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Chapter 16
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 The Choice of Payout Policy
 How Firms Pay Dividends and Repurchase Stock
 How Do Companies Decide on The Payout?
 Information in Dividends and Stock Repurchases
 The Payout Controversyy y
 The Rightists
 Taxes and the Radical Left
 The Middle of the Roaders
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1. Cash Dividend
 Regular Cash Dividend
 Special Cash Dividend
 Dividend reinvestment plans (Drips)
2. Stock Dividend – stock split?
3 Stock Repurchase (4 methods)3. Stock Repurchase (4 methods)
1. Buy shares on the market
2. Tender Offer to Shareholders (20% higher)
3. Dutch Auction
4. Private Negotiation (Green Mail –
repurchase bidder)
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Ex-Dividend Date - Date that determines
Cash Dividend - Payment of cash by the firm
to its shareholders.
Record Date - Person who owns stock on this
date received the dividend.
whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.
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1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on
absolute levels.
3. Dividends changes follow shifts in long-run,
sustainable levels of earnings rather than short run
Lintner’s “Stylized Facts”
(How Dividends are Determined)
sustainable levels of earnings rather than short-run
changes in earnings.
4. Managers are reluctant to make dividend changes that
might have to be reversed.
5. Firms repurchase stock when they have accumulated a
large amount of unwanted cash or wish to change their
capital structure by replacing equity with debt.
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We are reluctant to make a change that may have to be
reversed
We consider the change in the dividend
Rather than reducing dividends we would raise new funds
to undertake a profitable project
The cost of external capital is lower than the cost of a
dividend cut
Dividend Decision Survey (2004)
0 10 20 30 40 50 60 70 80 90 100
We try to avoid reducing the dividend
We try to maintain a smooth dividend stream
We look at the current dividend level
Executives who agree or strongly agree (%)
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Before
Dividend
After
Dividend
New
stockholders
Each share
worth this
before … and
offirm
before …
Old
stockholders
… and
worth
this
after
Totalvalueo
Total number
of shares
Total number
of shares
Example of 1/3rd of worth paid as dividend and raising money via new shares
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 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.have no impact on the value of the firm.
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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 to pay for
the dividend.
Record Date
Cash 1 000Cash 1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV 2,000
# of Shares 1,000
price/share $12
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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 to pay for the
dividend.
Record Date Pmt Dateeco d ate t ate
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
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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 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
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Example - continued - Shareholder Value
Record
Stock 12,000
Cash 0Cash 0
Total Value 12,000
Stock = 1,000 sh @ $12 = 12,000
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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.
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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 stockalready 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.
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Residual theory
 The firm pays a dividend only if it has retained earnings left
after financing all profitable investment opportunities
 This
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◦ maximises capital gains for shareholders, and
◦ minimises flotation costs of issuing new ordinary shares
◦ Hence, why “interim”, “final” dividend.
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.
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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 favorablyand 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.
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 If 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.
Other argument of signaling effect
 High dividend could also mean the company’s
outlook that growth is limited.
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97.78100pricestocksToday'
112.50112.50payoffpretaxTotal
100Dividend
102.50112.50pricesyear'Next
dividend(high
BFirm
dividend)(no
AFirm
20
0.101000.10100
78.9)94.04()72.410(1050.2)50.120(
94.072.4
0
05.151005.12100

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
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97.78
9.78
100
10
97.78
14.72
100
12.5
(%)returnofratetaxAfter
taxes)-gaincap(div
incomeTaxAfterTotal
.202.5012.50.2020%@GainCaponTax
4.0010.4040%@divonTax
(%)returnofratePretax
4.7212.50gainCapital
Cash Flow
In U.S., shareholders are taxed twice
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
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Rate of Income tax
15% 30% 47%
Operating Income 100 100 100
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)
Operating Income 100 100 100
Corporate tax(Tc=.30) 30 30 30
After Taxincome 70 70 70
Grossed up Dividend 100 100 100
Income tax 15 30 47
Taxcredit for Corp Pmt -30 -30 -30
Taxdue fromshareholder -15 0 17
Cash to Shareholder 85 70 53
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 Differential taxes
 The cost of information
◦ not equal for all
 Agency costs
◦ increase in monitoring costs
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◦ increase in monitoring costs
 Transactions in buying and selling
 A company will attract a clientele of investors
who are suited to its dividend policy
 small, foreign, fixed income, institutional
 anyone remember Solomon Lew vs. Coles board on
issue of “shareholder discount card” back in the late
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1990s?
 But will this increase shareholders’ value?
◦ An argument for a stable dividend policy

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 M&M argued that firms long ago adjusted
their dividend policy to the needs of their
clientele.
 So if dividend policy changed, then clientele
would change
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would change.
 But most importantly, it costs will change
 Shareholders receive dividends after tax has
been paid.
 The impact will depend upon the tax situation
of the investor.
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 Legal and accounting matters
◦ Convenants (refer last week’s material)
 Liquidity and finance
 Lack of sources of finance
 Contractual constraints
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 Contractual constraints
 Growth prospects
 Market considerations
 As the firm’s investment opportunities
increase then its dividend payout ratio
should decrease
 because we are using internally generated
finance
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finance.
 The real issue is the firms expected earning
power and the riskiness of those earnings.
 Dividend policy is a source of information
about expected future earnings