Tutorial 5 with solutions 2021 PDF

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FNCE20005 CORPORATE FINANCIAL DECISION MAKING TUTORIAL 5: PAYOUT POLICY

SECTION A QUESTION 1 If Demons Inc. is priced at $50.00 with a dividend of $5.00, and its price falls to $46.50 on the exdividend date, what is the implied rate of personal income tax (at which dividends are taxed) for its average stockholder? Assume that the personal tax rate on capital gains is 40% of the personal income tax rate.

QUESTION 2 Evaluate whether each of the following statements makes sense or not. (a) “Dividends today are more certain than capital gains later. Hence dividends are more valuable than capital gains. Stocks that pay dividends will therefore be more highly valued than stocks that do not.” (b) “Since the firm has excess cash on its hands this year and no investment projects this year, it needs to give the money back to stockholders.” QUESTION 3 Under the imputation tax system, there is an optimal dividend policy for all Australian companies: always pay the maximum possible franked dividend, given the balance in the franking account. Discuss this statement.

SECTION B 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? (b) What do you think were some of the motivating factors behind the buyback? [For example; Section 3.10 of the February announcement provides some insight into management thinking]

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

TUTORIAL 5: PAYOUT POLICY - SOLUTIONS SECTION A QUESTION 1 (Price before - Price After)/Dividend = (1- t) / (1-.4 t) where t is the personal income tax rate. Solving for the personal tax rate, 3.5/5 = (1-t)/(1-.4t) The personal income tax rate = 0.30/0.72 = 41.67%

QUESTION 2 (a) No. This argument is called “The Bird in the Hand” Fallacy which is about the resolution of uncertainty. The popularity of this fallacy is based on the intuition that investors would rather receive the cash than have managers invest it into negative NPV projects. But note that any increase in value is really caused by a change in investment policy (foregone negative NPV projects) and not by a change in dividend policy. To see this, note that if managers paid the dividend but raised funds for the bad projects through new equity issues (which caused a price drop), then no value would be created for shareholders. Dividends are less uncertain than capital gains, but investors can resolve uncertainty associated with capital gain by selling shares immediately.

(b) No. Excess cash might be a temporary phenomenon. So, the firm has to consider future financing needs. The cost of raising new financing in future years, especially by issuing new equity, can be staggering. In addition, initiating dividends with the cash will create the expectation that the firm will continue to pay those dividends, which might be unsustainable. Stock buybacks provide more flexibility in terms of future actions. Another alternative can be a special dividend.

QUESTION 3 Simply maximising the payout of franked dividends may not be an optimal dividend policy for all Australian companies. Companies should also pay attention to non-resident investors who do not benefit directly from tax credits. The possibility of distributing additional cash through buying back shares should also be considered. For other companies, the amount of cash available after paying dividends may serve as a constraint on payment of cash dividends, but any such constraint may be addressed by introducing a dividend reinvestment plan.

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SECTION B 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? Initially RIO stated that they were only looking to acquire $500m worth of shares via the off-market repurchase. (b) What do you think were some of the motivating factors behind the buyback? [For example; Section 3.10 of the February announcement provides some insight into management thinking] A variety of factors could be discussed here including (but not limited to): •

A desire to return free cash flow to investors in the wake of ‘…lower commodity prices, and uncertain global economic trends…’

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Large franking account balance – and hence a desire to pass on franking credits in the most efficient way possible.

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Signalling to the market that the firm is taking a disciplined approach to capital management.

(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? According to section 3.5 – both EPS and ROE are expected to improve. Gearing ratios would be expected to increase but “… will remain at prudent levels and the Board does not expect that the Buy-Back will affect the credit ratings of Rio Tinto”. (d) According to the February announcement – what was the capital component buyback price and how would the rest of the payment be treated? $9.44 was the capital component – with the rest treated as a dividend which was intended to be fully franked.

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(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] Shareholders who wanted to participate had to decide upon the discount at which they were willing to tender their shares (relative to the specified five day volume weighted average share price) as well as the number of shares they were willing to offer at each discount level [unless the shareholder had less than 85 shares in which case they all had to be offered at the same discount level]. There were 7 discount levels specified increasing in 1% increments from 8% to 14%. (f) According to the April announcement which provided final details on the buyback – 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? $560m worth of shares were bought back via the share repurchase. The final buyback price was $48.44 per share which represented a 14% discount to the specified Market Price. This buyback was extremely popular – as indicated by the fact that it was massively oversubscribed with more than 10 times as many shares being offered for sale by shareholders at the highest discount level than had been sought by the company. This resulted in a scale-back process being instituted – whereby the number of shares tendered for sale by each shareholder was reduced by 91.02% (except for those shareholders who would have been left with a parcel of less than 35 shares – these shareholder were able to sell all of their shares into the buyback).

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