Payout Policy and Capital Structure

1
Payout Policy and Capital Structure

• Chapter 16

2
Payout Policies
Cash Dividend
vs.
Stock Repurchase
3
Dividend Stock Repurchases
U.S. Data 1980 - 2002
Billions
4
Types of Dividends

• Cash
• Regular Cash
• Special Cash
• Stock
• Stock Repurchase (4 methods)
• 1. Buy shares on the market
• 2. Tender offer to shareholders
• 3. Dutch auction
• 4. Private negotiation (Green Mail)

5
Dividend Payments
Mar 8 Mar 19 Mar 20 Mar
22 Apr 18 Declaration With-
Ex-dividend Record Payment date
dividend date date
date date
Share
price falls
6
The Dividend Decision
Lintners Stylized Facts (How Dividends are
Determined)

• 1. 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.

7
Dividend Policy
Before Dividend
After Dividend
New stockholders
Each share worth this before

and worth this after
Total value of firm

Old stockholders
Total number of shares
Total number of shares
Example of 1/3rd of worth paid as dividend and
raising money via new shares
8
Dividend Policy
Dividend financed by stock issue
No dividend, no stock issue
New stockholders
New stockholders
Shares
Cash
Firm
Cash
Shares
Cash
Old stockholders
Old stockholders
9
Dividend 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.
• Dividend policy will have no impact on the value
  of the firm
• Miller and Modigliani (1961)

10
Dividend Policy is Irrelevant

• Example - Assume Rational Demiconductor has no
  extra cash, but declares a 1,000 dividend. They
  also require 1,000 for current investment needs.
  Using MM 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
• Cash 1,000
• Asset Value 9,000
• Total Value 10,000
• New Proj NPV 2,000
• of Shares 1,000
• price/share 12

11
Dividend Policy is Irrelevant

• Example - Assume Rational Demiconductor has no
  extra cash, but declares a 1,000 dividend. They
  also require 1,000 for current investment needs.
  Using MM 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
• Cash 1,000 0
• Asset Value 9,000 9,000
• Total Value 10,000 9,000
• New Proj NPV 2,000 2,000
• of Shares 1,000 1,000
• price/share 12 11

12
Dividend Policy is Irrelevant

• Example - Assume Rational Demiconductor has no
  extra cash, but declares a 1,000 dividend. They
  also require 1,000 for current investment needs.
  Using MM 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 Pmt
• Cash 1,000 0 1,000 (91 sh _at_ 11)
• Asset Value 9,000 9,000 9,000
• Total Value 10,000 9,000 10,000
• New Proj NPV 2,000 2,000 2,000
• of Shares 1,000 1,000 1,091
• price/share 12 11 11
• NEW SHARES ARE ISSUED

13
Dividend Policy is Irrelevant

• Example - continued - Shareholder Value
• Record
• Stock 12,000
• Cash 0
• Total Value 12,000
• Stock 1,000 sh _at_ 12 12,000

14
Dividend Policy is Irrelevant

• Example - continued - Shareholder Value
• Record Pmt
• Stock 12,000 11,000
• Cash 0 1,000
• Total Value 12,000 12,000
• Stock 1,000sh _at_ 11 11,000

15
Dividend Policy is Irrelevant

• Example - continued - Shareholder Value
• Record Pmt Post
• Stock 12,000 11,000 12,000
• Cash 0 1,000 0
• Total Value 12,000 12,000 12,000
• Stock 1,091sh _at_ 11 12,000
• Assume stockholders purchase the new issue with
  the cash dividend proceeds.

16
Dividends Increase Value

• Market Imperfections and Clientele Effect
• Natural clients for high-payout stocks
• But, a firm does not necessarily benefit by
  increasing its dividends
• High dividend clientele already have plenty of
  high dividend stock to choose from
• Clients increase the price of the stock through
  their demand for a dividend paying stock

17
Dividends Increase Value

• Dividends as Signals
• Dividend increases send good news about cash
  flows and earnings
• Dividend cuts send bad news
• Why dont all firms increase dividends?
• A high dividend payout policy will be costly to
  firms that do not have the cash flow to support it

18
Dividends Decrease Value

• Tax Consequences
• Companies can convert dividends into capital
  gains
• If dividends are taxed more heavily than capital
  gains, taxpaying investors should welcome such a
  move and value the firm more favorably
• The total cash flow retained by the firm and/or
  held by shareholders will be higher than if
  dividends are paid

19
Taxes and Dividend Policy

• Since capital gains are taxed at a lower rate
  than dividend income, companies should pay the
  lowest dividend possible
• Dividend policy should adjust to changes in the
  tax code
• Investors should accept lower pretax rate of
  return from securities offering returns from
  capital gains rather than dividends

20
Taxes and Dividend Policy
21
Taxes and Dividend Policy
In U.S., shareholders are taxed twice (figures in
dollars)