Lecture 10 - Optimal payout policy and valuation

Question 1

What do the three opposing points of view between dividends v repurchases state?

Answer 1

1) Right hand side (conservatives): argue that investors pay more for firms with stable, generous dividends
2) On the left side: repurchases mean high stock prices as capital gains are taxed at a lower rate than dividends
3) Centre: Argue that neither repurchases or dividends are better

Question 2

What argument did M&M found?

Answer 2

The middle road party - dividend policy is value irrelevant in a perfect market

Question 3

Why is the payout policy irrelevant in a perfect capital market when the investments and capital structure are not changed?

Answer 3

Increase dividend payout: Will need to issue more shares to fund payout
Decrease dividend payout: Will need to buy back some existing shares with cash that is saved
Thus: any change will be offset by the sale or repurchase of shares

Question 4

Why does shareholder wealth remain the same whether a dividend is paid or shares are bought back?

Answer 4

Either way - the total market capitalisation of the firm (i.e. value) will decrease due to cash being distributed to shareholders

• Dividend: Value per share will fall - but will be offset by the amount received in dividends so therefore shareholder wealth remains the same
• Bought back: The market capitalisation of the firm will decrease (given cash has been paid out) but as the number of shares have decreased.. shareholder wealth will remain exactly the same

Question 5

What then is the difference between a dividend and share repurchase?

Answer 5

• Repurchases avoid the issue of the share price falling on the ex dividend date
• Repurchases also reduce the overall number of shares… so future earnings and dividends per share are higher than if the amount was paid out as dividends

Question 6

What does the discounted cash flow model say that the stock price is?

Answer 6

Stock price= PV of future dividends

Question 7

How do we value shares using the discounted dividend model when the number of shares changes due to a repurchase?
2 methods and explain which will be cum and ex div

Answer 7

Method 1: Calculate new market cap using FCF
PV (or market cap)= FCF/r (cost of capital)
Market cap/ no. of shares= share price (ex div)

Method 2: Dividend growth:
PV of share= Div/ (r-g) - this formula gives the cum (with) div value

Question 8

What impact will there be if 50% of FCF is paid out as dividends, while remainder used for repurchases?

Answer 8

Impact: Perpetual growth rate will increase by 5% every year… constant share repurchases will mean that the dividend amount per share will increase

Question 9

Will market capitalisation and share price be affected by how payout is split?

Answer 9

NO

Question 10

What will the effect of shifting payout to repurchases be?

Answer 10

Reduces the current dividends.. but has an offsetting effect where future earnings and dividend per share will actually increase

Question 11

When will firms not have to worry about dividend policy at all?

Answer 11

Where there are no taxes, issue costs and other complications

Question 12

What do the ‘rightists’ say in relation to payouts? What are the four reasons to support this argument?
What does the right side say in relation to dividends and firm value?

Answer 12

Investors look for firms that pay dividends because of real world imperfections:
1) some financial institutions are restricted legally from holding stock that does not have a dividend history
2) Dividends are ‘spendable’ whereas capital gains are ‘additions to the principle’
3) Some people rely on dividends as a source of income
4) Dividends relieve shareholders of transaction costs and the inconvenience of selling shares
Dividends and firm value:
Companies are free to adjust the supply of dividends to demand and if the supply already meets demand, no firm can increase its value (as investors do not have to pay more for companies that may dividends as there are so many)

Question 13

When will shareholders demand that a payout is made?

Answer 13

When there is plenty of free cash flow but few profitable investments for firms to invest cash in

Question 14

Why might a mature organisation be less willing to give payouts to shareholders?

Answer 14

When corporate governance is weak & the interests of shareholders and managers are not closely aligned

Question 15

What does the ‘left wing’ say in relation to payouts

Answer 15

The left side argue that firms should minimise dividend payouts - as long as dividends are taxed more heavily than capital gains
- use cash to repurchase shares and lower personal taxes

Question 16

What is the problem with the ‘left wing approach’. What do the left wing say in response to this issue

Answer 16

Problem: Why would a company every pay dividends when personal taxes on dividends will always be higher than capital returns
Response: Firms should cut out dividends to the point at which stock issues are unnecessary

Question 17

Which type of payout do lightly taxed institution investors prefer? What about heavily taxed investors?

Answer 17

High yield stocks for low income investors, lower yield stock for higher income investors

Question 18

How has tax affected payouts in Australia & comparatively, in the US?

Answer 18

Australia - dividend imputation (avoids double taxation): firms become more willing to increase payout
US: Tax penalty on dividends mean dividend stocks tended to sell at lower prices

Question 19

What does M&Ms theory have to do with the firm life cycle and payouts?

Answer 19

M&M state that - firms should FIRST focus on investment and financing decisions - pay out whatever is left over:

• Younger, growing companies with profitable investment opportunities: do not pay out cash and rarely repurchase stock (reduces costs of issuing securities and minimises shareholders taxes)
• Mature company- surplus cash accumulated - investors press for payout - worry managers will overinvest with excess cash

Question 20

Will a firm pay dividends or repurchase shares when it becomes mature?

Answer 20

Repurchase first… investors expect the dividend to continue

Question 21

What is the three criteria for cash surplus and hence a payout?

Answer 21

1) The firm is generating positive free cash flow after making all investments with positive NPVs and the positive FCF is likely to continue
2) Debt level is prudent and manageable
3) Firm has a warchest of cash or unused debt capacity

Question 22

What does the P:E ratio represent?

Answer 22

How much investors are willing to pay for $1 of income per share

Question 23

What will the payout policy be and P:E ratio be for the following:

• Risk companies - high risk companies
• One time even - decline in profits
• Growth companies that expect to decline

Answer 23

• Risk companies - high risk companies: Low payouts and low P:E ratio
• One time even - decline in profits : Companies that have a temporary decline in profits: High payout and high P:E ratio
• Growth companies that expect to decline : Low payout and low P:E ratio

Question 24

Are generous dividend payouts and high price: earnings positively correlated?

Answer 24

NO