B9 Payout policy

Question 1

Use of Free Cash Flow

Answer 1

• *Retain**: Invest in new projects or increase cash reserves
• *Pay out**: Repurchase shares or pay dividends

Question 2

MM dividend irrelevance

Answer 2

In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price.
Old shareholder sell a portion of their shares to new stockholders, receiving cash -> Homemade dividend

Question 3

Dividends: tax consequences

Answer 3

If dividends are taxed more heavily than capital gains, taxpaying investors would welcome if firms convert dividends into capital gains. Thus, total CF retained will be higher than if dividends are paid

Question 4

Dividend clienteles

Answer 4

Preferences for share repurchases rather than dividends depend on the difference between dividend tax rate and capital gains tax rate
As tax rates vary by income, jurisdiction and whether stocks are held in retirement accounts, firms attract different groups of investors.

Question 5

Effective dividend tax rate

Answer 5

(PCUM-PEX)/D = (1-td)/(1-tg)
with td: dividend tax rate and tg: capital gains tax rate

Question 6

Why do firms pay dividends despite the tax disadvantage?

Answer 6

(1) Trusts and endowments: May be permitted to spend dividend income but capital gains would remain part of the endowment
Transaction costs for small investors: Selling small quantities of shares may be associated with a high fixed cost
(3) Lots of tax free investors (pension funds)
(4) taxation of intracompany dividends is complex, but tends to favor dividends over capital gains
(5)You can sell your stock temporarily to tax free entity and repurchase the stock cheaply after the dividend payment

Question 7

Dividends and stock returns / firm value

Answer 7

Dividends could signal information on the firm and increase firm value:
…if firms are opaque
…if dividends are a signl of management’s expectation of sustained earnings growth
evidence:
investors are concerned with a change in dividends but not with their level
Only good firms pay dividends,, because dividend payments attract institutional investors that monitor the performance of the firm more closely
Once a firm has decided to pay dividends and increased its ownership share of institutional investors, it is very costly to stop paying dividends
Share repurchases fluctuate over time and are not smooth, because these firms have shareholders „taxable individuals” that are unable to force out management

Question 8

Payout vs retention

Answer 8

In perfect capital markets: firm is indifferent (MM irrelevance)
With market imperfections: tradeoff, as retaining cash can reduce costs of raising capital in the future, but it can also increase taxes and agency costs

Question 9

Free cash flow theory (Jensen 1986)

Answer 9

Financial buffers prevent an efficient allocation of resources
— buffers are financial slack, inviting management to undertake (reversable) projects that have negative NPVs in order to keep the funds
— managers do not act in the interest of the shareholders -> agency costs
=> FCF should be distributed to shareholders who are able to re-invest the amounts in more profitable ventures

Question 10

Dividend signaling

Answer 10

Increasing dividends can signal both:
positive signal that management expects to be able to afford the higher dividend for the foreseeable future
negative signal that there is a lack of investment opportunities

Question 11

Signaling and share repurchases

Answer 11

Differences to signaling with dividends:

(1) managers are less committed to repurchases
(2) firms do not smooth repurchases
(3) costs of repurchase depends on stock price: credible signal that shares are underpriced as for overpriced stock a share repurchase is costly for current shareholders

Question 12

Summary Payout policy

Answer 12

(1) in absence of taxes and other frictions, dividend policy is irrelevant (MM theorem II)
(2) With taxes, firms should never pay dividends, unless there are „tax clienteles” that like dividends or the firm wants to signal its quality and attract shareholders that add value
(3) For asymmetric information about future prospects:
(a) costly to issue new equity (pecking order)
(b) financial buffer may be costly as investors are concerned about that managers may invest in bad projects (FCF theory)
(c) complete payout may prevent management from exploiting their superior knowledge (trade-off yields some optimal payout-ratio)