Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

example

On 26 April 2011, the warehouse club retailer,

Costco, announced a US$0.24 quarterly dividend

to be paid on 27 May to shareholders of record as

of Friday 13 May. The ex-dividend date was set two

business days before the record date, on Wednesday

11 May. Investors who purchased Costco shares

on or before 10 May received the dividend, and

those who purchased on 11 May or later missed it.

Costco’s shares closed at US$82.23 on the afternoon

of 10 May, and opened the next morning US$0.20

lower at US$82.03. As anticipated, the share price

fell after the shares went ex-dividend, although the

price decline was slightly less than the amount of the

dividend payment.

Research shows that, in the United States and many other countries, the ex-dividend price drop

tends to be less than the dividend payment. One explanation for this pattern is related to investor taxes.

If a share priced at $51 falls to $50.30 when the company pays a $1 dividend, then this may indicate

that the investor faces a 30% dividend tax rate and so valued the dividend at only 70 cents in the first

place. That is, the $51 represented $50.30 in long-run value plus the after-tax proceeds from the $1

dividend. After the dividend is paid, the $50.30 in remaining long-run value dictates the company’s

share price.

In Australia, the dividend imputation system means that companies are able to frank their dividends.

If their dividends are fully franked, then investors receive a franking credit that reflects the corporate

tax paid by the company, meaning that they only need to pay (or receive) the net difference between the

franking credits and the dividend income tax they would pay using their marginal tax rate. This factor

should reduce the negative impact of taxation on ex-dividend prices in Australia that is typically seen in

the US (as described above).

15 -1b TYPES OF DIVIDEND PAYOUT POLICIES

Before discussing the basic types of dividend policies, we should briefly consider some of the practical

issues related to formulating a value-maximising policy. (Theoretical issues are discussed in later

sections.) These include legal constraints, contractual constraints, internal constraints, the company’s

growth prospects and owner considerations.

For example, negative covenants in loan agreements sometimes constrain a company’s ability to

pay cash dividends. Generally, these constraints prohibit cash dividends until the company achieves

a certain level of earnings, or they may limit dividends to a certain dollar amount or percentage of

earnings. Constraints on dividend payments help protect creditors from losses due to insolvency. If a

company violates one of these contractual restrictions, creditors generally have the right to demand

immediate repayment of their loans. The case of Keybridge Capital Limited (discussed in Section 17.1d

of Chapter 17) provides an example of such a situation; because of its debt obligation, the company

was required to sweep all of its cash into making debt repayments, and was not allowed to make any

dividend payments to equity shareholders.

FIGURE 15.2 A TIME LINE ILLUSTRATING IMPORTANT DATES IN THE DIVIDEND PROCESS

Board of directors

announces dividend

Shares go

ex-dividend

Record

date

Date

payable