1Chapter 17Payout Policy17- 2Choice of Payout PolicyCompanies can pay out cash to shareholders in 2 ways– Dividend– Stock repurchase– In the U.S. 64% of firms paid a dividend in 1980 but by 2005 it was only 41% of firms.• Some quit, many new growth companies had become public companies17- 3Dividend & Stock Repurchases-200-10001002003004005006007008001980198219841986198819901992199419961998200020022004Earnings less repurchases & dividendsRepurchasesDividends$ BillionsU.S. Data 1980 - 200517- 4How firms pay dividends Declaration Date Ex-dividend Date Record Date Payment Date– Example:• Oct. 15, company declares a dividend (declaration date)• Nov. 1, shares trade ex-dividend• Nov. 3, dividend will be paid to holders of record on that date• Dec. 1, dividend checks are mailed to shareholders17- 5Types of DividendsRegular Cash DividendSpecial (or extra) DividendStock Dividend– Example – a stock dividend of 10%, for every 100 shares one owns, they will be given 10 additional shares.– Essentially the same as a stock split17- 6Repurchase Stock4 methods of stock repurchase– Buy shares on the market– Tender offer to shareholders– Dutch Auction• Company tells prices that it would repurchase stocks at, shareholders tell how many shares they would sell at those prices– Private Negotiation with major shareholder• Sometimes “Green Mail”. An instance in which the company is getting a bidder to leave the target alone.217- 7The Dividend Decision1. Firms have longer term target dividend payout ratios.2. Managers focus more on dividend changes than on absolute levels.3. Dividend changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings.4. Managers are reluctant to make dividend changes that might have to be reversed. 5. Firms repurchase stock when they have accumulated a large amount of unwanted cash or wish to change their capital structure by replacing equity with debt.Lintner’s “Stylized Facts”(How Dividends are Determined)17- 8Dividend Decisions0 10 20 30 40 50 60 70 80 90 100We try to avoid reducing the dividendWe try to maintain a smooth dividend streamWe look at the current dividend levelWe are reluctant to make a change that may have to be reversedWe consider the change in the dividendRather than reducing dividends we would raise new funds to undertake a profitable projectThe cost of external capital is lower than the cost of a dividend cutExecutives who agree or strongly agree (%)Dividend Decision Survey (2004)17- 9Information in DividendsInvestors can learn from managers actions– There is some disagreement if there is information in dividend announcements.– Typically:• Higher dividends prompt increases in stock prices.• Lower dividends result in stock price decreases.– Most managers will not increase dividends unless they believe they can continue this into the future.17- 10Information in RepurchasesStock Repurchases may signal confidence about the future.– These are typically one time events.– If a company is willing to buy back it shares, it could be a signal that mgmt believes that the stock is undervalued.17- 11Payout ControversyA change in payout may provide information about the future. Does the payout change the value of the firm?– 3 groups• (1) increase in dividend increases firm value• (2) higher dividend reduces firm value• (3) payout policy makes no difference.• No difference – MM’s 1961 proof, and is generally accepted (although market imperfections and taxes may alter the situation)17- 12Dividend Policy is IrrelevantAssume firm has investment program. Any surplus will be paid as dividends.Firm wants to increase dividend. If borrowing (investment program is fixed), the only way to finance the dividend is sell more stock and use that to pay dividend.317- 13Dividend PolicyBefore DividendAfter DividendNew stockholdersEach share worth this before …Old stockholders… and worth this afterTotal value of firmTotal number of sharesTotal number of sharesExample of 1/3rdof worth paid as dividend and raising money via new shares17- 14Dividend Policy is IrrelevantSince investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm.17- 15Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.Record DateCash 1,000Asset Value 9,000Total Value 10,000 +New Proj NPV 2,000# of Shares 1,000price/share $1217- 16Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.Record Date Pmt DateCash 1,000 0Asset Value 9,000 9,000Total Value 10,000 + 9,000New Proj NPV 2,000 2,000# of Shares 1,000 1,000price/share $12 $1117- 17Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.Record Date Pmt Date Post PmtCash 1,000 0 1,000 (91 sh @ $11)Asset Value 9,000 9,000 9,000Total Value 10,000 + 9,000 10,000New Proj NPV 2,000 2,000 2,000# of Shares 1,000 1,000 1,091price/share $12 $11 $11NEW SHARES ARE ISSUED17- 18Dividends Increase ValueMarket Imperfections and Clientele EffectThere are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from.These clients increase the price of the stock through their demand for a dividend paying stock.417- 19Dividends Increase ValueDividends as SignalsDividend increases send good news about cash flows and earnings. Dividend cuts send bad news.Because a high