PAYOUT POLICY Flashcards
What are the uses of free cash flow?
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.
PAYOUT POLICY
The way a firm chooses between the alternative ways to pay cash out to shareholders.
Explain how a special dividend works.
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.
TYPES OF DIVIDEND (payout methods)
Regular cash dividend
Extra dividend
Special dividend
Liquidating dividend
REGULAR CASH DIVIDEND
Semi-annually or quarterly for instance.
EXTRA DIVIDEND
Generally at the same time as a regular cash dividend.
SPECIAL DIVIDEND
A one-time payment a firm makes, which is usually much larger than a regular dividend.
LIQUIDATING DIVIDEND
The final dividend paid to shareholders when a firm is liquidated.
What payout methods do not involve a distribution of value?
Stock dividend
Stock split
Share repurchase/buybacl
STOCK DIVIDEND
When a company issues a dividend in shares of stock rather than cash to its shareholders.
STOCK SPLIT
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.
SHARE REPURCHASE/BUYBACK
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.
How do share buybacks differ from dividends?
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.
MM DIVIDEND IRRELEVANCE
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.
What are the assumptions of perfect capital markets?
- No taxes, transaction costs, etc.
- Homogeneous expectations
- The investment and borrowing policies of the firm are set ahead of time.
How do market imperfections arise?
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.
How are dividends taxed?
Generally taxed as ordinary income.
How are share repurchases taxed?
Taxed as capital gains.
What are dividend tax rate factors?
Income level
Investment horizon
Tax jurisdiction
Type of investor or investment account
How are long term investors taxed?
More heavily taxed on dividends, so they would prefer share repurchases to dividend payments.
What tax preference would one-year investors, pension funds, and other non-taxed investors prefer?
NO TAX PREFERENCE for share repurchases over dividends; they would prefer a payout policy that most closely matches their cash needs.
CLIENTELE EFFECTS
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.
PAYOUT VERSUS RETENTION OF CASH: Retaining cash with perfect capital markets
- 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
PAYOUT VERSUS RETENTION OF CASH: Retaining cash with imperfect capital markets. TAX
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.
