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Topic 11

Payout policy
Chapter 15
Finance T3 2017
Department of Finance
Recap – Topic 10
• The effect of financial leverage on the company’s
risk and return
• Modigliani-Miller propositions I & II with no taxes
and with taxes
• Trade-off model (with financial distress cost, and
agency cost)
• Pecking-order theory

• What is financial leverage?
• Uses more debt in capital structure, magnifies company’s
both upside gains and downside losses, earnings become
risker with leverage.
• So, financial leverage increases financial risk, increases firm
beta, and increases return on equity.

• Modigliani and Miller propositions and the assumptions

• MM proposition I without tax: capital structure does not
matter for the value of firms. VL = E + D = VU
• MM proposition II without tax: capital structure does not
matter for the cost of capital:

rl = r + r  rd
• MM proposition I with tax: total value of the levered firms
increases by the amount of interest tax shield compared to
unlevered firms.
VL = VU + PV (interest tax shield) or VL = VU + T D C

• MM proposition II with tax: the cost of capital of the levered firms

decreases in comparison to unlevered firms.
 E   D 
r  rl  
 d r (1  Tc) 
 D  E   D  E 

• Trade-off theory with taxes, financial distress/insolvency and

agency costs (make sure you understand Figure 13.5)

V Levered = V Unlevered + PV tax shields  PV insolvency costs

+ PV agency costs of outside equity
 PV agency costs of outside debt
• The pecking-order theory
1. Internal earnings (but do not leave too much cash, otherwise,
managers become lazy and slack)
2. Borrowing/debt (Borrow too less: not enjoy the benefit of tax shield on
interest enough; borrow too much: financial distress or insolvency)
3. Issuing equity (last resort due to the negative signalling effect of
issuing equity, share price being overvalued)
• Optimal Capital Structure
1. Taxes: interest deductibility with higher taxes will encourage more debt.
2. Assets: types of assets determine borrowing costs
• Tangible assets (plant, buildings): Financial distress costs are less
• Intangible assets (human capital, technological advantage): Financial distress
costs are greater, the value of intangible assets quickly disappear
3. Operating income (for small firms and firms with low barriers to entry)
• More uncertain operating income means more likelihood of financial distress
4. Consider the three theories of capital structure
The trade-off model

• This model describes the optimal level of debt for a given company as a
trade-off between the benefits of corporate borrowing and the increasing 6
agency and insolvency costs that come from additional borrowing.
• The optimal debt B is chosen to maximise company value.
Learning outcomes
After studying this topic, you will be able to
• Discuss the fundamentals of payout policy
• Discuss why payout policy is irrelevant in a world
with perfect capital markets
• Discuss dividend relevance in the imperfect world,
including agency and signaling models

Payout policy fundamentals
• Payout policy describes the choice about
distributing cash to a company’s shareholders
• The level of cash distribution
• The form of the distribution
• The stability of the distribution

Major Types of Dividends
Cash dividends (a.k.a ordinary or regular dividends):
• By far the most popular.
• Dividends are “sticky” in that they are relatively insensitive to changes
in profitability.
• In Australia they are typically payed half yearly, in some other
countries they are paid quarterly.

Special Dividends:
• Just like ordinary dividends except not expected to continue.
• The small difference has major signalling impacts.
• It has the opposite signaling effect compared to share buybacks

Scrip/Stock Dividends:
• Rather than paying cash, companies sometimes award bonus shares,
small stock dividends, large stock dividends and share splits
• Economically they are equivalent to cash dividends.
Types of dividend payout policies
Constant payout • The ratio indicates the percentage of each
ratio policy dollar earned that is distributed to the owners.

• Based on the payment of a fixed-dollar

Constant nominal dividend in each period.
payments policy • Companies often increase the regular
dividend once a proven increase in earnings
has occurred.

