6. CORPORATE FINANCE

Question 1

“Corporate Payout Policy” by DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner (2008).

What is the residual and lifecycle theory?

Answer 1

Residual theory = Firms pay out excess cash as it arrives.

Lifecycle theory = Firms payouts are based on the benefits and costs of retention over time.

Question 2

“Corporate Payout Policy” by DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner (2008).

How do payout policies differ between young and mature firms?

Answer 2

Young firms avoid payouts due to limited earnings despite many profitable investment opportunities. Generate negative FCF (earnings < CapEx needs to undertake new NPV>0 projects).

Mature firm earnings grow, but investment opportunities stabilize or fade, thus payouts become attractive. Generate positive FCF (earnings > CapEx needs to undertake new NPV<0 projects).

Question 3

“Corporate Payout Policy” by DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner (2008).

Describe the strategic use of dividend policy.

Answer 3

Managers can use payout policy in an attempt to influence the behaviour of non-stockholder consituents (employees, customers, the government, etc.) by convincing them to view the firm in a certain light.

For instance, technology firms avoid dividends to continue to be viewed by their customers, employees and investors as “exciting” growth firms with profitable investment opportunities.

Question 4

“Corporate Payout Policy” by DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner (2008).

Name the behavioral biases of investors that can influence payout policy.

Answer 4

 “Consume only out of dividends” – require higher dividends for current consumption (to protect against self-destructive inclinations to sell too much stock now to fund excessive consumption today).

 “Regret aversion” – investors would rather consume out of dividends, since if they sell shares now, they may regret it later if the price increases.

 “Mental accounting” – Investor’s value income coming from different sources differently (dividends might be “more valuable” than capital gains).

 “Catering theory” - “investor sentiment” for dividends varies over time → firms are predicted to supply more dividends in some periods, and less in others, depending on the sentiment premium or discount that investors assign to dividends in those periods.

Question 5

“Corporate Payout Policy” by DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner (2008).

How do corporate manager behavioural biases influence payout policy?

Answer 5

Investors demand that mature firms make substantial payouts to prevent managers from holding cash – because internal cash accumulation encourages a managerial mindset of abundance. Overconfidence can further lead managers to be less disciplined about capital outlays.

Question 6

“Corporate Payout Policy” by DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner (2008).

Describe the idea behind clientele effects/ theories.

Answer 6

Clientele theories predict that because stockholders differ in their desires for current dividends versus capital gains (i.e., future payouts), firms will tailor their payout policies to reflect the demand heterogeneity of the investor population.

Question 7

“Corporate Payout Policy” by DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner (2008).

What are some of the reasons for high dividends?

Answer 7

 Lower agency costs: Fewer opportunities for wasteful spending by managers

 Low growth companies: Mature companies with a lack of good investment prospects (only zero/negative NPV projects are available) -> life cycle theory

 Signaling theory: Dividends signal firm’s future performance (try not to cut dividends to avoid a decrease in share prices because of information asymmetry)

 Bird in hand theory: If investments are highly uncertain, shareholders will prefer the money to be paid out as dividend than invested (desire for current income)

 Clientele effect: Attract investors who are interested in high dividends payouts (e.g., companies facing low taxes)

 Trading costs: Costly to replicate dividends payouts (i.e., “homemade” dividends)

Question 8

“Corporate Payout Policy” by DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner (2008).

What are some of the reasons for low dividends?

Answer 8

 Costs of financial distress: Rather sit on cash than deal with costs of financial distress due to defaulting on debts – especially for highly leveraged companies.

 Good growth prospects: Positive NPV investment opportunities → Typically for younger firms (lifecycle theory)

 Personal taxes of shareholders: Use repurchases trying to minimize taxes for shareholders

 Clientele effect: Trying to attract tax-conscious investors

Question 9

“Corporate Payout Policy” by DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner (2008).

What are the advantages of stock repurchases?

Answer 9

 Financial flexibility

 Correct stock market undervaluation

 Remove low valuation stockholders

 Allocation of voting rights

 Increase reported EPS

 Save transaction costs

 Provide liquidity to investors who want to sell shares