CF Chapter 19: Distribution Policy

Payout (Distribution) Policy was also developed by…

M&M

Basic Observation: Firms often have more cash than they need for their core business and must figure out…

what to do with this free cash flow

Two questions regarding distribution policy

1. If a firm wants to return $X of cash to equity investors, should it pay a dividend or conduct a share repurchase?

   1. How TO pay

2. How much cash should a firm return to investors vs. holding the cash internally

   1. How MUCH pay

The two questions regarding distribution policy impact…

Firm Value

What are the two ways of distributing cash to shareholders

1. Dividends

2. Share Repurchases

Many companies pay a _______ cash dividend

regular

• Public companies often pay quarterly

• Sometimes firms will throw in an extra cash dividend (special dividend)

Stock repurchases information

• Instead of declaring cash dividends, firms can get rid of excess cash through buying shares of their own stock

  • Open market repurchase

  • Tender offer repurchase

• Recently share repurchases have become an important way of distributing earnings to shareholders

The four important dates for dividend payment procedures

1. Declaration Date

2. Cumulative-Dividend Date

3. Ex-Dividend Date

4. Record Date

Definition: Declaration Date

The Board of Directors declares a payment of dividends

Cumulative Dividend Date

The last day a buyer of a stock is entitled to the dividend

Ex-Dividend Date

The first day the seller of a stock is entitled to the dividend

Record Date

The corporation prepares a list of all individuals believed to be stockholders

Important dates for dividends visual timeline

If the initial price is $10 and the company pays out a $1 dividend, what day will the stock price drop?

The ex-dividend date

Price behavior around the Ex-Dividend Date:

• In a perfect world, the stock price will fall by… on the ex-dividend date

The price will drop by the amount of the cash dividend being paid

When calculating beta, you must use which price?

Adjusted closing price

What does the energy industry pay high dividends?

Low future growth opportunities

Why do IT companies pay low dividends?

LOTS of future growth opportunities, use excess cash flows to pay for those investments, not paying dividends

What can you gather from this visual?

1. The proportion of companies paying a dividend has declined over time

2. Repurchases have been increasing over time

3. Firms exhibit considerable heterogeneity in dividend payout ratios

T/F A dividend cut is a good sign to the market

FALSE, actually a really bad sign

• A dividend INCREASE is a good sign to the market

T/F a company should only increase a dividend payment amount when they know that they can maintain that amount for future dividend payments

TRUE

For dividend policy in a perfect world, we must assume

1. No taxes

2. No transactions costs

3. Investment financing (capital structure) and operating activities (assets) of the firm are fixed

If we assume a dividend policy in a perfect world, what are the answers to the two questions regarding payout policy?

1. Choice of dividends vs. share repurchases doesn’t matter

2. Choice of how much cash to keep on hand doesn’t matter

T/F A company buys back stock at the current market price

TRUE

• Price stays the same but N goes down after a repurchase

**When there is a repurchase announcement the price will rise and the number of shares stays the same.

T/F if the returns are different, then the stock price cannot be the same for both a dividend payout and share repurchase today

TRUE

Stock price today is ___________ by how much cash is distributed — stock price tomorrow is _________ by how much cash is distributed

Stock price today is unaffected by how much cash is distributed — stock price tomorrow is affected by how much cash is distributed

T/F A $10 stock vs. a $9 stock + $1 dividend are equivalent

TRUE

T/F as long as the cash inside the firm has a present value of the og amount, shareholders do not care if the cash is on the inside or outside of the firm

TRUE

What is the purpose of the Homemade Dividend Strategy?

Replicate payout of another company using our company’s financial information

There WILL be a question on the exam about Homemade Dividends

Ok

T/F With homemade dividends, both dividends and dividend policy are relevant

FALSE

• Dividends are relevant but policy is irrelevant

T/F In a perfect world, you can replicate the impact of a dividend

TRUE

2 Arguments about Payout Policy in an imperfect world

1. Dividends increase value

2. Dividends decrease value

Dividends increase value: Desire for Current Income

There are natural clients for high-payout stocks. These clients increase the price of stock through their demand for a dividend paying stock

• Ex: Elderly who live on dividends

**Homemade dividends are an option, but entail transaction costs and inconvenience (tax costs)

• Since there is an inconvenience, pay a premium

Dividends increase value: Dividend signaling

Dividends may play an important role in providing information to the market concerning a firm’s prospects

• Basic Fact: Market reacts positively to dividend increases because the market believes that this signals higher future earnings

  • 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 increase value: Agency costs of equity

Distributing cash to shareholders may be a good thing if managers have a tendency to invest excess cash in poor pet projects

• reduces Free Cash Flow in a company

Dividends increase value: Agency costs of equity → Free Cash Flow Hypothesis

Agency cost of equity, conflict of interest between managers and shareholders

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

Dividends decrease value: Observation 1 - Paying out cash and then selling stock is a dumb idea

The only cash you should consider paying out is excess cash (Free Cash Flow)

Dividends decrease value: Observation 2 - If you pay out excess cash, stock repurchases are more tax efficient

Capital gains taxes are effectively lower because of deferral and basis reduction

T/F dividends are taxed more heavily in the US

TRUE

T/F Personal taxes favor equity (capital gains/share repurchase) financing

TRUE

What kind of tax are we talking about with payout policy?

Personal tax

Dividends decrease value: Observation 3 - The payout decision depends on corporate tax rates

→ what are the inequalities between the two

• If corporate tax rate > personal tax rate → payout excess cash

• If corporate tax rate < personal tax rate → keep cash inside the firm

Corporate dividends are substantial

Dividend payouts (dividends/earnings) have averaged 40%-60% range over the past 40 years

Smaller portion of publicly traded companies pay dividends today compared to 20 years ago

However, the firms with high earnings are paying dividends, explaining why the overall dividend payout ratio has not decreased sharply overtime

Repurchase activity has ___________ sharply overtime because…

increased sharply because Managers view repurchases as more flexible

• ALSO do not need to maintain stock repurchases like dividend prices

• The PRIMARY REASON though is taxes

Firm characteristics matter for payout policy

Firms with low cash-flow uncertainty and those at the mature stage in their life cycle pay high dividends

The market reacts ___________ to dividend changes

Sharply

• Dividend initiations and increases are good news

• Dividend cuts and decreases are bad news