CORPORATE FINANCE

16. Payout Policy

 Questions to Answer

1. How much cash should a corporation pay to its

shareholders?

2. Should the cash be distributed by paying cash

dividends or by repurchasing shares?

José Azevedo Pereira Gestão Financeira II 2

 Topics Covered

 Facts About Payout

 Information in Dividends and Stock Repurchases
 Dividends or Repurchases? The Payout
Controversy
 The Rightists
 Taxes and the Radical Left
 Payout Policy and the Life Cycle of the Firm

José Azevedo Pereira Gestão Financeira II 3

Payout Policies
Dividend & Stock Repurchases

U.S. Data 1980-2013

 How Firms Pay Dividends

Stock Dividend - Distribution of additional

shares to a firm’s stockholders

Stock Splits - Issue of additional shares to

firm’s stockholders

Cash Dividend - Payment of cash by the firm

to its shareholders
-Regular
-Special
 16-1 FACTS ABOUT PAYOUT

• Dividend Payments
• Cash Dividend
• Payment of cash by firm to shareholders

• Ex-Dividend Date
• Date that determines when stockholder is entitled to dividend
payment
• Record Date
• Person who owns stock on this date receives dividend

José Azevedo Pereira Gestão Financeira II 7

 FIGURE 16.2 EXXON MOBIL'S DIVIDENd

January 5, February 8, 2012 February 10, 2012 March 9, 2012

2012
Exxon Mobil
declares Shares start to Dividend will be
paid Dividend checks
quarterly trade ex- mailed
dividend dividend to shareholders
registered to shareholders
of $.42 per share
on this date

Declaration date Ex-dividend date Record Payment

date date

José Azevedo Pereira Gestão Financeira II 8

 16-1 FACTS ABOUT PAYOUT
• Types of Dividends
• Cash Dividend

• Regular Cash Dividend

• Special Cash Dividend

• Stock Dividend

• Distribution of additional shares to firm’s stockholders

• Stock Splits

• Issue of additional shares to firm’s stockholders

José Azevedo Pereira Gestão Financeira II 9

 16-1 FACTS ABOUT PAYOUT
• Stock Repurchase (4 methods):
• Firm buys back stock from its shareholders
• Buy Shares on Market

• Tender Offer to Shareholders

• Dutch Auction

• Private Negotiation (greenmail)

José Azevedo Pereira Gestão Financeira II 10

 16-1 FACTS ABOUT PAYOUT

• Cash Dividend versus Stock Repurchase

• Cash Dividend
• Dividends are rarely cut-back, managers do not increase
dividends unless confident that dividend can be maintained
• Stock Repurchase
• Repurchases are more flexible and repurchases are tax-
advantaged

José Azevedo Pereira Gestão Financeira II 11

16-2 The Information Content of Dividends

Senior Executive Dividend Policy Features

(How Dividends are Determined)
1. Managers are reluctant to make dividend changes
that might have to be reversed
2. Managers “smooth” dividends and hate to cut them.
Dividends changes follow shifts in long-run, sustainable
levels of earnings.
3. Managers focus more on dividend changes than on
absolute levels

José Azevedo Pereira Gestão Financeira II 12

16-2 The Information Content of Dividends

 Dividends and stock repurchase decisions

contain information
 The information contained in the decisions varies
 Asymmetric information may be conveyed
 Dividend increases could mean overpriced stock
or increased future profits
 The signal varies based on prior information
about the company

José Azevedo Pereira Gestão Financeira II 13

 FIGURE 16.3 DIVIDEND POLICY
SURVEY 2004

José Azevedo Pereira Gestão Financeira II 14

 16-3 DIVIDENDS OR REPURCHASES? PAYOUT
CONTROVERSY

José Azevedo Pereira Gestão Financeira II 15

16-3 DIVIDENDS OR REPURCHASES? PAYOUT
CONTROVERSY

Rational Demiconductor Balance Sheet (Market Values)

Surplus cash 1 000 000,00 € - € Debt
Fixed assets and net Equity market capitalization (1
working capital 10 000 000,00 € 11 000 000,00 € million shares at €11)
Total 11 000 000,00 € 11 000 000,00 €

1. Payment of a cash dividend of €1 million

What will be the price per share after the payment of the dividend?

Cash dividend 1 000 000,00 €

Number of shares
outstanding 1000000
Price per share after
dividend payment 10,00 €
Global amount of
wealth owned by the
shareholder after the
dividend payment
(per single share
owned) 11,00 €

José Azevedo Pereira Gestão Financeira II 16

16-3 DIVIDENDS OR REPURCHASES? PAYOUT
CONTROVERSY

José Azevedo Pereira Gestão Financeira II 17

16-3 DIVIDENDS OR REPURCHASES? PAYOUT
CONTROVERSY
2. Repurchase of shares with a market value of € 1 million
What will be the price per share after the share repurchase?
Round values Non round values
Market value of the
shares to repurchase 1 000 000,00 €
Number of shares to
repurchase: 90909,00 90909,09
Number of shares
outstanding after the
repurchase: 909091,00 909090,91
Market price per
share 11,00 € 11,00 €
Market value of all
shares outstanding 10 000 001,00 € 10 000 000,00 €

It is irrelevant for a stockholder to sell or not => If she sells part of her stake in the company,
she will end having part of her health in cash and part in shares. If she does not sell, all her
health will be in shares. The total value will be the same.
By selling all the shares owned she makes €11 per share in
By not selling any of the shares owned she will own a
value of €11 per share in a security.

