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FNCE30002 CORPORATE FINANCE 2018 TUTORIAL 4: PAYOUT POLICY: FORMS AND INFLUENCES

SECTION A TEXTBOOK (PBEHP, 12e): CHAPTER 11 Question 6 Are the following statements true or false? a) A company can pay a dividend only if it is currently earning profits. - It can be firms retained earnings from the past profitable periods, reserves the right to pay it to the shareholders as dividends in future - Can borrow money to pay dividend - Sell part of the assets and make a gain to pay dividend b) In Australia, dividends and capital gains are taxed at the same rate for individual investors. - Under imputation tax system, dividends are effectively taxed at shareholder’s marginal rate, but capital gain may be tax-advantaged for some investors - T(dividend) > t(capital gain) c) The residual dividend policy is used by most companies. - Residual dividend policy: used by companies which finance new projects through equity that is internally generated - Dividends are made from residual equity (equity that remains after all the project capital needs are met) d) The imputation system involves personal tax being collected at the company level. - Imputation tax system: tax made by companies may be attributed to shareholders through franking credit to prevent double taxation - Franking credit: nominal unit of tax paid by companies using dividend imputation - Shareholders don’t need to pay tax on dividend as company has already paid e) To Australian resident investors, a dollar of franked dividends is worth more than a dollar of unfranked dividends. Franked dividend: dividend that has a tax credit attached to them Unfranked dividend: does not have tax credit attached to it f) According to the Miller and Modigliani dividend irrelevance theorem, an unmanaged (residual) dividend policy is no better or worse than a carefully designed, managed policy. - Dividend irrelevance theory: company’s declaration and payment of dividends have little to no impact on company’s stock price (value of company) - Residual dividend policy: firms make distributions only when more earnings are available than needed to support the optimal capital budget

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Questions 7 Dividends are taxed at a lower rate than capital gains. This suggests that companies should have high dividend-payout ratios. Discuss this statement, giving special attention to its appropriateness in the Australian tax environment. -

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Depends critically whether the dividends are franked or unfranked o Statement is true if it is a franked dividend  Investors will pay lower tax on dividend and thus more profitable o False if it is an unfranked dividend – less tax shield Depends investors realised capital gain before or after 12 months – CGT discount o Before 12 months  Dividend will be taxed at the same rate as short-term capital gains o After 12 months  Long-term capital gain will be taxed at much lower rate Depends on investors are residents or non-residents o Non-residents – not eligible for franking credit – prefer capital gain even it is franked dividend If company has additional cash to distribute, resident investors will prefer it to be distributed via share buy-backs o Receive returns as capital gains

Questions 8 Explain the likely effects on dividend-payout ratios of each of the following: a) The imputation tax system is modified to allow investors only partial (50 per cent) credit for company tax - Decrease in demand for dividends – dividend payout ratios expected to fall b) Personal income (but not capital gains) tax rates are increased. - Decrease in demand for dividends – need to pay more tax – dividend payout ratio fall c) Capital gains tax is abolished. - Retention of profits are more attractive – dividends are unfavorable – low dividend payout ratio d) Interest rates increase substantially. - Low profit – dividend likely to be maintained – dividend payout ratio increase e) Company profitability increases. - Dividends are likely to increase but the rate of increasing is lower than the rate of raising profits – dividend payout ratio falls f) Prospectus requirements are tightened, increasing the costs of share issues. - Higher cost of raising capital make retention of profits more attractive – dividend payout ratio expected to fall

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Questions 13 Usually the Board of Directors increases dividend per share only slowly in response to rising profits and is even more reluctant to decrease dividend per share than to increase it. Give reasons for this behaviour pattern. Is this behaviour more likely to be observed under an imputation tax system than under a classical tax system? Why, or why not? - Investors gain information from an announcement of a change in dividends - Decrease in dividend have a greater effect on share price than increase in dividends - Under imputation system, management would adjust the dividend per share in response to the balance available in the company’s franking account - Greater fluctuation in dividend per share from year to year

