Title: Payout Policies
1Payout Policies
2Payout Policies
- Introduction
- MM irrelevance theorem
- Personal taxation and dividend policy
- Signaling and dividends
- Dividend smoothing
- Disappearing dividends
- Agency costs and dividends
- Stock repurchases
3Introduction
- Cash dividends and stock repurchases are the two
principal means by which firms distribute cash to
shareholders. - Cash dividends are paid to all shareholders on a
pro rata basis. - In an ideal market, the firms stock price falls
by the per-share amount of the dividend.
4Introduction
- In a stock repurchase, the firm uses cash to
retire some outstanding shares, buying shares
from any investors who choose to sell. - In a perfect capital market, a stock repurchase
reduces the number of shares outstanding as well
as the firms assets (cash), but should have no
effect on stock prices.
5Introduction
- Dividends are the traditional means of
distributing cash to shareholders, but stock
repurchases have become increasingly more common,
especially in the U.S. - Should firms pay dividends?
- Does dividend policy affect firm value?
- What is the optimal dividend policy?
6Payout Policies
- Introduction
- MM irrelevance theorem
- Personal taxation and dividend policy
- Signaling and dividends
- Dividend smoothing
- Disappearing dividends
- Agency costs and dividends
- Stock repurchases
7MM irrelevance theorem
- Is the value of the firm affected by a firms
dividend policy? - MM 1961
- In the absence of taxes, agency costs or
information asymmetry, dividend policy is
irrelevant. - Dividend policy does not affect the value of the
firm.
8MM irrelevance theorem
- In MM world - the availability of external
financing that makes the value of the firm
independent of dividend policy. Why? - Assuming perfect capital markets, two firms which
are identical in every fashion except for the
current dividend payout must have the same value - A firms value will be the same whether it pays a
high, low or no dividend.
9MM irrelevance theorem
- In the MM world, firm values are determined
- solely by real considerations such as the
earning power of the firms assets and its
investment policy - and NOT by how the firms earnings are packaged
for distribution.
10MM irrelevance theorem
- MM (1961) - irrelevance of dividend policy
- It doesnt matter what sort of dividend a firm
pays - it has no impact on firm value. - MM assume (amongst other things)
- no personal taxes
- no asymmetric information
- no agency costs
11Payout Policies
- Introduction
- MM irrelevance theorem
- Personal taxation and dividend policy
- Signaling and dividends
- Dividend smoothing
- Disappearing dividends
- Agency costs and dividends
- Stock repurchases
12Personal taxation and dividend policy
- Firm A earns 10m per year
- it can retain this 10m and invest
- it can pay out the 10m as div. And issue equity
to fund investment - no personal taxes - MM result
- personal taxes of 40 - ? value of SHs payout to
6m - Would S/Hs prefer capital gains income rather
than dividend income?
13Personal taxation and dividend policy
- Capital gains tax lt income tax
- prefer capital gains or dividend?
- Capital gains tax income tax
- prefer capital gains or dividend?
- capital gains taxes are taxed upon realization
- a tax payment delayed is a tax payment rendered
less valuable
14Personal taxation and dividend policy
- Stock repurchase
- firm itself makes an offer to repurchase shares
from investors at an above-market price - Stock repurchases are taxed as capital gains
15Personal taxation and dividend policy
- So why arent share repurchase schemes used
instead of dividends? - Potential threat from tax authorities to tax
income received from share repurchase program at
a higher rate - they discourage specialists from making a market
in the firms stock because they would be forced
to trade with the company (with superior
information advantages)
16Personal taxation and dividend policy
- Dividend policy is no longer irrelevant!
- Firms should pay no dividends because of the tax
disadvantage of ordinary income over capital
gains. - Theoretical work - Farrar and Selwyn (1967)
Brennan (1970)
17Personal taxation and dividend policy
- Masulis and Trueman (1986)
- important assumptions
- personal tax rates on dividend income differ
across individuals - there is a large dividend exclusion from taxes on
all dividends paid by one corporation to another
18Personal taxation and dividend policy
- High tax bracket SHs will prefer more earnings to
be retained and invested. - Low tax bracket SHs (espec. firms) will prefer
less investment and more dividends - investors self-select into clienteles
- low tax bracket individuals buy shares of high
dividend firms - vice versa
19Personal taxation and dividend policy
20Personal taxation and dividend policy
- Pettit found that low dividend stocks are
preferred by - investors with high income
- younger investors
- investors whose ordinary tax and CGT rates differ
substantially - investors whose portfolios have high systematic
risk
21Payout Policies
- Introduction
- MM irrelevance theorem
- Personal taxation and dividend policy
- Signaling and dividends
- Dividend smoothing
- Disappearing dividends
- Agency costs and dividends
- Stock repurchases
22Signaling and Dividends
- If firm ? dividend payout - signaling that it has
expected future CFs that are large enough to meet
debt payments dividends payments without ? risk
of bankruptcy - ? ? VL
- it is expensive for less successful firms to
mimic the signal.
