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Finance 2 > PAYOUT POLICY > Flashcards

PAYOUT POLICY Flashcards

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1
Q

What are the uses of free cash flow?

A

If you RETAIN free cash flow it can be INVESTED IN NEW PROJECTS or used to INCREASE CASH RESERVES.

If you PAY OUT free cash flow you can either REPURCHASE SHARES or PAY DIVIDENDS.

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2
Q

PAYOUT POLICY

A

The way a firm chooses between the alternative ways to pay cash out to shareholders.

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3
Q

Explain how a special dividend works.

A

DECLARATION DATE: Board declares special dividend of specified amount.

EX-DIVIDEND DATE:
Buyers of stock on or after this date do not receive dividend.

RECORD DATE:
Shareholders recorded by this date receive dividend.

PAYABLE DATE:
Eligible shareholders receive payment.

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4
Q

TYPES OF DIVIDEND (payout methods)

A

Regular cash dividend

Extra dividend

Special dividend

Liquidating dividend

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5
Q

REGULAR CASH DIVIDEND

A

Semi-annually or quarterly for instance.

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6
Q

EXTRA DIVIDEND

A

Generally at the same time as a regular cash dividend.

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7
Q

SPECIAL DIVIDEND

A

A one-time payment a firm makes, which is usually much larger than a regular dividend.

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8
Q

LIQUIDATING DIVIDEND

A

The final dividend paid to shareholders when a firm is liquidated.

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9
Q

What payout methods do not involve a distribution of value?

A

Stock dividend

Stock split

Share repurchase/buybacl

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10
Q

STOCK DIVIDEND

A

When a company issues a dividend in shares of stock rather than cash to its shareholders.

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11
Q

STOCK SPLIT

A

Similar to stock dividends, but it involves the distribution of a larger multiple of the outstanding shares. This tends to occur infrequently during the life of a company.

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12
Q

SHARE REPURCHASE/BUYBACK

A

The firm uses cash to buy shares of its own outstanding stock through open market repurchase, tender offer (fixed price and dutch auction), or targeted share repurchase.

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13
Q

How do share buybacks differ from dividends?

A

Share buybacks:

  • Do not represent a pro-rata distribution of value to the shareholders because not all shareholders participate.
  • Reduce the number of shares outstanding and the ownership structure.
  • Have different tax rates
  • Are accounted differently on the balance sheet.
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14
Q

MM DIVIDEND IRRELEVANCE

A

In 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.

Investors are indifferent to dividend policy because investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm.

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15
Q

What are the assumptions of perfect capital markets?

A
  1. No taxes, transaction costs, etc.
  2. Homogeneous expectations
  3. The investment and borrowing policies of the firm are set ahead of time.
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16
Q

How do market imperfections arise?

A

Through taxes.
Dividends are typically taxed at a higher rate than capital gains. Long term investors can defer capital gains tax forever by not selling.

THE OPTIMAL DIVIDEND POLICY WHEN THE DIVIDEND TAX RATE EXCEEDS THE CAPITAL GAIN TAX RATE IS TO PAY NO DIVIDENDS AT ALL.

17
Q

How are dividends taxed?

A

Generally taxed as ordinary income.

18
Q

How are share repurchases taxed?

A

Taxed as capital gains.

19
Q

What are dividend tax rate factors?

A

Income level
Investment horizon
Tax jurisdiction
Type of investor or investment account

20
Q

How are long term investors taxed?

A

More heavily taxed on dividends, so they would prefer share repurchases to dividend payments.

21
Q

What tax preference would one-year investors, pension funds, and other non-taxed investors prefer?

A

NO TAX PREFERENCE for share repurchases over dividends; they would prefer a payout policy that most closely matches their cash needs.

22
Q

CLIENTELE EFFECTS

A

When the dividend policy of a firm reflect the tax preferences of its investor clientele.

  • Individuals in the highest tax brackets have a preference for stocks that pay no or low dividends.
  • Tax free investors and corporations have a preference for stocks with high dividends.

The dividend policy of a firm is optimised for the tax preference of its investor clientele.

23
Q

PAYOUT VERSUS RETENTION OF CASH: Retaining cash with perfect capital markets

A
  • Buying and selling securities is a zero-NPV transaction, so it should not affect firm value.
  • Shareholders can make any investment a firm makes on their own if the firm pays out the cash.
  • The retention versus payout decision is irrelevant.
  • MM payout irrelevance
24
Q

PAYOUT VERSUS RETENTION OF CASH: Retaining cash with imperfect capital markets. TAX

A

TAXES AND CASH RETENTION:
-Cash can be thought of as equivalent to negative leverage so the tax advantage of leverage implies a tax disadvantage to holding cash.

INVESTOR TAX ADJUSTMENTS:

  • 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.

The net result is that interest on retained cash is taxed twice.
Under most tax regimes there remains a substantial tax disadvantage for the firm to retaining excess cash even after adjusting for investor taxes.

25
Q

Why would firms retain cash in imperfect markets for issuance and distress costs?

A
  • Firms retain cash balances to cover potential future cash shortfalls, which allows a firm to avoid the transaction costs of selling new debt or equity issues.
  • Used to avoid financial distress during temporary periods of operating losses.

A firm must balance the tax costs of holding cash with the potential benefits of not having to raise external funds in the future.

26
Q

What are the agency costs of retaining cash?

A
  • There is no benefit to shareholders when a firm holds cash above and beyond its future investment or liquidity needs.
  • There are likely to be agency costs associated with having too much cash in the firm.

Paying out excess cash though dividends or share repurchases can boost the stock price by reducing managers’ ability and temptation to waste resources.

27
Q

DIVIDEND SMOOTHING

A
  • 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.
28
Q

DIVIDEND SIGNALLING HYPOTHESIS

A

The idea that dividend changes reflect managers’ views about a firm’s future earning prospects.

This signal is weaker than that of leverage changes.

29
Q

SIGNALLING OF SHARE REPURCHASE

A
  • Share repurchases may be less of a signal than dividends about future earnings of a firm due to less commitment.
  • But, share repurchases are a credible signal that the shares are under priced, because if they are over priced a share repurchase is costly for current shareholders.

Finance 2 (10 decks)

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