Principles of
Corporate Finance
Chapter 7 Tenth Edition
Payout Policy
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
11-2
Topics Covered
➢ Facts About Payout
➢ How Firms Pay Dividends and Repurchase
Stock
➢ How Do Companies Decide on Payouts?
➢ Information in Dividends and Stock
Repurchases
➢ The Payout Controversy
➢ The Rightists
➢ Taxes and the Radical Left
➢ The Middle of the Roaders
11-3
Payout Policies
11-4
Dividend & Stock Repurchases
U.S. Data 1980 - 2008
1200
1000
Dividends Repurchases Remaining earnings
800
600
$ Billions
400
200
0
-200
-400
-600
-800
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
11-5
Dividend Payments
April 15, 2009 May 11, 2009 May 13, 2009 June 10, 2009
Exxon Mobil Dividend will be Dividend checks
declares regular Shares start to paid are mailed
quarterly trade ex to shareholders to shareholders.
dividend dividend. registered
of $.42 per on this date. Payment
share. Record Date
Ex-dividend
Declaration Date Date
Date
11-6
Types of Dividends
Cash Dividend
Regular Cash Dividend
Special Cash Dividend
Stock Dividend
Stock Repurchase (4 methods)
1. Buy shares on the market
2. Tender Offer to Shareholders
3. Dutch Auction
4. Private Negotiation (Green Mail)
11-7
Dividend Payments
Cash Dividend - Payment of cash by the
firm to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a
dividend payment; anyone holding stock
before this date is entitled to a dividend.
Record Date - Person who owns stock on
this date received the dividend.
11-8
Dividend Payments
Stock Dividend - Distribution of
additional shares to a firm’s
stockholders.
Stock Splits - Issue of additional
shares to firm’s stockholders.
Stock Repurchase - Firm buys back
stock from its shareholders.
11-9
The Payout Decision
Dividend Decision Survey (2004)
The cost of external capital is lower than the cost of a
dividend cut
Rather than reducing dividends we would raise new funds
to undertake a profitable project
We consider the change in the dividend
We are reluctant to make a change that may have to be
reversed
We look at the current dividend level
We try to maintain a smooth dividend stream
We try to avoid reducing the dividend
0 10 20 30 40 50 60 70 80 90 100
Executives who agree or strongly agree (%)
11-10
The Payout Decision
Lintner’s “Stylized Facts,”
as updated by Brav, Graham, Harvey, Michaely (2004)
1. Managers are reluctant to make dividend changes that may have
to be reversed. They are particularly worried about having to
rescind a dividend increase and, if necessary, would choose to
raise new funds to maintain the payout.
2. To avoid the risk of a reduction in payout, managers smooth”
dividends. Consequently, dividend changes follow shifts in long-
run sustainable earnings. Transitory earnings changes are
unlikely to affect dividend payouts.
3. Managers focus more on dividend changes than on absolute
levels. Thus paying a $2.00 dividend is an important financial
decision if last year’s dividend was $1.00, but no big deal if last
year’s dividend was $2.00.
11-11
Information in Payouts
➢ 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
11-12
Information in Payouts
➢Attitudes concerning dividend targets
vary
DIV1 = target dividend
= target ratio EPS1
➢Dividend Change
DIV1 - DIV0 = target change
= target ratio EPS1 - DIV0
11-13
Information in Payouts
➢Dividend changes confirm the following
DIV1 - DIV0 = adjustment rate target change
= adjustment rate (target ratio EPS1 - DIV0 )
11-14
Dividend Policy
Impact of Dividend Changes on EPS
Change EPS/Price at t = 0 as %
15
10
-5
Div Rise
Div Cut
-10
-15
Year
Source: Healy & Palepu (1988)
11-15
Dividend Policy
Before After
Dividend Dividend
New
stockholder
Total value of firm
Each share s
worth this
before … … and
worth
this
after Old
stockholder
s
Total Total
number of number of
shares shares
Example of 1/3rd of worth paid as dividend and raising money via
new shares
11-16
Dividend Policy
Dividend
financed by stock No dividend, no
issue stock issue
New stockholders New stockholders
Shares
Cash
Firm Cash Shares
Cash
Old stockholders Old stockholders
11-17
Dividend Policy is Irrelevant
➢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.
11-18
Dividend Policy is Irrelevant
Example - Assume Rational Demi conductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.
Record Date
Cash 1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV 2,000
# of Shares 1,000
price/share $12
11-19
Dividend Policy is Irrelevant
Example - Assume Rational Demi conductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.
Record Date Pmt Date
Cash 1,000 0
Asset Value 9,000 9,000
Total Value 10,000 + 9,000
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11
11-20
Dividend Policy is Irrelevant
Example - Assume Rational Demi conductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.
