Advanced Corporate Finance Chapter 6

Payout Policy

Set of decisions governing how a firm distributes its free cash flow to shareholders- and whether it distributes it at all

Mechanisms of Payout Policy

Cash dividends and share repurchases

Mechanisms of retaining cash

Invest in new projects or build cash reserves

MM Dividend Irrelevance Theorem

In perfect capital markets, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price. A dividend is simply a transfer of wealth from inside the firm to outside- shareholders own the money either way.

Same logic applies to repurchases

Cash Dividend

Pro-rate cash distribution to all shareholders

• Reduces cash and equity; taxes as ordinary income in most jurisdictions

• No change in share number

Special Dividend

One-time, usually large cash payment

• Signals unusual cash surplus; not expected to recur

Spinoff

Subsidiary shares distributed to parent shareholders as a dividend

• Creates two independently traded firms; no cash changes hands

Stock Dividend

New shares issued to shareholders instead of cash

• No change in firm value; equivalent to a stock split

• Proportional change in share number

• Share price falls proportionally

Liquidating Dividend

Distribution of firm assets to shareholders upon dissolution

• Firm is winding down; returns remaining capital to owners

Open Market Repurchase

Firm buys its own shares in the open market (~95% of repurchases)

• Flexible, ongoing; no commitment; most common form

• Reduces assets

• Decreases share number, share price is unchanged

Tender Offer

Firm offers to buy shares at a premium (10-20%) for a set period (~20 days)

• Fast, large-scale; signals undervaluation

Targeted Repurchase

Firm buys shares directly from a specific shareholder

• Often used to neutralize activist investors (“greenmail”)

Greenmail

Occurs when a firm buys back shares from a hostile or activist investor at a substantial premium to the market price, effectively paying the investor to go away

• Protects incumbent management at the expense of remaining shareholders, who effectively subsidize the premium paid to the departing activist

Why has there been a rise of share repurchases

Favorable tax treatment of capital gains, the flexibility of open-market repurchase programs, and the signaling value of buybacks as undervaluation and an expression of management confidence in the firm’s intrinsic value

Declaration

Board formally announces the dividend amount and future dates

• Share price often rises on announcement if dividend surprises the market

Ex-Dividend Date

First day on which buyers no longer receive the declared dividend

• In a perfect market: share price falls by the dividend amount

Record Date

Firm records all shareholders eligible to receive the dividend (typically 1 day after the ex-div date)

• Administrative date; no additional price effect

Payable Date

Eligible shareholders receive the dividend payment

• Cash leaves the firm; no further price effect

Stock Split

Increases the number of shares outstanding

Reduces the price per share proportionally

Reverse Stock Split

Consolidates shares into fewer units at a higher price

Homemade Dividends

Even if a firm does not pay dividends, an investor who wants cash can create a “homemade dividend” by selling shares, Conversely, an investor who prefers not to receive a dividend can reinvest it in additional shares.

Tax Advantage of Repurchases

MM Irrelevance breaks down, dividends are taxed at higher rates than capital gains, creating tax advantage for share repurchases.

Repurchases deliver more after-tax value per dollar distributed

High-Bracket Individuals

• Dividends taxed at high rates (up to 37%+); capital gains at lower rates

  • Prefer stocks with low or no dividends; prefer repurchases

Retirees and income investors

Rely on regular cash income; may be in lower tax brackets

• Prefer stocks with regular, predictable dividends

Tax-exempt institutions (pensions, endownments)

No dividend or capital gains tax

• Indifferent between dividends and repurchases; may prefer dividends for predictbility

Corporations holding stock

Dividend received deduction (70-100% exclusions in US)

• Strongly prefer dividends (near-zero effective tax on dividend income)

Clientele Effect

The tendency for firms with different payout policies to attract different clienteles of investors.

Dividend Initiation or Increase

Management confident in sustained future cash flows; firm is mature and profitable

• May also signal lack of posititve-NPC investment opportunities

Dividend Cut

Earnings expected to fall; management concerned about cash generation

• May also reflect a value-creating strategic shift toward investment

Special (one-time) Dividend

Extraordinary cash surplus; not a commitment to future payouts

• Ambiguous- could mean good news or no investment opportunities

Share repurchase announcement

Management believes shares are undervalued; positive future outlook

• May also reflect lack of attractive investment projects

No dividend, no repurchase

Reinvesting aggressively in growth (positive interpretation) OR low cash generation (negative interpretation)

• Highly depended on industry context and firm stage

Agency Theory

Suggests that managers may use excess cash for empire-building, excessive perquisites, or low-return acquisitions that entrench their positions. By distributing cash as dividends or repurchases, the firm reduces the pool available for such wasteful spending.

Bird in the Hand Principle

A dollar paid out to shareholders today is worth more than a dollar retained because of agency costs

• Once the dollar is in the firm’s hands, there is a risk that it will be invested in negative-NPV projects, used for wasteful spendind, or otherwise misallocating

Ex-dividend Price

P_ex=P_cum-Dividend per share (perfect market)

Stock split/ reverse split

Price x (1/split ratio); no value created or destroyed

MM Dividend Irrelevance

In perfect markets, payout policy does not affect share price

Homemade Dividend

Sell shares to create cash; buy shares to undo a received dividend

Repurchase vs dividend (perfect market)

Shares repurchased= Cash/ P_cum; P_post=P_pre; total wealth equal

Tax Advantage of Repurchase

After-tax repurchase > after-tax dividend when cap gains tax < dividend tax

Clientele Effect

High-tax investors prefer repurchases; low-tax/ tax-exempt prefer dividends

Retention Decision

Retain if ROI > cost of capital (NPV> 0); pay out otherwise

Negative-NPV Investment Signal

Higher EPS from negative-NPV investment destroys share price

Dividend Signaling

Dividends signal confidence in future cash flows; cuts signal bad news

Repurchase Signaling

Buyback announcement signals management believes stock is undervalued

Agency Cost of Cash

Distributing cash reduces manager’s ability to waste on negative-NPV projects

Spinoff Pricing

P_ex(parent)= P_cum(parent) - shares received x price of spun-off subsidiary