Payout Policy
Pages 434-441, Sections 15.3 and 15.5
1
Paying out Cash to Shareholders
• How much cash to be paid out?
• In what way?
– Stock repurchase or cash dividend?
– Are stock repurchases similar to cash
dividends?
• Or, are stock repurchases only transactions
between the company and shareholders?
2
How much? See Figure 1.2
3
Miller and Modigliani
How much cash to be paid out to stockholders
depends on capital budgeting as well as debt
policy
▪ Some firms pay out little cash because they retain
more earnings for expansion.
▪ Some firms pay out much cash because they finance
expansion by more borrowing.
Firms should invest in all +NPV projects, have
“optimal” debt-to-equity ratios (see later notes),
and pay out cash left behind
• Residual dividend policy is the best, assuming
perfect market
4
Residual Dividend Policy
• E.g.:
o Need $5 million for new projects (+NPV)
o Target capital structure: D/E = 2/3
o Net Income = $4 million
• Calculate dividend:
o 40% projects to be financed with new debt ($2 million)
o 60% projects to be financed with new equity ($3 million)
o Net Income – equity needed = $1 million, to be paid out
as dividend (or SR)
• $3 million becomes the increase in retained earnings at the
end of this year; $2 million new bonds to be issued
5
MM: Perfect Market Assumptions
1. No personal or corporate income taxes.
2. No transaction costs or stock issuance
costs.
3. Strong-form efficient market
We will later relax the above assumptions…
6
MM: “Dividend policy is …”
• Given residual div policy, the remaining
question is only about cash dividend
versus stock repurchase
– Which one?
7
Cash dividend or stock repurchase?
• Cash dividend
o #shares outstanding constant, whereas cash
balance decreases on ex-dividend date
o Stock price as well as (assets – liab) per share
decreases on ex-dividend date
• DPS = difference between cum-dividend stock price
and ex-dividend stock price.
8
Cash dividend or stock repurchase?
• Stock Repurchase (SR)
o #shares outstanding and cash balance decrease on
a day when shares are repurchased
o Assuming perfect market:
▪ Symmetric information
▪ (Assets – liab) per share does not change and stock price
does not change when SR
▪ %ownership of a shareholder will decrease if he sells some
of his shares to the company (so as to satisfy his cash need)
‒ this does not matter to him or the company (which is widely
held), as long as the SR price is fair
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The original mkt cap
Price per share
P0
D0
Q0
Q
10
Mkt cap after SR
Price per share
P0
DSR
Q0-Q1=SR
Q1 Q0
Q
11
The black and red rectangles have the same area (mkt cap)
Price per share
P0-P1=DPS
P0
P1
DSR
DCD
Q1 Q0
Q0-Q1=SR
Q
12
Cash dividend or stock repurchase?
• Cash dividend versus stock repurchase
▪ Total equity as well as (assets - liab)
decreases by the amount of cash paid out,
only #shares outstanding and (assets - liab)
per share differ across these 2 mechanisms
▪ The equity beta and E(rE) are the same for
these 2 mechanisms
▪ E(rE) can be split into dividend yield and
capital gains yield
oIn the long run, only a trade-off between
dividend yield and capital gains yield
13
MM: “Dividend policy is irrelevant”
• Given residual div policy, the remaining
question is only about cash dividend
versus stock repurchase
– Which one?
– Doesn’t matter, if perfect market.
• Thus, given optimal capital budgeting
policy and borrowing policy, how much
to pay and how to pay become trivial
questions in perfect market.
14
MM: Perfect Market Assumptions
1. No personal or corporate income taxes.
2. No transaction costs or stock issuance costs.
3. Strong-form efficient market
Residual div. policy will lead to time-varying cash
paid by companies to shareholders
Cash dividend and share repurchase should be
equally likely
Do we observe these in the real world?
15
Figure 15.1 Dividends and Stock Repurchases by
Nonfinancial Companies in the United States, 1985-2020
16
US nonfinancial firms, 2011-2020
17
Cash dividend vs. share repurchase
❑Today, share repurchase seems a bit
more common than cash dividend in US
❑Total payout has changed over time, but
dividends have been much more stable
than share repurchase
– Regular dividend
– Share repurchase is irregular (see a later
slide)
❑In US, given the tax disadvantages, why
regular cash dividends?
18
A market imperfection: Taxes
• US:
– Shareholders pay: dividend income tax >
capital gains tax
▪ The total cash flows from a share to the
shareholder (after-dividend-tax dividends plus
after-capital-gain-tax selling price) will be higher
if companies repurchase more and pay less
dividends
19
A market imperfection: Taxes
• HK
– Zero tax on dividend income or capital gains
– Mechanisms for cash dividend are simple
– Stock repurchase mechanisms are
cumbersome (see later slides), so not
common
20
USA: 2003 (President Bush)
• In May 2003, he reduced the
maximum tax rate on dividends
income from 38.6% to 15%
▪ 15% = maximum tax rate on capital gains
before and after 2003
• Note that capital gains are taxed
when realized → PV(cg tax) <
PV(div tax)
21
Presidents Obama, Trump, and Biden
• In Jan 2013, Obama increased max
dividend tax rate and max capital
gains tax rate from 15% to 23.8%
• In Jan 2018, Trump cut corporate
tax rate and individual ordinary
income tax rate (to be discussed later), but
not the max dividend tax rate and
max capital gains tax rate
• Biden hasn’t made changes
22
Cash dividend vs. share repurchase
❑Today, share repurchase seems a bit
more common than cash dividend in US
❑Total payout has changed over time, but
dividends have been much more stable
than share repurchase
– Regular dividend
– Share repurchase is irregular (see a later
slide)
❑In US, given the tax disadvantages, why
regular cash dividends?
