W10: 16. Payout Policy (dividend policy)

Question 1

How do corporations payout to their shareholders?

Answer 1

1. Paying dividends

2. stock repurchase - buying back some of their shares

Question 2

why would a firm buy back shares?

Answer 2

to invest in growth or to ‘survive’ during hard times. (stock repurchases have become increasingly common)

Question 3

main ways that firms pay dividends

Answer 3

1. stock dividend
2. stock splits
3. cash dividend

Question 4

stock dividend

Answer 4

Distribution of additional shares to a firm’s stockholders, you receive more shares but your wealth remains the same.
Firms retain profits but give stocks to shareholders. (Stock-holders own more shares but wealth hasn’t increased, unless firm value changes, if share price/market cap changes it doesn’t matter, not really increasing personal wealth). But firm growth could cause firm value to increase (in future). At the present, when you receive stocks, it doesn’t change your wealth.

Question 5

stock splits

Answer 5

Issue of additional shares to firm’s stockholders
 (company divides its existing shares into multiple shares to boost the liquidity (& achieve greater flexibility of the shares & lower trading price of stock to a range deemed comfortable by most investors. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because the split does not add any real value. The most common split ratios are 2-for-1 or 3-for-1, which means that the stockholder will have two or three shares, respectively, for every share held earlier.)
- The price of the shares adjusts automatically in the markets.
 share price of firm has increased so much that liquidity of firm starts to decrease, not many people trade the share. The transaction costs and spread increases, makes it hard to achieve an even distribution of ownership. Usually just institutions that can own this stock (highly skewed ownership). So firm’s manager splits stock, causing the stock to become liquid to reduce spread/transaction costs.
- Eg, google shares went up to $1000, performed stock split, which then increased share-prices as it was good news. (but may not be good news for smaller firms)

Question 6

cash dividend

Answer 6

Payment of cash by the firm to its shareholders

• Regular (steady dividend payments, consistent payout ratio overtime, whilst it increases overtime due to earnings increase, but no sudden changes)
• Special (for large firms it signals to investors they have been highly profitable. Small firms, however, may use this as a way of pleasing shareholders by turning assets into cash, when the firm is struggling

Question 7

timeline for ASX dividend payments

Answer 7

1. declaration date (if you purchase after this date you’re not registered to recieve a dividend)
2. ex-dividend date (shareprice drops on this date in proportion to the dividend paid out)
3. record date (ownership of dividend value occurs on day after ex-dividend date)
4. payment date

Question 8

why does the shareprice drop on the ex-dividend date

Answer 8

Stock’s on this day are trading w/o the value of the next div payment.
If you’ve bought the share after the ex-dividend date you’ve actually lost the value of the dividend in the stock, means that stock should be cheaper.

The drop is usually about 80% of the dividend paid. Always less of a drop than the actual dividend
 This is due to tax and the imputation tax system. You don’t lose the 28c, since the 30% you get back.
 Some of the stockholders could be foreign, you don’t get back the franking credit (ie 30c of corporate tax that’s paid out of the $1)
• So because domestic owners are reimbursed the price doesn’t fully drop by dividend

Question 9

why is the drop in the share price not equal to 100% of the dividend and instead usually only 80%?

Answer 9

This is due to tax and the imputation tax system. You don’t lose the complete div value, since the 30% you get back.
 Some of the stockholders could be foreign, you don’t get back the franking credit (ie 30c of corporate tax that’s paid out of the $1)
So because domestic owners are reimbursed the price doesn’t fully drop by dividend

Question 10

why would a firm choose stock repurchases over dividend payments?

Answer 10

in times of financial distress, or to invest in future growth, firm’s by back the stocks to sell them and receive capital gains.
you can delay capital gains, but not dividend payments. Thus, can control when to drive capital gains for tax purposes.

o Eg, If you have stocks with -ve capital gains, sell +ve capital gains stocks to pay less tax in same financial year.
o Or if you hold a no. stocks where capital gains are always positive and want to avoid paying tax on capital gains, they delay capital gains, to delay taxation into other years.  you control the decision.
•

Question 11

Why aren’t repurchases fully equivalent to dividends?

