(LT) Payout policy (3)

Question 1

What does Payout policy mean?

And when a firm pay outs excess cash flows, what 2 things can it do?

Answer 1

What a company does with any cash flow left over, Does it return it to its shareholders and if so How?

1) Repurchase its own shares in the market ]
2) Pay dividends

Question 2

What is a cash dividend and what is a Stock dividend?

Answer 2

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)

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.( it is a dividend because if the shareholder really needs cash, then you can sell them 10 shares for cash and still hold them 100 shares in a firm.)

Question 3

What does deceleration and record date mean?

Question 4

What is deceleration and record date?

Answer 4

Declaration date: Board authorises payment of dividend and
announces dividend amount.
Record date: Only people recorded as shareholders on this date
receive a dividend.

Question 5

What is the Ex-dividend date?
What is the cum-dividend date?
What is payment date?

Answer 5

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. ( the person who sells shares on this date will receive the dividend.
Cum-dividend date: The day before the ex-dividend date.
Payment date: Firm distributes dividend.

Question 6

Identify the Deceleration date, ex-dividend date, record date and payable date

Answer 6

Question 7

What are 2 types of share repurchase?

Answer 7

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%).

Question 8

What is a dutch auction?

Answer 8

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.

Question 9

what is private negotiation ?

Answer 9

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”).

Question 10

In perfect capital markets does dividend payout policy affect a firms value?

Answer 10

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”).

Question 11

What are the five perfect capital market assumptions?

Answer 11

1 Investment is held constant (
2 No transactions costs ( no brokerage fees when you buy and sell shares)
3 Efficient capital markets ( all information reflected in prices, so strong form efficiency, all financial transactions are 0 NPV.)
4 Managers maximise shareholders’ wealth
5 No taxes (or, dividends and capital gains are taxed in the same way.)

If this holds, it doesn’t matter what the firm’s dividend policy is, whether it pays large or small dividend, it has no affect on firm value.

Question 12

How much does the share price drop by?

Answer 12

The share price drops by the amount of the dividend (technically, on the
ex-dividend date). This should happen in perfect markets.

Question 13

Answer 13

Before the dividend, your shareholder value was:
Stock: 1,000 shares @ $55 = $55,000
After the dividend payment:
Stock: 1,000 shares @ $50 = $50,000
Cash: $5/share × 1,000 shares = $5,000
Total: $55,000

Question 14

There is, no impact on shareholder value from dividend payout policy, but there are differences in how this value is distributed between shares and cash. Should this difference matter to investors?

Answer 14

In perfect capital markets, no! If there are no transaction costs, shareholders can create any dividend they desire by selling or buying shares. They don’t need firms to raise cash for them.

Question 15

Suppose Firm A opts to pay a $2 dividend per share but you wanted
$5 per share. After receiving the dividend, you can do what? ( essentially you short of $3000 of cash.

Answer 15

You have 1000 shares, each worth $53, so you just sell some of your shares, to create more cash
Sell (3, 000/53) ≈ 56.60 shares @ $53 = $3,000
Total Cash: $2,000 + $3,000 = $5,000
Shares: 1, 000 − 56.60 = 943.40 shares @ $53 = $50,000
This is the exact distrubtion you would of earned if the firm had paid a $5 dividend per share dividend.
HENCE WE HAVE CREATED A HOMEMADE DIVIDEND.

Question 16

Without doing the maths we should know the answer is?

Answer 16

NOOO. if the assumptions of M&M hold.

Question 17

From previous flashcard fill this in?

Answer 17

The price at which the shares was issued = to the price immediately after issuance, hence issuance was fair, NPV = 0. (A New shareholder has spent $11 to acquire a new share and has received a share worth $11.

Question 18

What is the value to old shares before dividend issuement and after?
Saying that there is 1 shareholder who owns all 1000 shares?

Answer 18

Initial Shareholder value:
Stock: 1,000 shares @ $12 = $12,000.

Value to old shareholders after dividend payment:
Cash: $1,000
Stock: 1,000 shares @ $11 = $11,000
Total: $12,000

Question 19

Lets say that as the investor who owns 1000 shares what else could you do to make your value stay the same of $12000?

Answer 19

Dividend irrelevance is easily seen if the old stockholders just purchase the
new issue themselves with the proceeds from the dividend:
Buy $1, 000/$11 = 91 shares
+ 1,000 shares already owned
= 1,091 shares @ $11 = $12,000

Question 20

What has happened, why are new and old shareholders no better or worse off?

Answer 20

New shareholders contribute to cash – That goes to old shareholders in the form of a dividend.
2) In exchange, the old shareholders have to give something up, which is the 100% ownership of shares – New shareholders receive shares of the company giving them claims to future cash flow. So instead of 100% of old shareholders in this example they have 91% claim of cash flows

If capital markets are 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.

Question 21

So evidence tends to suggest that dividend policy does matter in the market, so what does it mean about Modigliani & Miller dividend irrelevance theroem?

Answer 21

That dividend does matter in the real world and they only way it does is if the one or more of the 5 assumptions of perfect capital markets are relaxed.

Question 22

LETS LOOK AT EACH OF THE 5TH Assumptions of MM?

1) Investment may not be held constant explain?

Answer 22

1) Firms may have used that surplus cash to invest in negative NPV projects like getting a fancy desk, thus paying out dividends increases firms value. Hence the assumptions managers at in best interest of firm is violated here.
2) If paying dividends means sacrificing valuable investment, then it
decreases firm value.

Question 23

LETS LOOK AT EACH OF THE 5TH Assumptions of MM?

2) There are transaction costs

Answer 23

There are costs to mailing dividends (small nowadays) and
buying/selling stocks, e.g. brokerage fees, bid-ask spread, flotation
costs (also smaller nowadays).
Hence homemade dividends are not easy to do.

Question 24

LETS LOOK AT EACH OF THE 5TH Assumptions of MM?

3) Capital markets are not efficient

Answer 24

Information asymmetry – e.g. managers know more about the firm
than outsiders
‘Irrationality’ – markets predictably make mistakes when pricing stocks ( share prices are way higher than true fundamental value of the stock.)
Result: capital transactions are not always conducted at fair prices

Question 25

What are dividend increases in the market?

Answer 25

They are a signal in the market
Dividend decreases are followed by a stock price decline of −1.1 to
−1.4%.
Dividend increases send good news about managers’ confidence in
future cash flows and earnings.
Signals are not credible 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.

Question 26

LETS LOOK AT EACH OF THE 5TH Assumptions of MM?

4) Managers’ preferences differ from shareholders’ preferences

Answer 26

Managers may have short-term objectives, e.g. manipulate dividend policy to benefit themselves e.g may announce a dividend increase, in the SR as it will result in a dividend increase and maybe a managers compensation is linked to this.

Question 27

LETS LOOK AT EACH OF THE 5TH Assumptions of MM?

Taxes are not equivalent

Answer 27

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.

Question 28

With taxes in mind, why might dividends reduce firm value?

Answer 28

Dividends are tax-inefficient
-Taxes for dividends are usually higher
- Cannot be deferred
As a result, dividend paying firms should be less valuable than
non-dividend paying firms