Record Date Pmt Date Post Pmt
Cash 1,000 0 1,000 (91 sh @ $11)
Asset Value 9,000 9,000 9,000
Total Value 10,000 + 9,000 10,000
New Proj NPV 2,000 2,000 2,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11
NEW SHARES ARE ISSUED
11-21
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record
Stock 12,000
Cash 0
Total Value 12,000
Stock = 1,000 sh @ $12 = 12,000
11-22
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record Pmt
Stock 12,000 11,000
Cash 0 1,000
Total Value 12,000 12,000
Stock = 1,000sh @ $11 = 11,000
11-23
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record Pmt Post
Stock 12,000 11,000 12,000
Cash 0 1,000 0
Total Value 12,000 12,000 12,000
Stock = 1,091sh @ $115 = 12,000
➢ Assume stockholders purchase the new issue with the
cash dividend proceeds.
11-24
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
11-25
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.
11-26
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.
11-27
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.
11-28
Taxes and Dividend Policy
➢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.
11-29
Taxes and Dividend Policy
Firm A Firm B
(no dividend) (high dividend)
Next year' s price 112.50 102.50
Dividend 0 10
Total pretax payoff 112.50 112.50
Today' s stock price 100 97.78
Capital gain 12.50 4.72
Pretax rate of return (%) 12.5
100 100 = 12.5 14.72
97.78 100 = 15.05
Tax on div @ 50% 0 .40 10 = 4.00
Tax on Cap Gain @ 20% .20 12.50 = 2.50 .20 4.72 = 0.94
Total After Tax income
(0 + 12.50) − 2.50 = 10 (10 − 4.72) − (4 + 0.94) = 9.78
(div + cap gain - taxes)
After tax rate of return (%) 10
100
100 = 10.0 9.78
97.78
100 = 10.0
11-30
Taxes and Dividend Policy
In U.S., shareholders are taxed twice (figures in dollars)
Cash Flow
Operating Income 100.00
Corporate tax at 35% 35.00
After Tax income (paid as div) 65.00
Income tax paid by investors at 15.0% 9.75
Cash to Shareholder 55.25
11-31
Taxes and Dividend Policy
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)
Rate of Income tax
15% 30% 47%
Operating Income 100 100 100
Corporate tax (Tc=.30) 30 30 30
After Tax income 70 70 70
Grossed up Dividend 100 100 100
Income tax 15 30 47
Tax credit for Corp Pmt -30 -30 -30
Tax due from shareholder -15 0 17
Cash to Shareholder 85 70 53
16-32
Dividend Theories
Residual Dividend Policy
MRI = IRR
12 % COC
QTY $$$
16-33
Stock price
1. Company X has 100 shares outstanding. It earns $1,000 per year and expects to
pay all of it as dividends. If the firm expects to maintain this dividend forever,
Calculate the stock price today. (The required rate of return is 10%)
2. Company X has 100 shares outstanding. It earns $1,000 per year and expects to
pay all of it as dividends. If the firm expects to maintain this dividend forever,
Calculate the stock price after the dividend payment. (The required rate of return
is 10%)
3. Company X has 100 shares outstanding. It earns $1,000 per year and expects
repurchase its shares in the open market instead of paying dividends. Calculate the
number of shares outstanding at the end of year-1, if the required rate of return is
10%.
16-34
Value of dividend
1. Two corporations A and B have exactly the same risk and both have a current
stock price of $100. Corporation A pays no dividend and will have a price of $120
one year from now. Corporation B pays dividends and will have price of $113 one
year from now after paying the dividend. The corporations pay no taxes and
investors pay no taxes on capital gains but pay a tax of 30% income tax on
dividends. What is the value of the dividend that investors expect corporation B to
pay one year from today?
2. A firm in Australia earns a pretax profit of $A10 per share. It pays a corporate tax
of $3 per share (30% tax rate) in taxes. The firm pays the remaining $A7 in
dividends to a shareholder in 30% tax bracket. What is the amount of tax paid by
the shareholder under the imputation tax system?
16-35
Stock outstanding / Split stocks
1. FPT has excess cash of $2,187.5 and other assets of $35,500. Equity is worth
$25,000. The firm has 2,000 shares of stock outstanding and net income of $3,750.
The firm has decided to spend all of its excess cash on a share repurchase
program. How many shares of stock will be outstanding after the stock repurchase
is completed? Knowing that A firm has a market value equal to its book value.
2. DHG has 20,000 shares of stock outstanding with a par value of $1 per share and a
market price of $17.50 a share. The balance sheet shows $20,000 in the common
stock account, $425,000 in the capital in excess of par value account, and $98,000
in the retained earnings account. The firm just announced a 5-for-3 stock split.
What will the market price per share be after the split?