Answer 11

there’s a bias. There’s more implied wealth back to shareholder through stock repurchases, due to the added flexibility (like having value in an option)

Question 12

methods of share repurchasing

Answer 12

1. buy shares on the market
2. tender offer to shareholders (- option to submit, or tender, a portion of or all of their shares within a certain timeframe and at a premium to the current market price (no. shares decreases, due to share concentration increase, expect share-price to increase))
3. dutch auction (- specifies a price range within which the shares will ultimately be purchased)
4. Private negotiation (green mail)

Question 13

1. Buy shares on the market

Answer 13

a. Firm may need to absorb price impact, ie if firm announces stock repurchase, individuals will start to buy the stock, people want to buy the stock (It’s legal, people are free to go into the market before the stock repurchase) because they know there will be a +ve price impact in the future (meaning firms actually lose some money because of this impact)
b. Firm’s have to overpay due to the price impact (that people have already pre-purchased)

Question 14

2. Tender offer to shareholders - option to submit, or tender, a portion of or all of their shares within a certain timeframe and at a premium to the current market price (no. shares decreases, due to share concentration increase, expect share-price to increase)

Answer 14

a. Shareholders receive letter and can submit choices across a range of stock prices that they’re willing to sell stock back to the firm for.
b. Firm receives all the letters, complies an average and then calculates whether they can return this value back to the shareholders, ie what amount should they sell the shares for? They calculate the ultimate amount to shareholders, so capital gains exactly = amount of dividends that they’re willing to give back to the shareholder

Question 15

3. Dutch auction - specifies a price range within which the shares will ultimately be purchased

Answer 15

a. Those willing to accept this price, will sell it back to the firm.
b. Once market clears for that price, firm will work from lowest price and work upwards.
c. Eventually they hit a ceiling,
d. This is acceptable to shareholders

Question 16

4. Private negotiation (Green Mail)

Answer 16

a. Firm goes to certain shareholders and state that they’re willing to buy back shares, usually to institutions,
b. Reduces price impact, private negotiations, usually go to original owners of the firm
c. Quick and effortless, much faster than announcing to market and having price impact
i. It’s a private transaction, shares more concentrated, price goes up and everyone receives benefit of share repurchase

Question 17

4. Private negotiation (Green Mail)

Answer 17

a. Firm goes to certain shareholders and state that they’re willing to buy back shares, usually to institutions,
b. Reduces price impact, private negotiations, usually go to original owners of the firm
c. Quick and effortless, much faster than announcing to market and having price impact
i. It’s a private transaction, shares more concentrated, price goes up and everyone receives benefit of share repurchase

Question 18

How are dividends determined? Manager treatment of dividends + the signals they give

Answer 18

1. Managers are reluctant to make dividend changes that might have to be reversed
2. Managers “smooth” dividends and hate to cut them. Dividends changes follow shifts in long-run, sustainable levels of earnings. (Slow increases in payout ratio, ie each year by 2%, want to do it slowly as they want to ensure their increase is backed up. )
3. Managers focus more on dividend changes than on absolute levels

Question 19

Why are managers reluctant to make dividend changes that could be reversed?

Answer 19

1. People are interested in the growth of dividend payouts
2. Growth formula (d1/(r-g)  if growth goes down in future it has perpetual effect on share-price (observed in market)
3. g goes down, denominator goes up, so share-price goes down
4. big fall in stock price if dividends aren’t backed up in the future  growth goes down, people don’t see value in buying stock so they sell it

Question 20

why do managers focus more on dividend changes than on absolute levels?

Answer 20

1. This is because changes are so sensitive.
2. Eg, dividend changing from 80c to $1.40 has significance, but the % change means more, because this actually sends signals to the market.
3. If dividend changed from 1c to 2c, it’s a 100% jump.
4. The smaller the firm, the proportion of the dividend to firm value is far higher
5. the changes are what matters
   there’s a high sensitivity of information signals sent to market for payout policy, this is why managers avoid large changes to policy, any large changes are done slowly by ‘smoothing’

Question 21

what does a dividend increase mean for small and large firms?

Answer 21

• Large firm  good news, you think firm will back it up
• Small firm could be bad news

these differences reflects the asymmetric information that’s conveyed (different interpretations)

Question 22

for small firms dividend increases could mean …. but for large firms

Answer 22

could mean overpriced stock for small firms (so stock price goes down, so firm will do dividend payment or stock repurchase) or increased future profits for large firms

Question 23

dividend signals vary based

Answer 23

on prior info about the company

Question 24

Dividend theories

Answer 24

• Dividend does not affect value
• Dividends increase value – rightists
• Leftist theory with some reality thrown in
• Residual Dividend Policy

Question 25

Dividend does not affect value theory

Answer 25

(MM theory, firm value won’t change, but assumes frictionless market, no tax, transaction costs, infinite no. substitutes –> unrealistic in real world) The notion is that since investors don’t need dividends to convert shares to cash they won’t pay higher prices for firms with higher dividend payouts, ie dividend policy won’t impact firm value, –> value won’t balloon if payout ratio increases

Question 26

Rightist theory of dividends

Answer 26

• Dividends increase value

o Dividends are positive, more dividends  firm value increases

Question 27

Leftist theory of dividends

Answer 27

a bit more realistic, dividend policy can send -ve signals to market-place
o If firm pays out too much dividends can decrease firm value

Question 28

Residual dividend policy

Answer 28

o Attempts to create a realistic, comprehensive theory as to investment, finance and dividend payout policy decisions

Question 29

The rightists: market imperfections & clientele effect

Answer 29

o There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from.
o These clients increase the price of the stock through their demand for a dividend paying stock.

