Chapter 15:
Payout Policy
Corporate Finance, 3e
Graham, Smart, and Megginson
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Payout Policy Fundamentals

A firm’s payout policy refers to the choices its
managers make about distributing cash to shareholders.



Whether to pay shareholders a regular (recurring) cash dividend
How large the cash dividend should be
How frequently it should be paid

The dividend payout ratio, calculated by dividing the
cash dividend per share by its earnings per share,
indicates the percentage of its profits that a firm
distribute to its owners.

The dividend yield, which equals a stock’s dividend
divided by its price, measures the rate of return
represented by the dividend payment.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Cash Dividend Payment
Procedures

In the U.S., as in most countries, shareholders
have no legal right to receive dividends.

Instead, a firm’s board of directors decides what
dividends the firm will pay.

Most U.S. firms that pay dividends do so once
every quarter.

The most common practice is to adjust the
dividend once per year.
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Relevant Dividend Dates




Shareholders of record are entitled to the
dividend.
Because it takes time to make bookkeeping
entries after stocks trade, investors who buy
stock on the record date will miss the
dividend payment.
To receive the dividend, an investor must
own the stock before the ex-dividend date,
usually two business days prior to the date of
record.
Firms distribute dividends on the payment
date, which usually comes a few weeks after
the record date.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Other Forms of Dividends

Firms sometimes declare one-time special
dividends after an unusually profitable year or a
large infusion of cash (e.g., from an asset sale).

Stock dividends
 Additional

shares of stock rather than cash
Stock splits
 Share
price declines because the number of
outstanding shares increases (e.g., 2-for-1, 3-for-2,
3-for-1).
 Reverse stock splits replace a certain number of
outstanding shares with just one new share.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Dividend Trends: Share
Repurchase Programs

Repurchase programs: companies can buy
back some of their own shares, usually through
open-market purchases.

Share repurchases give managers an alternative
method to distribute cash to shareholders.

The annual value of share repurchases in the
United States sometimes exceeds that of
dividends, and investors clearly welcome
repurchase announcements.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Methods to Repurchase Shares
 Open-market
share repurchase: Firms buy
back their shares in the open market.
 Tender
offer, or self-tender: Firms offer to
buy back a certain number of shares,
usually at a premium above the current
market price.
 Dutch
auction repurchase: Firms ask
investors to submit prices at which they
are willing to sell their shares.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
The Conservative View of Dividends
1. Firms have long-run target dividend payout
ratios.
2. Dividend changes follow shifts in long-run,
sustainable earnings (not short-run changes in
earnings).
3. Managers are reluctant to increase dividends if
they might have to be cut later.
4. Managers focus on dividend changes rather
than on dividend levels.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Evidence on Payout Policy

Firms maintain constant nominal dividend
payments per share for significant periods of
time.

Whereas the number (and fraction) of publicly
traded companies that pay dividends has been
declining since roughly the 1970s, the aggregate
payout ratio of the U.S. corporate sector has
been increasing.

Investors react positively to dividend (and share
repurchase) initiations and increases but react
negatively to dividend decreases or eliminations.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Dividend Irrelevance in a World
With Perfect Capital Markets
 Miller
and Modigliani demonstrated that in
a world of frictionless capital markets,
payout policy cannot affect a firm’s value.
 As
long as the firm accepts all positiveNPV investment projects and has costless
access to capital markets, it can pay any
level of dividends it desires.
 If
payout policy does affect firm value, it
must be because markets are imperfect.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Dividends, Repurchases, and
Taxes

Dividends are normally taxed at an individual’s
ordinary income tax rate.

Income from repurchases may be taxed at a
lower long-term capital gains rate, and then
only if the investor chooses to sell shares back
to the company.

This encourages firms to shift payout away
from dividends and toward repurchases.
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Agency Cost Model of Dividends
 Agency
cost/contracting model of
dividends
 Assumes
that firms begin paying to overcome
the agency problems resulting from a
separation of corporate ownership and control
 Privately-held
vs. public firms
 Predicts
that dividend payers are older,
larger firms that generate more cash and
have fewer growth opportunities
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Agency Cost Model of Dividends
 If
we compare U.S. firms that pay
dividends with firms that do not, we find
that
 (1)
the average market value of dividend
payers is much greater than that of nonpayers
and
 (2) payers grow much more slowly. The
average age of dividend payers is more than
twice the average age of nonpayers.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Signaling Model
 The
signaling model of dividends assumes
that managers use dividends to convey
positive information to poorly informed
shareholders.
 Like
the agency cost model, the signaling
model predicts that stock prices should
rise (fall) in response to dividend increases
(cuts).
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Catering Theory
 The
catering theory of dividends predicts
that corporate managers cater to investor
preferences by…
 paying
dividends when investors assign a
premium to dividend-paying stocks, and
 not paying when investors assign a discount
to dividend payers.
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Payout Policy: Key Lessons

Firms take a conservative approach to dividends.

The key factor driving dividend payments is the
stability of long-run cash flows.

Dividends are smoothed and do not vary as
much as earnings from year to year.

Firms are reluctant to reduce dividends once
they begin paying them.

Managers view share repurchases as more
flexible.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.