mbf2263 portfolio management lecture 7: payout policy · •policy 1: pay dividend with excess cash...

MBF2263 Portfolio Management

Lecture 7: Payout Policy

Learning Objectives

• Identify the different ways in which companies can make distributions to

shareholders

• Understand why the way in which they distribute cash flow does not affect

value absent market imperfections

• Indicate how taxes and other market imperfections can influence the payout

policy for a firm

• Explain how increased payouts can reduce agency problems but potentially

reduce financial flexibility

• Assess how an imputation tax system impacts on the valuation of shares in a

firm

• Describe alternate non-cash methods for payouts

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Distributions to Shareholders

• A firm can retain free cash flow - either investing in new projects or accumulating it - or pay out to shareholders through a dividend or share repurchase.

• The way which a firm chooses between those alternatives is referred to as payout policy.

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• Dividends

The company’s board of directors declares the dividend that will be paid and decides when the payment will occur:

• Ex-dividend date

• Record date

• Payment date

• Most companies in Australia pay dividends twice a year –usually as an interim and a final dividend.

• Occasionally, a firm may pay a one-time, special dividend that is usually much larger than a regular dividend.

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• Share Repurchases (buybacks)

• The firm uses cash to buy shares of its own outstanding shares.• The shares are then typically cancelled and held in the corporate

treasury; they can be reissued if company needs to raise equity in the future.

• Types of buybacks:

• On- market buyback

• Off-market buyback

• Dutch auction

• Selective buyback

Dutch auction - a method of selling in which the price is reduced until a buyer is found

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Dividends vs. Share Repurchases in a Perfect Capital Market

• If company decides to pay cash to shareholders, how will it choose between dividends or share repurchases?

• Consider the case of Genron Corporation, which has $20 million in excess cash and no debt.

• The firm expects to generate additional free cash flows of $48 million per year in subsequent years.

• If Genron’s unlevered cost of capital is 12%, then the enterprise value of its ongoing operations is:

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• Policy 1: Pay Dividend with Excess Cash

• With 10 million shares outstanding, Genron will be able to pay

a $2 dividend immediately.

• Because the firm expects to generate future free cash flows of

$48 million per year, it anticipates paying a dividend of $4.80

per share each year thereafter.

• Calculate Genron’s share price just before and after the stock

goes ex-dividend to estimate the impact of this decision.

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• Just before the ex-dividend date, the stock is said to trade cum-dividend (‘with the dividend’), here:

• After the stock goes ex-dividend, new buyers will not receive the current dividend:

• In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend.

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16.2 Dividends vs. Share Repurchases in a Perfect Capital Market

• Policy 2: Share Repurchase (no dividend)

• Suppose that Genron does not pay a dividend this year, but instead uses the $20 million to repurchase its shares on the open market.

• How will the repurchase affect the share price?

• With an initial share price of $42, Genron will repurchase:$20 million $42 per share =

0.476 million shares, leaving only 10 – 0.476 = 9.524 million shares outstanding.

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• Genron’s market value balance sheet:

• In this case, the market value of Genron’s assets falls when the company pays out cash, but the number of shares outstanding also falls from 10 million to 9.524 million.

• The two changes offset each other, so the share price remains the same at $42.

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• Genron’s Future Dividends• In future years, Genron expects to have $48 million in free

cash flow, which can be used to pay a dividend of $48 million 9.524 million shares = $5.04 per share each year.

• Therefore, the share price does not fall after the repurchase:

• In perfect capital markets, an open market share repurchase has no effect on the share price, and the share price is the same as the cum-dividend price if a dividend were paid instead.

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• Investor Preferences

• If Genron repurchases shares and the investor wants cash, she can

raise cash by selling shares.

• For example, she can sell $4000 $42 per share = 95 shares to raise

about $4000 in cash.

• She will then hold 1905 shares, or 1905 $42 $80,000 in shares.

• Thus, in this case of a share repurchase, by selling shares and

investor can create a homemade dividend.

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• Investor Preferences

• Similarly, if dividends gets paid and the investor does not want the cash they can reinvest dividends into new shares.

