Lecture No. 20

Payout Policy
Question is
Can a company increase its value through its choice of payout
policy
Payout/Distribution policy is defined as
(1) The level of distributions,
(2) The form of distributions (cash dividends versus stock
repurchases),
(3) The stability of distributions?
Payout Policy
Uses of FCF
There are only five potentially “good” ways to use positive free
cash flow:
(1) Pay interest expenses
(2) Pay down the principal on debt
(3) Pay dividends
(4) Repurchase stock
(5) Buy non-operating assets such as Treasury bills or other
marketable securities
Payout Policy
Amount of FCF
• The source of FCF depends on a company’s investment
opportunities and its effectiveness in turning those
opportunities into realities.
• A company with many opportunities will have large investments
in operating capital and might have negative FCF even if the
company is profitable.
• But when growth begins to slow, a profitable company’s FCF will
be positive and very large
Payout Policy
Uses of FCF- Interest expense and Principal repayments
• A company’s capital structure choice determines its payments
for interest expenses and debt principal.
• A company’s value typically increases over time, even if the
company is mature, which implies its debt will also increase
over time if the company maintains a target capital structure.
• If a company instead were to pay off its debt, then it would lose
valuable tax shields associated with the deductibility of interest
expenses.
• Therefore, most companies make net additions to debt over
time rather than net repayments, even if FCF is positive.
Payout Policy
Uses of FCF – Buy Non-Operating Assets
• A company’s working capital policies determine its level of
marketable securities.
• Marketable securities decision involves a trade-off between the
benefits and costs of having a large investment in marketable
securities.
• In terms of benefits, a large investment in marketable securities
reduces the risk of financial distress should there be an economic
downturn. Also, if investment opportunities turn out to be better
than expected, marketable securities provide a ready source of
funding that will not incur the flotation or signaling costs due to
raising external funds.
• However, there is a potential agency cost: If a company has a large
investment in marketable securities, then managers might be
tempted to use the money on perks (such as corporate jets) or high-
priced acquisitions.
Payout Policy
Use of FCF -Payout
• Company’s investment opportunities and operating plans
determine its level of FCF
• The company’s capital structure policy determines the amount
of debt and interest payments.
• Working capital policy determines the investment in marketable
securities.
• The remaining FCF should be distributed to shareholders, with
the only question being how much to distribute in the form of
dividends versus stock repurchases.
Payout Policy
Procedures for Cash Distributions
• Declaration date
The directors meet and declare the regular dividend, issuing a statement similar to the
following:
“On December 8, 2020, the directors of XYZ Corporation met and declared the regular
quarterly dividend of $1 per share, payable to holders of record as of January 11, 2021,
payment to be made on February 8, 2021
• Holder-of-record date
The company closes its stock transfer books and makes up a list of shareholders as of
that date.
• Ex-dividend date
The date when the right to the dividend leaves the stock is called the ex-dividend date
• Payment date
The company actually pays the dividend
Dividend goes with stock: January 8, 2021

