Payout policy Flashcards
What can firms do with free cash flows from earnings?
1) Retain earnings either by saving as cash or investing in projects
2) Pay out earnings either by repurchasing shares or paying dividends
How to find the cum-dividend price
d1/ (r-g) + d0
How to find the ex-dividend price
d1/ (r-g)
What is a stock repurchase?
Use of balance sheet to repurchase shares from existing shareholders
What are the ways to carry out a stock repurchase?
1) Tender offer- offering to buy back at a premium
2) Dutch auction- shareholders list quantity and price they want to buy shares.
Advanatges of dividends
By imposing dividends we can curb management’s empire building
Disadvantages of dividends
The firm has fewer assets against creditors which can conflict with debt covenants.
How does the market react to changes in dividend payment?
1) Initiations (starting to pay the dividend)- positive returns as it signals good news.
2) Omissions (stopping dividends)- negative returns as it signals bad news.
What stock repurchases show?
1) Signalling hypothesis- management will conduct stock repurchase if stock is udnerpriced. It reveals private information about firm value.
2) Free cash flow hypothesis- management has less surplus cash to pursue inefficient empire building.
3) Expropriation hypothesis- by reducing the firm’s assets and its equity base via stock repurchases, value can be expropriated from creditors
Why choose dividends over share repurchases?
1) Undervaluation
2) Finaical flexability- stock repurchase is more flexible as there is no need for consistent dividends
3) Managerial preference- if managers have stock options they’ll prefer repurchases as there isn’t a drop in price
4) Tax- investors prefer stock repurchases as selling shares has more favourable tax conditions than dividends
What does MM (1961) show?
In a perfect world, the value of a firm with a fixed investment policy is independent
of its dividend policy
What is the value of selling after record day with tax?
(Ex-dividend price - capital gains tax) * (Ex-dividend price - price at which share purchased) + dividend * (1-tax on dividends)
What is the value of selling before ex-div day with tax?
(Cum-dividend price - capital gains tax) * (cum dividend price - price at which share purchased)
What happens if we have the ex-dividend effect?
Sub in (Cum-dividend price = dividend + ex-dividend price)
H= d * (capital gain tax-dividend tax)
What is thre tax clientel theory of dividends
1) Income oriented investors/ low marginal tax rate investors prefer high dividends
2) Growth oriented investors/ high marginal tax rate investors prefer low dividends
