SW9: Payout Policy
Definition: the way a firm chooses the alternative ways to distribute free cash flow to equity
Dividends:
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Declaration Date: The date on which the board of directors authorizes the payment of a
dividend
Record Date: When a firm pays a dividend, only shareholders on record on this date receive
the dividend
Ex-dividend Date: A date, two days prior to a dividend’s record date, on or after which
anyone buying the stock will not be eligible for the dividend
Payable Date (Distribution Date): A date, generally within a month after the record date, on
which a firm mails dividend checks to its registered stockholders
Special Dividend: one time payment a firm makes much larger than a regular dividend
Stock Split: when a company issues a dividend in shares of stock rather than cash to its
shareholders
Share repurchases:
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The firm uses cash to buy shares of its own outstanding stock.
Open Market Repurchase: When a firm repurchases shares by buying shares in the open
market
o Open market share repurchases represent about 95% of all repurchase transactions.
Tender Offer: A public announcement of an offer to all existing security holders to buy back
a specified amount of outstanding securities at a prespecified price (typically set at a 10% to
20% premium to the current market price) over a prespecified period of time (usually about
20 days)  If shareholders do not tender enough shares, the firm may cancel the offer, and
no buyback occurs.
Dutch Auction: A share repurchase method in which the firm lists different prices at which it
is prepared to buy shares, and shareholders in turn indicate how many shares they are
willing to sell at each price. The firm then pays the lowest price at which it can buy back its
desired number of shares
Targeted Repurchase: When a firm purchases shares directly from a specific shareholder –
Greenmail: When a firm avoids a threat of takeover and removal of its management by a
major shareholder by buying out the shareholder, often at a large premium over the current
market price
Comparison of Dividends and Share Repurchases(Example)
Modigliani-Miller and Dividend Policy Irrelevance
- Trade off between current and future dividens.
 Current higher dividend= future dividends are lower
Dividend irrelevance: in a perfect capital markets, the
firms choice of dividend policy is irrelevant and doesn’t
affect the initial share price
Tax Disadvantage of Dividends:
- Shareholders pay taxes on dividends they receive and
pay capital gains taxes when they sell their shares
- Dividend taxes are normally higher than capital gains
- Taxes on Dividends and Capital Gains
o The higher tax rate on dividends makes it undesirable
for a firm to raise funds to pay a dividend When
dividends are taxed at a higher rate than capital gains, if
a firm raises money by issuing shares and then gives that
money back to shareholders as a dividend, shareholders are hurt because they will
receive less than their initial investment.
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Optimal Dividend Policy with Taxes
If tax rate on dividends is greater than tax rate on capital gains, shareholders will pay lower
taxes if a firm uses share repurchases tax savings increase the value of the firm then
Optimal dividend policy: dividend tax rate exceeds the capital gain tax rate is to pay no
dividends payments of dividends has declined
Tax rates very by income, jurisdiction etc maybe different investor groups are attracted
Effective Dividend Tax rate:
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Consider buying a stock just before it goes ex-dividend and selling the stock just after.
The equilibrium condition must be
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The effective dividend tax rate is:
Clientele Effects
When the dividend policy of a firm reflects the tax preference of its investors clientele
Dividend Capture Theory:
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Investors can trade shares at the time of the dividend so that non-taxed investors receive the
dividend large trading volume in a stock around the ex-dividend day
Payout vs Retention of Cash
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Perfect capital markets: Once a firm has all positive NPV investments, it is indifferent
between saving excess cash and paying it out
Market imperfections: trade-off, retaining cash can reduce costs of raising capital in the
future but can also increase taxes and agency costs
Retaining Cash with Perfect Capital Markets
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If a firm has already taken all positive NPV projects, any additional projects are zero or
negative NPV investments the firm should use the cash to purchase financial assets
 In a perfect capital market, buying and selling securities is a zero NPV transaction so it
shouldn’t affect the firm value retention versus payout decision is irrelevant
Corporate taxes make it costly for a firm to retain excess cash equal to negative leverage
Adjusting for Investor Taxes
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Decision to pay out vs retain may also affect the taxes paid by shareholders
o When a firm retains cash, it must pay corporate tax on the interest it earns. In
addition, the investor will owe capital gains tax on the increased value of the firm. In
essence, the interest on retained cash is taxed twice
If the firm paid the cash to its shareholders instead, they could invest it and be taxed only
once on the interest that they earn.
o The cost of retaining cash therefore depends on the combined effect of the
corporate and capital gains taxes, compared to the single tax on interest income.
Issuance and Distress Costs
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Firms retain cash balances to cover potential future cash shortfalls, despite tax disadvantage
Cost of holding cash to cover future potential needs should be compared to the reduction in
transaction, agency and selection costs of raising new capital through new debt
Agency (buying or selling for the account and risk of customer) costs of retaining cash
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Firms should choose to retain to help with future growth opportunities to avoid distress
costs
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Dividend smoothing
o Practice of maintaining relatively constant dividends infrequent dividend changes
Dividend Signaling
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Signaling hypothesis:
o Idea that dividend changes reflects managers’ views about a firm’s future earning
prospects if dividends are smoothed, the choice will contain info regarding
management’s expectations of future earnings
Increased dividends= positive signals to investors and vice versa
Share repurchases: credible signal that shares are underpriced because if they are
overpriced, a share repurchase is costly for current shareholders
Stock Dividends, Splits and Spin offs
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Stock dividends and Splits:
o With a stock dividend, a firm does not pay out any cash to shareholders.
o As a result, the total market value of the firm’s equity is unchanged. The only thing
that is different is the number of shares outstanding. The stock price will therefore
fall because the same total equity value is now divided over a larger number of
shares
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Stock dividends aren’t taxed no real consequence
Number of shares is increased, and price is proportionally reduced—> no change in value
Share price is in a range thought to be attractive to small investors
On average, announcements of stock splits are associated with a 2% increase in the stock
price
reverse split: when stock falls to low so company reduces the number of outstanding shares
Spin off: when a firm sells a subsidiary by selling shares in the subsidiary alone avoids
transaction costs and special dividend is not taxed as a cash distribution
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