Payout policy Flashcards
Leverage and commitment
- Wasteful spending more likely when firms have high cash flows after taking on all +ve NPV projects with no payment commitments
Leverage ↑ firm’s value because firms are committed to future interest payments, =⇒ ↓ excess cash and wasteful investments - When cash is tight, managers will be motivated to run the firm as efficiently as possible
- In highly levered firms, creditors closely monitor the actions of managers. An additional layer of management oversight.
- Can information asymmetry motivate managers to alter capital structure? if yes, and how?
- Leverage can be a Credible Signal*
- Firm can communicate that their share price is undervalued or is undertaking a highly valued project by taking on more leverage
- Shows that firm can pay interest on debt – positive signal that the firm is involved in profitable ventures
You are an analyst who follows Deliveroo’s stock. Although the current stock price is £100, you believe the stock is worth either £75 or £125, depending on the success of a new product launch. If Deliveroo’s CEO announces that she plans to buy 10,000 additional shares in the company, how will the share price change?
- Implies CEO believes share price are undervalued and thus the share price will go up
Implications for Equity Issuance of the Lemon Principle
- Firms tend to issue equity when information asymmetries are minimized
- The stock price declines on the announcement of equity issuance
Implications for capital structure
- Managers who perceive the firm’s equity is under-priced will have a preference to fund investment using retained earnings, or debt, rather than equity
- The converse is also true
Payout policy
Firm can either retain cash:
- increase cash reserves
- invest in new projects
or payout:
- repurchase shares
- pay dividends
Dividends
The amount of money a company pays regularly (i.e. annually) to its shareholders out of its profits, reserves or liquidation of its assets.
Special Dividend: A one-time dividend payment- usually larger than regular divided
* Stock Dividend (Stock Split) - dividend paid with shares rather than cash
Declaration date
The date on which the board of directors authorizes the
payment of a dividend.
Record date
When a firm pays a dividend, only shareholders on record on this date receive the dividend.
Ex-dividend date
A date, two days prior to a dividend’s record date, on or after which anyone buying the stock will not be eligible for the dividend.
Payable/distribution date
A date, generally within a month after the record date, on which a firm mails dividend checks to its registered stockholders.
Return of capital
When a firm, instead of paying dividends out of current earnings (or accumulated retained earnings), pays dividends from other sources, such as paid-in-capital or the liquidation of assets
Liquidating dividend
A return of capital to shareholders from a business operation that is being terminated
Share repurchases
An alternative to dividend payments is through share repurchasing
The firm uses cash to buy shares of its own outstanding stock.
Forms of share repurchases
Open market repurchase
Tender offer
Dutch auction
Targeted repurchase
Open market repurchase
- Firms repurchases shares by buying shares in the open market. -
- Open market share repurchases represents 95% of all repurchase transactions
Tender offer
A public announcement of offer to all existing shareholders to buy back a specified number of outstanding securities at a prespecified over price* over a specified time period*
* (typically set at a 10% to 20% premium to the current market price) over a prespecified period of time (usually about 20 days).
* – If shareholders do not tender enough shares, the firm may cancel the offer, and no buyback occurs.
Dutch auction
A share repurchase method where:
* Firms lists different prices at which it is prepared to buy shares
Shareholders indicate number of shares they are open to sell at each price.
* The firm then pays the lowest price at which it can buy back its desired number of shares
targeted repurchase
- When a firm purchases shares directly from a specific shareholder
Greenmail
– When a firm avoids a threat of takeover and removal of its management by a major shareholder by buying out the shareholder, often at a large premium over the current market price
Investor preference for payout policy
- In perfect capital markets, investors are indifferent
- Could use homemade dividends replicate either payout methods
- Reinvesting dividends if the firm pays dividends
- Investor sells shares if the firms does not pay dividends
Homemade dividends
In the case of Genron, if the firm repurchases shares and the investor wants cash, the investor can raise cash by selling shares.
If the firm pays a dividend and the investor would prefer stock, they can use the dividend to purchase additional shares
Perfect capital markets vs reality
n 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.
– In a perfect capital market, the type of payout is irrelevant.
– In reality, capital markets are not perfect, and it is these imperfections that should determine the firm’s payout policy.
There is a tradeoff between current and future dividends. – If Genron pays a higher current dividend, future
dividends will be lower.
– If Genron pays a lower current dividend, future dividends will be higher.
The tax disadvantage of dividends
- – Shareholders must pay taxes on the dividends they receive, and they must also pay capital gains taxes when they sell their shares.
- – Dividends are typically taxed at a higher rate than capital gains. In fact, long-term investors can defer the capital gains tax forever by not selling.
– The higher tax rate on dividends makes it undesirable for a
* firm to raise funds to pay a dividend.
* § When dividends are taxed at a higher rate than capital gains, if a firm raises money by issuing shares and then gives that money back to shareholders as a dividend, shareholders are hurt because they will receive less than their initial investment.
Optimal dividend policy with taxes
- When the tax rate on dividends is greater than the tax rate on capital gains, shareholders will pay lower taxes if a firm uses share repurchases rather than dividends.
– This tax savings will increase the value of a firm that uses share repurchases rather than dividends.
The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all.
– The payment of dividends has declined on average over the last 30 years while the use of repurchases has increased.