23
Regular Dividend & Clientele Effect
• Some investors like stocks that offer low regular
dividend (usually called growth stocks)
– E.g., individuals with higher income tax rates
• Other investors like stocks that offer high regular
dividend (usually called income stocks)
– E.g., tax-exempt investors such as retirees and pension
funds (regarded as imprudent to buy stocks with 0 div record)
• Firms should not suddenly switch from being
income stocks to growth stocks or vice versa
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MM: Perfect Market Assumptions
1. No personal or corporate income taxes.
2. No transaction costs or stock issuance
costs.
3. Strong-form efficient market
Residual div policy will lead to time-varying
payouts, which shareholders understand
and agree
25
Residual Dividend Policy
• E.g.:
o Need $5 million for new projects (+NPV)
o Target capital structure: D/E = 2/3
o Net Income = $4 million
• Calculate dividend:
o 40% projects to be financed with new debt ($2 million)
o 60% projects to be financed with new equity ($3 million)
o Net Income – equity needed = $1 million, to be paid out
as dividend (or SR)
• $3 million becomes the increase in retained earnings at the
end of this year; $2 million new bonds to be issued
What if Net Income is only $0.5m? No cash to be paid out,
and the company will need to issue new shares of $2.5m
(“negative stock repurchase” using general cash offer).
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Dividend and Signaling
• Information asymmetry: the market is not strongform efficient, and investors may not believe in a
beautiful story told by managers
• Changes in regular dividend per share convey
information (a credible signal)
– If dividend decreases, the stock market may think:
• Management believes it can no longer sustain the current level
of dividends
– Expectation of lower or more volatile future net income
• Signal of a firm that may have financial difficulties
– If dividend increases, the stock market may think:
• Management believes it can be sustained
– Expectation of higher or less volatile future net income
• Signal of a healthy, growing firm
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Information content of dividends
❑Event study by Healy and Palepu, 1988
– companies that made a first dividend payment between
1970 and 1979
• experienced flat earnings growth until the year before
announcement of first div
• in that year earnings grew by average 43%
• earnings grew by further 164% over next 4 years
• average CAR of 4% on announcement of dividend initiation
– Cut in dividend
• Stock price fell on average 9.5% on announcement
• Net income fell in the following four quarters
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Residual Dividend Policy
• MM’s assumption of perfect market is
not valid in the real world
▪ Time-varying payout will lead to problems
(disturbing the clientele and sending out a
misleading signal)
• Residual div policy should be carried
out in the long run, not in the short run
▪ E.g., determining the long-run regular
dividend
• In the short-run, compromise dividend
policy
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Compromise Dividend Policy
• A company should avoid cutting regular dividend even
if residual div policy suggests a need to cut div in a
year
• In the example of residual div policy calculation: What
if Net Income is only $0.5m?
• Rank in order of importance (the lower goals can be
deviated in the short run):
–
–
–
–
–
Avoid cutting back on +NPV projects
Avoid cuts in regular dividend per share
Avoid the need to issue new equity
Maintain a target debt/equity ratio
Maintain a target dividend payout ratio
30
Compromise Dividend Policy
• A company should avoid cutting regular dividend even
if residual div policy suggests a need to cut div in a
year
• In the example of residual div policy calculation: What
if Net Income is only $0.5m?
• Borrow $5m, pay out $0.5m dividend
– The company may borrow more than $5m and pay out
more than $0.5m dividend
• This may be done this year, but should not be
repeated for several years…
31
Compromise Dividend Policy suggests:
• A newly listed company should start with zero or low
regular dividend
• Keep some cash reserves as buffer for future years
by retaining more Net Income than a residual
dividend policy would suggest
• Having a lot of residual cash in a year, a company
may issue special dividend (or repurchase shares),
but not significantly increase regular dividend
• Remark: what’s impact of special dividend versus
increase in regular dividend?
32
Stock repurchase:
Stock price effect in imperfect market
• Announcement of unexpected stock repurchase is often
accompanied by an increase in stock price.
– Why?
– Signaling?
• No, stock repurchase is flexible or irregular, and may not be
repeated in the future.
• The actual reason for the increase in stock price:
– Information asymmetry (stock market timing by the company)
• Recent stock price < V estimated using inside information
• V per share re-estimated upwards by the market
33
After announcing share repurchase
Price per share
P1
P0
Q0
Q
34
After share repurchase is finished
Price per share
P1
P0
Q1 Q0
Q
35
Stock Repurchase: Mechanism 1
• The company submits buy orders to the stock
exchange to match with sell orders of
shareholders
• Common in US (infrequent in HK)
• In the beginning of a year, a company may announce
the Q of stock repurchase for the coming year
• In US, the average CAR (on the announcement) is about
2%
• Usually, Q actually repurchased during the year < Q of
repurchase announced in the beginning of the year
• Irregular share repurchase
• According to regulations, in a day, repurchases cannot
exceed a small fraction of trading volume, and the
repurchase price cannot be much higher than the recent
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market price
Stock Repurchase: Mechanism 2
• Tender Offer
• Less common than mechanism 1 in US (never
observed in HK)
• A company announces repurchase Q and P
(often 20% higher than the recent market price)
• Stockholders, who choose to participate, send their
shares back to the company, which then sends out
cheques
• In US, the average CAR on tender offer
announcements is about 11%
• Why higher than 2% (mechanism 1)?
• Why lower than 20%? Arbitrage opportunities?
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