Australian Dividendsand Shareholder Reinvestment

Dividends Divided:

Australian Dividendsand Shareholder Reinvestment

James Murray*

Christchurch Polytechnic Institute of Technology

Michael Skully

Monash University

Abstract

This paper examines dividendsizewhen the firm offers a dividend reinvestment plan (DRP). Reinvestment affects total dividend size as it is jointly determined by management and shareholders. Management merelydeclares the maximum possible dividend buttheeffectivedividend is determinedbyshareholder reinvestment. DRPs are often usedbylistedAustraliancompanies and on average over fortyper cent of theirdeclared cash dividend is reinvested. Such reinvestment suggests dividend policy research should incorporatethese DRP effects butthis is one of the few papers to do so. The empirical results indicate that management considers the reinvestmentexpected whendetermining dividend size and can impact this reinvestment bymodifying plan design. Together this allows them to influence theeffective dividend’s size and manage the agency costs of excess free cash flow.

*Corresponding Author

Department of Business

Christchurch Polytechnic Institute of Technology

PO Box 540

Christchurch 8140

New Zealand

1Introduction

This paper examines the effect of shareholder reinvestment on dividend size when firms use a dividend reinvestment plan (DRP). Dividend reinvestment allows management to set the maximum possible dividend but the actual cash payout will depend on shareholders’ reinvestment decisions. This paper extends on a recent trend to use a broader definition of dividend which includes other types of distribution.[1]Prior reinvestment plan research has considered theeffectofadeclared dividend on the level of reinvestment but inter-relationships, suchaswhether management considersexpectedreinvestmentlevelswhensettingthedeclareddividend, are largely unexamined. To fill this gap in the literature we explicitly combine the reinvestment rate into an analysis of dividend size.

Firms with DRPs offer shareholders the option of having their cash dividend applied to the purchase of additional shares. He (2009) classifies DRPs into three main types based on the source of the shares; open market plans, new issue plans, and combined open market and new issue plans. In open market plans existing shares are purchased, usually by a third party trustee or DRP administrator, and then transferred to the reinvesting shareholder’s account. In new issue plans the firm issues new shares directly to the reinvesting shareholders. In combined plans the firm can mix the two sources according to their needs. Plan type has little direct importancefor individual shareholders as they receive the same number of shares. It issignificant for the firm as open market plans do not affect the firm’s cash distribution where as new issue plans provide a regular source of new capital.Larkin, et al. (2005) found that in the United States the majority of DRP firms used open market plans. In contrast we find that Australian DRP firms almost exclusively use new issue plans.[2]

This study uses Australian data because of the prevalence of new issue DRPs and the relativeease in calculating the reinvestment ratein Australia. Australian data also allows us to generate a large dataset of DRP reinvestment rates that would be difficult to replicate elsewhere. In the United States, for example, researchers are limited to either surveying firms (see Pettway and Malone,(1973) and Baker and Johnson (1988)), or searching for reinvestment rate information in annual reports (Lyroudi (1999).Both approaches have produced relatively small samples. In contrast Australian firms using new issue plans must disclose the price and quantity of new share issues. This allows researchers to calculate the reinvestment rate directly.This examination of dividend policy and reinvestment in Australia is also motivated bya need to understand the impact of Australia’s imputation tax system on reinvestment.

With new issue DRPs cash is retained by the firm and reduces the size of the actual payout. This is important if dividend size affects firm value. However the value relevance of dividendsremains an unresolvedissue in finance. At one extreme the Miller and Modigliani (1961) irrelevance propositions show that in a perfect capital market dividends will not affect firm value, but as real world capital markets are far from perfect there is an abundance of research exploring possible reasons dividends are value relevant. Of these Lease, et al. (2000) identified the three main market imperfections linking dividend policy to firm value as; information asymmetry, taxation, and agency costs. They also identified as transaction costs, floatation costs and irrational investor behaviour as minor market frictions that could make dividends value relevant.If, for any reason, dividends can affect value then reinvestment should also have an effect.

If dividend size is value relevant then management should adopt a dividend policy that maximises firm value. Ideally shareholders would recognise this and not reinvest if reinvestment diminishes firm value. However it is not realistic to expect shareholders to know the optimal dividend size. Even if they did know,they face a coordination problem in arranging the optimal level of reinvestment.Alternatively, if reinvestment rates are predictable then management can declare larger dividends with the expectation that reinvestment will reduce the effective payout close to the optimal level. If this does not occur, then new issue reinvestment plans risk undermining managements’ value optimising dividend decisions.

The empirical results show that reinvestment firms declare smaller dividends and, with reinvestment over forty percent, the effective distribution is much smaller. Reinvestment levels are determined by plan features with a firm’s financial and ownership characteristics having little impact. Dividend size does not appear to affect shareholders’ reinvestment decisions, but expected reinvestment is a significant factor in setting the declared dividend. This means that most relationships between financial characteristics and dividend size are maintained after taking reinvestment into account.