José Azevedo Pereira Gestão Financeira II 18

 16-3 DIVIDENDS OR REPURCHASES? PAYOUT
CONTROVERSY
• Important Repurchases:
• Calculate Market Capitalization
• Done by forecasting and discounting free cash flow paid to
shareholders
• To calculate share price, divide market capitalization by number
of outstanding shares
• Calculate Value of Dividends Per Share
• Account for increased dividend growth rate per share
• Caused by declining number of shares as shares are
repurchased
José Azevedo Pereira Gestão Financeira II 19
16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY (Stock
Repurchases and DCF Models of Stock Price)

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16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY (Stock
Repurchases and DCF Models of Stock Price)
b) Calculate the present value of the dividends per share, taking account of the increased
growth rate of dividends per share caused by the declining number of shares as shares are
repurchased:
Start with an assumtion that Rational Demiconductor will not repurchase shares in the
future and will only pay dividends, the forecasted dividend stream will be level (and
perpetual) at € 1 per share

Suppose that Rational anounces instead that henceforth it will pay out exactly 50% of the
FCF as dividends and the other 50% as repurchases:
E(DIVn+1) 50% FCF
Next Year
repurchase: 500 000,00 €
Next year dividend: 0,50 €
Ex-dividend price
next year 10,50 €
Number of shares
to repurchase
next year 47619
Number of shares
outstanding after
share repurchase
next year 952381 g = 5%
E(FCF) per share The € 0,5 reduction in dividend in year 1 is offset by
in year 2 1,05 € a growth in the FCF per share from € 1 to 1,05 in
If we keep using 50% of the FCF for repurchases in
the future, we continue to generate a future
growth rate of 5%
Price per share 10

José Azevedo Pereira Gestão Financeira II 21

16-3 DIVIDENDS OR REPURCHASES? PAYOUT
CONTROVERSY (Dividends and Share Issues)
• Original Modigliani and Miller (MM) construct:
• It is possible to modify value by changing (increasing or
decreasing) the level of dividends, if we assume that
investment and debt-equity policies are held without any
changes?
• If a company wants to distribute more dividends than what it
could by its own means (with cash flow released that is not
needed to other purposes, given the current investment and
financing policies), the only solution consists in issuing additional
shares.

José Azevedo Pereira Gestão Financeira II 22

 16-3 DIVIDENDS OR REPURCHASES? PAYOUT
CONTROVERSY

• If Rational wants to distribute more than $1 million, with investment and

financing policies unchanged, the only solution would be to issue new
shares.
• But then, it would be possible to create value for current stockholders, if new
stockholders would accept to make investments with negative net present
values

José Azevedo Pereira Gestão Financeira II 23

 16-4 Dividend Policy
Before After
Dividend Dividend

New
stockholders
Total value of firm

Each share
worth this
before … … and
worth
this
after Old
stockholders

Total Total
number of number of
shares shares
Example of 1/3rd of worth paid as dividend and raising money via new shares
José Azevedo Pereira Gestão Financeira II 24
 16-4 Dividend Policy

Dividend financed No dividend, no

by stock issue stock issue
New stockholders New stockholders
Shares
Cash

Firm Cash Shares

Cash
Old stockholders Old stockholders

José Azevedo Pereira Gestão Financeira II 25

 16-4 THE RIGHTISTS (DIVIDEND THEORIES)

• Dividend Theories:
1. Dividend Policy Is Irrelevant (MM and “Middle
of the Roaders”)
• 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 value of firm

José Azevedo Pereira Gestão Financeira II 26

16-4 THE RIGHTISTS (DIVIDEND THEORIES)
• Dividend Theories:
2. The Rightists (high dividend yields are good)
• MM rationale works in a perfectly rational world

• Market Imperfections and Clientele Effect

• Natural clients for high-payout stocks:

• Financial institutions that are legally restricted from owning stocks without established
dividend records (some trust and endowment funds)
• Elderly people

• People that appreciate the self discipline imposed by spending only dividend income

• However, it is important to note that high-dividend clienteles have several high-

dividend stocks to choose from
• Being so, firms cannot benefit by increasing dividends => middle of the roaders
win, even if clienteles are correctly identified

José Azevedo Pereira Gestão Financeira II 27

16-4 THE RIGHTISTS (DIVIDEND THEORIES)

• Dividends Increase Value

• Dividend increases send good news about cash-flow earnings and prevent
managers from misusing or wasting funds
• Dividend cuts send bad news

• High-dividend payout policy will be costly to firms that do not have cash flow to
support it
• Dividend increases signal company’s good fortune

• Increase in manager’s confidence in future cash flow

José Azevedo Pereira Gestão Financeira II 28

16-5 TAXES AND RADICAL LEFT
• Dividend Theories:
3. The Leftists (high dividend yields are bad)
• Taxes and Dividend Policy
• Capital gains taxed at lower rate than dividend income so companies should
pay lowest dividend possible
• Dividend policy should adjust to changes in tax code

• Problems with rationale:

• If leftists are right, why to pay any dividend at all?

• The difference in taxation is nowadays much less than the average historical
gap
• The difference is not relevant for significant segments of the financial markets
(i.e., pension funds in the US)

José Azevedo Pereira Gestão Financeira II 29

TABLE 16.1 TAXES DIVIDEND POLICY

In most countries, returns to shareholders are still

taxed twice

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TABLE 16.2 TAXES DIVIDEND POLICY
Australian Tax Credit to Shareholders
(Imputation Tax System)

José Azevedo Pereira Gestão Financeira II 31

16-6 Payout and the Life Cycle of the Firm
• Young promising firms:
• Plenty of profitable investment opportunities;
• Need all the money available to fund investments.

• Mature firms:
• Less positive NPV investment opportunities;

• Increased ability to distribute dividends.

• Ageing firms:
• More and more payout called for.

José Azevedo Pereira Gestão Financeira II 32

 Dividends Increase Value

Apple stock price increased, despite paying no dividend. It

sent a signal of growth.
Thank You