Chapter 17 - Payout policy Flashcards
(43 cards)
two ways of distributing cash to equity holders
repurchase shares and pay dividendes
generally speaking, what can a firm do with free cash flow
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.
If a firm choose to pay its owners, what options does it hgave?
dividends or stock repurchase
What shapes a firm’s payout policy
market imperfections. Taxes, transaction costs, asymmetric informaiton.
What is “payout policy”?
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.
who determines how much dividends to pay?
firms board of directors
What do we call the day that the board authorize the divident?
The declaration date
What is so special about the declaration date?
It signifies an obligaiton to pay the dividend.
When will the firm pay the dividend?
When a firm do a share repurchase, what is typically done with the shares+
usually kept in their treasury, keeping them readily avialble should they need to raise capital.
3 types of share repurchases
Open market repurchase
Tender offer
Targeted repurchase
elaborate on the open market repurchase
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.
When do firms use other methods than the open market repurchase+
if the repurchase is very significant, it might be better to use the other ways.
Elaborate on the tender offer
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.
elaborate on the targeted repurchase
Find a major shareholder, and buy his shares. the price is negotiated directly with this dude.
What is a dutch auction?
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.
What is greenmail?
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
In perfect capital markets, do we prefer share repurchase or dividends?
Doesnt matter
What does it mean if soemthng trades cum-dividend?
trade with the dividend. happens right before the ex-dividend date, because everyone who owns the share is entitled to the dividend.
Elaborate on what happens to the value of the firm and the value from equity holders’ perspective when a dividend happens
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.
What is a homemade dividend?
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.
elaborate on share repurchase in perfect capital markets
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.
In perfect capital markets, does it matter to use dividends or stock repurchase?
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.
elaborate on the high dividend case
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.