Topic 10 - Dividend Policy Flashcards
Payout policy
the way a firm chooses between the alternative ways to distribute free cash flow to equity holders
3 options for excess cash flow
- Pay out all of it as dividends
- Use it to repurchase shares
- Pay high dividend right now with excess cash and equity raised by selling new shares
how does share repurchase impact share price
in perfect capital markets it shouldn’t impact the stock price. the price should remain the same before and after share repurchase.
how does high dividend pay out influence share price
again, share value should be unchanged. there is a trade-off between current and future dividends
MM Dividend Irrelevance
in perfect capital markets, holding fixed the investment policy of a firm, the firms choice of dividend policy is irrelevant and does not affect the initial share price
the tax disadvantage of dividends
typically dividend tax > capital gain tax
shareholders pay less tax if the firm uses share repurchase rather than dividends.
share repurchase allows shareholders to control the timing of their tax liability, because they’ll only pay tax when they sell their shares.
dividend capture theory
when investors buy stock just before the ex dividend date to capture the dividend payment and then sell it after they’ve received it
Signalling from share repurchase
share repurchase is a credible signal that the shares are under-priced, this warrants a positive market reaction
if an investor observes share repurchase, they will want to buy more shares because they think the price will go up. this alone will drive up the price and allow them to sell for profit
Dividend signalling hypothesis
dividend changes represent managers view about the firms future earnings
div ^ = positive signal that they’ll be able to afford higher divs soon
- could also mean lack of investment opportunity
div drop = negative signal that management expects a bad forecast and need to reduce divs to save cash
- could also mean new positive NPV investment opportunity