The rest of this paper is organised as follows. Section 2 reviews the types of reinvestment plans used by Australian firms and existing literature on dividendsize and dividend reinvestment. Section 3 describes the data and research methodology. Section 4 presents results and analysis. Section 5 concludes the paper.

2Dividends and Reinvestment Plan Literature

The main issue in dividend policy is whether a firm should distribute profits. If a distribution is made,then there are then two supplementary issues; the amount to be paid and the form of payment. This paper is primarily concerned with the issue of dividend size when the payment form includes a reinvestment option.This section first describes the types of reinvestment plan used in Australia. It then reviewsdividend theory and the potential impact of reinvestment; specifically floatation and transaction costs, investor irrationality, information asymmetry, taxation, agency costs and reinvestment rates.

2.1Reinvestment plans in Australia

Australian firms use two types of reinvestment plan; the Dividend Reinvestment Plan (DRP) and the Bonus Share Plan (BSP). Both types allow shareholders to receive shares instead of cash, but have different taxconsequences.DRPs are the most common type.All shareholders receive taxable dividend income but some allow the firm to retain the cash as payment for shares. In contrast BSP shareholders elect to receive bonus shares instead of a dividend. These bonus shares are structured as capital distributions so that participating shareholders do not receive taxable dividends,but rather paycapital gains tax (CGT) when the shares are sold.[3] As Australia has a full imputation tax system there is no uniform tax advantage to DRP or BSP reinvestment.The individual circumstances of some shareholders, however, can mean that one form of reinvestment is more tax effective than the other.

BSPs were introduced in Australia in 1978. At the time Australia had a classical tax system with no capital gains tax, creating a significant tax advantage for BSP participants. By electing to receive shares instead of dividends shareholders avoided income tax and were not liable for CGT when the shares were sold. Surprisingly despite the obvious tax advantages BSPs were not widely adopted. Skully (1982)explains this, noting that directors were uncertain whether the Government would allow the tax advantages to remain and accounting restrictions meant only firms with a share premium account could issue bonus shares. The subsequent introduction of CGT, a full imputation tax system, dividend streaming and capital streaming laws has removed many BSP tax advantages.[4] These tax changes also mean that BSPs and DRPs are now virtually indistinguishable for firms as their franking account balance is reduced as if a cash dividend was paid, but shareholders do not receive franking credits if electing BSP reinvestment.

The first Australian DRP was offered in 1981 by General Property Trust. Property trusts are not subject to income tax when all income is distributed. A DRP allowed General Property Trust to legally distribute all profits while retaining cash, which would not have occurred if they had used a BSP. In 1982 Lend Lease Limited became the first Australian company to offer a DRP.[5]

Australia’s dividend imputation tax system,introduced in July 1997, has a central role in corporate dividend policy. Under imputation a resident shareholder’s tax on dividend income is reduced by a firm’s prior payment of Australian corporate tax. As Marks (1990) noted, in imputation systemscorporate taxes are the prepayment of personal tax. When the corporate tax rate exceedsa shareholder’s personal tax rate,paying franked dividends reduces the effective tax rate on corporate income. When the personal tax rate is higher than the corporate rate,high marginal rate shareholders pay additional taxand should prefer investments offering capital returns to dividends. During imputation’s first year of operation the top marginal rate for individuals was aligned to the corporate rate. Every year since, however, the top marginal rate has exceeded the corporate rate. The low concessional tax rates paid by complying superannuation funds havenevertheless created a strong clientele ofinstitutional investors seekingdividends with franking credits.

Franking credits have no value unless there is an expectation the firm will distribute them and DRPs make this distribution easier. Bruckner, et al. (1994) raised the possibility that some firms hadaccumulated large credit balances which would be difficult to distribute. This supposition is supported by the Hathaway and Officer (2004)finding that the full value of credits generated by corporate tax payments was not being passed on to shareholders. DRPs can help firms manage their franking account by distributing more franking credits relative to cash. With conventional dividends firms are limited to attaching tax credits worth D$(tc/1-tc) where D$ is the cash dividend and tc is the corporate tax rate. With DRPs both the dividend paid in cash (D$) and the dividend paid in shares (Ds) carry franking credits. The maximum value of credits distributed (D$+Ds)(tc/1-tc) is greater than that of an equivalent cash only dividend. However, as shareholders determine their level of reinvestment, DRP firms don’t know how much cash they need to budget for the dividend.[6]

2.2Dividend Theory and Reinvestment

While the finance literature on normal dividends is far from settled as to why firms pay dividends and how large those should be, arguments spanning information asymmetry, taxation, agency costs, floatation costs, transaction costs, and investor irrationality generally suggest that dividend size is important. Both standard measures of dividend size, yield and payout ratio, are reduced by reinvestment. Boehm and DeGennaro (2011) distinguish between theexplicit, or declared, dividend and the effective dividend after reinvestment. They also note that a DRP firm’s declared yield needs to be higher to match the effective yield of a non-DRP firm.

