Chapter 17

Payout Policy

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How companies Pay Out Cash to Shareholders

• Companies pay out cash to shareholders in two ways; namely cash dividends and share repurchases.

• Ex-dividend simply means without dividend. An investor that buys the stock after the ex-dividend date does not receive the most recently declared dividend.

• Research shows that when a share “goes ex-dividend”, its price falls by the amount of the dividend.

• The law protects creditors from large dividend payouts by limiting companies that are close to insolvency.

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Share Dividends and Stock Splits

• Stock dividend is the distribution of additional shares to a company’s shareholders. For a 10% stock dividend, one additional share is given to a share holder of 10 shares.

• A stock split is the issue of additional shares to a company’s shareholders. In a two-for-one stock split, each investor receives one additional share for each share already held.

• A two-for-one stock split is similar to a 100% stock dividend.

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• Stock splits and share dividends do not affect the company’s assets, profits or total value.

• Stock split and share dividend announcements usually result in a price increase as it may signal management’s confidence in the future.

Share Dividends and Stock Splits

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Example on Stock Dividends and SplitsSuppose that you own 1,000 shares of Nocash Corp. And the company is about to pay a 25% stock dividend. The stock currently sells at $100 per share.

a. What will be the number of shares that you hold and the total value of your equity position after the dividend is paid?

1,000 * 1.25 =1,250 shares

Price per share will fall to: $100/1.25 = $80

Initial value of equity is: 1,000 * $100 = $100,000

The value of the equity position remains at: 1,250 * $80 = $100,000 5

b. What will happen to the number of shares that you hold and the value of your equity position if the firm splits five for four instead of paying the stock dividend?

Example on Stock Dividends and Splits

A 5-for-4 split will have precisely the same effect on price per share, and the value of your equity position as the 25% stock dividend.

In both cases, The number of shares held increases by 25%

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Share Repurchases

• Share repurchases are popular in recent years yet were very rare in the 1980s.

• Share repurchases are a way for a company to hand back cash to its shareholders. The company would simply buyback some of its shares from the shareholders.

• The company can keep these reacquired shares in its treasury and resell them if it needs money later.

• There are four ways to implement a stock repurchase namely open-market repurchase, tender offer, auction or direct negotiation.

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Share Repurchases

• The Open-market repurchase is the most common method of share repurchase. The company announces that it plans to buy shares in the secondary market, just like any other investor.

• In a Tender offer the company offers to repurchase a stated number of shares at a fixed price. The company should find the required number of investors to accept the offer.

• In an auction the company states a range of prices at which it is prepared to buyback shares. Shareholders then submit offers of number of shares for each price, then the company calculates the lowest price.

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Share Repurchases

• Direct negotiation is were the company may negotiate repurchase of a block of shares from a major shareholder.

Hewlard Pocket Example Table 17-1 page 477 BMMBefore Dividend/ Share repurchase

Market Value $1 million

Outstanding Shares 100,000 shares

Price per share $10

After buyback at 10,000 shares at $10 each – hence $100,000 in repurchase.

Market Value $900,000

Outstanding Shares 90,000 shares

Price per share $10 9

Share Repurchase

• A shareholder that owns 1000 shares before repurchase has $10,000 wealth.

• If shareholder sells 100 shares he would have $1000 cash.

• Shareholder is left with 900 shares worth $9000.• Total wealth after share repurchase remains as $10,000• On the whole, share repurchases reduce the number of

shares and increase future dividends per share.

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Cash Dividends

• Cash dividends are popular among mature and profitable companies.

• Hewlard Pocket Example Table 17-1 page 477 BMMBefore Dividend/ Share repurchase

Market Value $1 million

Outstanding Shares 100,000 shares

Price per share $10

After Cash Dividend of $1 per share – hence $100,000 in dividends

Market Value $900,000

Outstanding Shares 100,000 shares

Price per share $9

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Cash Dividends

• A shareholder that owned 1000 shares before cash dividend owns $10,000.

• The cash dividend is worth $1000 in cash.• The $1000 shares are worth $9000 after dividend• Total wealth after dividend is $10,000Healy and Palepu (2008) evidence suggests that the

announcement of a company’s first dividend causes an immediate price increase of 4% on average.

Announcements of dividend cuts are usually taken as bad news whereas those of dividend increases are good news.

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Dividend ExampleBeta corporation had 1,000 shares outstanding and a market value of £90,000 prior to the declaration of a £5 per share dividend. To finance a new project they will issue equity. What will be the market value of the firm after the dividend?

Share price prior to declaration:

= 90,000 / 1,000 = $90Share price after declaration:

= $90 - $5 = $85

Market value of firm = $85 * 1,000 = $85,00013

MM Dividend Irrelevance Proposition

• There are three main arguments about dividend irrelevancy.

o One group believe that high dividends increase value. o Others argue that high dividends bring high taxes and

therefore reduce firm value.o MM (1961) group suggest that payout policy makes no

difference.• Modigliani and Miller (1961) proves that under ideal

conditions, the value of a company is not affected by its dividend policy.

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MM Dividend Irrelevance Proposition

• MM argue that Investors don’t need dividends to convert their shares to cash therefore will not pay higher prices for companies with higher dividend payouts.

• As long as investment policy and borrowing are held constant, a firm’s overall cash flows are the same regardless of dividend policy.

• MM assume an efficient capital market therefore are not a description of the real-world.

• An argument against MM is that some investors would pay more for high dividends. However, the high-dividend clienteles already have plenty of high-dividend stocks to choose from.

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Dividends May Reduce Value

• Companies that are highly taxed on dividends should pay a low cash dividend and use the surplus cash to repurchase shares. Shareholders who sell shares back to their company pay tax only on any capital gains realised in the sale.

• Though share repurchases avoid taxes, companies that replace dividends for regular share repurchase would be recognised by the tax authorities. Hence, financial managers would give another explanation for their share repurchase even when their motive is to reduce tax.

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References

• P. Healy and K. Palepu, “Earnings information conveyed by dividend initiations and omissions,” Journal of Financial Economics 21 (1988), pp.149-175.

• M. H. Miller and F. Modigiliani, “Dividend policy, growth and the valuation of shares,” Journal of Business 34 (October 1961), pp. 411-433.

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