1. Chapter 16 Payout Policy Principles of Corporate Finance Tenth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

2. Topics Covered 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 2 2 2 2 3 2

3. Payout Policies
Cash Dividend
vs.
Stock Repurchase

4. Dividend & Stock Repurchases
U.S. Data
$ Billions

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

6. Types of Dividends 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)

7. Dividend Payments
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. 5

8. Dividend Payments
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. 8

9. Dividend Decision Survey (2004)
The Payout Decision
Dividend Decision Survey (2004)
Executives who agree or strongly agree (%)

10. The Payout Decision 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. 18

11. Information in Payouts
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

12. Information in Payouts
Attitudes concerning dividend targets vary
Dividend Change 18

13. Information in Payouts
Dividend changes confirm the following 18

14. Dividend Policy } { Before Dividend After Dividend New stockholders
Each share worth this before … }
… and worth this after
Total value of firm {
Old stockholders
Total number of shares
Total number of shares
Example of 1/3rd of worth paid as dividend and raising money via new shares

15. Dividend Policy Dividend financed by stock issue
No dividend, no stock issue
New stockholders
New stockholders
Shares
Cash
Firm
Cash
Shares
Cash
Old stockholders
Old stockholders

16. Dividend Policy is Irrelevant
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. 19

17. Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor 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 20

18. Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor 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
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11 22

19. Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor 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 (91 $11)
Asset Value 9,000 9,000 9,000
Total Value 10, , ,000
New Proj NPV 2,000 2, ,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11
NEW SHARES ARE ISSUED 22

20. Dividend Theories 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

21. Dividends Increase Value
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.

22. Dividends Increase Value
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.

23. Dividends Decrease Value
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.

24. Taxes and Dividend Policy
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.

25. Taxes and Dividend Policy

26. Taxes and Dividend Policy
In U.S., shareholders are taxed twice (figures in dollars)

27. Taxes and Dividend Policy
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)

28. Web Resources Click to access web sites Internet connection required