23Signaling and Dividends
- Optimal dividend policy
- The signaling value of dividends is ve and can
be traded off against the tax loss associated
with dividend income as opposed to capital gains. - Signaling theories explain how an optimal
dividend policy may arise. - However, they do not explain differences in
dividend payouts across industries or countries.
24Signaling and Dividends
- Empirical evidence
- initiation or ? of dividend ? ? share price
- Recently, initiations of dividends by high-tech
firms has resulted in ? share price . Why? - ? dividend ? ? share price (and sometimes very
large ?) - How do these findings tie in with theory?
25Signaling and Dividends
- Ross (1977)
- in the MM world - market knows the return stream
of the firm - in reality, there is asymmetric information
- managers (but not the market) know the return
stream
26Payout Policies
- Introduction
- MM irrelevance theorem
- Personal taxation and dividend policy
- Signaling and dividends
- Dividend smoothing
- Disappearing dividends
- Agency costs and dividends
- Stock repurchases
27Dividend smoothing
- Almost all firms maintain constant nominal
dividend payments per share for long periods of
time - smoothing of dividend payments
- dividends only ? when permanent income ?
- Why?
28Dividend smoothing
- Lintner (1956) - seminal paper on dividends
- firms have a target dividend payout
- most mgt avoid making changes to divs. that will
be reversed in short-term - ? permanent income ? ? dividend payment (and vice
versa) - investment requirements have little impact on
dividend behaviour
29Payout Policies
- Introduction
- MM irrelevance theorem
- Personal taxation and dividend policy
- Signaling and dividends
- Dividend smoothing
- Disappearing dividends
- Agency costs and dividends
- Stock repurchases
30Disappearing dividends
- Fama and French (2001)
- Find for the U.S. that
- proportion of firms paying cash dividends falls
from 66.5 in 1978 to 20.8 in 1999 - Disappearing dividends!
- Could this be due to increased usage of stock
repurchases?
31Disappearing dividends
- Changing firm characteristics
- there is a greater proportion amongst traded
firms of small firms with low profitability and
strong growth opportunities - These are characteristics of firms that have
never paid dividends
32Disappearing dividends
- Why are small firms more likely to pay no
dividends? - Pecking order model
- high transactions costs of issuing securities
- Why are high profitability firms more likely to
pay dividends? - Controls the agency costs of free cash flow -
Jensen (1986) - Why are firms with good investment opportunities
more likely to pay no dividends? - Pecking order model
33Disappearing dividends
- Lower propensity to pay
- Why?
- A. lower transactions cost for selling stock for
consumption purposes (clientele effect) - B. larger holdings of stock by managers who
prefer capital gains to dividends (personal tax
reason) - C. better corporate governance technologies that
lower the benefits of dividends in controlling
agency problems between stockholders and managers.
34Disappearing dividends
- Many interpret the evidence of Fama and French as
dividends themselves are disappearing. - However, Fama and French find that it is dividend
payers which are disappearing NOT dividends.
35Disappearing dividends
- DeAngelo et al (2004) find that
- Dividends paid by US industrial firms actually
increased by 22.7 in real terms over the period
1978-2000 - Why did aggregate real dividends increase despite
a 50 fall in the number of payers? - Large increase in earnings and hence dividends of
largest payers. - The largest 25 dividend payers in 2000 supplied
54.9 of aggregate industrial dividends.
36Payout Policies
- Introduction
- MM irrelevance theorem
- Personal taxation and dividend policy
- Signaling and dividends
- Dividend smoothing
- Disappearing dividends
- Agency costs and dividends
- Stock repurchases
37Agency costs and dividends
- Free cash flow and agency costs
- Discipline of capital market
- Agency costs and cross-sectional differences in
payout ratios - LLSV (2000)
38Free cash flow and agency costs
- Dividend policies address agency conflicts
between - corporate insiders
- outside shareholders
- unless profits are paid out to SHs they may be
- diverted by insiders for personal use
- committed to projects with -ve NPVs which
provide personal benefits to insiders
39Free cash flow and agency costs
- By paying dividends, insiders are giving earnings
to SHs and ?cant use these earnings for their
own benefit - Dividend payments serve as a type of bonding
mechanism - They bond insiders to a certain type of behaviour.
