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Financial Management > Payout Policy > Flashcards

Payout Policy Flashcards

1
Q

What does payout policy refer to?

A
  • Refers to all cash distributions made by the firm to its shareholders
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2
Q

What does payout policy include?

A
  • Dividends

- Share repurchases

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3
Q

Define dividends.

A
  • Cash that firm distributes to its S/Hs (in proportion to their # of shares)
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4
Q

Define share repurchases.

A
  • Stock that firm buys from its S/Hs
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5
Q

What does MM refer to?

A

Modigliani-Miller Dividend Proposition

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6
Q

What does the MM Irrelevance Proposition state?

A
  • In a world w/ perfect capital markets, payout policy is irrelevant (hence dividend v. share repurchases are irrelevant)
  • the value of a firm is independent of its corporate payout policy
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7
Q

What does a perfect world imply in the MM Irrelevance Proposition?

A
  • Firms’ investments are unaffected by payout policy
  • No tax advantage to dividends vs. capital gains
  • No info asymmetry
  • No transaction costs
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8
Q

What is the value of MM when discussing payout policy?

A
  • Helps us answer the question “under what conditions does payout policy not matter”
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9
Q

What are the two intuitions for the MM Irrelevance Proposition?

A

1) Firm’s value is just sum of the NPV of all its projects; perfect markets implies investors are indifferent about how they get their money (dividends vs. capital gains); dividends only affect how cash is distributed from the firm to investors
2) If co. investment policy is unaffected by dividend policy, then dividend policy has no impact on value of firm (projects not affected by dividend policy)

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10
Q

In perfect capital markets, what does not affect share value?

A

Dividend policy

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11
Q

Dividends are reported in what three equivalent ways?

A

1) Dividends per share (DPS): $/share
2) Dividend yield: DPS/share price
3) Payout ratio: DPS/EPS

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12
Q

Is the level of dividends generally fixed?

A

NO

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13
Q

Are dividends generally paid annually?

A

No, usually QUARTERLY

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14
Q

What two types of dividends do companies distinguish between?

A
  • Regular dividends

- Special dividends

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15
Q

Define regular dividends

A

Expected to be maintained in the future (recurring)

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16
Q

Define special dividends

A

Less likely to be repeated (one-time cash payment)

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17
Q

What happens on the declaration date?

A

Firm announces its next dividend, as well as its record and payment dates

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18
Q

What happens on the cum-dividend date?

A

Last day when shares are traded with right to receive the dividend (5 days before record date)

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19
Q

What happens on the ex-dividend date?

A

First day when shares are traded w/o right to receive the dividend (day after cum-dividend date)

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20
Q

What happens on the record date?

A

S/Hs are recorded to receive dividends

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21
Q

What happens on payment date?

A

Dividend checks mailed out

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22
Q

What happens to the share repurchased in the US?

A

In US, company just keeps the shares, and they are excluded when computing any meaningful statistic (they’re called treasury shares; issued but not outstanding)

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23
Q

Is there usually a premium offered to induce S/Hs to sell?

A

YES (premium to realize capital gains and pay taxes)

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24
Q

What are three different methods of share repurchases?

A

1) Open market repurchase
2) Fixed price tender offer
3) Dutch auction tender offer

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25
Q

What happens in an open market repurchase?

A
  • Co. announces plan to repurchase # shares over time period
  • Firm buys desired # of shares using “standard” market transactions
  • No obligation for firm to purchase the shares
  • S/H approval is required in some countries
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26
Q

What is the most common method of share repurchase?

A

Open market repurchase

27
Q

What is usually the effect on stock price from an open market share repurchase?

A

Stock price increases 2-3% on average

28
Q

What are open market share repurchases normally used for?

A

Smaller repurchases

29
Q

Why does the SEC limit the number of shares a company can repurchase to a max of 15% of average daily volume?

A

To prevent price manipulation

30
Q

What is the most important issue we need to understand with the different methods of share repurchases?

A

Whether the firm is signaling something to the market (or not)

31
Q

What happens in a fixed price tender offer?

A
  • Firm offers to buy a specified # of shares at a specified fixed price during a specified time period
32
Q

In a fixed price tender offer, if more than the max # of shares are tendered, how are shares acquired?

A
  • Shares acquired on a pro rata basis
33
Q

What is typically the premium on fixed price tender offers?

A

20% premium over market

34
Q

What is usually the effect on stock price from a fixed price tender offer?

A
  • Stock price rises 11% when announced (good for signalling purposes)
35
Q

What happens in a dutch auction tender offer?

A
  • Co. specifies # of shares it wants to buy and the price range for S/Hs bids (S/Hs indicate at which price they want to sell)
36
Q

Is the premium paid on dutch auctions higher than fixed price tender offers?

A

No, it’s lower at 13% (as opposed to 20% for fixed price tender offers)

37
Q

What is usually the effect on stock price from a dutch auction?

A

Stock price increase on average = 8%

38
Q

In a dutch auction, what is the repurchase price set at?

