1. 16 PAYOUT POLICY McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 16-1 FACTS ABOUT PAYOUT Cash Dividend versus Stock Repurchase
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
These are two payout policies—cash dividends and stock repurchases. Stock repurchases also give shareholders cash.

3. FIGURE 16.1 DIVIDEND AND STOCK REPURCHASES
The histogram shows data on dividends and repurchases over the years.

4. 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
Cash dividend procedure needs to be explained. Shareholders get a check in the mail. The firm’s board of directors declares the dividend. Generally, the stock price falls by the amount of the dividend on the ex-dividend date. The payment will be made to all stockholders who are registered on the record date. Firms are not allowed to pay a dividend out of legal capital, which is generally defined as the par value of outstanding shares. Checks are mailed to the shareholders on the payment date.

5. 16-1 FACTS ABOUT PAYOUT Dividend Payments Stock Dividend Stock Splits
Distribution of additional shares to firm’s stockholders
Stock Splits
Issue of additional shares to firm’s stockholders
Stock Repurchase
Firm buys back stock from its shareholders
Additional terminology associated with dividend payment is provided. A 5% stock dividend means that the firm will send five extra shares to each shareholder for every 100 shares currently owned. For example, a 2-for-1 stock split means that shareholders will receive one new share for every two shares currently owned. A stock split resembles stock dividends, but usually it is much larger.

6. FIGURE 16.2 EXXON MOBIL'S DIVIDENd
January 5, 2012
February 8, 2012
February 10, 2012
March 9, 2012
Exxon Mobil
declares
quarterly dividend
of $.42 per share
Shares start to
trade ex- dividend
Dividend checks
mailed
to shareholders
Dividend will be paid
to shareholders
registered
on this date
Declaration date
Ex-dividend date
Record
date
Payment
date
It is sometimes difficult for students to grasp the concept of ex-dividend. It might be beneficial to review this slide along with a handwritten example of how the stock price changes when a stock goes ex-dividend. Show how the removal of cash from a firm reduces its value.

7. 16-1 FACTS ABOUT PAYOUT Types of Dividends Cash Dividend
Regular Cash Dividend
Special Cash Dividend
Stock Dividend
Stock Repurchase (4 methods)
Buy Shares on Market
Tender Offer to Shareholders
Dutch Auction
Private Negotiation (greenmail)
Various types of dividends paid by firms are shown. There are four methods for stock repurchase: Buy shares in the open market, tender offer to shareholders, Dutch auction process, and private negotiation (greenmail). Stock repurchases have increased in recent years.

8. FIGURE 16.3 DIVIDEND POLICY SURVEY 2004
This is the result of a survey of financial executives.

9. 16-2 INFORMATION CONTENT OF DIVIDEND AND REPURCHASES
Payout Decision
Managers are reluctant to make dividend changes that may be reversed
Managers worry about rescinding dividend increases and raising new funds to maintain payout
John Lintner has developed a simple model which is consistent with the above observations and explains dividend payments well. This model suggests that the dividend depends partly on the firm’s current earnings and partly on the dividend for the previous year. Current dividends are related to a weighted average of current earnings and past earnings.

10. 16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES
Payout Decision
To avoid risk of reduction in payout, managers “smooth” dividends
Dividend changes follow shifts in long-run sustainable earnings
Transitory earnings changes unlikely to affect dividend payouts
John Lintner has developed a simple model which is consistent with the above observations and explains dividend payments well. This model suggests that the dividend depends partly on the firm’s current earnings and partly on the dividend for the previous year. Current dividends are related to a weighted average of current earnings and past earnings.

11. 16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES
Payout Decisions
Managers focus on dividend changes over absolute levels
Paying a dividend of $2.00 per share is important if last year's dividend was $1.50
Paying a dividend of $2.00 is not important if last year's dividend was $2.00
John Lintner has developed a simple model, which is consistent with the above observations and explains dividend payments well. This model suggests that the dividend depends partly on the firm’s current earnings and partly on the dividend for the previous year. Current dividends are related to a weighted average of current earnings and past earnings.