Question 30

Rightist’s perspectives on dividends

Answer 30

o Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news.
o Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.
o Firms only increase payout if they can back up in the future, only shown to work for some firms (mostly large firms)
dividends increase firm value

Question 31

Leftist perspective on dividends decreasing value

Answer 31

o Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favourably.
o In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.

Question 32

advantage to corporations for dividends

Answer 32

o Corporations pay corporate income tax on only 30% of any dividends received from investments in other corporations.

Question 33

advantage to investors for repurchases

Answer 33

o Capital gains taxes are deferrable

Question 34

Residual dividend policy

Answer 34

• Suggests a firm only considers dividend payout policy after they consider internal investments.
• fund capital expenditures with available earnings before paying dividends
• creates more volatility in dollar amount of dividends paid to investors each year

Question 35

limitations of residual dividend policy

Answer 35

• Whilst theory follows pecking order theory it is still problematic, however, means returns are volatile based on whatever projects its doing year to year, but firms want smooth dividend payments.

Question 36

Imputation system of tax

Answer 36

System where firms pay corporate tax on the dividend which stockholders receive as taxed dividend. Stockholders then receive tax deduction via a franking credit which is equivalent in value to the amount of corporate tax that the firm has paid. (** this assumes personal income tax is lower than corporate tax, but if it’s higher then you’d have to pay the difference in tax for the dividend).

Indicates that under an imputation system it doesn’t actually matter how much corporate tax the company pays as you will ultimately receive this under a franking credit (however if you cannot exercise all franking credits then it will matter), the only rate that will reduce your income (dividend + FC) is the personal tax on equity.

Question 37

classical system of tax

Answer 37

corporate tax paid by the company does not reduce how much tax you must then pay.

Question 38

Imputation tax system formula for value of dividend

Answer 38

Value(Dividend)
=Dividend Amount × [(1−Tc)/(1 − Tpersonal)]
​

Question 39

Formula for classical tax system dividend

Answer 39

Value(Dividend)=Dividend Amount×(1−Tpe)

In this instance you don’t receive any franking credits so the corporate tax rate is irrelevant in determining the value once you have ascertained the post-corporate tax value of the dividend.

Question 40

APV (week 10)

Answer 40

= base case value
+ PV(tax shield) + value of financing +side effects

(if there are costs incurred for equity raising just subtract these at the end)

Question 41

terminal value (week 10)

Answer 41

assumes a set growth rate after a forecasted period

Question 42

horizon value –> PVh (week 10)

Answer 42

=FCFh+1/(WACC-g)

Question 43

when you’re trying to find the PV of the horizon value, which year do you discount by? (week 10)

Answer 43

by 1 year less than actual year, since PVh is always 1 yr before the year you’re looking at.

Question 44

rebalancing, what is it and what does it do?(week 10)

Answer 44

WACC formula assumes that D rebalanced to maintain a constant D/V. Rebalancing ties level of future tax shields to FV of company, making tax shields riskier, but noting that fixed debt levels (no rebalancing not really risky to firm). When the debt is rebalanced next yrs interest is unknown but there’s a certainty for 1 year so it’s discounted for 1 yr at the higher risky rate and 1 year at the lower risky rate –> much more realistic since it recognises the uncertainty of the future events

Question 45

what’s the free CF to equtiy(week 10)

Answer 45

= CF from operations - Capex + net debt issued

uses of costs of equity as discount rate and and CfFs to equity after interest and taxes

Question 46

do you include short term debt in the WACC? (week 10)

Answer 46

onlyif it’s at least 10% of total liabilities or if net working cap is -ve

Question 47

what does miles ezzel formula used to adjust the cost of capital assume? (week 10)

Answer 47

that firm rebalances once a year instead of continuously rebalancing

Question 48

If you’re only told that the stock is planning on changing its next dividend payment to a repurchase, with no indication of how far away that payment will be, what must you assume when looking at whether the announcement will cause an increase in the share price?

