Chapter 17 - Payout policy

Question 1

two ways of distributing cash to equity holders

Answer 1

repurchase shares and pay dividendes

Question 2

generally speaking, what can a firm do with free cash flow

Answer 2

if the firm has positive NPV projects, it could invest the FCF into these, which will increase the value of the firm.

Or, it could use the FCF to pay directly to investors.

The decision of what to do with the FCF depends on the maturity of the firm amongst other things.

insane as it sounds, many firms are so large that they produce more cash than they need for their projects. Although some cash reserve is great to have, it is usually good to pay it out.

Question 3

If a firm choose to pay its owners, what options does it hgave?

Answer 3

dividends or stock repurchase

Question 4

What shapes a firm’s payout policy

Answer 4

market imperfections. Taxes, transaction costs, asymmetric informaiton.

Question 5

What is “payout policy”?

Answer 5

Payout policy refers to the way a firm choose to spend its FCF.

A firm can retain or pay out FCF. Retaining is about investing in new projects or to increase cash reserve.
Payout is split between dividends and stock repurcahse.

Question 6

who determines how much dividends to pay?

Answer 6

firms board of directors

Question 7

What do we call the day that the board authorize the divident?

Answer 7

The declaration date

Question 8

What is so special about the declaration date?

Answer 8

It signifies an obligaiton to pay the dividend.

Question 9

When will the firm pay the dividend?

Answer 9

Question 10

When a firm do a share repurchase, what is typically done with the shares+

Answer 10

usually kept in their treasury, keeping them readily avialble should they need to raise capital.

Question 11

3 types of share repurchases

Answer 11

Open market repurchase

Tender offer

Targeted repurchase

Question 12

elaborate on the open market repurchase

Answer 12

This is the most common way firms buy back shares.

Typically done by the firm first announcing the fact that they want to buy shares, and then buy shares during a period of time, like any other investor.

The firm is not obligated to buy the shares. However, there are some rules by the SEC that prevent manipulation of price, like buying excessive amount very fast etc.

Question 13

When do firms use other methods than the open market repurchase+

Answer 13

if the repurchase is very significant, it might be better to use the other ways.

Question 14

Elaborate on the tender offer

Answer 14

Tender shares, which means that the firm offer everyone who owns shares to sell the share for some pre specified price witihn some time.. Typically at a substantial premium.
if there are not enough shareholders interested to tender the shares, the firm can elect to not do it.

Question 15

elaborate on the targeted repurchase

Answer 15

Find a major shareholder, and buy his shares. the price is negotiated directly with this dude.

Question 16

What is a dutch auction?

Answer 16

The firm list different prices at which it is willing to buy shares. Then the shareholders can choose how many shares they are willign to sell at eahc price etc.

Question 17

What is greenmail?

Answer 17

greenmail refers to the case where the firm choose to buy out a major shareholder, typically at a large premium, as a result of the shareholder threatening to remove the management etc

Question 18

In perfect capital markets, do we prefer share repurchase or dividends?

Answer 18

Doesnt matter

Question 19

What does it mean if soemthng trades cum-dividend?

Answer 19

trade with the dividend. happens right before the ex-dividend date, because everyone who owns the share is entitled to the dividend.

Question 20

Elaborate on what happens to the value of the firm and the value from equity holders’ perspective when a dividend happens

Answer 20

cum-dividend, the share price is equal to dividend + PV(future dividends), and divided by shares outstanding.

Right after the dividend, the value is PV(future dividends) divided by shares outstanding. So, in other words, the value of the firm falls by an amount equal to the dividend. This makes a lot of sense, since this represent cash that the firm no longer posess.

From the equity holder, it is tempting to say that he loose value because the sahre price goes down. However, the investor is also given teh dividend.
if there is only one owner, he will receive the entire dividend, which is exactly equal to the loss in firm value. So, while his value from the market value of equity drops, he gains the exact same amount from the transaction, leaving him with the same amount.

I suppose that this generalize to the fact that in perfect capital markets, this is simply a financial transaction that doesnt create nor destroy value. Therefore, the equity owner should be indifferent, if disregarding the fact that he might need cash to increase utility and all that. Purely looking from a value perspective, the value that the investor owns is the same.

The question is, why is this happening? If it did not happen, there would be an arbitrage opportunity. FOr instance, if the stock happen to not trade exactly at the div+PV(future div), then we could buy it, receive the dividend, and then when the stock goes to PV(future div) we sell it. We’d get the difference between the cum-dividend price and the dividend.

Question 21

What is a homemade dividend?

Answer 21

A homemade dividend refers to the case where the firm choose to pay out money buy buying back shares, and the investor have the option to sell shares to essentially create the same cash flow he would have got from a dividend. In perfect capital markets, this would result in the exact same cash distribution as if the firm just chose dividend from the start, and never repurchased shares.

Question 22

elaborate on share repurchase in perfect capital markets

Answer 22

The core idea is that this is a financial transaction. It takes cash out of the firm, but at the same time the shares outstanding is reduced. the market value of the is reduced, but so is the number of shares. This means that from the perspective of the original shareholders, they will receive the full benefit of this transaction.

If the firm has 20 million in excess cash, and it choose to use this cahs to buy back shares, then the market value of equity will be reduced by 20 million. However, assuming the shares are bought at a fair price (Market value of equity / shares outstanding, where market value of equity is computed from something like PV(Future dividends)), the shares outstanding is reduced so that there is an offset happening, and the share price remains the same.

