Principles of

Chapter 11 Corporate Finance

Tenth Edition

Payout Policy

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Topics Covered
11-2

 Facts About Payout

 How Firms Pay Dividends and Repurchase
Stock
 How Do Companies Decide on Payouts?
 Information in Dividends and Stock
Repurchases
 The Payout Controversy
 The Rightists
 Taxes and the Radical Left
 The Middle of the Roaders
 11-3

Payout Policies

11-4

Dividend & Stock Repurchases

U.S. Data 1980 - 2008
1200
1000
Dividends Repurchases Remaining earnings
800
600
$ Billions

400
200
0
-200
-400
-600
-800
80

82

84

86

88

90

92

94

96

98

00

02

04

06

08
19

19

19

19

19

19

20

20

20
19

19

19

19

20

20
 Dividend Payments
11-5

April 15, 2009 May 11, 2009 May 13, 2009 June 10, 2009
Exxon Mobil Dividend will be Dividend checks
declares regular Shares start to paid are mailed
quarterly trade ex to shareholders to shareholders.
dividend dividend. registered
of $.42 per on this date. Payment
share. Record Date
Ex-dividend
Declaration Date Date
Date

Types of Dividends
11-6

Cash Dividend
Regular Cash Dividend
Special Cash Dividend
Stock Dividend
Stock Repurchase (4 methods)
1. Buy shares on the market
2. Tender Offer to Shareholders
3. Dutch Auction
4. Private Negotiation (Green Mail)
 Dividend Payments
11-7

Cash Dividend - Payment of cash by the

firm to its shareholders.

Ex-Dividend Date - Date that determines

whether a stockholder is entitled to a
dividend payment; anyone holding stock
before this date is entitled to a dividend.

Record Date - Person who owns stock on

this date received the dividend.

Dividend Payments
11-8

Stock Dividend - Distribution of

additional shares to a firm’s
stockholders.

Stock Splits - Issue of additional

shares to firm’s stockholders.

Stock Repurchase - Firm buys back

stock from its shareholders.
 The Payout Decision
11-9

Dividend Decision Survey (2004)

The cost of external capital is lower than the cost of a

dividend cut

Rather than reducing dividends we would raise new funds

to undertake a profitable project

We consider the change in the dividend

We are reluctant to make a change that may have to be

reversed

We look at the current dividend level

We try to maintain a smooth dividend stream

We try to avoid reducing the dividend

0 10 20 30 40 50 60 70 80 90 100

Executives who agree or strongly agree (%)

The Payout Decision

11-10

Lintner’s “Stylized Facts,”

as updated by Brav, Graham, Harvey, Michaely (2004)

1. Managers are reluctant to make dividend changes that may have

to be reversed. They are particularly worried about having to
rescind a dividend increase and, if necessary, would choose to
raise new funds to maintain the payout.
2. To avoid the risk of a reduction in payout, managers smooth”
dividends. Consequently, dividend changes follow shifts in long-
run sustainable earnings. Transitory earnings changes are
unlikely to affect dividend payouts.
3. Managers focus more on dividend changes than on absolute
levels. Thus paying a $2.00 dividend is an important financial
decision if last year’s dividend was $1.00, but no big deal if last
year’s dividend was $2.00.
 Information in Payouts
11-11

 Dividends and stock repurchase decisions

contain information
 The information contained in the decisions
varies
 Asymmetric information may be conveyed
 Dividend increases could mean overpriced
stock or increased future profits
 The signal varies based on prior information
about the company

Information in Payouts
11-12

Attitudes concerning dividend targets

vary
DIV1  target dividend
 target ratio  EPS1

Dividend Change
DIV1 - DIV0  target change
 target ratio  EPS1 - DIV0
 Information in Payouts
11-13

Dividend changes confirm the following

DIV1 - DIV0  adjustment rate  target change

 adjustment rate  target ratio  EPS1 - DIV0 

Dividend Policy
11-14

Impact of Dividend Changes on EPS

Change EPS/Price at t = 0 as %

15

10

-5
Div Rise
Div Cut
-10

-15
Year
Source: Healy & Palepu (1988)
 Dividend Policy
11-15

Before After
Dividend Dividend

New
stockholder
Total value of firm

Each share s
worth this
before … … and
worth
this
after Old
stockholder
s

Total Total
number of number of
shares shares
Example of 1/3rd of worth paid as dividend and raising money via
new shares

Dividend Policy
11-16

Dividend
financed by stock No dividend, no
issue stock issue
New stockholders New stockholders
Shares
Cash

Firm Cash Shares

Cash
Old stockholders Old stockholders
 Dividend Policy is Irrelevant
11-17

Since investors do not need dividends

to convert shares to cash they will not
pay higher prices for firms with higher
dividend payouts. In other words,
dividend policy will have no impact on
the value of the firm.

