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UvA Finance 2 complete summary
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Summary Endterm Finance 2Chapter 17: Payout Policy
There are alternative uses of FCF. The way a rm chooses between these alternatives is referred
to as its payout policy. Firms can choose between paying dividends and repurchasing shares.
The board of directors determines the amount of dividend to be paid and decides when the
payment takes place.
• The declaration date: the date on which the board authorises the dividend.
After the board declares the dividend, the rm is legally obligated to make the payment.
• The record date: the day that the dividend is paid.
Only shareholders who purchase stock at least three days prior to the record date receive
the dividend.
• The ex-dividend date: the date two business days prior to the record date. Just before this
date, the stock is traded cum-dividend.
Anyone who purchases the stock on or after this data will not receive the dividend.
• The payable date (or distribution date): the rm mails dividend checks to the registered
shareholders (generally a month after the record date).
Most companies that pay dividends pay them at regular, quarterly intervals. They only adjust the
dividends a little. Occasionally, a rm may pay a one-time special dividend that is usually much
larger than a regular dividend. A stock split or stock dividend means a rm issues shares instead
of money to the shareholder. With a stock split, the number of shares increases so more analysts
will follow the stock. Therefore, it signals that you are doing well.
In a share repurchase, the rm uses cash to buy shares of its own outstanding stock. These
shares are generally held in the corporate treasury and can be resold if the company needs to
raise money in the future. There are three possible transaction types for a share repurchase:
1) Open market repurchase: a rm announces its intention to buy its own shares in the open
market and then proceeds to do so over time. It may take a year or more. This is the most
common way for rms to repurchase shares.
2) Tender o er: a rm o ers to buy shares at a pre-speci ed price during a short time period
(generally within 20 days). The price is usually set at a substantial premium (10%-20%) to the
current market price. If shareholders do not tender enough shares, the rm may cancel the
o er and no buyback occurs.
A related method is the Dutch auction share repurchase, in which the rm lists di erent
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 rm then pays the lowest price at which it
can buy back its desired number of shares.
3) Targeted repurchase: the rm purchases shares directly from a major shareholder. In this
case, the purchase price is negotiated directly with the seller. In the case that a major
shareholder wishes to sell shares but cannot do so without severely a ecting the price, he is
prepared to sell back to the rm at a discount. Or, if the shareholders is threatening to take
over the rm, the rm is prepared to buy out the shareholder at a large premium over the
current market price. This is called a greenmail.
The principle of no arbitrage implies that in a perfect capital market, when a dividend is paid, the
share price drops by the amount of the dividend when the stock begins to trade ex-dividend.
Cum-dividend price is €42 with a dividend of €2 so ex-dividend price is €40.
In a share repurchase, the value of assets of a rm will fall but this is o set by a decrease in
number of shares so the share price will remain the same.
Value of assets is €420m before with a share price of €42. The company uses €20m to buy
back (€20m / €42 =) 476,190 shares. It has 9,523,810 shares left. The share price is still
(€,523,810 =) €42.
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, By not paying a dividend today and repurchasing shares instead, a rm is able to raise its
dividends per share in the future. This increase in future dividends compensates shareholders for
the dividend they give up today.
“In perfect capital markets, an open market share repurchase has no e ect on the stock price,
and the stock price is the same as the cum-dividend price if a dividend were paid instead.”
For an investor, the value of shares will not change will the rm pay dividend or repurchase
shares. The only di erence is that with dividends, the investor will have partial cash holdings. It
will, therefore, depend on the preference of owning cash whether an investor will prefer dividends
over share repurchases. However, an investor is able to create homemade dividend by selling
shares in the case of a share repurchase. Similarly, when the rm opts for dividends but the
investor prefers stock holdings, he can buy additional shares with the dividend amount.
So: in perfect capital markets, investors are indi erent between the rm distributing funds via
dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate
either payout method on their own.
When the rm has an equity issue (so it doesn’t have enough cash to pay out the desired amount
of dividends) but wants to issues a larger dividend, the rm can raise capital by issuing shares.
Doing this will increase the number of shares outstanding but the cum-dividend share price will
remain the same. The initial share value is unchanged by this policy and increasing the dividend
has no bene t to shareholders.