40Lecture outline
- Free cash flow and agency costs
- Discipline of capital market
- Agency costs and cross-sectional differences in
payout ratios - LLSV (2000)
41Discipline of capital markets
- By paying dividends, managers must go to the
capital market more often to raise funds. - In doing so, they are subject to the scrutiny and
disciplining effects of investment professionals - Shareholders are willing to accept higher
personal taxes in exchange for this monitoring by
the investment community
42Lecture outline
- Free cash flow and agency costs
- Discipline of capital market
- Agency costs and cross-sectional differences in
payout ratios - LLSV (2000)
43Agency costs and cross-sectional differences in
payout ratios
- Rozeff (1982) argues that agency costs may
explain cross-sectional differences in dividend
payouts across firms. - Rozeff argues that insider ownership and dividend
payments are substitutes. What does this imply? - Industry patterns (across the world)
- firms in mature industries have higher dividend
payouts than firms in young, rapidly growing
industries. Why? - Utility cos. have very high dividend payouts.
Why?
44Agency costs and cross-sectional differences in
payout ratios
- Industry patterns (across the world)
- large firms (on average) have higher dividend
payouts than small firms. Why? - regulated companies have higher dividend payouts.
Why?
45Lecture outline
- Free cash flow and agency costs
- Discipline of capital market
- Agency costs and cross-sectional differences in
payout ratios - LLSV (2000)
46LLSV (2000)
- Agency explanation rationalises why there are
differences across industries. - But why do they differ across countries?
- National differences in dividend policies
- highest in industrialised nations
- developing countries pay low or no dividends
- countries that rely on capital markets pay higher
dividends - Socialist economies tend to discourage dividends
(France)
47LLSV (2000)
- Why do these differences exist?
- LLSV (2000) argue that agency costs and investor
protection regimes explain differences in
dividend policies across the world.
48LLSV (2000)
- Outcome model
- Dividends are an outcome of legal protection of
shareholders. - Not necessarily legal rights to dividends.
- Minority shareholders can force companies to pay
out cash using legal powers e.g. voting for
directors, takeovers, suing company. - Firms cant rip off minority shareholders ? they
will return cash to them
49LLSV (2000)
- Predictions of outcome model
- dividend payout ratios are higher in countries
with good legal protection of shareholders - companies with good investment opportunities
will have lower dividend payout ratios
50Dividends / Earnings
High investor protection
Low investor protection
Investment Opportunities
51LLSV (2000)
- Substitute model
- Dividends serve as a substitute for legal
protection of S/Hs - This view rests on the need for firms to come
occasionally to the market to raise capital. - Firms need a good reputation to raise money
continually.
52LLSV (2000)
- Paying dividends gives a firm a reputation for
not expropriating SHs - Firms want this reputation so that they can raise
further equity finance. - When does reputation become of no value?
53LLSV (2000)
- Predictions of substitute model
- dividend payout ratios are lower in countries
with good legal protection of shareholders - companies with good investment opportunities may
pay out more to maintain their reputations
54Dividends / Earnings
Low investor protection
High investor protection
Investment Opportunities
55LLSV (2000)
- Examine dividend payouts of 4,104 firms from 33
countries - Classify countries into
- High and Low protection economies
- Common and Civil law economies
- Common law countries typically have high investor
protection regimes
56LLSV (2000)
- Common law countries typically have higher payout
ratios than civil law countries - High investor protection countries have higher
payout ratios than low investor protection
countries
57LLSV (2000)
- Evidence supports outcome agency model of
dividends. - Why?
- Firms appear to pay cash out to investors
because the opportunities to steal or misinvest
it are in part limited by law, and because
minority shareholders have enough power to
extract it
58Payout Policies
- Introduction
- MM irrelevance theorem
- Personal taxation and dividend policy
- Signaling and dividends
- Dividend smoothing
- Disappearing dividends
- Agency costs and dividends
- Stock repurchases
59Stock repurchases
- What are stock repurchases?
- The equivalence of dividends and stock
repurchases - Why do companies repurchase shares?
- Why increased usage of stock repurchases?
60What are stock repurchases?
- aka Corporate Equity Repurchases
- Average cash distribution is usually large - 20
of firms market value - A firm can use 2 methods to repurchase
outstanding shares. - Open market stock repurchase scheme
- Shares are purchased on the open market gradually
over time. - Most used method
61What are stock repurchases?
- Tender offer
- Shares are repurchased on a one-time basis
- leads to sudden and dramatic changes in the
number of issued shares - NB shareholders are NOT forced to sell their
shares.
62What are stock repurchases?
- By repurchasing shares, the number of outstanding
shares is reduced. - These shares are held by the firm and can be
- Resold later e.g. in conjunction with exercise of
employee or executive stock options - Reissued as compensation in a acquisition
63What are stock repurchases?
- Stock repurchases have at least five practical
effects - Firms assets are reduced as cash is paid out.
