1. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Chapter 15: Payout Policy Corporate Finance, 3e Graham, Smart, and Megginson

2. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.  A firm’s payout policy refers to the choices its managers make about distributing cash to shareholders.  Whether to pay shareholders a regular (recurring) cash dividend  How large the cash dividend should be  How frequently it should be paid  The dividend payout ratio, calculated by dividing the cash dividend per share by its earnings per share, indicates the percentage of its profits that a firm distribute to its owners.  The dividend yield, which equals a stock’s dividend divided by its price, measures the rate of return represented by the dividend payment. 2 Payout Policy Fundamentals

3. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Cash Dividend Payment Procedures  In the U.S., as in most countries, shareholders have no legal right to receive dividends.  Instead, a firm’s board of directors decides what dividends the firm will pay.  Most U.S. firms that pay dividends do so once every quarter.  The most common practice is to adjust the dividend once per year. 3

4. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Relevant Dividend Dates  Shareholders of record are entitled to the dividend.  Because it takes time to make bookkeeping entries after stocks trade, investors who buy stock on the record date will miss the dividend payment.  To receive the dividend, an investor must own the stock before the ex-dividend date, usually two business days prior to the date of record.  Firms distribute dividends on the payment date, which usually comes a few weeks after the record date. 4

5. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Other Forms of Dividends  Firms sometimes declare one-time special dividends after an unusually profitable year or a large infusion of cash (e.g., from an asset sale).  Stock dividends  Additional shares of stock rather than cash  Stock splits  Share price declines because the number of outstanding shares increases (e.g., 2-for-1, 3-for-2, 3-for-1).  Reverse stock splits replace a certain number of outstanding shares with just one new share. 5

6. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.  Repurchase programs: companies can buy back some of their own shares, usually through open-market purchases.  Share repurchases give managers an alternative method to distribute cash to shareholders.  The annual value of share repurchases in the United States sometimes exceeds that of dividends, and investors clearly welcome repurchase announcements. 6 Dividend Trends: Share Repurchase Programs

7. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Methods to Repurchase Shares  Open-market share repurchase: Firms buy back their shares in the open market.  Tender offer, or self-tender: Firms offer to buy back a certain number of shares, usually at a premium above the current market price.  Dutch auction repurchase: Firms ask investors to submit prices at which they are willing to sell their shares. 7

8. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. The Conservative View of Dividends 8 1. Firms have long-run target dividend payout ratios. 2. Dividend changes follow shifts in long-run, sustainable earnings (not short-run changes in earnings). 3. Managers are reluctant to increase dividends if they might have to be cut later. 4. Managers focus on dividend changes rather than on dividend levels.

9. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.  Firms maintain constant nominal dividend payments per share for significant periods of time.  Whereas the number (and fraction) of publicly traded companies that pay dividends has been declining since roughly the 1970s, the aggregate payout ratio of the U.S. corporate sector has been increasing.  Investors react positively to dividend (and share repurchase) initiations and increases but react negatively to dividend decreases or eliminations. 9 Evidence on Payout Policy

10. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Dividend Irrelevance in a World With Perfect Capital Markets  Miller and Modigliani demonstrated that in a world of frictionless capital markets, payout policy cannot affect a firm’s value.  As long as the firm accepts all positive- NPV investment projects and has costless access to capital markets, it can pay any level of dividends it desires.  If payout policy does affect firm value, it must be because markets are imperfect. 10

11. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.  Dividends are normally taxed at an individual’s ordinary income tax rate.  Income from repurchases may be taxed at a lower long-term capital gains rate, and then only if the investor chooses to sell shares back to the company.  This encourages firms to shift payout away from dividends and toward repurchases. 11 Dividends, Repurchases, and Taxes

12. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Agency Cost Model of Dividends  Agency cost/contracting model of dividends  Assumes that firms begin paying to overcome the agency problems resulting from a separation of corporate ownership and control  Privately-held vs. public firms  Predicts that dividend payers are older, larger firms that generate more cash and have fewer growth opportunities 12

13. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Agency Cost Model of Dividends  If we compare U.S. firms that pay dividends with firms that do not, we find that  (1) the average market value of dividend payers is much greater than that of nonpayers and  (2) payers grow much more slowly. The average age of dividend payers is more than twice the average age of nonpayers. 13

14. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Signaling Model  The signaling model of dividends assumes that managers use dividends to convey positive information to poorly informed shareholders.  Like the agency cost model, the signaling model predicts that stock prices should rise (fall) in response to dividend increases (cuts). 14

15. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Catering Theory  The catering theory of dividends predicts that corporate managers cater to investor preferences by…  paying dividends when investors assign a premium to dividend-paying stocks, and  not paying when investors assign a discount to dividend payers. 15

16. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Payout Policy: Key Lessons  Firms take a conservative approach to dividends.  The key factor driving dividend payments is the stability of long-run cash flows.  Dividends are smoothed and do not vary as much as earnings from year to year.  Firms are reluctant to reduce dividends once they begin paying them.  Managers view share repurchases as more flexible. 16