Payout Policy Lecture 05What is payout policyAlternatives availableCenter Financial DividendWhat this means?Significance of Ex-Dividend DateExpected Stock Price MovementFactors Affecting Payout PolicyRepurchase of shares as an alternative to dividend paymentsSlide 10Dutch Auction ExampleRecent observationsPayout PolicyWhy?10b-18 RuleDividend SignalingSlide 17Slide 18Slide 19Healey and Palepu and Dividend SignalingLintnerThe Lintner ModelHow can we determineLintnerRegressionRepurchases and SignalingRepurchases and SignalsSlide 28Slide 29SignalsSlide 31Explanation?Agency Cost Free Cash Flow TheoryCapital Market ReallocationDividend SubstitutionCapital Structure AdjustmentsStock LiquidityDividend reductions accompanied by a repurchase agreementSlide 39Slide 40General PolicyWe want to know:Slide 43Slide 44The Information Content of DividendsDividend Policy versus announcement effectSlide 47Slide 48Slide 49Slide 50Slide 51Payout PolicyLecture 05FINA 7330Fall, 2010Ronald F. SingerWhat is payout policy•A firm generates cash flow: •It then invests some of it•The question is how much of the cash flow is paid out to investors and what form will the payment take?•Basically: What is the effect of a change in payout policy, give n the firm’s capital budgeting and borrowing decision?Alternatives available•Ordinary Dividend•Extraordinary Dividend •Repurchase of shares•Repurchase of other securitiesCenter Financial Dividend LOS ANGELES--(BUSINESS WIRE)--Sept. 11, 2009—Center Financial Corporation (NASDAQ: CLFC), the holding company of Center Bank, today announced that its Board of Directors declared a quarterly cash dividend of $0.05 per share. The cash dividend will be paid on or about October 8, 2009 to shareholders of record at the close of market on September 24, 2009. What this means?•There are four critical dates here, although only three are contained in the announcement:–Announcement Date: September 11, 2009–Record Date: September 24, 2009–Payment Date: October 8, 2009–Ex-Dividend Date: September 22, 2008–The Ex-Dividend date is defined by the Exchange or Nasdaq and is 2 business days before the record date. –We say that before the ex-date, the stock is trading “cum-dividend”Significance of Ex-Dividend Date The ex-dividend date is the date on which ownership of the dividend is determined. If you held the stock on the close of business on September 21, you owned the dividend. So if you sold the stock on the ex-date, Sept. 22 you still would be paid the dividend on October 8.If you first bought the stock on Sept. 22 you would not receive the dividend even though you continued to own it through the payment date of October 8Expected Stock Price Movement CLFC•Announcement Date •Ex-Dividend Date •Record Date •Payment DateFactors Affecting Payout Policy •Signaling •Agency Problems•Taxes•Capital Structure Adjustments •Excess Cash Flow •Provide LiquidityRepurchase of shares as an alternative to dividend payments•We have seen a dramatic increase in the incidence of Share Repurchases•What kind of share repurchases are there?–Fixed Price tender offer –Dutch Auction–Open Market Purchases –Direct negotiation with large stockholderTEL AVIV (MarketWatch) -- Farmers Capital Bank Corp., (FFKT 17.88) the Frankfort, Ky., financial holding company, said that under its modified Dutch auction tender offer, it accepted for payment 559,000 of its common shares for $32 each. The shares represent 7.1% of its shares outstanding as of Aug. 21. The range within which holders could have tendered their shares was $31 to $35. The offer expired at 12:01 a.m. Eastern Time Thursday. In a Dutch auction, a company sets a number of shares it will buy and a price range within which holders can tender to the auction. The final purchase price is set at the lowest level at which the company can buy all the shares it sought to buy.Dutch Auction Example •Offer: to buy 559,000 shares•Stockholders’ are invited to offer bids for the shares at various prices •Hypothetical Auction results Total – 104,000 shares offered at $35 1,066,000– 301,000 shares offered at $34 962,000– 102,000 shares offered at $33 661,000– 239,000 shares offered at $32 559,000 – 320,000 shares offered at $31 320,000Recent observations•Open Market is the overwhelming dominant means of purchasing shares (91%), and they are increasing in proportion •Repurchases are increasing over time relative to Dividends •Repurchases as a proportion of Earnings have increasedPayout Policy•The ratio of repurchases to earning increase from the 1970’s to 2002 from about 7% to 34% of earnings•Dividend Payouts have increased also but more modestly from 41% to 48% over the same period. •Repurchase as a percent of total payouts have increased from about 12% to about 71%.Why?•1982: Clarification of rules regarding stock price manipulation (10b-18)–Rule 10b-18 provides a “safe harbor” for stock repurchases. The problem is that Corporations are “insiders” and as such are limited in their dealings in stock transactions of their own firm. However, Stock buybacks will not in general be questioned if they satisfy the conditions of 10b-18; to wit:10b-18 Rule•Cannot trade at opening, and cannot trade within 30 minutes of the close•Cannot pay a price greater than the last recorded sale price or the highest bid quotation•Only one broker or dealer may be used• Corp. must publicly announce the intent to buy back •During any one day can not buy back more stock than 25% of the average daily trading volume over the last four weeks–Block trades privately negotiated are excluded•After announcement there can not be significant non-public information revealed (Rule 10b-5)Dividend Signaling•But what does payouts signal?–Suppose a firm that was announcing fairly regular, flat earnings historically of say $1.20 per quarter. Suddenly it announces earnings of $1.38 a 15% increase. As an investor what would you like to know about that announcement?Dividend Signaling•But what does payouts signal?–Suppose a firm that was announcing fairly regular, flat earnings historically of say $1.20 per quarter. Suddenly it announces earnings of $1.38 a 15% increase. As an investor what would you like to know about that announcement?–The Dividend is forward looking and is generally tied to the long run earnings