SECTION B – ANSWERS TO BE HANDED IN AT THE BEGINNING OF THE TUTORIAL PLEASE REMEMBER TO MAKE A PHOTOCOPY OF YOUR ANSWER AS YOUR ORIGINAL ANSWER WILL BE RETAINED BY THE TUTOR. REMEMBER ALSO THAT ALL ANSWERS MUST BE HANDWRITTEN. TEXTBOOK (PBEHP, 12e): CHAPTER 11 Problem 6 [Tip: A common ‘multiple’ used in financial markets is the Price:Earnings ratio which measures the ratio of share price to earnings per share. It measures share price per dollar of earnings and is seen by many market participants as a useful measure of the pricing of a stock relative to other comparable stocks. For example – one might multiply the EPS of a company by the average P/E ratio of companies in the same industry to gain an insight into whether the company’s shares are mispriced] Share buybacks are sometimes motivated by the desire to increase earnings per share. Falcon Ltd recorded an operating profit of $2 million in the last financial year. It has 4 million shares on issue and the market price of the shares is $5 each. Falcon announces that it will repurchase 10 per cent of each shareholder's shares at $5 per share. a. Calculate Falcon's price-earnings ratio before the buyback. P/E = share price / earnings per share = market cap (value of company) / total earnings = 5 / 0.5 = 10 EPS = total earnings / total number of shares = $2million / $4million = 0.5 P/E (before buyback) = 10 (no units as it is ratio) b. An observer comments as follows: 'Falcon's buyback should boost its earnings per share from 50 cents to 55 cents, so with the price-earnings ratio remaining the same, the share price should increase'. i. If the observer's argument is correct, what will Falcon's share price be after the buyback? EPS increase from $0.50 to $0.55 P/E ratio remain unchanged (P/E = share price / EPS) P/E ratio = 10 Share price = $0.55 * 10 = $5.50 3

ii. Critically evaluate the observer's argument. - Increase buyback, leverage ratio (debt ratio/gearing ratio) increase o Debt goes up (debt amount increases relatively)  Raise debt to buyback equity – raise debt for issuing dividend o Shares are more risky  P/E ratio goes down, share price goes down  Shares increases (buy back), earnings decrease, excess CF decrease, investment decrease, profits decrease, total earnings go down  Lower earnings, lower distribution to shareholder, share price goes down (firm not attractive) ADDITIONAL QUESTION On 12 February 2015 – the large materials company Rio Tinto Ltd announced its intention to undertake a significant off-market share buyback via a series of media releases to the market – as documented in the company announcements section of the ASX website [the ASX ticker code for Rio Tinto is “RIO”]. You will need to review the following two specific company announcements by RIO in order to complete the tasks associated with this question: 1. “Rio Tinto Limited off-market buy-back tender” dated 25 February 2015 2. “Successful completion of A$560 million off-market buy-back” dated 7 April 2015 (a) How much was RIO initially intending to buy back? -

Target size: A$500 million of shares (pg 5)

(b) What do you think were some of the motivating factors behind the buyback? [For example; Section 3.20 of the February announcement provides some insight into management thinking] -

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Large franking account balance, desire to return free cash flow to investors o Utilise the remaining fund in an efficient way o Positive market reaction Huge franking credit balance in firm o Transfer benefits to shareholders Signal market that the firm is taking a discipline approach to capital management o Not using money to build empire (not using money to investment in whatever they want) – using the money wisely and prudent

(c) According to the February announcement (looking at section 3) – what impact would the buyback have on both the earnings per share for the company as well as the company’s leverage?