Who might this affect? - Leverage is increased.
- Firm is adding substantially to the demand for
its stock driving up stock price - The firms active involvement in the secondary
market may enhance liquidity. - The liquidity of shares decreases either because
the number of free-floating shares falls or the
dealers increase their bid-ask spread as they
face the firm as an ongoing informed trader
64What are stock repurchases?
- Have become increasingly common
- US firms
- Average repurchase payout ratio
- 1974 3.7 1998 13.6
- Average dividend payout ratio
- 1974 22.3 1998 13.8
- Firms that have repurchased shares
- 1974 27 1998 81
65Lecture outline
- What are share buybacks?
- The equivalence of dividends and stock
repurchases - Why do companies repurchase shares?
- Why increased usage of stock repurchases?
66The equivalence of dividends and stock repurchases
- Goo.com earned 4m in 2005 and decides to payout
50 either as dividends or share repurchase. - The company has 1m shares outstanding with a
market value of 10 per share. - It can
- pay dividends of 2 per share
- repurchase shares at 10/share
67- Current value of firm 10m.
- For 2m, it can repurchase 200,000 shares
- ?after repurchase, value of firm
- 10m - 2m 8m
- share price 8m / 800,000 10 (no price
effect from repurchase)
68- Comparison of shareholders wealth before tax
- Pay dividends
- 2 dividend ex-div share price 8 (8m / 1m
shares) - Share repurchase
- Share price 10 (whether shareholder sold
shares to company or not)
69Lecture outline
- What are share buybacks?
- The equivalence of dividends and stock
repurchases - Why do companies repurchase shares?
- Why increased usage of stock repurchases?
70Why do companies repurchase shares? Tax
avoidance hypothesis
- Managers use share repurchases instead of
dividends to minimise shareholders taxes. - Capital gains are taxed less heavily than
dividend income - What impact will the elimination of taxes on
dividends in the US have on corporate behaviour?
71Why do companies repurchase shares? Signalling
hypothesis
- Managers are better informed about the future
prospects of the firm than outside shareholders. - A share repurchase could signal that
- Firm has exhausted all profitable investment
opportunities - Expect future cash flows to increase
- But why choose repurchases rather than dividends
to do this?
72Why do companies repurchase shares? Agency costs
of free cash flow hypothesis
- If firms no longer have profitable investment
opportunities they may make a share repurchase to
reduce the amount of free cash they have. - This prevents managers expropriating it.
- Studies have shown that the market reacts
favourably to share buyback programs whose
investment opportunities have declined.
73Why do companies repurchase shares? Leverage tax
shield hypothesis
- If repurchase is financed by issuing debt ?
leverage ? and if gain to leverage, SHs benefit - Usually via a tender offer leads to dramatic
and sudden changes in capital structure compared
to a debt-financed dividend payout or open market
repurchase
74Why do companies repurchase shares? Bondholder
expropriation hypothesis
- Repurchase may unexpectedly reduce the amount of
collateral backing bond issues. - However, this only applies to unsecured lenders,
and the ability of firms to repurchase should be
factored into the interest rate charged by the
lender.
75Why do companies repurchase shares? Stock option
hypothesis
- Executive compensation over the past 20 years has
contained more and more stock options. - As share prices increase, stock options become
more valuable. - What happens share prices if firms retain
earnings rather than pay out dividends? - Once options are exercised, firms then repurchase
shares.
76Why do companies repurchase shares? Stock option
hypothesis
- However, firms may repurchase shares after
options are exercised to offset the increase in
common equity resulting from the option being
exercised. - This may only be the case for employee stock
options.
77Lecture outline
- What are share buybacks?
- The equivalence of dividends and stock
repurchases - Why do companies repurchase shares?
- Why increased usage of stock repurchases?
78Why increased usage of share buybacks?
- Firms have now reached the stage where they
distribute more cash via repurchases than
dividends. Why has this arisen? - Regulatory changes less regulatory hostility to
buybacks. - Tax efficiency reasons less likely to explain
changes - Increasing use of stock options most likely
explanation.
79Reading
- Baker, H., Powell, G. and Veit, E. (2002),
Revisiting the Dividend Puzzle Do All of the
Pieces Now Fit, Review of Financial Economics,
11 241-261. - Fama, E. F. and French, K. R. (2001),
Disappearing Dividends Changing Firm
Characteristics or Lower Propensity to Pay?,
Journal of Financial Economics, 60 3-43. - La Porta, R., Lopez-De-Silanes, F., Shleifer, A.
and Vishny, R. W. (2000), Agency Problems and
Dividend Policies Around the World, Journal of
Finance, 551-33. - Relevant Chapters in 1) Arnold
- 2) Brearly Myres