Ex-dividend date: January 9 and 10, 2021
Holder-of-record date: January 11, 2021
Payout Policy
Procedures for Stock Repurchase
• Stock repurchases occur when a company buys back some of its own outstanding
stock.
• Three situations can lead to stock repurchases.
(1) First, a company may decide to increase its leverage by issuing debt and using the
proceeds to repurchase stock
(2) Second, many firms have given their employees stock options, and companies
often repurchase their own stock to sell to employees when employees exercise the
options.
(3) Third, a company may have excess cash.
• Stock repurchases are usually made in one of three ways.
(1) A publicly owned firm can buy back its own stock through a broker on the open market.
(2) The firm can make a tender offer, under which it permits stockholders to send in (that
is, “tender”) shares in exchange for a specified price per share. In this case, the firm
generally indicates it will buy up to a specified number of shares within a stated time
period (usually about two weeks). If more shares are tendered than the company wants to
buy, purchases are made on a pro rata basis.
(3) The firm can purchase a block of shares from one large holder on a negotiated basis.
Payout Policy
Cash distribution and Firm value
• A company can change its value of operations only if it changes the cost of
capital or investors’ perceptions regarding expected free cash flow.
• This is true for all corporate decisions, including the distribution policy. Is
there an optimal distribution policy that maximizes a company’s intrinsic
value?
• The answer depends in part on investors’ preferences for returns in the form
of dividend yields versus capital gains. The relative mix of dividend yields and
capital gains is determined by the target distribution ratio, which is the
percentage of net income distributed to shareholders through cash dividends
or stock repurchases, and the target payout ratio, which is the percentage of
net income paid as a cash dividend.
• A high distribution ratio and a high payout ratio mean that a company pays
large dividends and has small (or zero) stock repurchases. In this situation,
the dividend yield is relatively high and the expected capital gain is low.
• If a company has a large distribution ratio but a small payout ratio, then it
pays low dividends but regularly repurchases stock, resulting in a low
dividend yield but a relatively high expected capital gain yield.
Payout Policy
Cash distribution and Firm value
Three theories of investor preferences for dividend yield versus capital gains:
(1) The dividend irrelevance theory,
(2) The dividend preference theory (also called the “bird in the hand” theory),
(3) The tax effect theory.
Payout Policy
(1) The dividend irrelevance theory,
• The original proponents of the dividend irrelevance theory were Merton Miller and Franco
Modigliani (MM).
• They argued that the firm’s value is determined only by its basic earning power and its
business risk.
• In other words, MM argued that the value of the firm depends only on the income
produced by its assets, not on how this income is split between dividends and retained
earnings.
• To understand MM’s argument, recognize that any shareholder can in theory construct his
own dividend policy. For example, if a firm does not pay dividends, a shareholder who
wants a 5% dividend can “create” it by selling 5% of his stock.
• Conversely, if a company pays a higher dividend than an investor desires, the investor can
use the unwanted dividends to buy additional shares of the company’s stock. If investors
could buy and sell shares and thus create their own dividend policy without incurring
costs, then the firm’s dividend policy would truly be irrelevant.
• In developing their dividend theory, MM made a number of important assumptions,
especially the absence of taxes and brokerage costs. If these assumptions are not true,
then investors who want additional dividends must incur brokerage costs to sell shares and
must pay taxes on any capital gains. Investors who do not want dividends must incur
brokerage costs to purchase shares with their dividends. Because taxes and brokerage
costs certainly exist, dividend policy may well be relevant.
Payout Policy
(2) The dividend preference theory (also called the “bird in the hand” theory)
• The principal conclusion of MM’s dividend irrelevance theory is that dividend policy
does not affect a stock’s value or risk. Therefore, it does not affect the required rate of
return on equity, rs.
• In contrast, Myron Gordon and John Lintner both argued that a stock’s risk declines as
dividends increase: A return in the form of dividends is a sure thing, but a return in
the form of capital gains is risky.
• In other words, a bird in the hand is worth more than two in the bush.
• Therefore, shareholders prefer dividends and are willing to accept a lower required
return on equity.
• The possibility of agency costs leads to a similar conclusion. First, high payouts reduce
the risk that managers will squander cash because there is less cash on hand.
• Second, a high-payout company must raise external funds more often than a low
payout
• company, all else held equal. If a manager knows that the company will receive
frequent scrutiny from external markets, then the manager will be less likely to
engage in wasteful practices.
• Therefore, high payouts reduce the risk of agency costs. With less risk, shareholders
are willing to accept a lower required return on equity.
Payout Policy
(3) Tax Effect theory
• There are two reasons why stock price appreciation still is taxed more favorably than
dividend income.
• First, the time value of money means that a dollar of taxes paid in the future has a
lower effective cost than a dollar paid today.
• So even when dividends and gains are taxed equally, capital gains are never taxed
sooner than dividends. Second, if a stock is held until the shareholder dies, then no
capital gains tax is due at all: the beneficiaries who receive the stock can use its value
on the date of death as their cost basis and thus completely escape the capital gains
tax.
• Because dividends are in some cases taxed more highly than capital gains, investors
might require a higher pre-tax rate of return to induce them to buy dividend-paying
stocks.
• Therefore, investors may prefer that companies minimize dividends. If so, then
investors should be willing to pay more for low-payout companies than for otherwise
similar high-payout companies

Lecture No. 20

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Payout Policy

Dividend goes with stock: January 8, 2021

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