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.
Dividend capture and tax clienteles
- The preference for share repurchases rather than dividends depends on the difference between the dividend tax rate and the capital gains tax rate.
- – Tax rates vary by income, by jurisdiction, and by whether the stock is held in a retirement account.
- – Given these differences, firms may attract different groups of investors depending on their dividend policy.
Tax differences across investors
- The effective dividend tax rate differs across investors for a variety of reasons.
– Income Level
– Investment Horizon
– Tax Jurisdiction
– Type of Investor or Investment Account - As a result of their different tax rates, investors will have varying preferences regarding dividends.
Payout vs retention of cash
- In perfect capital markets, once a firm has taken all positive-NPV investments, it is indifferent between saving excess cash and paying it out
- With market imperfections, there is a tradeoff: Retaining cash can reduce the costs of raising capital in the future, but it can also increase taxes and agency costs
Retaining cash with perfect capital markets
- If a firm has already taken all positive-NPV projects, any additional projects it takes on are zero or negative-NPV investments.
- – Rather than waste excess cash on negative-NPVprojects, a firm can use the cash to purchase financial assets.
- – In perfect capital markets, buying and selling securities is a zero-NPV transaction, so it should not affect firm value.
Thus, with perfect capital markets, the retention versus payout decision is irrelevant.
MM payout irrelevance
shareholders are indifferent about whether the firm pays the dividend immediately or retains the cash.
MM Payout Irrelevance
– 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 share price.
Taxes and cash retention
Corporate taxes make it costly for a firm to retain excess cash.
– Cash is equivalent to negative leverage, so the tax advantage of leverage implies a tax disadvantage to holding cash.
cash retention and adjusting for investor taxes
The decision to pay out versus retain cash may also affect the taxes paid by shareholders.
- – When a firm retains cash, it must pay corporate tax on the interest it earns.
- – In addition, the investor will owe capital gains tax on the increased value of the firm.
- – In essence, the interest on retained cash is taxed twice.
If the firm paid the cash to its shareholders instead, they could invest it and be taxed only once on the interest that they earn.
- §The cost of retaining cash therefore depends on the combined effect of the corporate and capital gains taxes, compared to the single tax on interest income.
- §These combined effects lead to an effective tax disadvantage of retaining cash
Signalling with payout policy
- Dividend Smoothing
– The practice of maintaining relatively constant dividends
§ Firm change dividends infrequently, and dividends are much less volatile than earnings.
Management believes that investors prefer stable dividends with sustained growth.
– Management desires to maintain a long-term target level of dividends as a fraction of earnings.
§ Thus, firms raise their dividends only when they perceive a long-term sustainable increase in the expected level of future earnings and cut them only as a last resort.
Dividend signalling hypothesis
– The idea that dividend changes reflect managers’ views about a firm’s future earnings prospects
§ If firms’ smooth dividends, the firm’s dividend choice will contain information regarding management’s expectations of future earnings.
- When a firm increases its dividend, it sends a positive signal to investors that management expects to be able to afford the higher dividend for the foreseeable future.
- When a firm decreases its dividend, it may signal that management has given up hope that earnings will rebound in the near term and so need to reduce the dividend to save cash.
Dividend signalling exceptions
- Although an increase of a firm’s dividend may signal management’s optimism regarding its future cash flows, it might also signal a lack of investment opportunities.
- Conversely, a firm might cut its dividend to exploit new positive-NPV investment opportunities.
– In this case, the dividend decrease might lead to a positive, rather than negative, stock price reaction.
Signalling and share repurchases
- Share repurchases are a credible signal that the shares are underpriced, because if they are overpriced a share repurchase is costly for current shareholders.
– If investors believe that managers have better information regarding the firm’s prospects and act on behalf of current shareholders, then investors will react favorably to share repurchase announcements.
Stock dividends and splits
With a stock dividend, a firm does not pay out any cash to shareholders.
§ As a result, the total market value of the firm’s equity is unchanged.
§ The only thing that is different is the number of shares outstanding.
– The stock price will therefore fall because the same total equity value is now divided over a larger number of shares.
Stock splits
Stock dividends are not taxed, so from both the firm’s and shareholders’ perspectives, there is no real consequence to a stock dividend.
§ The number of shares is proportionally increased, and the price per share is proportionally reduced so that there is no change in value.
- – The typical motivation for a stock split is to keep the share price in a range thought to be attractive to small investors.
- – If the share price rises “too high,” it might be difficult for small investors to invest in the stock.
- Keeping the price “low” may make the stock more attractive to small investors and can increase the demand for and the liquidity of the stock, which may in turn boost the stock price.
- § On average, announcements of stock splits are associated with a 2% increase in the stock price.
Reverse split
When the price of a company’s stock falls too low and the company reduces the number of outstanding shares
Spin-offs
Rather than pay dividend using cash or shares of its own stock, a firm can also distribute shares of a subsidiary – referred to as spin-offs
§ Technically, the firm is selling off its subsidiary.
§ Non-cash special dividends are commonly used to Spin- off assets or a subsidiary as a separate company
Spin offs offer two advantages
– It avoids the transaction costs associated with a subsidiary sale.
– The special dividend is not taxed as a cash distribution.
The tax disadvantage of dividends
- Shareholders must pay taxes on dividends received and capital gains taxes when they sell
Taxes on dividends typically higher than taxes on capital gains - The higher tax rate on dividend makes it undesirable for firms to raise funds to pay dividends.
Suppose a firm raises $10 million from shareholders and uses this cash to pay them $10 million dividends. If the dividend is taxed at 40% rate, and if capital gains are taxed at a 15% rate, how much will shareholders receive after taxes? - When the tax rate on dividends is > 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 instead of dividends
- The optimal dividend policy in this case is to pay no dividends at all.
The effective dividend tax rate
If Div(1−τd)>(Pcum −Pex)(1−τg),investor earns profits by trading to capture dividends
However, if Div (1 − τd ) < (Pcum − Pex )(1 − τg ) investor makes loss.
Clientele effects
Differences in tax preferences across investor groups create clientele effect.
* That is, the dividend policy of a firm reflects the tax preference of its investor’s clientele.
* Another clientele strategy is the dynamic clientele effects, also called the dividend-capture theory
* It states that absent transaction costs, investors can trade shares at the time of dividend so that non-taxed investors receive the dividend
Advantages of stock dividends
Not taxed - no real consequences to stock dividends.
- It keeps share price in a range thought to be attractive to small investors
- This in turn increases demand/liquidity of stock.
- Recent examples in 2022 includes Tesla Inc (3:1), Fortinet Inc (5:1) etc
Signalling vs cash retention
A dividend payout is a good signaling tool to investors on the current and future prospects of a firm.
When a firm retains its earnings, this increases the information asymmetry between investors and managers of the firm. That is investors do not know if the firm is in good standing or not. Only managers know the current and future prospects of the firm.
If this firm in question, is faced with new investment opportunities with positive NPV and needed to raise funds, investors (both debt and equity) are less willing to invest except at very high returns because of the information asymmetry between the information set of the manager and investors. As such they will require a higher return.
This will lead to adverse selection (the market for lemons). Firms with good future and current prospects reduce the information asymmetry by signaling through dividend payouts. As such can raise new capital at a lower cost. Firms with poor prospects, will not pay dividends and will face higher costs on their new capital.
In sum, the implication here is that retaining earnings can lead to a high cost of raising new capital due to adverse selection. When a firm retains its earnings, that earning might not be sufficient to fund all new positive NPV projects.
