Chapter 19 - Payout Policy - 4/6 MCQs

Irrelevance Theory (MM)

*Assumptions* -no taxes or transaction costs -no information asymmetry -the investment policy is constant (does not change with dividends). Under these assumptions, dividend policy does not affect the value of the firm. *Irrelevance for the Firm*: -Dividends are just a residual. - *E (retained earnings) - I(investments) = D(dividends)* - If the firm wants to issue more dividends than E - I, it can issue shares. -*E (retained earnings) - I(investments) + S ( the change in shares outstanding multiplied by the stock price) = D(dividends)* *Irrelevance for the Investors*: -Since investors do not need dividends to convert shares into cash, they will not pay higher prices for firms with higher dividend payouts (remember: no transaction costs and no taxes). -Dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by creating homemade dividends.

Payout Policy in Practice? What we know about dividend policy

*Corporations "Smooth" Dividends* -Managers tend to maintain the level of dividends constant. Even when earnings increase, firms adjust dividends very slowly. *Dividends Provide Information to the Market* -Stock price rises when dividends increase and falls when dividends decrease *Firms Should Follow a Sensible Dividend Policy* -do not forgo positive NPV projects just to pay a dividend -Avoid issuing stock to pay dividends. -Consider share repurchases instead of dividends when there are no better uses for the cash.

Procedure for Cash Dividend Payments (dates)

*Declaration Date*: The date in which the board decides to pay dividends. *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*: The date at which the firm prepares the list of stockholders entitled to receive dividends. *Date of Payment*: the day the investor receives the check.

Possible Reasons to Issue Dividends

*Desire for Current Income*: -Some people like to get a regular income every quarter. -to do that they might sell stocks instead of invest in firms that pay dividends. -The problem is that when you sell stocks you incur in transaction costs. -From this point of view, dividends may be a cheaper source of regular income. *Behavioral Finance*: -The idea is based on (lack of) self-control. *Agency Costs:* -Lets consider a firm with a large quantity of cash flows but no positive NPV project to invest in. -In this case, managers are tempted to use cash to consume perks(and as consequence reduce the value available to shareholders). -Dividends can be used to reduce agency costs. They will reduce the quantity of cash managers can squander. *Signaling:* -Dividends can be used to lower information asymmetry between managers and investors. -If a firm pay higher dividends, investors infer that current and future earnings are higher than expected. -Can't bad-quality firms lie (increase dividends even though their earnings are not good)? It is too costly for them. bad quality firms do not have enough cash and would need to cut investment to pay high dividends.

Firms that Should Pay & Firms that Shouldn't Pay Dividends

*Firms Without Enough Cash to Pay Dividends*: -In a world with personal taxes (and transaction costs), firms should not issue stock to pay dividends. ? *Firms with Enough Cash to Pay Dividends:* -Lets suppose a firm does not have positive NPV projects to invest in: 1. the company can invest cash in securities (stocks, bonds of other firms, or treasury bills) and pay dividends later. 2. The company can pay dividends and let investors invest in other securities. -If personal taxes are higher than corporate taxes, then option 1 is better. -If personal taxes are lower than corporate taxes, then option 2 is better.

Share Repurchases Advantages

*Lower Taxes*: -Only pay tax on capital gains. *Executive Compensation*: -Managers usually receive stock options. -They do not receive dividends. -Dividends actually decrease the value of stock options, managers are better off repurchasing shares. *Flexibility*: -A firm with very volatile cash flows may prefer repurchases over dividends since repurchases can be interrupted without big repercussions on the stock price. *Undervaluation*: -managers might buy back shares when the think their stock is undervalued. -Indeed stock prices increase after share buybacks announcement.

Irrelevance for the Firm

-Dividends are just a residual. - E (retained earnings) - I(investments) = D(dividends) - If the firm wants to issue more dividends than E - I, it can issue shares. -E (retained earnings) - I(investments) + S ( the change in shares outstanding * multiplied by the stock price) = D(dividends)

Signaling

-Dividends can be used to lower information asymmetry between managers and investors. -If a firm pay higher dividends, investors infer that current and future earnings are higher than expected. -Can't bad-quality firms lie (increase dividends even though their earnings are not good)? It is too costly for them. bad quality firms do not have enough cash and would need to cut investment to pay high dividends.

Stock Price Change at Ex-Dividend Date

-In a perfect market the stock prices will fall by the amount of the dividend on the ex-dividend date.

Share Repurchases

-Instead of declaring cash dividends, firms can distributive excess cash by buying back shares. -Recently, share repurchases have become an important easy of distributing earnings to shareholders. -The most common way a firm buys shares back is through open market repurchases. The firm announces how many shares it plans to buy back. It usually completes the buy-back in 3 years, buying a few shares every quarter (the number of shares bought each quarter depend on the cash flows available).

Agency Costs

-Lets consider a firm with a large quantity of cash flows but no positive NPV project to invest in. -In this case, managers are tempted to use cash to consume perks(and as consequence reduce the value available to shareholders). -Dividends can be used to reduce agency costs. They will reduce the quantity of cash managers can squander.

Cash Dividends

-Many companies pay a regular cash dividend. -Public companies often pay quarterly. -Sometimes firms will throw in an extra cash dividend.

Irrelevance for the Investors

-Since investors do not need dividends to convert shares into cash, they will not pay higher prices for firms with higher dividend payouts (remember: no transaction costs and no taxes). -Dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by creating homemade dividends.

Desire for Current Income

-Some people like to get a regular income every quarter. -to do that they might sell stocks instead of invest in firms that pay dividends. -The problem is that when you sell stocks you incur in transaction costs. -From this point of view, dividends may be a cheaper source of regular income.

Stock Dividends

-Sometimes companies declare stock dividends -No cash leaves the firm -The firm increases the number of shares outstanding (and the stock price goes down accordingly).

Behavioral Finance

-The idea is based on (lack of) self-control

Recent Trends

-Three groups of companies exists: *1. Firms that pay dividends and make regular share repurchases. 2. Firms that make regular share repurchases. 3. Firms that make occasional share repurchases.* -Firms that only pay dividends are almost extinct. -Larger/More Mature companies that pay dividends keep paying but instead to increase dividend payout, prefer to buy back shares if they have extra earnings to distribute (1). -Young companies instead of initiate dividend payments just distribute cash though share repurchases (higher flexibility)(2/3).

Dividends When Personal Taxes are Considered

-To get the result that the dividend policy is irrelevant. we assumed that we do not have taxes. -Both cash dividends and capital gains are taxes at 15% (20% for highest bracket tax-payer). -Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains. -Companies that invest in stocks of other dividend-paying firms, pay only 30 5 of the taxes om dividends ( for companies it is good to invest in dividends). -There are other benefits related to dividends that con overcome the tax penalty.

Share Repurchases vs. Dividends

?

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

The date at which the firm prepares the list of stockholders entitled to receive dividends.

Declaration Date

The date in which the board decides to pay dividends.

Date of Payment

the day the investor receives the check.