• Some companies allow investors to register for a dividend reinvestment program (DRIP).

• In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases.

• By reinvesting dividends or selling shares, they can replicate either payout method on their own.

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• Policy 3: High dividend (equity issue)

• Suppose the firm wants to start paying a higher dividend from today, worth $48 million.

• Because it has only $20 million in cash today, Genron needs an additional $28 million to pay the larger dividend now.

• Let’s consider an equity issue.

• Given a current share price of $42, Genron could raise $28 million by selling $28 million $42 per share = 0.67 million shares.

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• Policy 3: High dividend (equity issue)

• Because this equity issue will increase Genron’s total number of shares outstanding to 10.67 million, the amount of the dividend per share each year will be:

• Under this new policy, Genron’s cum-dividend share price is:

• The initial share value is unchanged by this policy and increasing the dividend has not benefit for the shareholders.

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Example 16.1 Homemade dividends

Problem:

• Suppose Genron does not adopt the third alternative policy, and instead pays a $2 dividend per share today.

• Show how an investor holding 2000 shares could create a homemade dividend of $4.50 per share 2000 shares = $9000 per year on her own.

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Solution:

Plan:

• If Genron pays a $2 dividend, the investor receives $4000 in cash and holds the rest in stock.

• She can raise $5000 in additional cash by selling 125 shares at $40 per share just after the dividend is paid.

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Execute:

• The investor creates her $9000 this year by collecting the $4000 dividend and then selling 125 shares at $40 per share.

• In future years, Genron will pay a dividend of $4.80 per share.

• Because she will own 2000 – 125 = 1875 shares, the investor will receive dividends of 1875 $4.80 = $9000 per year from then on.

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Evaluate:

• Again, the policy that the firm chooses is irrelevant—the investor can transact in the market to create a homemade dividend policy that suits her preferences.

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• Modigliani-Miller: dividend irrelevance

• In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and doesn’t affect the initial share price.

Table: Genron’s dividends per share each under the three alternative policies

• Dividend Policy with perfect capital markets

• By using share repurchases or equity issues a firm can easily alter its dividend payments.

• While dividends do determine share prices, a firm’s choice of dividend policy does not.

• The value of a firm ultimately derives from its underlying free cash flow which pays the dividends.

• It is the imperfections in capital markets that should determine the firm’s payout policy.

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Dividends vs. Share repurchase under personal taxes

• Taxes are an important market imperfection that influence a firm’s decision to pay dividends or repurchase shares.

• Shareholders typically must pay:

• Taxes on the dividends they receive at their relevant marginal tax rate; and

• Capital gains taxes when they sell their shares

• How are dividends and capital gains taxed in the hands of shareholders in your country, and what are the implications for the firm?

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• Dividend Imputation

• Some countries (like Australia) operates under a dividend imputation system.

• Dividend imputation: Provides a mean by which Australian companies are able to pass on credits to their shareholder for corporate taxes already paid by attaching franking credits.

• Franking credit: A tax credit that can be used to offset personal taxes payable on dividend income.


• Dividend Imputation

• For example, if an Australian company generates profits for a shareholder

of $100 before company tax, pays $30 tax and distributes $70 as income

the franking credit attached to the dividend would be $30.

• If the tax payable by the shareholder is assessed at $45, the $30 franking

credit is offset against the $45 to reduce the tax payable to $15.

• Without the imputation system, income tax would be levied twice, when

profit is made by the income and when income is received by the

shareholder.


Table 16.2 Taxation of dividend income

Table 16.2 Taxation of capital gains

• Optimal dividend policy with taxes

• When personal tax payable on dividends is less than the personal tax

payable on capital gains, shareholders will pay lower taxes if a firm uses

dividends for all payouts rather than share purchases.

• Under this scenario, the optimal dividend policy is to structure all payouts

as dividends.

• The reverse holds when personal taxes payable on dividends exceed

personal taxes payable on capital gains.


Summary of dividends vs. repurchases

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Payout Versus Retention of Cash

• How should a firm decide the amount it should payout to shareholders and the amount it should retain?

• What are the advantages and disadvantages of retaining cash and investing in securities (in perfect capital markets)?

