CHAPTER 16 PAYOUT POLICY Brealey Myers and Allen

CHAPTER 16 PAYOUT POLICY Brealey, Myers, and Allen Principles of Corporate Finance 12 th Edition

Topics Covered Facts About Payout Information in Dividends and Stock Repurchases Dividends or Repurchases? The Payout Controversy The Rightists Taxes and the Radical Left Payout Policy and the Life Cycle of the Firm

Payout Policies

Dividend & Stock Repurchases U. S. Data 1980 -2013

How Firms Pay Dividends Stock Dividend - Distribution of additional shares to a firm’s stockholders Stock Splits - Issue of additional shares to firm’s stockholders Cash Dividend - Payment of cash by the firm to its shareholders -Regular -Special

Dividend Terms Record Date Declaration Date Payment Date Ex-Dividend Date

Dividend Payments Dec. 15, 2014 Feb. 4, 2015 Pfizer declares regular quarterly dividend of $. 28 per share. Shares start to trade ex dividend. Declaration date Ex-dividend date Feb. 6, 2015 Dividend will be paid to shareholders registered on this date. Record date Mar. 3, 2015 Dividend checks are mailed to shareholders. Payment date

How Firms Repurchase Stock Repurchase - Firm buys back stock from its shareholders Stock Repurchase (4 methods) 1. Buy shares on the market 2. Tender offer to shareholders 3. Dutch auction 4. Private negotiation (Green Mail)

The Information Content of Dividends Senior Executive Dividend Policy Features (How Dividends are Determined) 1. Managers are reluctant to make dividend changes that might have to be reversed 2. Managers “smooth” dividends and hate to cut them. Dividends changes follow shifts in longrun, sustainable levels of earnings. 3. Managers focus more on dividend changes than on absolute levels

The Information Content of Dividends 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

The Payout Decision Dividend Decision Survey (2004)

Dividend Policy is Irrelevant Miller and Modigliani 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 Example - Shareholder Value Rational Demiconductor Stock Cash Total Value Record $11 0 $11 Pmt $10 $1 $11

Dividends or Repurchases?

Stock Repurchases and DCF Models of Share Price Calculate Market Capitalization � Done by forecasting and discounting free cash flow paid to shareholders � To calculate share price, divide market capitalization by number of outstanding shares Calculate Value of Dividends Per Share � Account for increased dividend growth rate per share � Caused by declining number of shares as shares are repurchased

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

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

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

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.

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.

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.

Taxes and the Radical Left 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 the Radical Left

Empirical Evidence on Dividends and Taxes In recent years, the case for low dividends has been weakened � Top tax rates on dividends: 15% � Top tax rates on capital gains: 15% One advantage to investors: � Capital gains taxes are deferrable One advantage to corporations: � Corporations pay corporate income tax on only 30% of any dividends received from investments in other corporations.

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

Alternative Tax Systems 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)

Payout Policy and the Life Cycle of the Firm Residual Dividend Policy r MRI = IRR 12% COC Qty. , $

Payout Policy and the Life Cycle of the Firm Questions for the Financial Manager 1. Is the company generating positive free cash flow after making all investments with positive NPVs and is the positive free cash flow likely to continue? 2. Is the firm’s debt ratio prudent? 3. Are the company’s holdings of cash a sufficient cushion for unexpected setbacks and a sufficient war chest for unexpected opportunities?

Dividends Increase Value Apple stock price increased, despite paying no dividend. It sent a signal of growth.