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Section 3.5 Improve earnings per share, EPS = earnings / no. of shares o Decrease in no. of shares, increase EPS Improve return on equity, ROE = net profit / equity 4

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o Decrease in equity, increase ROE Increase leverage = debt / equity (bad news) o Firm trying to explain that the increased gearing ratio will be remain at prudent level – will be safe zone where credit rating doesn’t change – need to have this statement to reduce the negative effect (impact) on the announcement of increased leverage

(d) According to the February announcement – what was the capital component buyback price and how would the rest of the payment be treated? -

Capital component: $9.44 (*calculation of deemed consideration!!! (share purchase price * weighted average return and growth – lecture slides) The rest of payment: dividend component – fully franked in this case (in exam: mentioned fully / partially/ not franked)

(e) According to the February announcement – there were two decisions that RIO shareholders had to make if they wanted to participate in the buyback. What were these two decisions? [Tip: look at the tender form contained in section 6 of the announcement] -

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Number of shares for each discount Discount level at which shareholders were willing to tender (how much you’re willing to sell for each share) o Higher discount level, lower buy back price (offer share at lower price) Off market share buyback o Dutch auction tender  shareholder: higher price, lower discount (tender from top to bottom)  company: lower price, higher discount (from bottom to top)  buy from cheapest to the more expensive one, until they’re able to buy back all the shares they want to repurchase (max number of buy back shares) – buy at the SAME price (the maximum price where the last number of shares located at - last share’s price)

(f) According to the April announcement – how much was bought back, what were the final terms of the buyback and were all shareholders able to sell as many shares as they wanted into the buyback? -

Bought back approximately A$560 million (11.6 million shares) @ A$48.44/share – 14% discount (highest) to the market price o indicates that firm is able to buyback more than what they need even at the lowest price with highest discount - shows that the buyback is overly subscribed – market is very responsive to the buyback (shareholders are willing to sell shares), firm is not very responsive to get back so many shares - scale back process: everyone wants to sell shares, can only reduce the amount proportionately (buy 80% of the shares)

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Summary -

Dividend o Regular: sticky (when you pay out dividend, shows market that you’re doing well, and market expect you to have a consistent dividend payout. If payout decreases, market will take it as company not doing well)  MM (perfect market: no change in capital structure - conservation of value, risk)  Dividend irrelevance o Homemade dividend: can create dividend themselves without any transaction cost and taxes 

Real world: 6 factors  Tax o Classical (most of the time prefer capital gain – lower tax)  Dividend: tax twice (tp + tc)  Capital: (50% if defer for 12 months and might go lower if defer longer) tp + tc o Imputation  Dividend: tp  Capital: x% tp + tc  CGT = 0:  tp < tc – dividend  tp > tc – capital gain  CGT > 0:  tp < tc – dividend  tp > tc – depends on what is the difference and how long it defers the capital gain for

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Important dates  right issues: downward fall in share price o announcement day  information asymmetry: Pecking order theory  Internal fund < debt < equity o Issue through equity shows the market the firm is not doing well Ex-right date  Shares traded without the rights - no dividend Compare with dividend o Announcement day  Share price going up – pay dividend (profitable) o Ex-right date  Share price going down (traded without dividend) o

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Special dividend: once off (stop paying dividend will not impact the decision of investors)

Shares repurchase / share buyback o 5 types o Off market share buyback (*calculation!!!!)  benefit (off market):  lower share repurchase price as compared to on market  tax purpose o Franked: can’t get in on market o Potential capital loss  Tax treatment of share buyback  Aim: reduce capital loss benefit to shareholder  Before introduction: o Share repurchase price (lower as compared to on market)  Dividend (franked)  Capital component  vs cost base (how much you purchase the shares for - Difference: capital loss / gain)  loss: Capital Component < Cost Base  After the rule: o Deemed consideration (*calculation – lecture slides)  Dividend (franked)  Capital component  vs cost base  often greater than share repurchase price – dividend always stay the same, capital component is deemed to be higher (CC > CB) lower chance of losses – more tax is paid to government o 5 factors of why firms buy back shares – compare between dividend and capital gain  Firms pay dividend > capital gain:  Operating cash flow is high AND permanent o Expectation on future cash flow is consistent – consistently pay same amount of dividend for a long period of time – confident on company prospect in the future  Less volatile cash flow (not growing firm)  Following good performance o Performance of firm is good and sustainable

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