Chapter 17

Payout Policy

Chapter Outline
17.1 Distributions to Shareholders
17.2 Comparison of Dividends and Share Repurchases
17.3 The Tax Disadvantage of Dividends
17.6 Signaling with Payout Policy

17-2

Learning Objectives
1. List two ways a company can distribute cash to its
shareholders.
2. Describe the dividend payment process and the openmarket repurchase process.
3. Discuss the effect of dividend payment or share
repurchase in a perfect world.
4. Assuming perfect capital markets, describe what
Modigliani and Miller (1961) found about payout policy.
17-3

Free Cash Flow

The cash flow available for distribution among all the
securities holders of an organization.
Firms often need to decide on the use of FCF generated by
its investments.
Firms of different ages/stages may have different
preferences over the use of the FCF. Example.
FCF is important: allows a company to pursue opportunities
that enhance shareholder ______. Eg: develop new
products, make acquisitions, pay dividends and reduce debt.
17-4

Free Cash Flow

Some think that FCF provides a clearer view on the firms ability
in generating profit.
Is negative FCF bad for firms?
Payout policy: the way a firm _________ between the
alternatives.

17-5

Figure 17.1 Uses of Free Cash Flow

Source of funds

Share issue + __________ + Cash =

Use of Funds

Dividend

+ Investments
17-6

Payout Policy
The overall policy concerning the _________ of value from a
firm to its stockholders.
Dividend
Something of value distributed to a firms stockholders on a
pro-rata basis (in proportion to the percentage of the firms
shares that they own).

17-7

Dividend and the value of the share

Example 1:
Company A:
Cash=$1,000;
Other assets=$9,000 (market value)
Shares outstanding=10,000 shares; and no debt.
Each share is worth $1.
-since the total value of the cash and the
other assets is $10,000 and the stockholders own it all.
17-8

Dividend and the value of the share

If the management distributes the $1,000 of cash as a
________.
Each stockholder receives 10 cents for each share that he
owns, and the value of each share declines to 90 cents (firm
is now worth $9,000 and there are still 10,000 shares.)
BUT, the stockholder still has $1 of value for each share
owned.

17-9

Dividend Distribution Procedure

Declaration Date
The date on which the board of directors authorizes (declares) the
payment of a dividend

Record Date
When a firm pays a dividend, only shareholders _____ record on
this date receive the dividend.

17-10

Dividend Distribution Procedure

Ex-dividend Date
A date, two days prior to a dividends record
date, ________which anyone buying the stock
will not be eligible for the dividend

Payable Date (Distribution Date)

A date, generally within a month after the record date, on which a
firm mails dividend checks to its registered stockholders

17-11

Figure 17.2
Important Dates for Microsofts Special Dividend

Share price is expected to ______ on ex-dividend date

17-12

Methods of Dividend Payout

Regular cash dividend
- A ______ dividend that is paid a regular basis. Typically quarterly
Extra Dividend
A dividend paid at the same time as a regular cash dividend to
distribute additional value.

17-13

Methods of Dividend Payout

Special Dividend
A ________ dividend payment a firm makes, which is usually
much larger than a regular dividend

Stock Split (Stock Dividend)

When a company issues a dividend in shares of _____ rather than
cash to its shareholders

17-14

Share Repurchases
An alternative way to pay cash to investors is through a
share repurchase or buyback.
The firm uses _____ to buy shares of its own outstanding stock.
Three possible ways for share repurchase

1) Tender Offer
A public announcement of an offer to all existing security
holders to buy back a specified amount of outstanding
securities at a pre-specified price (typically set at a 10%20% premium to the current market price) over a prespecified period of time (usually about 20 days)
If shareholders do not tender enough shares, the firm may
cancel the offer and no buyback occurs
17-15

Share Repurchases (cont'd)

1.2) Dutch Auction
A share repurchase method in which the firm lists different prices
at which it is prepared to buy shares, and shareholders in turn
indicate how many shares they are willing to sell at each price.
The firm then pays the lowest price at which it can buy back its
desired number of shares.

2) Targeted Repurchase
When a firm purchases shares directly from a specific (major)
shareholder
Purchase price (at premium/discount) is negotiated directly with
the seller

17-16

Share Repurchases (cont'd)

3) Open Market Repurchase
When a firm repurchases shares by buying shares in the open
market
Open market share repurchases represent about 95% of all
repurchase transactions.
Need to oblige the SEC guidelines, and not to appear to manipulate
the price.

