Lecture 4: Payout Policy

Question 1

What are the assumptions of perfect capital markets?

Answer 1

• No taxes
• No transaction or issuance costs
• The investment, financing, and op. policies of the firm are held fixed

Question 2

What does the MM Payout Policy Irrelevance say?

Answer 2

In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s choice of payout versus retention is irrelevant and does not affect the initial value of the firm

Question 3

What does the MM Dividend Policy Irrelevance say?

Answer 3

In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price

Question 4

What methods of paying dividends are there?

Answer 4

• Regular cash dividends
• Extra cash dividends/special dividends
• Liquidating dividends

Question 5

What methods of repurchases are there?

Answer 5

• Open market share repurchases
• Tender offer
• Targeted repurchases
• Accelerated share repurchases

Question 6

Explain the open market share repurchase (OMR)

Answer 6

• Board decides on program size and length
• Decision is followed by an announcement
• Treasury or broker continuously buy back shares in open market
• OMRs constitute 90% of repurchase volume in US

Question 7

Explain the tender offer

Answer 7

• Public offer to acquire stock at a specified price within a specified time window
• Offer includes a minimum and maximum amount of stock to be acquired

Question 8

Explain the targeted repurchase

Answer 8

Privately negotiated deal with a large shareholder

Question 9

Explain the accelerated share repurchase (ASR)

Answer 9

• Firms buy back stock from an investment bank at a fixed price
• Investment banks provide stock which they borrow from their clients
• After the transaction, investment banks acquire stock in the open market and return the stock back to their clients

Question 10

What is an advantage/disadvantage of an ASR?

Answer 10

Advantage; no price risk, less legal risk

Disadvantage: removing risk is usually costly

Question 11

How are OMRs regulated

Answer 11

OMRs are regulated via safe harbour rules

• Sticking to these rules exempts firms from legal prosecution with respect to anti-fraud provisions of the Securities Exchange Act of 1934
• These rules where first introduced in 1982 and led to an increase in OMR’s

Question 12

SEC safe harbour rule 10b-18

Answer 12

Manner of repurchase: all shares must be purchased from a single broker or deal during a single day
Timing: no trading within the last 30 (very liquid: 10) minutes of trading
Price: price must not exceed the highest independent bid or the last transaction price quoted
Volume: No more that 25% of the average daily volume

Question 13

How is payout policy affected by the following:

• Taxes
• Transaction costs
• Issuance and distress costs
• Information asymmetries

Answer 13

Taxes: affect level and method
Transaction costs: affect method
Issuance and distress costs: affect level
Information asymmetries: affect level and method

Question 14

What forms of informational asymmetry are there between corporate insiders and investors?

Answer 14

Signalling: changes to dividends and share repurchases are perceived by the market as signals
Timing ability: non-selling shareholders profit when firms buy back below a fundamental value of stock

Question 15

What signals do changes in dividend give?

Answer 15

Increase in dividends: positive signal

Decrease in dividends: negative signal

Question 16

What is the substitution hypothesis?

Answer 16

Dividends and share repurchases are perfect substitues

Question 17

What is the flexibility hypothesis?

Answer 17

Share repurchases provide more flexibility and, therefore, complement regular dividends

Question 18

What is the clientele effect?

Answer 18

Firms adjust payout such that their investors tax preference is accounted for.