Chapter 17

Payout Policy

Copyright 2015 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered
17.1 How Corporations Pay Out Cash to
Shareholders
17.2 The Information Content of Dividends
and Repurchases
17.3 Dividends or Repurchases? The
Payout Controversy
17.4 How Do Corporations Decide How
Much to Payout?
17.5 Why Dividends May Increase Value
17.6 Why Dividends May Reduce Value
17.7 Payout Policy and the Life Cycle of
the Firm

17- 2

Dividend & Stock Repurchases

U.S. Data 1980 - 2012
2,000,000
1,800,000
1,600,000

Repurcha
ses

1,400,000
Dollars,
millions
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0

17- 3

Dividend Payments

August 31

August 28

August 30

October 1

The date on
which the
firm
announces it
intends to
pay a
dividend
Declaration

Shares start
to trade
without the
dividend,
thus exdividend

Shareholder
s registered
on this date
will receive
the dividend

The date on
which
dividend
checks are
mailed to the
shareholders

Exdividend
Date

Record
Date

Payment
Date

Date

17- 4

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
17- 5

Dividend Payments
Stock Dividend - Distribution of
additional shares to a firms
stockholders
Stock Splits - Issue of additional
shares to firms stockholders
Stock Repurchase - Firm
distributes cash
to stockholders by repurchasing
shares
17- 6

Stock Dividend
Example
Amoeba Products has 2 million shares
currently outstanding at a price of $15
per share. The company declares a 50%
stock dividend. How many shares will be
outstanding after the dividend is paid?
Answer
2 mil .50 = 1 mil + 2 mil = 3 mil
shares
17- 7

Stock Dividend
Example continued
After the stock dividend, what is the new
price per share and what is the new value
of the firm?
Answer
The value of the firm was 2 mil $15
per share, or $30 mil. After the dividend,
the value will remain the same.
Price per share = $30 mil/3 mil shares
= $10 per share
17- 8

Payout Information
Information content of
dividends
Dividend increases convey
managers confidence about
future cash flow and earnings
Dividend cuts convey lack of
confidence and therefore are
bad news

17- 9

Stock Repurchase
Stock Repurchase (4 methods)
1. Open market repurchase
2. Tender offer to shareholders
3. Auction (Dutch auction)
4. Direct negotiation (Green mail)

17- 10

Dividend Decisions
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 20 40 60 80 100
Executives who agree or strongly agree (%)

17- 11

Stock Repurchase
Example - Cash dividend versus share
repurchase

A. Original balance sheet

Assets

Liabilities & Equity

A. Original balance sheet

Cash

$150,00
0

Debt

$0

Other assets

950,000

Equity

1,100,00
0

Value of firm

1,100,0
00

Value of firm

1,000,00
0

Shares outstanding = 100,000

Price per share = $1,100,000/100,000 = $11
17- 12

Stock Repurchase
Example - Cash dividend versus share
repurchase

B. After cash dividend of $1 per share

Assets

Liabilities & Equity

B. After cash dividend

Cash

$50,000

Debt

$0

Other assets

950,000

Equity

1,000,00
0

Value of firm

1,000,0
00

Value of firm

1,000,00
0

Shares outstanding = 100,000

Price per share = $1,000,000/100,000 = $10

17- 13

Stock Repurchase
Example - Cash dividend versus share
repurchase

C. After $100,000 stock repurchase program

Assets

Liabilities & Equity

C. After stock repurchase

Cash

$50,000

Debt

$0

Other assets

950,000

Equity

1,000,00
0

Value of firm

1,000,0
00

Value of firm

1,000,00
0

Shares outstanding = 90,909

Price per share = $1,000,000/90,909 = $11

17- 14

The Dividend Decision

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 long-run, sustainable levels of
earnings.
3. Managers focus more on dividend
changes than on absolute levels
17- 15

The Dividend Decision

Factors in the Dividend Decision
Process
1. Target payout ratios
2. Repurchase decisions
3. Information content of dividends and
repurchases

17- 16

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

17- 17

Dividend Policy is Irrelevant

Example
Assume Rational Demiconductor 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
Record
to pay for the dividend.
Date

Cash

1,000

Asset value

9,000

Total value

10,000
+

New project NPV

2,000

# of shares

1,000

Price per share

$12

17- 18

Dividend Policy is Irrelevant

Example continued
Assume Rational Demiconductor 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

Payme
nt
Date

Cash

1,000

Asset value

9,000

9,000

10,000

9,000

New project NPV

2,000

2,000

# of shares

1,000

1,000

$12

$11

Total value

Price per share

17- 19

Dividend Policy is Irrelevant

Example continued
Assume Rational Demiconductor 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 Payme
Date nt Date

PostPayment

Cash

1,000

1,000
(91 shares @
$11)

Asset value

9,000

9,000

9,000

10,000

9,000

10,000

New project
NPV

2,000

2,000

2,000

# of shares

1,000

1,000

1,091

Total value

NEW
SHARES
ARE
ISSUED
17- 20

Dividend Policy is Irrelevant

Example continued
Shareholder Value
Recor
d
Stock
12,000
Cash
0
Total value 12,000
Stock = 1,000
shares @ $12 =
12,000
17- 21

Dividend Policy is Irrelevant

Example continued
Shareholder Value
Recor Payment
d
12,000
11,000
0
1,000
12,000
12,000

Stock
Cash
Total
value
Stock = 1,000 shares @ $11
= 11,000

17- 22

Dividend Policy is Irrelevant

Example continued
Shareholder Value
Record Payme Post
nt
12,000 11,000 12,000
0
1,000
0
12,000 12,000 12,000

Stock
Cash
Total
value
Stock = 1,091 shares @ $11 =
12,000
Assume
stockholders purchase the new issue
with the cash dividend proceeds.
17- 23

Dividends Increase Value

Market Imperfections
There are natural clients for highpayout 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
17- 24

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
companys good fortune and its
managers confidence in future cash
flows
17- 25

Dividends Increase Value

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

17- 26

Dividends Decrease Value

Firm A

Firm B

Next years price

$112.50

$102.50

Dividend

$0

$10.00

Total pretax payoff

$112.50

$112.50

Todays stock price

$100

$97.78

Capital gain

$12.50

$4.72

Pretax rate of return (%)

12.5/100 =
12.5%

14.72/97.78 =
15.05%

Tax on dividend @ 40%

$0

.40 10 = $4.00

Tax on capital gain @ 20%

.20 12.50 =
$2.50

.20 4.72 = $.94

Total aftertax income

(dividend + capital gains
taxes)

(0 + 12.50)
2.50 = $10.00

(10.00 + 4.72)
(4.00 - .94) =
$9.78

Aftertax rate of return (%)

10/100 = .10 = 9.78/97.78 = .10

10%
= 10%

17- 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
17- 28

Taxation
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

17- 29