17-17

17.2 Comparison of Dividends and

Share Repurchases
Consider Genron Corporation. The firms board is meeting
to decide how to pay out $20 million in excess cash to
shareholders.
Genron has no debt, its equity cost of capital equals its
unlevered cost of capital of 12%.

17-18

Alternative Policy 1: Pay Dividend with Excess Cash

With 10 million shares outstanding, Genron will be able to
pay a $2 dividend immediately.
The firm expects to generate future free cash flows of $48
million per year, thus it anticipates paying a dividend of
$4.80 per share each year thereafter.

17-19

Alternative Policy 1: Pay Dividend with Excess Cash

(cont'd)
Cum-dividend
When a stock trades before the ex-dividend date, entitling anyone
who buys the stock to the dividend

The cum-dividend price of Genron will be

Pcum Current Dividend PV (Future Dividends) 2

4.80
2 40 $42
0.12

17-20

Alternative Policy 1: Pay Dividend with Excess Cash

(cont'd)
After the ex-dividend date, new buyers will ____ receive the
current dividend and the share price and the price of
Genron will be
4.80
Pex PV (Future Dividends)
$40
0.12

17-21

Alternative Policy 1: Pay Div with Excess Cash (cont'd)

Computing the share price via a simple mkt value B/S

17-22

Alternative Policy 1: Pay Dividend with Excess Cash

(cont'd)
In a perfect capital market, when a dividend is paid, the
share price ______ by the amount of the dividend when the
stock begins to trade ex-dividend.
Otherwise, arbitrage opportunities arises.
Cum-Div (Dec 11)
Share price
Div
Total Value

Ex-Div (Dec 12)

$42

$40

$2

$42

$42

17-23

Alternative Policy 2: Share Repurchase (No

Dividend)
Suppose that instead of paying a dividend this year, Genron
uses the $20 million to repurchase its shares on the open
market.
With an initial share price of $42, Genron will repurchase 476,000
shares.
$20 million $42 per share = 0.476 million shares

This will leave only 9.524 million shares outstanding.

10 million 0.476 million = 9.524 million

17-24

Dividend Irrelevancy
Share Repurchase (No Dividend)
The net effect is that the share price remains unchanged.

17-25

Dividend Irrelevancy
Share Repurchase (No Dividend)
The net effect is that the share price remains _________.

17-26

Alternative Policy 2: Share Repurchase (No Dividend)

(cont'd)
Genrons Future Dividends
It should not be surprising that the repurchase had _____ effect on
the stock price.
After the repurchase, the future dividend would rise to $5.04 per
share.
$48 million 9.524 million shares = $5.04 per share
Genrons share price is

Prep

5.04

$42
0.12
17-27

Alternative Policy 2: Share Repurchase (No Dividend)

(cont'd)
Genrons Future Dividends
In perfect capital markets, an open market share repurchase has
no effect on the stock price, and the stock price is the ______ as
the cum-dividend price if a dividend were paid instead.
By repurchasing shares today,
Genron is able to ______ its div.
p/shr in the future, hence
compensating the shr/holders for the
________ give up today.

17-28

Alternative Policy 2: Share Repurchase (No Dividend)

(cont'd)
Investor Preferences
In perfect capital markets, investors are ________ between the
firm distributing funds via dividends or share repurchases. By
reinvesting dividends or selling shares, they can replicate either
payout method on their own. Eg: homemade dividend

17-29

Alternative Policy 2: Share Repurchase (No Dividend)

(cont'd)
Investor Preferences
In the case of Genron, if the firm repurchases shares and the
investor wants cash, the investor can raise cash by _______
shares.
This is called a homemade dividend.

If the firm pays a dividend and the investor would prefer stock,
they can use the dividend to purchase additional shares.

17-30

Alternative Policy 3:
High Dividend (Equity Issue)
Suppose Genron wants to pay dividend larger than $2 per
share right now, but it only has $20 million in cash today.
Thus, Genron needs an additional $28 million to pay the larger
dividend now. To do this, the firm decides to raise the cash by
selling new shares.

17-31

Alternative Policy 3: High Dividend (Equity Issue)

(cont'd)
Given a current share price of $42, Genron could raise $28
million by selling 0.67 million shares.
$28 million $42 per share = 0.67 million shares
This will increase the total number of shares to 10.67 million.