There is an important trade-o : if the rm raises current dividend by issuing equity, it will have
smaller FCF per share to pay dividends in the future. If the rm lowers current dividend and
repurchases shares, it is able to pay a higher dividend per share in the future. The net e ect,
however, is that buying or selling shares remains a zero-NPV transaction so there is no e ect on
initial share price.
MM Dividend Irrelevance: In perfect capital markets, holding xed the investment policy of a
rm, the rm’s choice of dividend policy is irrelevant and does not a ect the initial share price.
Assuming imperfect capital markets:
- Paying out excess cash through dividends or share repurchases can boost the stock price by
reducing managers’ ability and temptation to waste resources.
- If there is a reasonable likelihood that future earnings will be insu cient to fund future positive-
NPV investment opportunities, a rm may start accumulating cash to make up the di erence.
- According to the managerial entrenchment theory of payout policy, managers pay out cash only
when pressured to do so by the rm’s investors.
- A share repurchase might signal nancial strength (credibility principle) so can increase the
stock price.
Taxes are an important market imperfection that in uence the decision of pay-out policy. When
shareholders receive dividend, they have to pay a dividend tax rate. When shareholders sell
shares to create homemade dividend, they have to pay the capital gains tax rate. If a higher tax is
paid for dividends, stockholders will prefer share repurchases.
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, When the tax rate on dividends exceeds the tax rate on capital gains, shareholders will pay lower
taxes if a rm uses share repurchases for all payouts rather than dividends. This tax savings will
increase the value of a rm that uses share repurchases rather than dividends. Firms that use
dividends will have to pay a higher pre-tax return to o er their investors the same after-tax return
as rms that use share repurchases. As a result, the optimal dividend policy when the dividend tax
rate exceeds the capital gain tax rate is to pay no dividends at all. The fact that rms continue to
issue dividends despite their tax disadvantage is often referred to as the dividend puzzle.
A company can retain cash to use it to invest in new projects. If there are positive NPV projects,
this is a good decision because it will create value for the company’s investors. When all positive
investments have already been made, cash can be held at the bank or used to purchase nancial
assets. In perfect capital markets, the retention versus payout decision is irrelevant to total rm
value.
MM Payout Irrelevance: In perfect capital markets, if a rm invests excess cash ows in nancial
securities, the rm’s choice of payout versus retention is irrelevant and does not a ect the initial
value of the rm.
-> If either a rm will invest money in a Treasury bill and receives interest or all shareholders invest
in that bill using dividends received and getting an interest is the same.
Corporate taxes make it costly for a rm to retain excess cash. As we have seen with leverage: a
rm paying interest leads to a tax deduction for that interest, whereas a rm receiving interest
means it owes taxes on that interest. Cash is equivalent to negative leverage, so the tax
advantage of leverage implies a tax disadvantage to holding cash.
-> A rm will have to pay taxes on the interest received from a Treasury bill while shareholders
themselves do not.
However, there is no bene t to shareholders when a rm holds cash above and beyond its future
investment or liquidity needs. There are also agency costs related to having too much money, for
instance managers using funds incorrectly. Leverage is one way to reduce a rm’s excess cash
and avoid these costs. For highly levered rms, shareholders will also have an incentive to pay out
money so the retained earnings will go to them instead of to the debt holders. Thus, paying out
excess cash through dividends or share repurchases can boost the stock price by reducing waste
or the transfer of the rm’s resources to other stakeholders.
In conclusion, rms need retained cash to preserve nancial slack for future growth opportunities
and to avoid nancial distress costs. However, these needs must be balanced agent the tax
disadvantage of holding cash and the agency cost of wasteful investment.
Another market imperfection is asymmetric information: Firms adjust dividends relatively
infrequently and dividends are much less volatile than earnings. Maintaining relatively constant
dividends is called dividend smoothing. Often, managers choose to increase dividends for two
reasons: they belief that investors prefer stable dividends with sustained growth and because of
their desire to maintain a long-term target level of dividends as a fraction of earnings. Thus, rms
raise their dividends only when they perceive a long-term sustainable increase in earnings and cut
them only as a last resort. But: it may also signal rm’s lack of investment opportunities.
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