L17 - Payout Policy Flashcards
What are the two alternative ways through which companies pay cash to their shareholders?
- Paying dividends
- Buying back some of the company’s stock –> buying off shareholders
After 1997 stock repurchases back more common and companies started paying a larger proportion of shareholder through stock repurchases than dividends
- in 2005 there was such a large buyback as the rule 10b-18 of SEC was adopted which prosecuted firms for manipulating their own shares
What are the different types of dividends?
- Regular cash dividend: the dividend paid to each stockholder every quarter (regular payment).
- Special cash dividend: a one-off supplement to the regular dividend (irregular payment). –> much larger than a regular payment
- Automatic Dividend Reinvestment Plans (DRIPs): sometimes offered to stockholders. New shares issued at discount from the market price. - the discount is savings that can be viewed as a cash payment to the stock holder
- Stock dividends (instead of cash): issue of additional shares to stockholders. If a stock dividend of 5% is paid, the company distributes 5 extra shares for every 100 shares currently owned.
How do firms pay dividends?
- The board of directors sets the dividend, e.g. $0.28 per share per quarter
- Declaration date: They make an announcement that payment will be made to all stockholders registered at the particular record date.
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Ex-Dividend Date: On the day before the record date, stocks trade ex-dividend, i.e. price falls by the amount of dividend. - if an investor that buyer it on or after this date is not eligible for the dividend payment
- This will go to whoever held it the previous day
- Record Date: Dividend cheques are mailed to registered shareholders.
- Payment Date: Dividend cheques are mailed to shareholders
How do firm;s repurchase stock?
Instead of paying a dividend to its stockholders, the firm can use the cash to repurchase stock.
This can be done by:
- Buying shares on the market: the firm announces that it plans to repurchase part of its stock in the open market.
- ‘Tender’ offer to shareholders: the firm offers to buy back part of the stock at a fixed price:
- usually with a mark-up over the current market price (as an incentive);
- shareholders may accept or decline the offer.
- ‘Dutch’ auction:
- the firm states a series of prices at which it is prepared to repurchase stock
- shareholders submit offers declaring how many shares they wish to sell at each price;
- the firm calculates the lowest price at which it can repurchase the desired number of shares.
- Private negotiation: direct negotiation with a major shareholder to repurchase a large amount of shares
What are some different reasons for different dividend policies?
A study by Brav, A., Graham, J., Harvey, C., and Michaely, R., 2004. Payout policy in the 21st century. Journal Financial Economics, 77, 483-527 revealed the following about dividends policy.
Three themes stand out:
- Managers are reluctant to make dividend changes that may have to be reversed. They are particularly worried about having to rescind a dividend increase and, if necessary would issue shares or borrow to maintain the dividend
- Managers “smooth” dividends/ Dividend changes follow shift in long-run sustainable earnings. Transitory earning changes are unlikely to affect dividends
- Managers focus more on dividend changes than on a absolute dividend. Thus paying a dividend of $2.00 per share is an important financial decision if last year’s dividend was $1.50, but no big deal if last year’s dividend was also £2
Why are announced of dividend increases good news for investors?
- signals managers’ confidence in future profits. If managers thought increase in earnings were temporary, they would be cautious about committing to cash payouts.
- predicts safer earnings. Managers are less likely to increase dividends when cash flows are uncertain and volatile.
- It is not the absolute value but the rate of change in the dividend that gives investors a signal on the sustainability of a company’s earnings:
- change in dividend increase: prompts share price increase
- change in dividend decrease: prompts share price decrease
Are all dividend cuts bad news for investors?
No they are not
Example: On 23rd February 2009, J.P. Morgan cut its quarterly dividend from 38 cents to 5 cents per share. The cut was a surprise to investors, BUT the bank’s share price increased by about 5%.
J.P. Morgan acted from a position of relative strength. It remained profitable when other large U.S. banks were announcing horrific losses as consequence of the Financial crisis.
The J.P. Morgan dividend cut would save $5 billion a year and prepare it for a worst-case recession.
It would also put the bank in a position to pay back more quickly the $25 billion that it took from the government relief programme.
Thus investors interpreted the dividend cut as a signal of confidence, not of distress
What happens to the value of a firm when investors buy new stock - with other policies fixed?
- Potential investors will buy the new stock (if it is fairly valued, i.e., reflecting the true valuation of the firm).
- However, as the asset, earnings and investment decisions are unchanged…
- The total (real) value of the firm does not change.
How does a stock repurchase announcement signal to investors?
- A repurchase announcement is not a commitment to continue repurchasing stock. –> normally a one-off payment
- Information content less strongly correlated than the announcement of dividend change.
- Stock repurchases arise when companies have earned more cash than they can invest profitability or want to take up more debt
- Repurchases signal that managers are:
- Not wasting resources on perks, empire-building etc.
- confident about the firm’s future prospects
- and that the company is currently undervalued.
- Therefore stock repurchasing announcements correlated with a subsequent rise in the share price. –> makes investors think this is a good stock if companies are buying back large amount at a premium price (boosts confidence)
Is it the payout policy that causes the change in the stock price?
- it is not the payout policy itself but the information it signals that causes the change in the stock value
Can the payout policy affect the value of the firm by itself?
Example in terms of politics
On the right, a “conservative party” argues that investors prefer higher dividend payouts, so they pay more for firms with generous and stable dividends. –> by paying more it drives up the stock price
On the left, a “labour party” argues that repurchases are better; higher dividends decrease value, because dividends are taxed more heavily than capital gains.
And in the center, there is a ”middle-of-the-road” that claims that the payout policy makes no difference!
Who founded the middle-of-the-road party when looking at dividend policy?
The middle-of-the-road party was “founded” in 1961 by Miller and Modigliani (MM).
They published a proof that dividend policy value irrelevant in a world without taxes, transaction costs, or other market imperfections (assuming that capital markets are efficient).
What was MM argument?
the dividend policy is irrelevant!
in the sense that
- higher dividends do not make shareholders either better or worse-off. (or maximise their wealth)
- Since investors do not need dividends to convert shares to cash,
- they will not pay higher prices for firms with higher dividend payouts. –> if they need cash more than the dividend they receive they will sell a part of their stock, and if they don’t they will just reinvest the dividend back into the stock
How can a company provide a higher dividend to existing shareholders if its asset, investment and borrowing policies are fixed?
Given that investment and borrowing policies have been fixed…
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the only way to raise the extra cash is via the issue of new equity
How can a firm sell more shares - given fixed policies?
Higher number of shares & unchanged total value
value per share must be lower!
There has to be a transfer of value from old to new shareholders.
How is value transferred from old to new shareholders?
- Existing shareholders’ value per share falls (if the new equity is to be sold).
- New shareholders get the new shares, but each will be worth less than before the extra dividend was announced.
- Old shareholders suffer capital loss on their shares.
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As capital loss borne by shareholders just offset extra dividend receive → indifference of shareholders to higher dividends!
What are the two ways in which their is a transfer of value between shareholders?
- Transfer of value caused by dilution in the value of each share
- Caused by reduction in the number of shares for old shareholders