2.2.1Floatation Costs, Transaction Costs, and Investor Irrationality

Floatation and transaction cost arguments both suggest firms should select an appropriate dividend policy that minimises the need for other, costly, transactions. For example if a firm pays too large a dividend, it will then need to raise funds and incur floatation costs. Similarly, if a dividend is larger than shareholders want, they can reinvest the surplus themselves, or if the dividend is too small or non-existent shareholders can sell shares to create a home-made dividend. Both adjustments involve transaction costs which an optimally sized dividend will minimise. Without reinvestment there will need to be trade-offs in setting an optimal dividend.A smaller dividend mayreduce floatation costs but increase shareholders’ transaction costs if they create home-made dividends instead. Even if transaction costs are minimised, differences between individual shareholders mean home-made dividends and reinvestment will still occur. A reinvestment plan will lower floatation costs if DRP issues are less costly than other forms of equity issue. This is likely as there is less need to prepare prospectuses, engage underwriters or sell shares at a significant discount to the current market price. Reinvestment plans should minimise transaction costs by providing large dividends that satisfy shareholders wanting dividend income, eliminating the need for home-made dividends, while providing reinvestment to those who prefer it.

The investor irrationality arguments summarised by Lease, et al. (2000)indicate that shareholders still want dividends, even when this imposes other costs. Regular dividend payments provide income for consumption and help shareholders resist the urge to withdraw investment capital, or by delegating the dividend decision to management shareholders are less likely to feel responsible if the decision turns out to be unwise.[7] If these arguments hold then reinvestment plans undermine adividend’s benefits, by moving responsibility for deciding the level of cash received back to the shareholder.

2.2.2Information Asymmetry and Signalling

The information asymmetry that exists between management and shareholders means that dividends can signal about a firm’s potential. Lintner (1956) argued that although recent earnings provide the main basis for shareholders’ expectations of future earnings, dividends provide valuable supporting evidence. As dividends need to be supported by underlying earnings, management is unlikely to increase dividends without a similar change to expected earnings. Such interaction effects, between dividend and earnings announcements in Australia, have been found by Easton (1991) and How, et al. (1992). Underlying these signals is the idea that while management can manipulate reported earnings, a declared dividend must be paid. However, if the firm has a DRP then the effective dividend can be much smaller than the declared dividend and this will undermine the strength of the signal.

Event studies are commonly used to test information asymmetry and have been extensively used in DRP research. These use an information asymmetry framework borrowed from research on share issues, rather than from dividend policy. Generally share issues are seen as negative signals,as management is more inclined to issue when share prices are relatively high, but that does not necessarily apply to DRPs.As Scholes and Wolfson (1989) argue, DRPs commit management to a series of regular small equity issues where timing is less likely to be of concern.Dubofsky and Bierman (1988) argue that introducing a DRP provides a positive signal if it shows the firm is using a lower cost source of capital or helping shareholders avoid transaction costs. The signal could be negative if the DRP moves the firm away from its optimal capital structure orhas high operational costs.

In Australia Chan, et al. (1993) found positive reactions to DRP introductions after the adoption of the imputation tax system. Similarly Chan, et al. (1996) found the market responded positively to DRP introduction but their results were mixed when the sample was divided according to the discount offered.The emphasis of these papers, however, is on the benefits of DRP use in an imputation environment rather than the reduction of information asymmetry.

2.2.3Taxation

The role of tax in dividend policy varies greatly and depends on the design of a country’s tax system. Classical tax systems discourage dividend payments by imposing an additional layer of tax when dividends are paid. Integrated tax systems, like Australia’s imputation system, allow individual tax to be offset by the corporate tax already paid. In Australia’s case the combination of dividend franking, where tax credits are attached to dividends, and progressive individual tax rates mean that some shareholders prefer dividends while others prefer capital gains. DRP transactions are deemed to occur after dividends, and their attached franking credits, are paid.Therefore shareholders are taxed identically irrespective of their preference for cash or shares. However, by reducing the cash outflow DRPs may allow Australian firms to declare larger dividends and distribute more franking credits than they could otherwise afford.

Although a classical tax system prevailed in Australia when DRPs wereintroduced,Bellamy (1994)and Pattenden and Twite (2008)found a significant increase in the number of firms offering DRPs following the introduction of dividend imputation. Pattenden and Twite also show BSP use peaked in 1987 as the introduction of imputation and CGT reduced the tax advantages BSPs had over DRPs. For example, low tax rate shareholders, including complying superannuation funds should prefer franked dividends, either as cash or DRP shares, to capital distributions through a BSP. Both types of plan remain in use today but very few companies continue to offer BSPs.Almost every BSP firm in our sample simultaneously offered a DRP.