E2: Payout policy

Question 1

What 3 qs must a financial manager ask themselves before deciding if cash is surplus and payout to shareholders can be exercised?

Answer 1

1. is company generating enough sustainable cash flow
2. is the firm’s debt ratio prudent
3. is there enough cash reserve in case of unexpected shocks etc

Question 2

What are the two ways companies can pay cash to their shareholders?

Answer 2

• paying a dividend
• buying back some of the company’s stock (repurchases)

Question 3

Define the process in which dividends are paid

Answer 3

1. board sets dividend
2. they announce date of payment
3. stock falls day before to pay dividend and they are mailed to shareholders

Question 4

Name the 4 types of dividend

Answer 4

• cash dividend: regular payment to each shareholder
• extra/ special cash dividend: one-off irregular payment
• Automatic dividend reinvestment plans (DRIPs): new shares issued at discounted price
• stock dividends: issues additional shares instea of cash

Question 5

How can firms repurchase stocks?

Answer 5

• buy them on the open market
• private negotiation with major shareholders
• fixed price offer to shareholders
• dutch auction

Question 6

What does the announcement of a dividend increase tend to mean?

Answer 6

• signals managers are confident in future prices
• signals managers are confident the cashflows are stable

prompts shareprice increase

Question 7

Is a cut in dividend payment always bad?

Answer 7

No, sometimes shareholders see it as an advantage as companies protect themselves from macroeconomic uncertainty by saving money on dividends.

-> eg Harley Davidson April 2020, cut D by 95% and the stock rose 15% (pandemic)

shows good financial management

Question 8

What do stock repurchases signal?

Answer 8

• managers believe the stock is currently undervalued

subsequent share price rise follows

Question 9

What do MM believe in reference to payout policy?

Answer 9

In a world without taxes, market imperfections, inefficiencies and transaction costs -> dividend policy is value irrelevant

therefore investors should be indifferent to payout policy

Question 10

In MM’s scenario, does the investors wealth change if a firm decides to spend surplus cash on dividends or repurchases ?

Answer 10

no, a repurchase doesn’t increase the stock price but avoids fall in stock price when D is paid. If dividend is paid then same shares outstanding so share price + D is same wealth.

Question 11

What happens to old shareholders and the firm if they increase D to the point they have to reissue new shares to raise money ?

MM scenarios

Answer 11

• old shareholder’s suffer a capital loss as share price drops, however it is offset by the higher dividends
• firm value stays same

-> shareholders indifferent to higher D!!!

Question 12

What causes the transfer of value between old and new shareholders?

Answer 12

• dilution in the value of each share as more are issued

Question 13

Challenges of MM payout-policy prop.?

Answer 13

1. Market is inefficient
2. trading in SE is costly
3. agency costs (managers prefer to reinvest into business, shareholders prefer profit)
4. dividends are taxed more heavily than cap. gains so D may be minimised

Question 14

What are the three main views of payout policy?

Answer 14

• D are preferred
• Repurchases are better
• MM: payout is irrelevant

Question 15

How do you calculate the opportunity value of a rights offering?

Answer 15

Opportunity value = (rights on price – issue price) / (N + 1)

Question 16

When there is a project NPV involved, how should you calculate share price?

Answer 16

M + m

Question 17

When a new D is announced and a firm needs to raise funds, how can you work out how many shares are needed to be issued?

Answer 17

(Difference between Ds x outstanding shares) / ex-D share price