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Payout policy

Dividends:
- The way a firm chooses between the alternative ways to distribute free cash flow to equity
holders
- Free Cash Flow Pay Out Repurchase Shares
Pay Dividends
Pay High Dividends (issue equity to raise capital and the
capital structure changes and the leverage ratio decreases)
Retain Invest in New Projects
Increase Cash Reserves
- If a firm decides to repurchase shares from the shareholders, the outside equity is reduced
- Therefore, the proportion of debt to equity will increase
- If the company retains some money in their reserves, in the next period it will have interest
free capital they can invest in NPV positive projects without any extra costs
Declaration Date: the date on which the board of directors authorizes the payment of a dividend
(normally, the price of the shares increase by the amount of the dividend)
Ex-dividend Date: two days prior to record date, a day on or after which anyone buying stock will
not be eligible for the dividend (share price falls by the amount of the dividend)
Record Date: only shareholders on record at this date receive 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






Cum Div: share price just before dividend is paid
Ex Div: share price after dividend is paid < Cum div
- Before ex-dividend day, the price of the share goes up by the amount of the dividend
- This pattern continues
Share Repurchases
- An alternative way to pay cash to investors is through a share repurchase or buyback
- Firm uses cash to buy shares of its own outstanding stock
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.
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 pre-specified period of time (usually about 20 days)
If shareholders do not tender enough shares, the firm may cancel the offer and no buyback
occurs
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%.
Pay Dividend with Excess Cash Share Repurchase
(No Dividend)
High Dividend (Equity
Issue)
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.
The cum dividend price of Genron
will be:
PV(cum) = Current Dividend +
PV(Future Dividends)
After the ex-dividend date, new
buyers will not receive the current
dividend, and the share price of
Genron will be:
P(ex)=PV (Future Dividends)
In a perfect capital market, when a
dividend is paid, the share price
drops by the amount of the
dividend when the stock begins to
trade ex-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


The net effect is that the
share price remains
unchanged


Modigliani- Miller and Dividend Policy Irrelevance
- There is a trade-off between current and future dividends
- If firm pays a higher current dividend, future dividends will be lower
- If firm pays a lower current dividend, future dividends will be higher
MM Dividend Irrelevance
- In perfect capital markets, holding fixed the investment policy of a firm, the firms choice of
dividend policy is irrelevant and does not affect the initial share price.
- In reality, capital markets are not perfect and it is these imperfections that should determine
the firms payout policy
The Tax Disadvantage of Dividends
- 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
- At the moment, both the taxes of dividends and the capital gains tax are same, at 15%
Optimal dividend policy with taxes
- The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to
pay no dividends at all
Dividend puzzle: when firms continue to issue dividends despite their tax disadvantage
Clientele Effect: when the dividend policy of a firm reflects the tax preference of its investor
clientele
- Preference on policy depends on what each group wants

- In perfect capital markets, once a firm has taken all positive NPV investments, it is indifferent
between saving excess cash and paying it out
- With market imperfections, there is a trade-off: retaining cash can reduce the costs of raising
capital in the future (financing), but it can also increase taxes and agency costs moral
hazard/agency problem
MM PAYOUT IRRELEVANCE
- In perfect capital markets, if a firm invests excess cash flows in financial securities, the firms
choice of payout versus retention is irrelevant and does not affect the initial share price
Taxes and Cash Retention: corporate taxes make it costly for a firm to retain excess cash
Issuance and Distress Costs:
- Generally, firms retain cash balances to cover potential future cash shortfalls, despite the tax
disadvantage to retaining cash
- The cost of holding cash to cover future potential cash needs should be compared to the costs
of raising new capital through new debt or equity issues
- If the cost of holding cash is less than the cost of taking a loan for example, firm will hold cash
Signaling with payout policy
Dividend smoothing:
- The practice of maintaining relatively constant dividends
- Firms change dividends infrequently and dividends are much less volatile than earnings
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
- Normally dividends will be a percentage of earnings
Dividend Signaling Hypothesis: the idea that dividends changes reflect managers views about a
firms future earnings prospects
- When a firm increases its dividends, it sends a positive signal to investors and vice versa
- An increase of a firms dividends may signal a lack of investment opportunities
- Conversely, a firm might cut its dividends to exploit new investment opportunities
Signaling and Share Repurchases
- Share repurchases are a credible signal that the shares are under-priced, because If they are
over-priced a share repurchase is costly for current shareholders
Stock Dividends and Splits
- With a stock dividend, a firm does not pay out any cash to shareholders.
- As a result, the total market value of the firms equity is unchanged. The only thing that is
different is the number of shares outstanding.
- Stock dividends are not taxed, so from both the firms and shareholders perspectives, there is
no real consequence to a stock dividend
- The typical motivation for a stock split is to keep the share price in a range thought to be
attractive to small investors
- If the share price rises too high, it might be difficult for small investors to invest in the stock
Spin-off: when a firm sells a subsidiary by selling shares in the subsidiary alone
- Non cash special dividends are commonly used to spin off assets or a subsidiary as a separate
company
- It avoids the transaction costs associated with a subsidiary sale
- The special dividend is not taxed as a cash distribution