L.S.

Ruzhanskaya

Corporate Finance and Corporate

Governance
Lectures for master program 38.04.02 “International Management”

 
Prepared by the Academic Department of International Economics and Management
Payout policy
Section 4.

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 Payout (Dividend) Policy
Payout policy: amount, method, and frequency of payment
Does a firm’s value depend on its payout policy?
If so, why and how?
Signaling with Dividend
Dividend as corporate governance device
Psychological reasons
What payout policy should a firm follow?
Types of corporate payout:
Cash dividends:
Regular (UK: half-yearly, US: quarterly)
Special (extreme case: liquidating dividends)
Stock dividends:
No cash leaves the firm; # shares increases
Stock repurchases:
Open market
Tender offer
Targeted repurchase from large shareholders
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 Procedure for cash dividends

Dates:
Declaration: board declares dividend
Cum dividend: last day buyer of stock is entitled to dividend
Ex-dividend: first day seller of stock is entitled to dividend
Record: list of shareholders entitled to dividend drawn up

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 Price behavior around Ex-Dividend Date
In a perfect world, the stock price will fall by the amount of the
dividend on the ex-dividend date:

Taxes complicate things a bit. Empirically, the price drop is less than the
dividend and occurs within the first few minutes of the ex-date 5
 Does firm value depend on payout policy?
Modigliani and Miller’s (1961) dividend irrelevance
Firm value is independent of dividend policy when
Perfect capital markets: no taxes, brokerage fees etc.
Homogeneous expectations on investments, profits etc.
Investment policy of firm is set ahead of time, unaltered by
dividend policy
Why?
Dividend payout is NPV=0 transaction
Vbefore = Vafter + dividend
Both shareholders and firm can replicate payout best suited to
their needs

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 M&M’s Irrelevance Proposition

Imagine two identical firms:

Each firm has 1,000 shares outstanding.
Each firm has the same assets side of balance sheet.
Balance sheet data are market values.

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 M&M’s Irrelevance Proposition
Thomson plc Thompson plc

Assets Liabilities Assets Liabilities

F.a. 5,000 Debt 0 F.a. 5,000 Debt 0

Cash 1,000 Equity 6,000 Cash 1,000 Equity 6,000

Total assets Total liab. Total assets Total liab.

6,000 6,000 6,000 6,000

• Thomson plc decides to pay out its cash reserves.

• Thompson plc keeps its reserves. 8
 M&M’s Irrelevance Proposition
Thomson plc Thompson plc

Assets Liabilities Assets Liabilities

F.a. 5,000 Debt 0 F.a. 5,000 Debt 0

Cash 0 Equity 5,000 Cash 1,000 Equity 6,000

Total assets Total liab. Total assets Total liab.

5,000 5,000 6,000 6,000

• Thomson plc decides to pay out its cash reserves.

• Thompson plc keeps its reserves. 9
 M&M’s Irrelevance Proposition

Thomson’s shares are now worth:

£5,000/1,000 = £5
The decrease in value of £1 is entirely compensated by
special dividend of £1.
Thompson’s shares are still worth £6.
M&M’s result implies that investors will not pay more for
firms with a higher dividend payout.
How relevant is MM irrelevance?
It helps us avoid illusions about payout policy
It helps us evaluate how payout policy affects firm value
when capital market imperfections are introduced

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 “Bird in the hand” – Theory or fallacy?

Argument:
Dividends today is safer than future dividend promise
Investors will pay a premium for dividend paying firms
Hence, dividends increase firm value
Reality:
Argument implies that investors prefer cash dividends to
investment in NPV>0 projects
Firm value changes are induced by investment policy,
dividend policy changes have NPV=0.
Investors and intermediaries can replicate payoffs.
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 Clients
Firms can convert dividends into capital gains
Dividends vs share repurchases
Taxes affect investors’ payout preferences:
All else equal capital gains are preferred due to lower effective tax
rate, net off against capital losses
In the past, dividends were taxed at a higher rate than capital gains in
the US and UK:
The difference has narrowed over the years
Marginal tax rate is different for different investors:
Individuals: prefer low (or no) dividend payouts (if dividends are
taxed at a higher or similar rate as capital gains).
Corporations: dividends from domestic subsidiaries not taxed;
dividends from international subsidiaries taxed but the effective tax
rate is similar to the capital gain
Pension/insurance funds: tax differentials between dividend income
and capital gains are much less
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 Clients

• Empirically: tax-paying individuals still hold considerable

amounts of dividend-paying stock
• Behavioural finance: regular dividends help self-control in
consumption choices
Overall implications for dividend policy:
There are natural clients for high-dividend stocks but
it does not follow that any particular firm can increase 13
its value by increasing its dividends
 Signaling
Lintner’s (1956) dividend model:
Managers have a long-term target payout ratio as a proportion of earnings
(), and smooth dividends over time .

Divt  f(  EPSt )

Lintner (1956): Managers focus on dividend changes rather than on levels of
dividend.
Dividends follow long-run shifts in sustainable earnings rather than
short-term earnings change
Dividends are permanent cash flow commitments; managers believe
shareholders dislike dividend reductions and are reluctant to change
dividends if they might need to reverse them in the future
Then, a dividend change is a signal on sustainable future growth
which stock prices will incorporate.

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Signaling - examples

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 Agency costs of outside equity
Separation of ownership and control
Control by shareholders is limited to selling shares,
AGM voting, etc
Free cash flow can lead to agency problems
Managers might engage in empire building by way of
takeovers or negative NPV projects
Managers might waste money on perks
Dividends exert discipline on management
Dispose of free cash flow
Force managers to external capital markets
when they need cash for investments
Shareholders can exercise some control by refusing to buy
the firm’s new securities if suspicious of managerial
behavior 16
Agency costs of outside equity - example

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 Agency costs of debt
Dividends induce wealth transfers from creditors to
shareholders
DeAngelo and DeAngelo (1990): Firms are reluctant to
cut dividends even when in financial distress
Extreme case: liquidating dividends
To protect themselves, creditors often
include
covenants in loan agreement
Dividends can only be paid if the firm has earnings,
cash flow and working capital above pre-specified
levels

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 Share repurchases
Similar signaling and agency implications
Increasingly popular
Possible reasons:
Flexibility, especially when one-off cash windfall
Shares are underpriced
Taxes
Executive stock options:
Managerial incentive to increase stock price
Takeover defense, buy out certain investors

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 Dividends vs repurchases

Source: Grullon and Michaely, JF 2002 20

 Empirical evidence on Payout Policies
Dividend payments have increased steadily over time

Share Repurchases have increased dramatically in the

late 1980’s (there was virtually none before).

There is no evidence that share repurchases substitute

cash dividend payments. Instead, these two policies act
as complements.

Regular dividend payments are still by far the most

prevalent method of distributing earnings to
stockholders. 21
 Summary
• Dividends – return to shareholders
• MM’s dividend irrelevance in perfect markets
• Imperfections:
Taxes
Informational asymmetries, agency problems
Behavioral considerations
• Share repurchases increasingly popular as
additional payout channel

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