Answer 48

sort of have to assume that the share price will not change between the date of announcement and the date of repurchase.

Question 49

If you’re told that the stock repurchase is going to start immediately in a year from now, then what will happen to share price on date of announcement?

Answer 49

The stock price will increase in 1 year (date when announced). During this year the company will be investing these funds at the cost of capital which will increase the value of internal funds and therefore the value of the company. In this instance the question states that the payout ratio is 1, and that the dividend is $4. Therefore the rate of return is 0.05 (4/80) which is what you assume will be the return the company generates when investing over the course of the year.

note the share price isn’t increasing to provide investors with the same rate of return, the share price is increasing because the company is investing the funds over the course of the year. Once the share repurchase occurs (in Q23) the share price will still be $84.

Question 50

4 methods of buying shares

Answer 50

1. Buy shares on the market
2. Tender offer to shareholders - option to submit, or tender, a portion of or all of their shares within a certain timeframe and at a premium to the current market price (no. shares decreases, due to share concentration increase, expect share-price to increase)
3. Dutch auction - specifies a price range within which the shares will ultimately be purchased
4. Private negotiation (Green Mail) (ususally to institutions, quicker, faster, cheaper, a private transaction, shares are more concentrated - price goes up)

Question 51

Dividend irrelevance argument MM

Answer 51

since investors don’t need dividends to convert shares to cash they won’t pay higher prices for firms with higher dividend payouts (div policy has no impact on firm value).

Holds that firms that pay more dividends have less price growth but provide the same total return in the absence of taxes or if divs or cap gains taxed at the same rate.

Question 52

Dividend irrelevance argument MM assumptions

Answer 52

new shares sold at fair price,
no taxes capital markets efficient,
depends on investment policy being set before the dividend decision and isn’t changed by the div policy

Question 53

leftist position

Answer 53

assuming no imputation tax system, dividends lower firm value:
since dividends taxed at lower rate than dividend income, companies should pay the lowest dividend possible.
Holds that stock repurchases are better due to higher stock prices and capital gains, assuming capital gains have been taxed at lower effective rates than dividends)

Question 54

lesftist position extra point

Answer 54

if divs taxed at higher rate than cap gains firms shuld pay the lowest cash dividends. by shifting their distribution policy, corporations can transfrom dividends into cap gains

Question 55

Rightist position

Answer 55

supports imputation tax system. dividend policy matters due to tax. Investors pay more for firms with generous stable dividends. Increase dividends = increase firm V –> you pay more for firms that pay dividends.

Question 56

it tax on dividends and capital gains is equal what’s the difference between them?

Answer 56

dif. is that dividends are taxed when they’re distributed but capital gains can be deferred

Question 57

per the rightist position why else do firms prefer cash dividends to capital gains?

Answer 57

cash dividends more certain (cap gains uncertain).
also many investors prefer cash for their living expenses
also view converged dividend payments as indicative of good firm performance

Question 58

imputation system of tax

Answer 58

system whereby shareholders are taxed on the dividends they pay but receive franking credits via tax deductions which is equivalent to their share of corporate tax that the company has paid. accordingly since dividends refer to payments made as a result of capital gains the value of debt tax shields which are created due to firms not having to pay tax on their interest repayments will be affected by the system such that the more debt a firm has the lower it’s corporate tax and thus the lower the franking credit received by teh stock holder.

Question 59

‘debt for equity swap’

Answer 59

= firm issues debt in return for buying-back equity = less equity = positive market signal due to informational assymetry

Question 60

‘equity for debt swap’ =

Answer 60

firm issues equity in return for buying-back debt = more equity = negative market signal due to informational assymetry

Question 61

Rebalanced firm-

Answer 61

the firm will continue to rebalance the capital structure of the firm to maintain a constant capital structure. For example, assuming the company is financed by 40% debt and 60% equity, when undergoing a new project the firm will ensure that it is financed with 40% debt and 60% equity. Or, if market value of equity rises, they will adjust their capital structure (take on more debt) to increase the % of debt in the firm to the level that it was before. In the attempt to keep capital structure constant, the repayments on the firm’s debt will continually change. Ie; the debt repayments are uncertain (risky).

Question 62

Fixed-

Answer 62

the firm will know how much interest they have to pay each period, thus lowering the risk of the tax shield. For example, company A doesn’t continually re-balance its capital structure, rather, it borrows x and will pay back y (interest payments) each period. As the company is pretty certain on what they have to pay each period, it is considered lower risk, thus allowing us to use rd rather than the wacc when computing the PV(tax shield).