Question 23

In perfect capital markets, does it matter to use dividends or stock repurchase?

Answer 23

no. In either case, the investor can choose to make homemade repurchase or homemade dividend by reinvesting the dividend into more shares or by selling some shares to receive a dividend.

Question 24

elaborate on the high dividend case

Answer 24

High dividend refers to suddenly payign more dividend than you have cash at hand.

Doing this requires either debt or selling equity first. The selling of equity would just offset the dividend addition, so it makes no difference.

Question 25

Do dividends determine stock prices?

Answer 25

Yes

Question 26

Does a firms choice of dividend policy affect the share price?

Answer 26

No. Note that this applies to perfect capital markets.

Question 27

Name an imperfection that affect the payout policy in regards to dividends vs share repurchase

Answer 27

Taxes

Question 28

How does taxes influecne payout policy

Answer 28

There is a different tax rate on dividends and on capital gain

Question 29

when taxes are involved, and the taxes are the same for dividends and capital gain, what is preferred?

Answer 29

Generally, we want to avoid taxation as long as possible. Therefore, especially for longer term investors, the stock repurchase is more beneficial

Question 30

What should the firm do if the tax rate is larger for dividends than for stock repurchases?

Answer 30

If it does not use stock repurchase, it will actually lower the value of the firm. we actually want to pay no dividends at all if the dividend tax rate is larger than the capital gain tax.

Question 31

what is the dividend puzzle?

Answer 31

Firms choosing to pay dividends even though the tax rate for dividends is higher than the capital gain tax rate.

Question 32

elaborate on retention of cash

Answer 32

Retention of cash means that the firm has more funds to invest in positive NPV projects. As we know, if an investment is positive NPV, it will increase the value of hte firm. However, if there are no available positive NPV projects, the firm is actually indifferent from paying out the cash vs holding it. It would not invest it, because it would not be positive NPV. This might look like it is beneficial to pay to investors. But, there is a tradeoff between holding and building cash reserves and having that capital ready when new positive NPV projects emerge, VS being taxed on the cash.

Question 33

If the firm has excess cash but dont have any positive NPV projects to invest in, what can it do with the cash?

Answer 33

Pay it, or invest in market securities. Can also just hold it.

Question 34

What is the MM outcome of payout vs retentoin?

Answer 34

This refers to whether investors are better of if the firm holds excess cash (not invest in NPV positive projects) or pay it out to investors. The MM result is that it does not matter, because in perfect capital markets, the outcome would be the same. The firm would use the excess cash to buy risk free securities, or hte investors would use the dividend to do it.

Question 35

The decision to retain cash, what does it actually depend on?

Answer 35

Various market imperfections. The main suspect is taxes. we also have issuance costs and distress costs. Then we have agency costs

Question 36

Elaborate on how taxes affect the decision on retaining cash

Answer 36

Consider the case where a firm can pay dividend of say 100 000 now, or invest it in risk free securities and pay in a year. The sum after tax in a year, is 100 000 x (1+riskFreeRate)x(1-corpTax) = 100 000 x (0.06)x(0.65) = 100 000 x 1.039 = 103 900. if the investors happen to use their retirement accounts, which is not taxed, they would get the full 6%, thus increasing the dividend's worth to 106 000. This example shows that the taxes can directly influence the decision to retain or pay out.

Question 37

what can a firm do with cash it choose to retain?

Answer 37

Keep it in risk free investment, or invest in projects with positive nPV

Question 38

In perfect capital markets, what is hte outcome of payout vs retaining cash, assuming all positive NPV projects are gone? how about in not perfect capital markets?

Answer 38

Actually indifferent. However, with market imperfections like taxes etc, it makes a difference.

Question 39

what happens if a firm invest in negative NPV projects?

Answer 39

It actually destroys value of the firm. We cannot do this

Question 40

In perfect capital markets, why does it not make a differnec whether the firm pay excess cash out or invest it themselves, assuming that there are no more positive NPV projects available?

Answer 40

The firm would use the cash and invest it in securities. This is exactly the same as the investor would. therefore, there is no differnece here. In perfect capitla markets, financial transactions have 0 NPV. Therefore, it should nti matter.

Question 41

Elaborate on the tax effect on retaining cash, and investing the retained cash in securites (no avilable positive NPV projects)

Answer 41

the firm woud invest in securities. For instance risk free bonds. The firm would be taxed on the returns here. This makes a fucked up case. If the firm payed the dividend immediately at t=0, for instance $100 000, this is what the dividend would be. however, assume the firm select to retain, invest, and pay the dividend one year later. Assuming a risk free rate of 10%, we'd get 110 000, but we'd be taxed on the returns. Since the profit was 10k, we'd be hit with a 10k x 35% tax, and we will pay a dividend of $110 000 - 10kx35% = $106 000. however, the shareholders who received the dividend after t=0, would have gotten the full amount. however, the shareholders would be taxed as well, but at a differnet rate than the corporate tax. Pension fund managers would prefer the dividend early, as they are not taxed on gains. This example represent the intricacies of retaining cash.

Question 42

elaborate on dividend smoothing and dividend signalling

Answer 42

Dividend smoothing refers to dividends that are extremely stable, even when the earnings may fluctuate much. It represent a wish to keep a target dividend and stable returns. Dividend signalling is the case of increasing or decreasing a stable dividend. it would clearly send a signal that the firm is either confident in improved situation, or that they have failed somehow.