Dividend Policy is Irrelevant

11-18

Example - Assume Rational Demi conductor has no extra cash, but

declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.

Record Date
Cash 1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV 2,000
# of Shares 1,000
price/share $12
 Dividend Policy is Irrelevant
11-19

Example - Assume Rational Demi conductor has no extra cash, but

declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.

Record Date Pmt Date

Cash 1,000 0
Asset Value 9,000 9,000
Total Value 10,000 + 9,000
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11

Dividend Policy is Irrelevant

11-20

Example - Assume Rational Demi conductor has no extra cash, but

declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.

Record Date Pmt Date Post Pmt

Cash 1,000 0 1,000 (91 sh @ $11)
Asset Value 9,000 9,000 9,000
Total Value 10,000 + 9,000 10,000
New Proj NPV 2,000 2,000 2,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11
NEW SHARES ARE ISSUED
 Dividend Policy is Irrelevant
11-21

Example - continued - Shareholder Value

Record
Stock 12,000
Cash 0

Total Value 12,000

Stock = 1,000 sh @ $12 = 12,000

Dividend Policy is Irrelevant

11-22

Example - continued - Shareholder Value

Record Pmt
Stock 12,000 11,000

Cash 0 1,000

Total Value 12,000 12,000

Stock = 1,000sh @ $11 = 11,000

 Dividend Policy is Irrelevant
11-23

Example - continued - Shareholder Value

Record Pmt Post

Stock 12,000 11,000 12,000
Cash 0 1,000 0
Total Value 12,000 12,000 12,000

Stock = 1,091sh @ $115 = 12,000

 Assume stockholders purchase the new issue with the
cash dividend proceeds.

Dividend Theories
11-24

Leftists (M&M) - Dividend does not effect value

Rightists - Dividends increase value

Middle of the roaders - Leftist theory with some

reality thrown in.

Residual Dividend Policy

 Dividends Increase Value
11-25

Market Imperfections and Clientele Effect

There are natural clients for high-payout stocks,
but it does not follow that any particular firm can
benefit by increasing its dividends. The high
dividend clientele already have plenty of high
dividend stock to choose from.

These clients increase the price of the stock

through their demand for a dividend paying
stock.

Dividends Increase Value

11-26

Dividends as Signals
Dividend increases send good news about cash
flows and earnings. Dividend cuts send bad
news.
Because a high dividend payout policy will be
costly to firms that do not have the cash flow to
support it, dividend increases signal a company’s
good fortune and its manager’s confidence in
future cash flows.
 Dividends Decrease Value
11-27

Tax Consequences
Companies can convert dividends into capital
gains by shifting their dividend policies. If
dividends are taxed more heavily than capital
gains, taxpaying investors should welcome such
a move and value the firm more favorably.

In such a tax environment, the total cash flow

retained by the firm and/or held by shareholders
will be higher than if dividends are paid.

Taxes and Dividend Policy

11-28

Since capital gains are taxed at a lower

rate than dividend income, companies
should pay the lowest dividend possible.
Dividend policy should adjust to
changes in the tax code.
 Taxes and Dividend Policy
11-29

Firm A Firm B
(no dividend) (high dividend)
Next year' s price 112.50 102.50
Dividend 0 10
Total pretax payoff 112.50 112.50
Today' s stock price 100 97.78
Capital gain 12.50 4.72
Pretax rate of return (%) 12.5
100
 100  12.5 14.72
97.78
 100  15.05
Tax on div @ 50% 0 .40  10  4.00
Tax on Cap Gain @ 20% .20  12.50  2.50 .20  4.72  0.94
Total After Tax income
(0  12.50)  2.50  10 (10  4.72)  (4  0.94)  9.78
(div  cap gain - taxes)
After tax rate of return (%) 10
100  100  10.0 9.78
97.78  100  10.0

Taxes and Dividend Policy

11-30

In U.S., shareholders are taxed twice (figures in dollars)

Cash Flow

Operating Income 100.00

Corporate tax at 35% 35.00
After Tax income (paid as div) 65.00
Income tax paid by investors at 15.0% 9.75
Cash to Shareholder 55.25
 Taxes and Dividend Policy
11-31

Under imputed tax systems, such as that in Australia,

Shareholders receive a tax credit for the corporate tax the firm
pays (figures in Australian dollars)

Rate of Income tax

15% 30% 47%

Operating Income 100 100 100
Corporate tax (Tc=.30) 30 30 30
After Tax income 70 70 70

Grossed up Dividend 100 100 100

Income tax 15 30 47
Tax credit for Corp Pmt -30 -30 -30
Tax due from shareholder -15 0 17
Cash to Shareholder 85 70 53

Dividend Theories
16-32

Residual Dividend Policy

MRI = IRR

12 % COC

QTY $$$
 Web Resources
11-33

Click to access web sites

Internet connection required

www.earnings.com
www.ex-dividend.com
www.dripcentral.com