WEEK 6 - Payout Policy Flashcards
What are the 2 alternate ways which companies pay cash to their shareholders?
- Paying a dividend
2. Buying back some of the company’s stock
What are the differing types of Dividends?
Regular cash dividend: the dividend paid to each stockholder every quarter (regular payment).
Special cash dividend: a one-off supplement to the regular dividend (irregular payment).
Automatic Dividend Reinvestment Plans (DRIPs): sometimes offered to stockholders. New shares issued at discount from market price.
Stock dividends (instead of cash): issue of additional shares to stockholders. If a stock dividend of 5% is paid, the company distributes 5 extra shares for every 100 shares currently owned.
How do firms pay dividends?
The board of directors sets the dividend, e.g. $0.28 per share per quarter
They make an announcement that a payment will be made to all stockholders registered at a particular record date.
On day before record date, stocks trade ex-dividend, i.e. price falls by amount of dividend.
Dividend cheques are mailed to registered shareholders.
How do firms repurchase stocks?
- Buying shares on the market: the firm announces that it plans to repurchase part of its stock in the open market.
- ‘Tender’ offer to shareholders: the firm offers to buy back part of the stock at a fixed price:
- usually with a mark-up over the current market price;
- shareholders may accept or decline the offer.
How else do Firms repurchase Stocks (PT 2)?
- ‘Dutch’ auction:
the 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 at each price;
the firm calculates the lowest price at which it can repurchase the desired number of shares. - Private negotiation: direct negotiation with a major shareholder.
What are the two ways the payout policy is a source of info for investors?
- Dividends
2. Stock Repurchasing
How are Dividends a source of info for investors?
The announcement of a dividend increase is good news for investors:
→ signals managers’ confidence in future profits. If managers thought increase in earnings were temporary, they would be cautious about committing to cash payouts.
→ predicts safer earnings. Managers are less likely to increase dividends when cash flows are uncertain and volatile.
Dividend UP : Share price UP
Dividend DOWN: Share price DOWN
How is Stock Repurchasing a source of info for investors?
A repurchase announcement is not a commitment to continue repurchasing stock.
Information content less strongly correlated than announcement of dividend change.
Repurchases signal that managers are:
- Not wasting resources on perks, empire building etc.
confident about the firm’s future prospects - and that the company is currently undervalued.
- Therefore stock repurchasing announcements correlated with a subsequent rise in the share price.
What are the political responses to Repurchasing and Dividend payouts?
Right wing -> argues that investors prefer higher dividend payouts, so they pay more for firms with generous and stable dividends.
Left wing -> argues that repurchases are better; higher dividends decrease value, because dividends are taxed more heavily than capital gains.
Center -> that claims that the payout policy makes no difference! (Dividend and Repurchase)
Who champions the centrist view that Payout policy does not matter?
Miller and Modigliani (MM)
- dividend policy value irrelevant in a world without taxes, transaction costs, or other market imperfections (assuming that capital markets are efficient).
How do Miller and Modigliani argue that the dividend policy is irrelevant?
in the sense that
higher dividends do not make shareholders either better or worse-off.
Since investors do not need dividends to convert shares to cash,
-> they will not pay higher prices for firms with higher dividend payouts
What is the Miller-Modigliani proposition in detail (PT 1)
Potential investors will buy the new stock (if it is fairly valued, i.e., reflecting the true valuation of the firm).
However, as the asset, earnings and investment decisions are unchanged…
The total (real) value of the firm does not change.
How can firm sell more shares?
→ Higher number of shares & unchanged total value
→ value per share must be lower!
There has to be a transfer of value from old to new shareholders.
What is the Miller-Modigliani proposition in detail (PT 2)
Transfer of value from old to new shareholders
↓
Existing shareholders’ value per share falls (if the new equity is to be sold).
New shareholders get the new shares, but each will be worth less than before the extra dividend was announced.
Old shareholders suffer capital loss on their shares.
↓
As capital loss borne by shareholders just offset extra dividend receive → indifference of shareholders to higher dividends
Does it matter to shareholders that they receive extra dividend and capital loss? (MM Model)
→ As long as capital markets are efficient:
old stockholders/investors do not need dividends to convert shares into cash;
they can raise the cash by selling their own shares
Therefore old shareholders can cash in either:
By persuading the management to pay higher dividend
Or by selling some of their shares
→ In either case, there will be a transfer of value from old to new shareholders.
What is the transfer of value caused by?
- Dilution in value of each share
- Reduction in number of shares for old shareholders
SEE GRAPH IN NOTES