17-32

Alternative Policy 3: High Dividend (Equity Issue)

(cont'd)
The new dividend per share will be
$48 million
$4.50 per share
10.67 million shares
And the cum-dividend share price will be
4.50
Pcum 4.50
4.50 37.50 $42
0.12
Again, the share value is __________

17-33

ModiglianiMiller
and Dividend Policy Irrelevance
There is a __________ between current and future
dividends.
If Genron pays a higher current dividend, future dividends will be
lower.
If Genron pays a lower current dividend, future dividends will be
higher.

17-34

Table 17.1 Genrons Dividends per Share Each Year Under the
Three Alternative Policies

Policy 1:Pay out____________.;

Policy 2:Share Repurchase ________;
Policy 3:________ Div (Issue new equity).

17-35

ModiglianiMiller and Dividend Policy Irrelevance

(cont'd)
MM Dividend Irrelevance

In perfect capital markets, holding

fixed the investment policy of a
firm, the firms ________ of
dividend policy is irrelevant and
does _____ affect the initial share
price.
17-36

ModiglianiMiller and Dividend Policy Irrelevance

(cont'd)
In perfect capital markets, buying and selling equity and debt
are _________ transactions.
Hence, no effect on firms value.
Any choice of leverage by a firm can be replicated by
investors using homemade leverage.

Hence, the firms choice of capital structure is

__________.
17-37

Dividend Policy
with Perfect Capital Markets
A firms free cash flow determines the level of payouts that it
can make to its investors.
In a perfect capital market, the type of payout is irrelevant.
In reality, capital markets are not perfect and it is these
imperfections that should determine the firms payout policy.

17-38

17.3 The Tax Disadvantage of Dividends

Taxes on Dividends and Capital Gains
Shareholders must pay taxes on the dividends they receive and
they must also pay capital gains taxes when they sell their shares.
Dividends are typically taxed at a higher rate than capital gains. In
fact, long-term investors can defer the capital gains tax forever by
not selling.

17-39

17.6 Signaling with Payout Policy

Dividend Smoothing
The practice of maintaining relatively constant dividends
Firm change dividends infrequently and dividends are much less volatile
than earnings.

17-40

17.6 Signaling with Payout Policy (cont'd)

Research has found that
Management believes that investors prefer stable dividends with
sustained growth.
Management desires to maintain a long-term target level of
dividends as a fraction of earnings.
Thus, firms raise their dividends only when they perceive a long-term
sustainable increase in the expected level of future earnings, and cut them
only as a last resort.

17-41

Dividend Signaling
Dividend Signaling Hypothesis
The idea that dividend changes reflect managers views about a
firms future earning prospects
If firms smooth dividends, the firms dividend choice will contain
information regarding managements expectations of future earnings.

17-42

Dividend Signaling (cont'd)

When a firm increases its dividend, it sends a ______ signal
to investors that management expects to be able to afford
the higher dividend for the foreseeable future.
When a firm decreases its dividend, it may signal that
management has given up hope that _________ will
rebound in the near term and so need to reduce the
dividend to save cash.

17-43

Dividend Signaling (cont'd)

While an increase of a firms dividend may signal
managements optimism regarding its future cash flows, it
might also signal a lack of investment opportunities.
Conversely, a firm might cut its dividend to exploit new
______________investment opportunities.
In this case, the dividend decrease might lead to a positive, rather
than negative, stock price reaction.

17-44

Signaling and Share Repurchases

Share repurchases are a credible signal that the shares are
__________, because if they are over-priced a share repurchase is
costly
for current shareholders.
If investors believe that managers have better information regarding the firms
prospects and act on behalf of current shareholders, then investors will react
favorably to share repurchase announcements.

17-45

Practical considerations in setting a Dividend

Payout
1. Over the long term, how much does the companys level of
earnings (CFs from operations) exceed its investment
requirements? How ___________ is this level?
2. Does the firms have enough financial _________ to
maintain div payouts in periods when earnings are
down/investment requirements are _____?

17-46

Practical considerations in setting a Dividend

Payout
3. Does the firm have sufficient financial __________ to
maintain dividends if unforeseen circumstances wipe out its
financial reserves when earnings are down?
4. Can the firm _______ raise capital if necessary?
5. If the company chooses to finance dividends by selling
equity, will changes in the number of stockholders have
implications for ________ of the company?

17-47

17-48