Payout Policy
Payout Policy
Payout Policy
Payout Policy
• Payout Policy
§ The way a firm chooses between the alternative ways
to distribute free cash flow to equity holders
• Declaration Date
§ The date on which the board of directors authorizes the
payment of a dividend
• Record Date
§ When a firm pays a dividend, only shareholders on
record on this date receive the dividend.
• Ex-dividend Date
§ A date, two days prior to a dividend’s record date, on
or after which anyone buying the stock will not be
eligible for the dividend
• Special Dividend
§ A one-time dividend payment a firm makes, which is
usually much larger than a regular dividend
• Return of Capital
§ When a firm, instead of paying dividends out of current
earnings (or accumulated retained earnings), pays
dividends from other sources, such as paid-in-capital or
the liquidation of assets
• Liquidating Dividend
§ A return of capital to shareholders from a business
operation that is being terminated
• Tender Offer
§ A public announcement of an offer to all existing
security holders to buy back a specified amount of
outstanding securities at a prespecified price (typically
set at a 10%-20% premium to the current market
price) over a prespecified period of time (usually
about 20 days)
§ If shareholders do not tender enough shares, the firm
may cancel the offer and no buyback occurs.
• Dutch Auction
§ A share repurchase method in which the firm lists
different prices at which it is prepared to buy shares,
and shareholders in turn indicate how many shares
they are willing to sell at each price. The firm then pays
the lowest price at which it can buy back its desired
number of shares
• Targeted Repurchase
§ When a firm purchases shares directly from a
specific shareholder
• Greenmail
§ When a firm avoids a threat of takeover and removal of
its management by a major shareholder by buying out
the shareholder, often at a large premium over the
current market price
• Cum-dividend
§ When a stock trades before the ex-dividend date,
entitling anyone who buys the stock to the dividend
• Investor Preferences
§ In perfect capital markets, investors are indifferent
between the firm distributing funds via dividends or
share repurchases. By reinvesting dividends or selling
shares, they can replicate either payout method on
their own.
• Investor Preferences
§ In the case of Genron, if the firm repurchases shares
and the investor wants cash, the investor can raise
cash by selling shares.
• This is called a homemade dividend.
• MM Dividend Irrelevance
§ In perfect capital markets, holding fixed the investment
policy of a firm, the firm’s choice of dividend policy is
irrelevant and does not affect the initial share price.
• Problem
§ Assume:
• A firm raises $25 million from shareholders and uses this
cash to pay them $25 million in dividends.
• Dividends are taxed at a 39% tax rate
• Capital gains are taxed at a 20% tax rate.
• Solution
§ On dividends, shareholders will owe:
• 39% × $25 million = $9.75 million in dividend taxes.
• Solution (continued)
§ Shareholders will pay a total of $4.75 million in taxes.
• $9.75 − $5.00 = $4.75 million
• Dividend Puzzle
§ When firms continue to issue dividends despite their tax
disadvantage
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• Clientele Effect
§ When the dividend policy of a firm reflects the tax
preference of its investor clientele
• Individuals in the highest tax brackets have a preference
for stocks that pay no or low dividends, whereas tax-free
investors and corporations have a preference for stocks
with high dividends.
• Dividend-Capture Theory
§ The theory that absent transaction costs, investors can
trade shares at the time of the dividend so that non-
taxed investors receive the dividend
• An implication of this theory is that we should see large
trading volume in a stock around the ex-dividend day, as
high-tax investors sell and low-tax investors buy the stock in
anticipation of the dividend, and then reverse those trades
just after the ex-dividend date.
• Problem
§ Payne Enterprises has $20,000,000 in excess cash.
§ Payne is considering investing the cash in one-year
Treasury bills paying 5% interest, and then using the
cash to pay a dividend next year.
• Problem (continued)
§ Alternatively, the firm can pay a dividend immediately
and shareholders can invest the cash on their own.
§ In a perfect capital market, which option will
shareholders prefer?
• Solution
§ If Payne pays an immediate dividend, the shareholders
receive $20,000,000 today.
§ If Payne retains the cash, at the end of one year the
company will be able to pay a dividend of $21,000,000.
• $20,000,000 × (1.05) = $21,000,000
• Solution (continued)
§ If shareholders invest the $20,000,000 in Treasury bills
themselves, they would have $21,000,000 at the end of
1 year.
• $20,000,000 × (1.05) = $21,000,000
• MM Payout Irrelevance
§ In perfect capital markets, if a firm invests
excess cash flows in financial securities, the
firm’s choice of payout versus retention is
irrelevant and does not affect the initial share
price.
• Problem
§ What if Payne, from Alternative Example 20.4,
has a marginal tax rate of 39%. Would a tax-
exempt endowment prefer that Payne use its
excess cash to pay the dividend immediately or
invest the cash in a Treasury bill paying 5%
interest and then pay out a dividend?
• Solution
§ If Payne pays a dividend today, shareholders
receive $20,000,000. If Payne retains the cash
for one year, it will earn an after-tax return on
the Treasury bills of:
5% × (1 − 0.39) = 3.05%
§ At the end of the year, Payne will pay a dividend
of $20,000,000 × (1.0305) = $20,610,000.
This amount is less than the $21,000,000 the
endowment would have earned if they had
invested the $20,000,000 in the Treasury bills
themselves.
Copyright © 2015 Pearson Canada Inc. 20-77
Example 20.6
• Problem
§ What if Payne, from Alternative Examples 20.4
and 20.5, were to pay a special dividend of
$20,000,000. How would this affect the present
value of the taxes Payne must pay?
• Solution
§ If Payne retains the $20,000,000 and invests in
Treasury Bills, the interest will be taxed at 39%.
The present value of the tax payments on
Payne’s additional interest income will be:
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• Problem
§ Altgreen is an all-equity firm with 250 million
shares outstanding. Altgreen has $300 million in
cash and expects future free cash flows of $150
million per year. Management plans to use the
cash to expand the firm’s operations, which will
in turn increase future free cash flows by 10%.
§ If the cost of capital of Altgreen’s investments is
7%, how would a decision to use the cash for a
share repurchase rather than the expansion
change the share price?
• Solution
§ If Altgreen uses the cash to expand, its future
free cash flows will increase by 10% to $150
million 1.10 = $165 million per year. Using the
perpetuity formula, its market value will be
$165 million ÷ .07 = $2.357 billion, or $2.357
billion ÷ 250 million shares = $9.43 per share.
• Solution
§ If Altgreen does not expand, the value of its
future free cash flows will be $150 million ÷ .07
= $2.143 billion. Adding the cash, Altgreen’s
market value is $2.443 billion, or $2.443 billion
÷ 250 million shares = $9.77 per share.
• Solution
§ If Altgreen repurchases shares, there will be no
change to the share price: It will repurchase
$300 million ÷ $9.77 per share = 30.71 million
shares, so it will have assets worth $ 2.143
billion with 250 million – 30.71 million = 219.29
million shares outstanding, for a share price of
$2.143 billion ÷ 219.29 million shares = $9.77
per share.
• Dividend Smoothing
§ The practice of maintaining relatively constant
dividends
• Firms change dividends infrequently and dividends are
much less volatile than earnings.
• Spin-off
§ When a firm distribute shares of a subsidiary in a
transaction.
§ Non-cash special dividends are commonly used to spin
off assets or a subsidiary as a separate company.
§ Examples: Bell Canada Enterprises (BCE) and Nortel.