T6 Payout Policy Flashcards
2 ways in which companies pay cash to shareholders
Dividend
Buy back some of company’s stock (repurchase)
How do firms pay dividends
Board of directors sets dividend price
Make an announcement a payment will be made to stockholders at a record date
Day before record date, stocks trade ex dividend i.e. price falls by amount of dividend
Dividend cheques mailed to shareholders
How does a firm repurchase stock
Buys back shares on the market:
‘Tender’ offer to shareholders - offers to buy back stock at fixed price. Dutch auction or private negotiation
How does a firm repurchase stock (Dutch Auction)
firm states a series of prices at which it is prepared to repurchase stock, shareholders submit offers declaring how many shares they wish to sell and firm calculates lowest price at which it can repurchase shares
Why is dividend increase good news for investors
Signals managers confidence in future profits
Predicts safer earnings - unlikely to increase dividends if clash flows are volatile
It is not the absolute value but the change in the dividend that gives investors a signal on the sustainability of companies earnings:
Dividend increase - prompts share price increase
Dividend decrease - prompts share price decrease
Example why not all dividend cuts are bad news
JP Morgan cut dividend but banks share price increased. This was because they acted from a position of relative strength to prepare themselves for a recession. Allowed them to pay off debts quicker.
what does a repurchase of stock signal
managers are not wasting resources on poor investment decisions
Confident about firms prospects and that company’s stock is undervalued
Therefore stock repurchasing announcements correlated with rise in share price
what does a repurchase of stock signal
managers are not wasting resources on poor investment decisions
Confident about firms prospects and that company’s stock is undervalued
Therefore stock repurchasing announcements correlated with rise in share price
Can the payout policy affect the value of the firm itself
It is not the payout policy itself but the information it signals that causes the change in stock value
Is dividend policy relevant in deciding the value of the firm
According to Miller - Modigliani dividend policy is irrelevant. Higher dividends do not make shareholders better or worse off as investors do not need dividends to convert shares to cash. Will not pay higher prices for firms with higher dividend payouts
Any change in the dividend payout must be offset by the sale or repurchases of shares. If markets are efficient the payout policy leaves the total value of the firm unaffected. Shareholders should be indifferent to pay out policy
Previous question continued
Effect of repurchases on stock price and number of shares
Does not increase stock price but avoids fall in stock price that would occur on ex div date if amount spent on repurchases was instead paid as cash dividends
Also reduce number of shares outstanding so future earnings per share are higher than if same amount were paid out as dividends
More shares a firm has in the company the lower the value per share as total value of company is unchanged
Dividends preferred - investors prefer higher dividend payouts so pay more for firms with generous and stable dividends
Repurchases preferred - higher dividends decrease value because dividends are taxed more heavily than capital gains
