Notes on Payout Policy – Chapter 14
Payout policy refers to the decisions that a firm makes regarding whether to
distribute cash to shareholders, how much cash to distribute and the means by
which cash should be distributed.
General Guidelines:
1. Rapidly growing firms generally do not pay out cash to shareholders
2. Slowing growth, positive cash flow generation and favourable tax
conditions can prompt firms to initiate cash payouts to investors.
Ownership base of the company can also be an important factor in the
decision to distribute cash.
3. Cash payout can be made through dividends or share repurchases.
4. When business conditions are weak, firms are more willing to reduce share
buybacks than to cut dividends.
Trends in Earnings and Dividends:
Firms pay dividends out of earnings, so for dividends to grow over the long-
term, earnings must also grow too.
Earnings series is much more volatile than the dividends series. Firms tend
to smooth dividends, increasing them slowly when earnings are growing
rapidly and maintaining dividend payments, rather than cutting them, when
earnings decline.
In 2007 to 2009, earnings decline due to recession. Dividends were cut
drastically. Even so the drop in dividends was slight compared to the
earnings decrease.
Three broad conclusions on Payout Policy from history:
Firms exhibit strong desire to maintain modest, steady growth in dividends
Share repurchases have accounted for a growing fractions of total cash
payouts over time.
When earnings fluctuate, firms adjust their short-term payouts primarily by
adjusting share repurchases rather than dividends.
Mechanics of Payout Policy:
Dividend: Record date, Ex-dividend date, Payment date
Share Repurchase: Tender offer, Open-market share repurchase.
Tender Offer price is usually set at a significant premium above the current
market price. Dutch Auction.
Tax Treatment of Dividends and Repurchases
Stock Price Reactions to Corporate Payouts:
Relevance of Payout Policy
Does payout policy have a significant effect on the value of a firm?
Numerous theories and empirical findings concerning payout policy
Capital Budgeting and Capital Structure decisions are generally considered
far more important than payout decisions
The Residual Theory of Dividends is a school of thought that suggests that the
dividend paid by a firm should be viewed as a residual – the amount left over after
all acceptable investment opportunities have been undertaken
Step 1: Determine its optimal level of capital expenditures – Firms all +ve NPV
projects financed
Step 2: Using the optimal capital structure proportions, estimate the total amount
of equity financing needed to support the CAPEX finalized in Step 1
Step 3: Since cost of retained earnings rr is less than cost of new common stock
rn, use retained earnings to meet the equity requirement determined in
Step 2. If retained earnings are inadequate to meet this need, sell new
common stock. If available retained earnings are in excess of this need,
distribute the surplus amount – the residual- as dividends.
The Dividend Irrelevance Theory: M & M’s theory that in a perfect world, the firm’s
value is determined solely by the earning power and risk of its assets (investments)
and that the manner in which it splits its earnings stream between dividends and
internally retained (and reinvested) funds does not affect this value.
Tax effect – Historically, dividends have usually been taxed at higher rates than
capital gains
Clientele effect – The argument that different payout policies attract different
types of investors but still do not change the value of the firm.
M & M and other proponents of dividend irrelevance argue that, all else being equal,
an investor’s required return – and therefore the value of the firm – is unaffected
by dividend policy.
Arguments for Dividend Relevance:
Theory, advanced by Gordon and Lintner, that there is a direct relationship
between a firm’s dividend policy and its market value.
Bird-in-the-hand argument: The belief, in support of dividend relevance theory ,
that investors see current dividends as less risky than future dividends or capital
gains.
G & L argue that current dividend payments reduce investor uncertainty, causing
investors to discount the firm’s earnings at a lower rate and all else being equal,
to place a higher value on the firm’s stock.
M & M argued that bird-in-the-hand theory was a fallacy. Investors who want
immediate cash flow from a firm that did not pay dividends could simply sell off a
portion of their shares. By selling a few shares every quarter or year they can
replicate the same cash flow stream that they would have received if the firm had
paid dividends rather than retained earnings.
Informational content – The information provided by the dividend by the
dividends of a firm with respect to future earnings, which causes owners to bid
up or down the price of the firm’s stock. Studies have shown that large changes
in dividends do affect share price. Increases in dividends result in increased share
price and decreases in dividends result in decreased share price. Investors view a
change in dividend, up or down, as a signal that management expects future
earnings to change in the same direction.
Empirical studies have not provided evidence that conclusively settles the debate
about whether and how payout policy affects firm value.
Factors affecting Dividend Policy:
Legal constraints
Contractual constraints
Growth Prospects
Owner considerations – Tax status of a firm’s owners, owners’ investment
opportunities, Potential dilution of ownership
Market considerations
Other forms of dividends:
Stock dividends
Stock splits, Reverse stock split