Low regular and • Pays a low regular dividend, supplemented

extra dividend by an additional cash dividend when
warranted by earnings. 10
Payout policy irrelevance in
perfect capital markets
• Miller and Modigliani (1961) showed that dividend
policy cannot impact company value in a world without
market frictions (perfect capital markets).
• Dividend policy was irrelevant and value drives solely
from the inherent profitability of the company’s assets
and the competence of its management team.
• Two firms which are identical in every aspect except for
the dividend payout must have the same value
• A firm’s value will be the same whether it pays a
high, low or no dividend.
Example: Illustration of irrelevance
Consider two firms with $5000 FCF – Investors require a 10%
• Firm A pays dividends of $5,000 per year for each of the
next two years
• Firm B pays $4,000 next year, reinvests the other $1,000
into the firm and then will pay $6,100 the following year.

Firm A: Market Value with constant dividend

PV = 5,000 / 1.10 + 5,000 / 1.102 = 8,677.69
Firm B: Market Value with reinvestment
PV = 4,000 / 1.10 + 6,100 / 1.102 = 8677.69 12^

• The value of the two firms with different policies is the same.
15.3 M&M meet the real
(imperfect) world
• In perfect capital markets, payout decisions do not
affect company value.
• M&M state that operational and investment decisions,
not financial decisions, create value.
• Dividends matter: Stock price = PV of future dividends
• Several academic theories explain why dividend
decisions matter in the real world.
• Certain market imperfections, for example taxes or 13
agency costs, affect payout decisions in general.
Tax reasons
• High dividend preference
• Tax-exempt investors don’t have to worry about
differential treatment between dividends and capital
• Low dividend preference
• Dividends are taxed immediately but capital gains
are not taxed until the share is sold (potentially,
indefinite deferral)
• Individuals in upper income tax brackets might
prefer lower dividend payouts, in favor of higher
capital gains with the deferred tax liability 14
Agency costs
Paying dividends reduces Agency Costs.
between managers and shareholders.

External Financing puts
a company under the 
scrutiny of the ASIC
Lots of


HIGH dividends add to the value of a firm.
Signalling model
• Addresses asymmetric information – managers have more
information about a company's prospects than investors.
• Raising the dividend usually causes the share price to rise
and decreasing the dividend causes the share price to fall

Dividend changes may signal information to the
market concerning the firm’s future prospects
Other reasons
• Accumulated Earning Tax:
• In US, companies pay a tax penalty when they have too much
retained earnings (because it is deemed that they are giving their
investors a tax break)
• Cash Flow Needs:
• Small investors transaction costs may be too high and therefore they
might prefer dividends
• Transfer Wealth from creditors:
• Transfer wealth from bondholders to shareholders
• Some reasons to not pay dividends:
• Corporate taxes: Unlike interest payments, dividends aren’t tax
deductible for companies. Further, stockholders have to pay taxes on
dividend income. In Australia, the dividend imputation section limits
this disadvantage
• Personal income taxes: income taxes on capital gain are lower than 17
on dividend income. Also, individuals can time capital gains
15.3 M&M meet the real
(imperfect) world
Several competing theories have been advanced to explain
observed patterns in dividend policies:

The agency cost/contracting

The signalling model

Mainstream favourite: the agency cost/contracting model

The signalling model of dividends: companies pay dividends to

‘burn money’ and distinguish themselves from weaker rivals. 18
Unit Overview

Scope of
corporate Capital
(Topics 3 & 4), Capital Structure
finance (Topic 1) Budgeting
Risk and return Topics 10 & 11
Time value of Topics 7, 8 & 9
(Topics 5 & 6)
money (Topic 2)

Exam format
• The final exam is a 2-hour, closed-book exam
• 15 minutes reading time allowed before the start
• The exam is worth 60% of your assessment for the unit
• There are two parts and you must attempt ALL questions
• Part A – 30 marks
• 5 Short-answer questions (6 marks each)
• Consists of both theories and calculations
• Part B – 30 marks
• 3 Long-answer questions (10 marks each)
• 1 theory and 2 numerical questions
• A formula sheet will be provided. 20
• Hurdle requirement: Students are required to gain 50%
or more on the exam in order to pass the unit!
…The End.