Week 4 Payout Policy

Question 1

What is dividend?

Answer 1

A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits

Question 2

What are three types of dividends?

Answer 2

Regular cash dividend; public companies often pay quarterly, sometimes firms will throw in an extra cash dividend, the extreme case would be a liquidating dividend.

Stock dividend; no cash leaves the firm, the firm increases the number of shares outstanding

Dividend in kind; products or discounts

Question 3

Describe the timeline for cash dividend payment.

Answer 3

Declaration Date; the Board of Directors declares a payment of dividends

Cum-Dividend Date; the last day that the buyer of a stock is entitled to the dividend

Ex-Dividend Data; the first day that the seller of a stock is entitled to the dividend

Record Date; the corporation prepares a list of all individuals believed to be stockholders as of the record date

Payment date

Question 4

Describe the price behavior around the ex-dividend date in a perfect world.

Answer 4

In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date

Question 5

Remember; what was the third MM proposition?

Answer 5

A firm’s total market value is independent of its dividend policy.

Question 6

What is homemade dividend?

Answer 6

Homemade dividends refer to a form of investment income that is earned by selling a portion of the equity portfolio. Investors can sell a portion of their stocks to generate the required cash inflow, where the traditional dividend is insufficient or not forthcoming. Since investors do not need dividends to convert shares into cash, dividend policy will have no impact on the value of the firm.

Question 7

Why is dividend independent of the firm value?

Answer 7

Because of the existence of homemade dividend. Investors do not need dividends to convert shares into cash.

Question 8

What is the consequence of the irrelevance of dividend for the price investors are willing to pay for a stock?

Answer 8

Since investors do not need dividend to convert shares to cash, they will not pay higher prices for firms with higher dividend payouts. Investors can create whatever income stream they prefer by using homemade dividends.

Question 9

What happens with dividends in the presence of personal taxes?

Answer 9

1. Paying dividends is costly
2. Managers have an incentive to seek alternative uses for funds to reduce dividends
3. In most legislations, tax authorities treat share repurchases as capital gains… so they do not pay income taxes
4. Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends

Question 10

What is a stock repurchase?

Answer 10

Instead of declaring cash dividends, firms can buy their own stock. Recently, share repurchase has become an important way of distributing earnings to shareholders.

Question 11

What is a reason against dividend payments and prefers for stock repurchase?

Answer 11

Personal taxes on dividends and not on stock repurchase which is seen as capital gains

Question 12

What are methods to repurchase stocks?

Answer 12

Open-market
Fixed price tender
Dutch auction

Question 13

Describe the open-market method for stock repurchase.

Answer 13

A firm will announce that it will repurchase some shares in the market as market conditions allows it and maintains the option of deciding whether, when and how much to repurchase.

Question 14

Describe the fixed price tender method for stock repurchase.

Answer 14

Prior to 1981, all tender offer repurchases were executed using a fixed-price tender offer. This offer specifies in advance a single purchase price, the number of shares sought, and the duration of the offer. Shareholders decide whether or not to participate, and if so, the number of shares to tender to the firm.

Question 15

Describe the Dutch auction method for stock repurchase.

Answer 15

A Dutch auction offer specifies a price range within which the shares will ultimately be purchased. Shareholders are invited to tender their stock, if desired, at any price within the stated range. The purchase price is the lowest price that allows the firm to buy the number of shares sought in the offer, and the firm pays that price to all shareholders who tendered at or below that price.

Question 16

What kind of effect does stock repurchase have on CEO compensation?

Answer 16

Usually, CEOs and executives are paid with respect to their performance… A CEO may get bonuses based on the previous year level of earnings per share (EBIT / Number of shares). Share repurchases reduce the number of shares circulating, hence increasing earnings per share.

Question 17

How do firms exploit low interest rates?

Answer 17

Issue more debt. Debt can be used to buy back shares.
Cash is paid out to shareholders. Leverage ratio increases.
Increasing returns on equity.
Earnings per share increases.
Also financial risk increases!

Question 18

With personal income taxes, no firm should pay dividends. However, they still do. Name three reasons for this.

Answer 18

Clienteles
Asymmetric Information
Agency Costs

Question 19

What is the Clientele Effect?

Answer 19

Different groups of stockholders prefer different dividend payout policies.

Some investors prefer high payouts; many retirees, pension funds, and/or university endowment funds are in low tax brackets and need current cash income.

Other investors prefer low payouts; investors who are in high tax brackets and who have no need for current cash income should prefer low payout stocks.

Question 20

What does research suggest for the Clientele Effect?

Answer 20

1. Older investors are more likely to hold high dividend stocks.
2. Poorer investors tend to hold high dividend stocks (marginal tax rate is lower)
3. In countries where ordinary income is taxed more than capital gains, firms pay lower dividends

Question 21

What is the signaling hypothesis concerning dividend payouts?

Answer 21

Dividends can be signals to the market that you believe that you have good cash flow prospects in the future.

Dividend cuts are followed by negative stock returns.

Managers hate to cut dividends, so they will not raise them unless they think a raise is sustainable.

So, investors view dividend increases as signals of management’s view of the future.

Question 22

How much cash should a company retain according to agency consideration?

Answer 22

If there are not many investment opportunities… firms should disburse cash to shareholders. In principle, companies with low market to book ratio, working in traditional sectors, doing little R&D… should pay higher dividends.

Dividends are a disciplining tool, they are an instrument in the hand of shareholders that leads manager to pay cash when investment opportunities are low.

Question 23

Over the last decades, the paying of dividends fell hard. Why?

Answer 23

1. Increasing number of small, publicly traded firms with low reported earning and high growth that do not pay dividends.
2. Share repurchases
3. More sophisticated Corporate Governance Techniques… reducing the disciplining effect of dividends
4. Stock options to managers, managers prefer capital gains to dividends