Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy

Payout Policy a

ECO562-Financial Economics
Semester: Spring 2017

Dr. Zulfiqar Hyder

Institute of Business Administration, Karachi

April 15, 2017

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy-I

Suppose you own stock in a corporation that has $1 per share of

unneeded cash. It can hold on to the cash or it can pay an extra
cash dividend of $1 per share.
Does the decision matter?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy-II

The payout decision could also be an investment decision.

The payout decision would also be a borrowing decision.
To fully understand payout policy, we must separate payout
decisions from investment and borrowing decisions.
If we hold investment and borrowing fixed, changes in cash
dividends must be offset by issues or retirements of shares
[Trade-off].

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy-III

Explain how financial managers decide on the amount and

form of payout.
Payout Policy:
1 How is money being paid out?
2 How often is money being paid out?
3 How much money is being paid?
Also discuss the controversial question of how payout policy
affects shareholder value.
If so, why and how?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy-III

Firms transfer funds to shareholders through:

1 Cash dividends
2 Share repurchases

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Method 1: Cash Dividends

The level of dividends is not fixed (contrary to interest) and

can be changed by the firm at any time.
Usually, dividends are paid either quarterly or annually.
Companies distinguish between Regular dividends [expected to
be maintained in the future] and Special dividends [less likely
to be repeated]
Dividends are reported in three equivalent ways:
1 Dividend per share (DPS): dollar amount per share
2 Dividend yield: DPS divided by share price
3 Payout ratio: DPS divided by EPS

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Method 2: Share Repurchases

There are different forms of share repurchases:

1 Open market purchases
2 Fixed price tender offers
3 Dutch auctions [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.
Then the company calculates the lowest price at which it can
buy the desired number of shares.]
4 By direct negotiation with a major shareholder.
Note that in a share repurchase:
1 Shares purchased belong to the firms remaining shareholders
and usually, they are kept in the firms treasury.
2 They may be resold when the firm needs to issue new shares.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Cash Dividends vs Repurchases

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy-How Firms Pay Dividends and Repurchase

Stock
A companys dividend is set by the board of directors.
The announcement of the dividend states that the payment
will be made to all stockholders who are registered on a
particular record date.
Then a week or so later dividend checks are mailed to
stockholders.
Stocks are normally bought or sold with dividend (or cum
dividend ) until two business days before the record date, and
then they trade ex dividend.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

How Do Companies Decide on Payouts?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

M-M Dividend Irrelevance

M-M say the In perfect capital markets the value of a

firm is independent of its payout policy.
Paying dividends is a Zero NPV transaction so the value of
the firm before paying dividends must equal the value of the
firm after paying dividends plus the value of the dividends.
In perfect capital markets, investors who want dividends can
replicate dividends by selling part of their holdings in
companies that dont pay dividends
In perfect capital markets, investors who dont want dividends
can replicate a no-dividend stock by reinvesting their
dividends.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Example of Dividend Irrelevance

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Example of Dividend Irrelevance (conti. . . )

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Example of Dividend Irrelevance (conti. . . )

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Dividend Irrelevance

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Dividend Irrelevance

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Using this Result Sensibly

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy, Investment Policy, and Management

Incentives

Paying out funds to shareholders prevents managers

from misusing or wasting funds.
This helps to mitigate agency problems, HOW?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Microsofts Payout Bonanza

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy, Investment Policy, and Management

Incentives

Contrary to Microsoft, other cash-cow corporations may let go

of cash grudgingly under pressure from investors.
Stock price falls when investors sense excessive perks or
empire building.
The threat of a falling stock price is an excellent motivator,
particularly for top managers holding valuable stock options.
Corporate governance is effective in the U.S. and other
developed economies.
But governance is less effective/weak in many emerging
economies which results into smaller payout ratios.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy and Tax Policy

Whenever dividends are taxed more heavily than capital gains,

firms should pay the lowest cash dividend they can get away with.
Available cash should be retained or used to repurchase shares.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy and Tax Policy (conti. . . )

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy and Tax Policy (conti. . . )

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Payout Policy and the Life Cycle of the Firm

In MMs analysis, payout is a residual, a by-product of other

financial policies.
The firm should make investment and financing decisions, and
then pay out whatever cash is left over.
Therefore payout should change over the life cycle of the firm.

Young growth firms have plenty of profitable investment

opportunities so it is efficient to retain and reinvest all
operating cash flow.
As the firm matures, positive-NPV projects become scarcer
relative to cash flow. The firm begins to accumulate cash and
this leads to agency problem

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

The Signaling Hypothesis

How does an investor separate marginally profitable firms from

the real money makers?
Firms can signal positive information through dividends.
1 High quality firms can afford to pay dividends.
2 Low quality firms cannot afford to mimic high quality firms.
3 Therefore, by paying (or increasing) dividends, a firm can
signal that it is a high quality firm.

Of course, firms can cheat in the short run by overstating

earnings and scraping up cash to pay a generous dividend but
it is hard to cheat in the long run.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Payout Policy M-M Dividend Irrelevance Payout Policy and Management Incentives Payout Policy and Tax Policy Payout Policy a

Dividend and Share prices

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017