Payout PolicyPayout Policy

Advanced Corporate Finance

2 October 2007

Does payout policy affect firm Does payout policy affect firm value?value?

• Perfect capital markets analysis: Miller and Modigliani (1961) – Dividend policy is irrelevant!

• Investor taxation theories• Signaling theories• Agency cost arguments• Clientele effect• Is payout policy really irrelevant?• Role of repurchases in payout policy

Dividend IrrelevanceDividend Irrelevance

• Perfect capital markets

• Investment decision is all that matters to firm value.

• Investors are indifferent between capital gains and dividends.

• Any “excess” dividends would have to be financed with new financing.

Basic example of dividend Basic example of dividend irrelevanceirrelevance

• Next period net income = $5 per share.• Cost of equity = 10% and no economic

profits.• Decision: how much to pay to

shareholders during period?– Suppose 100% of NI– Suppose 50% of NI– Suppose none of it

• Value is equivalent regardless of payout.

Investor taxationInvestor taxation

• Suppose dividends are taxed at a different rate than are capital gains.

• Assume 40% tax rate on dividends and 0% on capital gains.

• Investors prefer less payout.– 100% payout: investor earns 6% after taxes.– 50% payout: 8% after taxes.– 0% payout: 10% after taxes.

Empirical implication of tax storyEmpirical implication of tax story

• Brennan (1970): If dividends are taxed at higher rate than capital gains, expected returns on stocks with higher dividend yields need to be higher.

• Equation 16.15 adds a “dividend yield” factor to CAPM.

• Mixed empirical support for the tax theory (see discussion in Section G…pp. 676 - 679).

Are dividends a signaling Are dividends a signaling mechanism?mechanism?

• Asymmetric information environment (remember pecking order?)

• Issuing securities is “bad” news.• Reverse argument: paying off investors signals

“good” news (i.e., positive announcement effect).• Unexpected dividend increase is associated with

greater earnings surprise (in theory).• Is dividend increase really predictive of future

earnings increases?

Agency costs, investment Agency costs, investment opportunities, and dividendsopportunities, and dividends

• Agency costs of free cash flow argument as benefit of dividends.

• Cost of dividends = flotation costs of raising new capital.

• Firms choose a dividend payout ratio in which the marginal benefits = marginal costs.

• Firms with more growth opportunities, higher risk, and fewer potential agency problems optimally pay lower dividend

Dividend clientele effectDividend clientele effect

• Elton and Gruber (1970)

• Another tax argument

• Investors in higher tax brackets choose stocks with lower dividend yields.

• Estimating tax bracket of average investor– Equation 16.29

Irrelevance of dividend irrelevance – Irrelevance of dividend irrelevance – DeAngelo & DeAngelo working paperDeAngelo & DeAngelo working paper

• Based on DeAngelo and DeAngelo (2006)

• Miller and Modigliani model includes implicit assumption that 100% of FCFE is paid out every period.

• Highly restrictive assumption that guarantees “irrelevance” result.

• Recall definition of FCFE from class session on valuation.

Irrelevance of dividend irrelevance Irrelevance of dividend irrelevance (cont’d)(cont’d)

• Define “investment value” of stock.• Define “distribution value” of stock.• Distribution value (DV) <= Investment value (IV)• Optimal payout policy results in DV = IV• Optimal payout policy = full PV of FCFE over

stock’s life.• Miller & Modigliani assumed payout is included

in set of optimal payout policy.• Timing and form (div vs. repurchase) do not

affect value as long as optimal payout policy is followed.

Irrelevance of dividend irrelevance (cont’d)Irrelevance of dividend irrelevance (cont’d)

• Firms trade off benefits vs. costs of retaining FCFE to determine payout level at any point in time.

• Factors that encourage retention.• Factors that discourage retention.• DeAngelo, DeAngelo, and Stulz (2006) life-cycle

theory:– Young firms largely face issues that encourage

retention while mature firms face higher marginal costs of retaining cash flow.

RepurchasesRepurchases

• Offer alternative means to distribute cash flow to shareholders (Recall definition of FCFE).

• Have taken much larger role in payout policy in last 20 years.

• Often misunderstood effect on value:– Relation between EPS and stock price– Does the act of repurchasing stock cause

higher stock price?

Basic valuation examplesBasic valuation examples

• All-equity company with zero expected economic profits and cost of equity = 10%

• Next year’s expected EBIT = 100• Tax rate = 40%• 12 shares of stock outstanding.• Examples:

– Use existing cash to repurchase stock.– Issue debt to repurchase stock.– Cuts dividend to repurchase stock.

““Payout Policy in the 21Payout Policy in the 21stst Century” Century”

• Brav et al. (2005): Survey of 384 financial execs.• Maintenance of dividend level of similar priority

to making good investments.– Dividends are paid “conservatively.”

• Repurchases reflect residual cash flow after investment.– Managers increasingly favor repurchases as payout

mechanism because of greater flexibility.– Many managers would prefer to reduce current

dividend payout.

Repurchases: Differences from Repurchases: Differences from dividend increasesdividend increases

• Evidence suggests that firms use repurchases as a substitute for increased dividends – Grullon and Michaely (2002).

• Other differences:– Role of market regulation (SEC in US).– Role of employee stock options – Kahle (2002).– Effect on value of exec stock options – Fenn and

Liang (2001).– Timing (valuation issues).– Effect on EPS – Bens et al. (2003).

ReferencesReferences• Bens, D.A., V. Nagar, D.J. Skinner, and M.H.F. Wong, 2003, “Employee stock options, EPS

dilution, and stock repurchases,” Journal of Accounting and Economics 36, 51-90.• Brav, A., J.R. Graham, C.R. Harvey, and R. Michaely, 2005, “Payout policy in the 21st century,”

Journal of Financial Economics 77, 483-527.• Brennan, M., 1970, “Taxes, market valuation and corporate financial policy,” National Tax

Journal, December, 417-427.• DeAngelo, H., and L. DeAngelo, 2006, “The irrelevance of the MM dividend irrelevance theorem,”

Journal of Financial Economics 79, 293-315.• DeAngelo, H., and L. DeAngelo, 2006, “Payout policy pedagogy: What matters and why,”

unpublished working paper.• DeAngelo, H., L. DeAngelo, and R.M. Stulz, 2006, “Dividend policy and the earned/contributed

capital mix: A test of the life-cycle theory,” Journal of Financial Economics 81, 227-254.• Elton, E.J., and M.J. Gruber, 1970, “Marginal stockholders’ tax rates and the clientele effect,”

Review of Economics and Statistics, February, 68-74.• Fenn, G.W., and N. Liang, 2001, “Corporate payout policy and managerial stock incentives,”

Journal of Financial Economics 60, 45-72.• Grullon, G., and R. Michaely, 2002, “Dividends, share repurchases, and the substitution

hypothesis,” Journal of Finance 62, 1649-1684.• Kahle, K.M., 2002, “When a buyback isn’t a buyback: Open market repurchases and employee

stock options,” Journal of Financial Economics 63, 235-261.• Miller, M.H., and F. Modigliani, 1961, “Dividend policy, growth, and the valuation of shares,”

Journal of Business 34, 411-433.