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Chapter 15:

Payout Policy
Corporate Finance, 3e

Graham, Smart, and Megginson

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Payout Policy Fundamentals

A firms payout policy refers to the choices its


managers make about distributing cash to
shareholders.

Whether to pay shareholders a regular (recurring) cash


dividend
How large the cash dividend should be
How frequently it should be paid

The dividend payout ratio, calculated by dividing


the cash dividend per share by its earnings per share,
indicates the percentage of its profits that a firm
distribute to its owners.

The dividend yield, which equals a stocks dividend


divided by its price, measures the rate of return
represented by the dividend payment.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Relevant Dividend Dates

Shareholders of record are entitled to


the dividend.
Because it takes time to make
bookkeeping entries after stocks trade,
investors who buy stock on the record
date will miss the dividend payment.
To receive the dividend, an investor
must own the stock before the exdividend date, usually two business
days prior to the date of record.
Firms distribute dividends on the
payment date, which usually comes a
few weeks after the record date.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 15.3 Timeline of Dates in


the Dividend Process

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Other Forms of Dividends

Firms sometimes declare one-time special


dividends after an unusually profitable year or
a large infusion of cash (e.g., from an asset
sale).

Stock dividends
Additional

shares of stock rather than cash

Stock splits
Share

price declines because the number of


outstanding shares increases (e.g., 2-for-1, 3-for-2,
3-for-1).
Reverse stock splits replace a certain number of
outstanding shares with just one new share.
2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Dividend Trends: Share


Repurchase Programs

Repurchase programs: companies can


buy back some of their own shares, usually
through open-market purchases.

Share repurchases give managers an


alternative method to distribute cash to
shareholders.

The annual value of share repurchases in


the United States sometimes exceeds that
of dividends, and investors clearly
welcome repurchase announcements.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Methods to Repurchase
Shares
Open-market

share repurchase: Firms buy


back their shares in the open market.

Tender

offer, or self-tender: Firms offer to


buy back a certain number of shares,
usually at a premium above the current
market price.

Dutch

auction repurchase: Firms ask


investors to submit prices at which they
are willing to sell their shares.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The Conservative View of


Dividends
1. Firms have long-run target dividend payout
ratios.
2. Dividend changes follow shifts in long-run,
sustainable earnings (not short-run changes in
earnings).
3. Managers are reluctant to increase dividends if
they might have to be cut later.
4. Managers focus on dividend changes rather
than on dividend levels.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Dividend Irrelevance in a
World With Perfect Capital
Markets
Miller and Modigliani demonstrated that
in a world of frictionless capital markets,
payout policy cannot affect a firms
value.
As

long as the firm accepts all positiveNPV investment projects and has costless
access to capital markets, it can pay any
level of dividends it desires.

If

payout policy does affect firm value, it


must be because markets are imperfect.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Example: Dividend Irrelevance in


a World With Perfect Capital
Markets

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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Dividends, Repurchases, and


Taxes

Dividends are normally taxed at an


individuals ordinary income tax rate.

Income from repurchases may be taxed


at a lower long-term capital gains rate,
and then only if the investor chooses to
sell shares back to the company.

This encourages firms to shift payout


away from dividends and toward
repurchases.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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Agency Cost Model of


Dividends
Agency

cost/contracting model of
dividends
Assumes

that firms begin paying to


overcome the agency problems resulting
from a separation of corporate ownership
and control

Privately-held

vs. public firms

Predicts

that dividend payers are older,


larger firms that generate more cash
and have fewer growth opportunities

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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Signaling Model
The

signaling model of dividends


assumes that managers use
dividends to convey positive
information to poorly informed
shareholders.

Like

the agency cost model, the


signaling model predicts that stock
prices should rise (fall) in response to
dividend increases (cuts).

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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Catering Theory
The

catering theory of dividends


predicts that corporate managers
cater to investor preferences by
paying

dividends when investors assign


a premium to dividend-paying stocks,
and
not paying when investors assign a
discount to dividend payers.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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Payout Policy: Key


Lessons

Firms take a conservative approach to


dividends.

The key factor driving dividend payments


is the stability of long-run cash flows.

Dividends are smoothed and do not vary


as much as earnings from year to year.

Firms are reluctant to reduce dividends


once they begin paying them.

Managers view share repurchases as more


flexible.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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