional (large mutual funds, pension funds, hedge funds) or retail (mom and pop investors), there will be certain preferences for income (earnings from the company being paid out versus being reinvested.

For institutional investors – especially asset managers with active or passive funds with dividend mandates, a dividend is a requirement for a stock to be investable.

For some mutual funds, all that is required is that a dividend is paid. Some funds will require a high dividend yield to be kept over a certain amount of time. Dividend growth champions or dividend aristocrat funds or indices require dividends to be bumped up once a year.

As such, increasing the dividend can add buying pressure to the stock by increasing the investor base. Speculative investors can also bet on short term gains on a stock by guessing which stocks will be increasing dividends and becoming eligible for certain indices and funds that use that index as a benchmark, resulting in the stock price getting pushed up.

Signalling from Dividend Increases

Generally, an increased dividend is associated with earnings growth and optimistic prospects going forward. Increasing a dividend in times of distress is not prudent. Accordingly, a higher dividend can boost the share price, especially if coupled with quarterly reported earnings beating expectations.

For companies where shareholders (especially activist shareholders) feel that cash is idle and should be deployed, a dividend announcement can boost the share price (Apple’s first dividend announcement being a good example).

However, if a company is distressed and raises debt to raise an unsustainable dividend, investors may punish the stock – especially if it is perceived that the company may have to issue equity later and dilute shareholders.

Dividend Considerations Versus Share Repurchases

The other major return of capital conduit other than dividend implementation or increases is the buying back of shares.

Before increasing the dividend, management must consider that dividends are viewed as “sticky”. If the dividend for a stock is increased from $1.25 to $1.60 for the quarter, it is expected that dividends will be at least $1.60 per quarter going forward. Without flexibility for returning capital, a company may be cash flow constrained and be forced to raise debt or equity if they want to purchase something or run into distress.

Share repurchases are seen as more opportunistic and non-committal. Should management view the market value of the firm to be below intrinsic value (they think that the share price is depressed), they can buy back stock for a certain time period with no expectation that repurchases will continue.

An added effect for share repurchases is that they can actually reduce the future dividends paid as the share count is lowered. In a period with one-time, robust free cash flow may be a good opportunity to engage in share buybacks to get rid of excess cash (cash has an opportunity cost) while lowering future cash flow needs.

1 In a world without tax

Related Reading for Dividends

Equity Capital MarketsWhat is a SPAC – Special Purpose Acquisition Company or Blank Cheque Company · Preferred Shares Primer · A Comparison Of Spin-Outs Versus Carve-Out IPOs: Part II · Subscription Receipts in Acquisition Finance · Investment Bankers Love Equity · Acquisition Finance: Equity Consideration · Block Trades/Block Sales · Dividend Reinvestment Plans (DRIP) · Introduction to Convertible Securities · Investment Banking Road Shows: Marketing and Distribution · Regulatory Regimes and Execution Bankers in Investment Banking ·
Corporate FinanceLooking at Capital Expenditures for Investment Bankers · Understanding a Merger and Understanding a Merger Model · Spreading Investment Banking Comps: Net Debt · Spreading Investment Banking Comps: Calculating Fully Diluted Market Capitalization · How to Answer “What Two Companies Do You Think Should Merge?” · A Comparison of Spin-Outs versus Carve-Out IPOs: Part I · Dividend Policy and Return of Capital · Accretion/Dilution Analysis – Part IV: Synergies and Source of Funds for M&A · Accretion/Dilution Analysis – Part III: Using Debt for Acquisitions · Accretion/Dilution Analysis – Part II: Accretion/Dilution Math and Breakeven Premium · Accretion/Dilution Analysis – Part I: EPS, Earnings Yield and All-Stock Transactions · Purchasing a Company via Cash or Stock · WACC and Optimal Capital Structure Reviews · Reasons for Mergers & Acquisitions · Early Bond Redemption Analysis · Hedging Interest Rate Risk ·
ex investment banking associate

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