Chapter 16

Payout policy, Investment policy, and management incentives

- In mature companies with plenty of free cask flow but few profitable investment opportunities shareholders do not always trust managers to spend retained earnings wisely and they fear overinvestment (e.g. empire building) - Payout policy is mixet up with firm´s investment and operating decisions. - Increase in payout (dividend or share repurchase) may lead to a rise in stock price not because dividends ar valuable in themselves, but because they signal a more carful, value-oriented investment policy.

Explain payout policy and the life cycle of the firm

- No idea in paying out cash to investors if the firm then has no replace the cash by borrowing or issuing more shares. - Retaining cash avoids cost of issuing dsecurities and minimizes shareholders´ taxes. - Investors are not worried about overinvestment, because investment opportunities are good, and managers´ sompensation is tied to stock price. - Investments are financed as much as possible with internally generated cash flow.

Middle-of-Roaders (focus on taxes) Does payout policy affect firm value according to middle-of-roaders?

- Payout policy is irrelecant. Individual company cannot change market value of stock by changing its payout policy. - Middle-of-road argument is based on supply effect: No company believes that it can increase its stock price simply by changing its dividend policy, because all clienteles are satisfied. - There are no unsatisfied clienteles (low, medium or high yield) and therefore no incentive for firms to change their dividend policy. If middle-of-road party is right, the vcalue of any individual company would be endependent of its choice of dividend policy.

What assumptions do Miller and Modigliani use?

- Perfect capital markets: No taxes, transaction cost, issue costs or other market imperfections. - Given capital budgeting decision. - Given borrowing decision. - Dividend policy must be isolated from investment decisions and capital structure decisions by asking: > What is the effect of a change in payout policy, given a firm´s capital budgeting and borrowing decision > Increase dividends --> Issure stock > Decrease dividends --> Repurchase stock.

Taxes and radical lefti (16.5) Does payout policy affect firm value according to radical left?

- Tax system is essential for a firm´s payout policy. - Whenever dividends are taxed more heavily than capital gains, firms should pay lowest cash dividend they can get away with. Available cash should be retained or used to repurchase shares. - Increased dividend payments reduce market value of stock. Corporations can transmute dividends into capital gains by paying lowest cash dividend possible and retain cash, repurchase shares or in some cases buy financial assets.

How much cash should the corporation pay out to its shareholders?

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how firms pay dividends

A regular cash dividend (e.g. each quarter or year) An extra or special dividend. A stock dividend (i.e. not in the form of cash)

Explain payout policy and the life cycle of the firm

As the firm ages, more and more payout is called for More payout may come as - Higher dividends - Larger share repurchases and/or - As result of takeover where the firm´s new owners generate cash by selling assets and restructuring operations.

How should a financial manager manage total payout (i.e. the sum of cash dividends and share repurchases)? Or put differently; how does a financial manager decide that cash is truly surplus cash?

By answering affirmative to the following three questions: - Is the company generating positive free cash flow after accepting all real investments with positive NPVs and is the positive free cash flow likely to continue? - Is the firm´s debt ratio prudent and manageable? Otherwise free cash flow is better used to pay down debt. - Are the company´s holdings of cash a sufficient cushion for unexpected setbacks and a sufficient war chest for unexpected opportunities?

How does a financial manager decide whether a firm is ready to start paying cash back to shareholders? Or put differently: how does financial manager decide that cash is truly surplus cash?

By answering three questions - Is the company generating positive free cash flow after accepting all real investments with positive NPVs and is the positive free cash flow likely to continue? - Is the firm´s debt ratio prudent and manageable? Otherwise free cash flow is better used to pay down debt. - Are the company´s holdings of cash a sufficient cushion for unexpected setbacs and a sufficient war chest for unexpected opportunities.

What is information content of share repurchases?

Companies may repurchase shares when they have accumulated large amount of unwanted cash. Paying out surplus cash reassures shareholders that the cash will not be wasted on overinvesting, excessive perks and / or excessive compensiation. Generally, a company announcing a share repurchase is not (neccessarily) making a long term commitment to repurchase in later years. Generally, the information content of a share repurchase announcement is less strongly positive than the announcement of a dividend increase

Illustrate MM´s proof that dividend policy is value-irrelecant

Companys pays out a third of its worth as a dicidend an raises the money by selling new shares.

Once a company announces a regular cash dividend, investors expect the cas tividend to continue unless the company encounters serious financial trouble.

