E2: Payout policy Flashcards
What 3 qs must a financial manager ask themselves before deciding if cash is surplus and payout to shareholders can be exercised?
- is company generating enough sustainable cash flow
- is the firm’s debt ratio prudent
- is there enough cash reserve in case of unexpected shocks etc
What are the two ways companies can pay cash to their shareholders?
- paying a dividend
- buying back some of the company’s stock (repurchases)
Define the process in which dividends are paid
- board sets dividend
- they announce date of payment
- stock falls day before to pay dividend and they are mailed to shareholders
Name the 4 types of dividend
- cash dividend: regular payment to each shareholder
- extra/ special cash dividend: one-off irregular payment
- Automatic dividend reinvestment plans (DRIPs): new shares issued at discounted price
- stock dividends: issues additional shares instea of cash
How can firms repurchase stocks?
- buy them on the open market
- private negotiation with major shareholders
- fixed price offer to shareholders
- dutch auction
What does the announcement of a dividend increase tend to mean?
- signals managers are confident in future prices
- signals managers are confident the cashflows are stable
prompts shareprice increase
Is a cut in dividend payment always bad?
No, sometimes shareholders see it as an advantage as companies protect themselves from macroeconomic uncertainty by saving money on dividends.
-> eg Harley Davidson April 2020, cut D by 95% and the stock rose 15% (pandemic)
shows good financial management
What do stock repurchases signal?
- managers believe the stock is currently undervalued
subsequent share price rise follows
What do MM believe in reference to payout policy?
In a world without taxes, market imperfections, inefficiencies and transaction costs -> dividend policy is value irrelevant
therefore investors should be indifferent to payout policy
In MM’s scenario, does the investors wealth change if a firm decides to spend surplus cash on dividends or repurchases ?
no, a repurchase doesn’t increase the stock price but avoids fall in stock price when D is paid. If dividend is paid then same shares outstanding so share price + D is same wealth.
What happens to old shareholders and the firm if they increase D to the point they have to reissue new shares to raise money ?
MM scenarios
- old shareholder’s suffer a capital loss as share price drops, however it is offset by the higher dividends
- firm value stays same
-> shareholders indifferent to higher D!!!
What causes the transfer of value between old and new shareholders?
- dilution in the value of each share as more are issued
Challenges of MM payout-policy prop.?
- Market is inefficient
- trading in SE is costly
- agency costs (managers prefer to reinvest into business, shareholders prefer profit)
- dividends are taxed more heavily than cap. gains so D may be minimised
What are the three main views of payout policy?
- D are preferred
- Repurchases are better
- MM: payout is irrelevant
How do you calculate the opportunity value of a rights offering?
Opportunity value = (rights on price – issue price) / (N + 1)