– Buying and selling securities is a zero-NPV transaction, so it should not affect firm value.

– Shareholders can make any investment a firm makes on their own if the firm pays out the cash.

– The retention versus payout decision is irrelevant.

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• Modigliani and Miller

• MM Payout Irrelevance: In perfect capital markets, if a firm

invests excess cash flows in financial securities, the firm’s

choice of payout versus retention is irrelevant and does not

affect the initial value of the firm.

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• Retaining cash with imperfect markets

– Based on MM’s payout irrelevance, the decision of whether

to retain cash depends on market imperfections.

Taxes and cash retention

Issuance and distress costs

Agency costs of retaining cash

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• Taxes and cash retention

– Taxes may make it better off for shareholders if the firm retains cash profits and invests them on behalf of the shareholders.

– However, this outcome depends on the marginal tax rate paid by the shareholders and tax costs of holding cash by the firm.

– If the personal marginal tax rate is less than 30%, we would find they would be better off if the firm pays out all of its cash profits as dividends.

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• Issuance and Distress Costs

• Firms may retain cash to cover for potential future shortfalls.

• This strategy would allow a firm to avoid the transaction costs of raising new capital (through debt or equity issues).

• A firm must therefore balance the costs of holding cash, such as low returns on liquid investments, with the potential benefit of not having to raise external funds in the future to avoid financial distress.

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• Agency costs of retaining cash

• There is no benefit to shareholders when a firm holds cash above and beyond its future investment or liquidity needs.

• Managers may use this cash inefficiently by continuing money-losing pet projects, paying excessive executive perks or overpaying for acquisitions.

• Leverage is one way to reduce a firm’s access cash.

• Paying out cash can boost the share price by reducing managers ability and temptation to waste resources.

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Signalling with Payout Policy

• Asymmetric information: When managers have better information

than investors regarding the future prospects of the firm, their

payout decisions may signal this information.

• Dividend smoothing: The practice of maintaining relatively

constant dividends, maintaining long-term target level of

dividends.

• Firms raise their dividends only when they perceive a long-term

sustainable increase in the expected level of future earnings, and

cut them only as a last resort.

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• Dividend signalling hypothesis: The idea that dividend changes

reflect managers’ views about a firm’s future earnings prospects.

– When a firm increases its dividend, it sends a positive signal to

investors that management expects to be able to afford the

higher dividend for the foreseeable future.

– When managers cut the dividend, it may signal that they have

given up hope that earnings will rebound in the near term and

so need to reduce the dividend to save cash.

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Signaling with Payout Policy

• Signalling and share repurchase

• Share repurchases, like dividends, may also signal managers’ information to the market:

1. Managers are much less committed to share repurchases as they are generally not expected by shareholders.

2. Firms don’t smooth their repurchases activity as they do with dividends, so they may be less of a signal than dividends about future earnings.

3. Share repurchases are a signal that the shares are under-priced, because if they are over-priced a share repurchase is costly for current shareholders.

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Signaling with Payout Policy

Dividends Reinvestment Plans and Bonus Issues

• Dividend Reinvestment Plans

• Under a DRP a firm issues new shares to shareholders instead of paying a cash dividend with the following advantages:

1. Shareholders receive new shares without paying brokerage and other transaction costs.

2. Shares are typically issued at a price discount to the prevailing market price.

3. Shareholders hold a larger number of shares upon which future dividends will be paid.

• Bonus issues: The issue of free shares to existing shareholders, usually in proportion to the number of existing shares held.

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Advice for the Financial Manager

Overall, as a financial manager, you should consider the following when making payout policy decisions:

1. For a given payout amount, try to maximise the after-tax payout to the shareholders. Repurchases and dividends are often taxed differently and one can have an advantage over the other.

2. Repurchases and special dividends are useful for making large, infrequent distributions to shareholders - neither implies any expectation of repeated payouts.

3. Starting and increasing a regular dividend is seen by shareholders as an implicit commitment to maintain this level of regular payout indefinitely.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 39

mbf2263 portfolio management lecture 7: payout policy · •policy 1: pay dividend with excess cash...

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