LT (3) Payout Policy Flashcards
What is payout policy?
Payout Policy: the way in which a firm decides how to distribute free cash flows to shareholders.
FCF –> Retain (invest in new projects or increase cash reserves) OR Payout (Pay dividend or repruchase shares.)
What is a cash dividend?
Cash Dividend: firm pays cash to shareholders on a pro-rata basis, e.g. shareholders receive $0.50 in cash for each share held.
Regular Cash Dividend (quarterly, semi-annual)
Special Cash Dividend (one-off)
What is a stock dividend?
Stock Dividend: firm pays additional stock to shareholders on a pro-rata basis, e.g. 10% stock dividend → shareholders receive 10 additional shares for every 100 currently held.
No actual transfer of cash to shareholders
Essentially a stock split with a much smaller split factor
e.g. 2-for-1 split: every 100 shares receive 100 new shares
What is the declaration date?
Declaration date: Board authorises payment of dividend and announces dividend amount.
What is the record date?
Record date: Only people recorded as shareholders on this date receive a divided
What is the ex-dividend date?
Normally 1-2 days before record date. Anyone purchasing shares on or after this date will not be eligible to receive the dividend.
What is the cum-dividend date?
The day before the ex-dividend date.
What is the payment date?
Payment date: Firm distributes dividend.
What is a share repurchase and what are two ways this can be done? (4 ways in total.)
Share repurchase: firm uses cash to purchase its own stock from shareholders.
Open market repurchase (most common):
Firm purchases shares in the open (i.e. secondary) market
anonymously.
Usually lasts up to 3 years
Tender offer:
Firm pre-specifies the number of shares and the price which it will offer to repurchase shares.
The offer price is normally at a premium to the current market price (typically 10-20%).
(Not obliged to purchase if undersubscribed, bad for exisiting shareholders if they are priced fairly)
Dutch auction:
Firm provides a schedule of possible repurchase prices and invites stockholders to state the number of shares they are willing to sell at each price.
The firm selects the lowest price at which it can repurchase the desired number of shares.
Private negotiation:
Firm offers to repurchase shares from a specific shareholder, normally at a significant premium to the market price. By buying out a major shareholder, the firm can remove the threat of a takeover (“greenmail”).
In perfect capital markets does dividend payout policy affect a firms value?
Franco Modigliani & Merton Miller (“MM”) showed that in perfect capital markets, this argument is incorrect. In such a world, payout policy is value-irrelevant (“Dividend Irrelevance”).
What are the five perfect capital market assumptions?
If the following assumptions hold: (perfect capital market assumptions.)
1 Investment is held constant
2 No transactions costs
3 Efficient capital markets
4 Managers maximize shareholders’ wealth (no agency problem costs)
5 No Taxes (or, dividends and capital gains are taxed in the same way.) –> does not imply same tax rate.
Then, dividend policy does not affect the value of the firm and the wealth of shareholders
There is, no impact on shareholder value from dividen payout policy, but there are differences in how this value is distributed between shares and cash. Should this difference matter to investors?
In perfect capital markets, no!
If there are no transaction costs, shareholders can create any dividend they desire by selling or buying shares.
SHAREHOLDERS CAN CREATE HOMEMADE DIVIDENDS.
Since investors do not need dividends to convert shares to cash they will not pay higher prices today for firms with higher dividend payouts.
→ In other words, dividend policy will have no impact on the value of the firm
→ Dividend policy is irrelevant
Does the decsion of a firm to repurchase shares affect shareholder wealth?
But what about (open market) share repurchases?
The same reasoning applies, ending in the same result: the decision to repurchase shares does not affect firm value or shareholder wealth (Problem Set!) (Shareholders are indfiferent.
What happens if a company decides to pay a larger dividend today than it has available surplus cash?
DIVIDEND IRRELEVANCE –> Shareholder value is the same.
Assume comany decides to pay the dividend and then issues shares to raise the required cash.
Old shareholders:
Receive cash dividend
Their ownership of the company is diluted (less valuable)
New shareholders: Contribute cash
In return, they receive shares of the company
I
f the capital market is efficient, the above transactions are fair, so the net gain/loss to everyone is 0.
The size of the company is unchanged. Thus dividend is irrelevant.
Why is dividend policy relavent?
How do we know when dividend payout policy may affect firm value?
When these assumptions (perfect capital market assumptions) don’t hold can be used to determine when dividend policy is relavent.
1) Investment may not be held constant
If investment decisions (positive or negative NPV) are affected by dividend policy, then firm value can change
If surplus cash will be wasted by managers, then paying out dividends increases firm value, or
If paying dividends means sacrificing valuable investment, then it decreases firm value.
2) There are transaction costs
There are costs to mailing dividends (small nowadays) and buying/selling stocks, e.g. brokerage fees, bid-ask spread, flotation costs (also smaller nowadays)
3) Capital markets are not efficient
Two possibilities:
I There is information asymmetry – managers know more about the firm than outsiders
Dividend changes can and do change the market’s perception of the firm’s value
What type of signals may dividends convey?
Future earning potentials are good. (For a signal to be credible, it has to be costly to fake.)
The market responds to dividend change announcements:
Dividend increases are followed by a stock price increase of approximately .36%
Dividend decreases are followed by a stock price decline of -1.1 to -1.4%
How big is the magnitude of the stock price response?
An annual equity rate of return of 12% implies a daily average return of 0.05%
Thus, dividends can serve as signals:
Dividend increases send good news about managers’ confidence in future cash flows and earnings.
Signals are not meaningful if everyone can send it.
‘Bad’ firms do not mimic, because they do not have the cash flow to support a high dividend payout policy.
II Markets predictably make mistakes when pricing stocks Result: capital transactions are not always conducted at fair prices.
Then the stock sale is no longer a zero NPV transaction Repurchase stocks when undervalued
A practice often called “market timing” (Positive reaction to share repurchases.)
4) Managers’ preferences differ from shareholders’ preferences
Managers may have short-term objectives (e.g. if they retire, change jobs, get replaced, etc.)
If they are not around tomorrow, they may prefer to underinvest and inflate dividends to (temporarily) increase the current stock price and their pay (e.g. bonus)
Solution: link managers compensation to the firms future stock price
Potential problem: managers may then want to overinvest to keep stock prices (temporarily) high, so such a link should be to long-term stock prices. (Feasible?)
5) Taxes are not equivalent
Dividends are taxed similar to ordinary income
Pay when you receive dividend
In the U.K., the first £2K in dividends is tax-free, then 7.5%, 32.5%, or 38.1% depending on your income
Capital gain is usually taxed separately Pay when you sell your investment
In the U.K., the first £11.7K capital gain is tax-free, then 10-20% depending on the size of gain and your income.
These rates vary a lot over time, across countries, and between investor-types.
