Week 3 - Payout policy Flashcards
Ex-dividend date vs Cum-dividend date
Anyone who BUYS SHARES on or after EX-DIVIDEND DATE won’t make it to the shareholder registers until after record date & WON’T get upcoming dividend. Ex-dividend price of share ignores the PV of the upcoming div.
Anyone who buys shares on CUM-DIVIDEND DATE will make it onto the register by record date and WILL GET UPCOMING DIVIDEND, so price of dividend will be included in share price they pay
4 types of share repurchase
- Open market repurchase (most common)
- firms will buy back shares at market price - Tender offer
- Firms PRE-SPECIFY the no. of shares & offer price at a PREMIUM to repurchase shares <- entering into a -VE NPV transaction for the firm
- Firms ask shareholders to subscribe; good for shareholders who participate, bad for shareholders that don’t participate
- IF assume that current market price is FAIR, then buying shares back at a premium is basically a TRANSFER OF WEALTH from those who don’t participate to those who do - Dutch auction
- Firm provides a RANGE of PRICE-QUANTITY PAIRS, provide shareholders a demand curve and ask how many shares shareholders are willing to sell back to the firm (ask for their supply curve). Then, firm selects the lowest price at which it can repurchase the desired no. of shares.
- similar to Tender offer but provides a range instead of a single specific price and no. - Private negotiation
- Firms target a SPECIFIC SHAREHOLDER to buy back shares from to get rid of an investor causing trouble (eg. hedge fund) or a major shareholder to remove the threat of a takeover
- By buying out a major shareholder, firm can remove the threat of a takeover (“GREENMAIL”)
Modigliani & Miller’s (MM) dividend irrelevance theorem
In PERFECT CAPITAL MARKETS, dividend payout policy is value-irrelevant, ie. no effect on firm value & shareholder wealth
Ie. NOT true that if a firm pays larger dividends, the value of the firm increases
5 assumptions that must hold for MM dividend irrelevance (perfect capital markets), ie. dividend policy does NOT affect firm value & shareholder wealth
- Investment is held constant
- dividend payments do not affect current/future free cash flows
- future investment policy is unaffected by cash paid out - No transaction costs
- Efficient capital markets
- Assume STRONG FORM EFFICIENCY; all publicly and privately avai. info is reflected in prices, therefore price reflects fundamental value
- All financial transactions are 0 NPV. Price paid per share exactly = PV of future dividends to be received - Managers maximise shareholders’ wealth
- No conflict of interest between managers and shareholders. Managers work in best interest of shareholders - No taxes (or, dividends & capital gains are taxed in the same way)
- Capital gains tax relevant to REPURCHASES, dividends tax relevant to dividends
In perfect capital markets, what happens to the share price on the ex-dividend date?
Share price drops by the amount of dividend on payment of dividends
Why shouldn’t investors care about a firm’s dividend policy according to MM?
Investors can replicate any payout distribution by reinvesting dividends or SELLING SHARES to convert into cash (create HOMEMADE DIVIDEND)
What if a company decides to pay a larger dividend today than it has available surplus cash?
- The firm needs to raise extra cash by issuing new shares
- Old shareholders
- receive cash dividend
- ownership of co. is DILUTED - New shareholders
- contribute cash
- receive shares of the co. in return
MM’s irrelevance theorem is WRONG b/c there is event study evidence that stock prices rise when firms start paying dividends (+ve stock market reaction).
So must be b/c 1 or more assumptions are wrong. Relaxing the 5 MM assumptions…
- Investment may not be held constant
- If surplus cash will be wasted by managers, then paying out dividends INCREASES firm value
- If paying dividends means SACRIFICING valuable investment, then DECREASES firm value - There are transaction costs
(Firms can reduce transaction costs in ways individuals can’t due to economies of scale. Therefore, homemade divs are no longer a perfect substitute for firm divs) - Capital markets are not efficient (ref. to strong form efficiency). 2 possibilities:
- Information asymmetry
eg. managers know more about the firm than outsiders
- Dividends can serve as CREDIBLE SIGNALS that managers are confident about future CFs & earnings -> MARKETS react +vely and increase FIRM’S VALUE - Irrationality
- market price doesn’t reflect fundamental value of firm’s share, then the stock sale is no longer a 0 NPV transaction
- so firms REPURCHASE stocks when UNDERVALUED / issue shares when over-valued (“market timing”) - Managers’ preferences differ from shareholders’ preferences
- managers may have short-term objectives & prefer to underinvest and inflate dividends to increase current stock price & their pay (eg. bonus)
- solution: tie managers’ compensation to the long-term stock prices of the firm - Taxes are not equivalent
- Dividend tax rates are usually HIGHER than capital gain tax rates
- Dividend taxes CANNOT be DEFERRED but capital gains tax can -> CGT is worth less on a present value basis
- Thus, dividend-paying firms should be worth LESS than non-dividend-paying firms.
> investors care about AFTER-TAX returns; 2 assets w/ identical risk should have equal after-tax returns
From PS3, shareholders will be indifferent to the dividend policy if new shares are issued at __?
If new shares are issued at FAIR PRICE
From PS3, what if Peng Corporation keeps the dividend at HK$5 but uses cash to repurchase shares in the open market at the current (and fair) market price of HK$267?
3 scenarios
The impact on the share price depends on INVESTOR EXPECTATIONS regarding the company’s use of the cash.
1. If investors expected the cash was used on growth projects (+ve NPV investments) but will now be used to repurchase shares (0 NPV investment), stock price will DECLINE
- b/c the growth opportunity disappears
2. If investors expected the cash was used on paying additional dividends, NO EFFECT on stock price
3. If investors expected the cash was wasted on managerial perks (-ve NPV), then this is good news & stock price INCREASES
2 key reasons as to why payout policy may be relevant (from W3 summary)
- Markets are not efficient
- payout is a credible signal that a firm is strong - Taxes are different for dividends and capital gains
- payout policy may be used to reduce shareholders’ tax burden
From PS3, how to show “should shareholders care whether the co. distributes the $20m in excess cash via a dividend or a repurchase?”
Option 1: dividend payout
1. Calculate the dividend per share $__
2. Calculate the market value to get share price $__
3. Show 100 shares x $__ = $200 cash and 100 shares x $__ = $4000 stock
Option 2: share repurchase
1. Suppose an investor has 100 shares of __ co.
2. Suppose the co. chooses SHARE REPURCHASE but the investor wants dividends.
3. Assuming the investor didn’t participate in the repurchase, they can easily create a HOMEMADE DIVIDEND of $200 by…
4. selling __ shares @ $42, leaving 100-__=__ shares @ $42
5. Multiply these no. of shares by the share price to show the ALLOCATION of CASH & STOCK they would’ve had if the co. had paid a DIVIDEND
> > In both cases, TOTAL SHAREHOLDER WEALTH after distribution is $4200, only difference being how this wealth is allocated between stock & cash.
In PERFECT CAPITAL MARKETS, investors will be indifferent between the co. distributing the excess cash via dividends or a share repurchase.
2 components of V_asset
V_asset = Cost + NPV