A
  • The lowest price that allows the firm to acquire the desired # of shares (lowest price that meets quantity requirement = applied to all shares offered for sale at that price or less)
39
Q

How do companies manage payout policy (Lintner 1956)?

A
  • Few companies have fixed/stable dividend payout ratio
  • Managers avoid increasing dividends if there is a possibility that decision will need to be reversed (as a result, dividend changes are smaller than change implied by the dynamics of earnings; managers “smooth” dividends, transitory earnings are ignored, LR shifts are reflected)
40
Q

What are four possible determinants of firms’ payout policies?

A

1) Transaction costs
2) Taxes
3) Signalling
4) Agency Theory/Other

41
Q

Do transaction costs have a relevant impact on payout policy?

A

Unclear whether transaction costs are having a relevant impact in terms of payout policy

42
Q

Do taxes have a relevant impact on payout policy?

A
  • YES
  • Taxes have an important effect on dividend policy and on choice b/w dividends and stock repurchases
  • Differences in taxes explain part of international differences in dividend policy (dividend payments and capital gains are taxed differently in most countries)
  • Overall, there is a tax advantage for share repurchases
43
Q

The longer a sale is deferred, the lower the what?

A

Lower effective tax rate will be

44
Q

Firms with higher dividend payout ratios will tend to attract what type of investors?

A

Relatively more institutional investors than firms with low dividend payout ratios

45
Q

Low dividend stocks attract what type of investors?

A

High tax individuals (rich people)

46
Q

Dividends are not preferred per se, but dividends provide what to whom?

A
  • Info to capital markets (dividends serve to communicate info that managers know to S/Hs)
  • In other words, signalling
47
Q

What did the empirical evidence on dividends from US firms suggest?

A
  • Investors like it when firms start paying dividends and really hate it when they stop doing it
48
Q

If a less profitable firm pays large dividends then, given its low earnings, it will eventually have to do what?

A
  • Cut dividends and get strongly penalized
  • Give up important projects b/c of lack of funds, thus making itself even less profitable
  • Issue equity to finance dividends (inefficient b/c must pay transaction costs for the issue and very suspicious)
  • Borrow to finance dividend (problem b/c creditors would demand reduction in payout ratio)
49
Q

Can signalling and trade-off arguments also be applied to stock repurchases?

A
  • YES
  • But dividends carry more weight b/c they are not likely to be cut in the future (recurring as opposed to one-time for stock repurchases)
50
Q

Payout policy is an alternative to debt for what?

A

Reducing FCF

51
Q

There are tax advantages of payout out vs. keeping cash internally and investing in T-bills. These tax advantages depend on what?

A

Investors’ tax rates

52
Q

For it to be optimal for a firm to keep cash, it must be able to do what?

A

Create value with it (e.g. have positive NPV projects)

53
Q

In the case of financial distress, what is the benefit of cash?

A

Reduces expected costs of financial distress

54
Q

Dividend payments and share repurchases leave management with less money to waste in what?

A
  • Poor acquisitions and neg. NPV projects
55
Q

What is the most effective signalling device? Why?

A

Dividends

  • Require commitment for the future
  • Co. will not start paying high dividends unless it believes it can sustain those payments (at least for a while)
56
Q

What is the most effective signalling device in regards to share repurchases? Expand.

A
  • Fixed price tender
  • If shares are bought @ a premium, then firm is signalling that shares are even worth more
  • Disadvantage: pay more for same # of shares
57
Q

What is the second most effective signalling device in regards to share repurchases? Expand.

A
  • Dutch auction

- Weaker signal than fixed price but pay less for shares

58
Q

What is the weakest signalling device in regards to share repurchases? Expand.

A
  • Open market share repurchases

- Lowest price but weakest signal

59
Q

Since dividends are tax inefficient, firms should only use share repurchases. True or False. Expand.

A

False.

  • Firms are “prohibited” from using share repurchases as a substitute for dividend payments
  • If firms use share repurchases regularly, they will be taxed as though they’re dividends
  • Legally, share repurchases should only be used to distribute extraordinary surplus CF and not on a regular-basis as dividend payments (difficult to enforce)
60
Q

What is the effect of a share repurchase in terms of concentration of ownership?

A
  • Share repurchases increase stock ownership of equity holders who don’t sell
  • This contributes to better alignment of incentives of management
61
Q

What is the effect of a share repurchase in terms of protection against hostile takeovers?

A
  • Concentrating ownership makes takeovers more difficult
  • Successfully signalling the true value of the firm when it is undervalued (e.g. repurchasing shares at a premium)increases cost of a takeover, and therefore reduces its probability
62
Q

Dividend policy in an MM world is irrelevant, but can matter if what?

A

If the standard assumptions fail

63
Q

With asymmetric info, dividend decisions are often viewed as what?

A

Signals from the co. (healthier firms can afford to pay higher dividends but doing so ties up cash)

64
Q

What does the Free Cash Flow Hypothesis state?

A
  • Managers are empire builders

- Dividends are a way to get money back to investors

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