Chapter 17: Payout policy Flashcards
How are dividends paid, and how do companies decide how much to pay? (LO17-1)
Dividends come in many forms. The most common is the regular cash dividend, but sometimes companies pay a stock dividend. A firm is not free to pay dividends at will. For example, it may have accepted restrictions on dividends as a condition for borrowing money.
Dividends do not go up and down with every change in the firm’s earnings. Instead, managers aim for smooth dividends and increase dividends gradually as earnings grow.
How are repurchases used to distribute cash to shareholders? (LO17-1)
Corporations also distribute cash by repurchasing shares, but stock repurchases do not always replace dividends. Mature firms that pay dividends also repurchase shares. On the
other hand, thousands of U.S. corporations pay no dividends at all. When they pay out cash, they do so exclusively through repurchases.
Why are dividend increases and repurchases usually good news for investors? Why are dividend cuts bad news? (LO17-2)
Managers do not increase dividends unless they are confident that the firm will generate enough earnings to cover the payout. Therefore, the announcement of a dividend increase
conveys the managers’ confidence to investors. Dividend cuts convey lack of confidence. Managers generally avoid them unless their firms are in trouble. This information content of dividends is the main reason that stock prices respond to dividend changes. Repurchases are usually also good news. For example, announcement of a repurchase program can reveal managers’ view that their company’s stock is a “good buy” at the cur- rent price.
Cash payouts by dividends and repurchases can also reassure investors who worry that managers might otherwise spend the money on empire-building and negative-NPV projects.
Why would payout policy not affect firm value in an ideal world? (LO17-3)
If we hold the company’s investment policy and capital structure constant, then payout policy is a trade-off between cash dividends and the issue or repurchase of common stock. In an ideally simple and perfect world, the choice would have no effect on market value. An increased cash dividend would require more shares issued or fewer shares repurchased. The increased cash in shareholders’ wallets would be exactly offset by a lower share price. This is MM’s dividend-irrelevance proposition.
How might differences in the tax treatment of dividends and capital gains affect payout policy? (LO17-4)
In the United States, individual investors currently pay tax on dividend income at a top rate of 23.8%. The top capital gains rate is also 23.8%, but the investor pays no tax on capital gains until his or her shares are actually sold. The longer the wait before the sale, the lower the present value of the tax. Thus, capital gains have a tax advantage for investors. The advantage was much greater in the 1970s and early 1980s, when the top tax rate on divi- dends was 50% and the top rate on capital gains only 20%.
If dividend income is taxed more heavily than capital gains, investors should shun high- dividend stocks. Instead of paying high dividends, corporations should shift to repurchases.
How does payout policy normally evolve over the life cycle of the firm? (LO17-5)
Young, rapidly growing firms are usually raising cash from investors, not distributing it. Such firms rarely pay dividends, although they may repurchase from time to time. Mature firms that generate positive free cash flow make regular payouts, often by repurchases as well as dividends. Commitment to a regular dividend can reassure investors who worry about free-cash-flow problems, that is, about overinvestment and inefficient operations.