Financial managers do not start/increase a cash dividend unless they are confident that the dividend can be maintained. Announcements of dividend institiations/increases usually cause a stock price increase, because the announcements signal managers´ confidence (the information content of dividends). Regular cash dividends are paid by mature, profitable firms. - But most firms that pay regular cash dividends also repurchase shares.

Information content of dividends and stock repurchases

Generally the announcement of an increase in dividends signals managers´ considerence in future profits (the information content of dividents) and is interpreted by investors as good news and the stock price increases

What are the two imprtant questions regarding payout policy?

How much cash should the corporation pay out to its sharholders. How should the cash be distributed? - by paying cas dividends or - by repurchasing shares

Assume a corporation has surplus cash. Should it distribut the surplus cash by paying a cash dividend, or should it do so by repurchasing shares?

In theoretical world with perfect capital markets: it does not matter. In the real world with imperfect capital markets: The choice may be important. - The information content of dividends and repurchases is different. - Cash dividends and share repurchases are typically taxed differently

Does payout policy affect firms value according to rightist:

Investors prefer a large fraction of earnings to be paid out to shareholders as dividends (i.e. investors prefer high dividend payout ratios) Increases dividend payout ratios incvrease market value of stock.

What are rightists´ arguments for advocating high payout ratios?

Market imperfections Effect of payout policy on management incentives

I Corporation has surplus has: It is best to pay the cash back to shareholders.

Paying out surplus cash reassures shareholders that the cash will not be wasted on -Overinvesting - Excessive perks - Excessive compensation. A firm wit surplus cash will probably start by repurchasins shares. - Share repurchases are more flexible than cash dividends.

Payout policy in perfect capital markets. Does payout policy matter in perfect capital markets?

Payout policy is value-irrelevant in a world with perfect vapital markets. - In perfect capital markets the choice between dividends and share repurchases has no effect on the market value of the firm. - In perfect capital markets increased dividend payments financed by issuin stocks has no effect on the market value of the firm (holding the firm´s assets, investment and borrowing policy fixed).

Market imperfections

Rightists´argue for existence of natural clientele for high-payout stocks. - Some financial instititions are legally restricted from holding stocks lacking established dividend reecords. - Trusts and endowment funds may prefer high dividend stocks. -- Dividends are regarded as spendable "income" -- Capital gains are "additions to principal" which cannot be spend. - Stocks with regular dividends relieve many of its shareholders of transaction costs and considerable inconvenience.

Assume radical left is correct

Stocks with low dividend yields Stocks with high dividend yields. Pretax risk-adjusted rate of return < Pretax risk-adjusted rate of return After-tax risk-adjusted rate of return (lower after tax) = After-tax risk-adjusted rate of return (higher after tax) Market value of equity > Market value of equity

In the US the most obvious and serious market imperfection has been the different tax treatment of dividends and capital gains

Taxes have favored share repurchases However, taxes alone cannot explain payout policy.

How firms repurchase stock

The firm states a series of prices at which it is prepared to repurchase stock. Shareholders submit offers declaring how many shares they wish to sell at each price. The company then calculates the lowerest price at which it can buy the desired number of shares. This procedure to repurchase stock is known as: - Open market transaction? - Tender offer? - Dutch auction? - Greenmail?

Explain payout policy and the life cycle of the firm

When the firm matures, positive-NPV projects (growth opportunities) become scarcer relative to cash flow, and the firm begins to accumulate surplus cash. - Investors begin to worry about overinvestment or excessive perks. - investors begin to pressure managment to start paying out cash. - Managers comply -Payout may come as share repurchase, but initiating a regular cash dividend sends a stronger signal of financial discipline. - Commitment to financial discipline can outwigh the tax cost of dividends.

Explain payout policy and the life cycle of the firm

Young growth firms have plenty of profitable capital budgeting proposals (growth opportunities) why is it efficient to retain and reinvest all operating cash flow, i.e. not pay out cash dividends and not (or rarely) repurchase shares. - It is smartest to not pay out dividend.

How should a financial manager manage total payout (i.e. the sum of cash dividends and share repurchases)? Or put differently; how does a financial manager decide that cash is truly surplus cash?

if a corporation has surplus cash: it is best to pay the cash back to shareholders. Paying out surplus cash reassures shareholders that the casl will not be wasted on - Overinvesting - Excessive perks - Excessive compensation