12. 16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES
Information Content of Dividends
Dividend stock repurchase decisions contain information
Information contained in decisions vary
Asymmetric information may be conveyed
Dividend increases could mean overpriced stock or increased future profits
Signal varies based on prior information about company
Review some aspects of signaling hypotheses. It would be helpful at this point to provide two opposing examples of how the market reacts differently to the same announcement from different companies. My favorite example is the decline in the price of Microsoft in the aftermath of its first-ever dividend and then the increase in price related to almost any utility making the same announcement.

13. 16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES
Information in Payouts
Varying attitudes toward dividend targets
DIV1 = target dividend
= target ratio × EPS1
Dividend change
DIV1 – DIV0 = target change
= target ratio × EPS1 – DIV0
Formula for dividend targets and dividend change.

14. 16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES
Information in Payouts
Dividend changes confirm thefollowing
DIV1 – DIV0
= adjustment rate × target change
= adjustment rate × target ratio × EPS1 – DIV0
Formula for what dividend changes confirm.

15. 16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY
Rational Demiconductor balance sheet example.

16. 16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY
Rational Demiconductor balance sheet example, continued.

17. 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

18. 16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY
Rational Demiconductor balance sheet example, ex-dividend in year 0.

19. 16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY
Change EPS/price at t = 0 as %
The graph shows the effect of dividend changes on EPS.
Year

20. FIGURE 16.4 DIVIDEND POLICY
This explains the Modigliani-Miller proposition on dividends. Dividend policy is irrelevant in perfect capital markets. This is proved using homemade dividend argument.

21. FIGURE 16.5 DIVIDEND POLICY
This explains the Modigliani-Miller proposition on dividends.

22. 16-4 THE RIGHTISTS Dividend Policy Is Irrelevant
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
Here Modigliani-Miller proposition is stated.

23. 16-4 THE RIGHTISTS Dividend Theories Leftists
Dividends do not affect value
Rightists
Dividends increase value
Middle of Roaders
Leftist theory with some reality thrown in
Describe the three dividend theories. Note that the residual is not defined. Provide a basic definition, but leave the details until the last slide, where a graph is provided to show how the residual dividend policy works. Simply stated, the residual dividend policy says the firm should pay a dividend of all money left over when all positive NPV projects have been funded.

24. 16-4 THE RIGHTISTS Market Imperfections Clientele Effect
Natural clients high-payout stocks
Firms can not benefit by increasing dividends
High-dividend clientele have several high- dividend stocks to choose from
Clients increase price of stock through demand for dividend-paying stock
This is called the clientele effect. For example: shareholders in high tax brackets prefer low-dividend paying stocks and shareholders in low tax brackets prefer high-dividend paying stocks.

25. 16-4 THE RIGHTISTS Dividends Increase Value
Dividend increases send good news about cash-flow earnings
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
Dividend payment or nonpayment sends good and bad news, respectively. Similarly dividend initiation implies good news, and dividend stoppage implies bad news. Dividend increase or initiation is good news. Dividend reduction or stoppage is bad news. Dividend payments send information on the manager’s confidence in future cash flows.

26. 16-5 TAXES AND RADICAL LEFT
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
If tax rates on dividends are higher than capital gains, then low-dividend payments increase the value of the firm. Dividend policy should adjust to changes in the tax code.

27. TABLE 16.1 TAXES DIVIDEND POLICY
Returns to Shareholders Taxed Twice
The income tax code given by the IRS. Shareholders in the U.S. face double taxation.

28. TABLE 16.2 TAXES DIVIDEND POLICY
Australian Tax Credit to Shareholders
Shareholders in Australia receive a credit on the taxes paid by the firm. A shareholder in the 15% tax bracket gets a tax credit of A$15 and a shareholder in the 47% tax bracket pays only A$17 in taxes. A shareholder in the 30% tax bracket does not pay any taxes.

29. FIGURE 16.6 DIVIDEND THEORIES
Apple's Growth
The residual dividend policy is displayed. The x-axis represents the cumulative dollars invested by a company when it accepts projects in descending order of IRR. MRI is the marginal return on investments (which equates to the IRR) for each of the projects available, in descending order. Be sure to explain that when the firm accepts the next project where the IRR is below the firm COC, the firm is destroying value since the shareholder’s opportunity cost of capital is the COC. As such, they should not take on projects with IRR below the COC and instead pay the remaining funds as a dividend.