Chapter 16
Principles of
Corporate Finance
Tenth Edition
Payout Policy
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Topics Covered
 Facts About Payout
 How Firms Pay Dividends and Repurchase Stock
 How Do Companies Decide on Payouts?
 Information in Dividends and Stock Repurchases
 The Payout Controversy
 The Rightists
 Taxes and the Radical Left
 The Middle of the Roaders
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Payout Policies
16-3
Dividend & Stock Repurchases
U.S. Data 1980 - 2008
1200
1000
Dividends
Repurchases
Remaining earnings
600
400
200
0
-200
-400
-600
-800
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
$ Billions
800
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16-5
Dividend Payments
April 15, 2009
May 11, 2009
Exxon Mobil
declares regular
quarterly dividend
of $.42 per share.
Shares start to
trade ex dividend.
Declaration
Date
Ex-dividend
Date
May 13, 2009
Dividend will be paid
to shareholders
registered
on this date.
Record
Date
June 10, 2009
Dividend checks
are mailed
to shareholders.
Payment
Date
Types of Dividends
Cash Dividend
Regular Cash Dividend
Special Cash Dividend
Stock Dividend
Stock Repurchase (4 methods)
1. Buy shares on the market
2. Tender Offer to Shareholders
3. Dutch Auction
4. Private Negotiation (Green Mail)
16-6
Dividend Payments
Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.
Record Date - Person who owns stock on this
date received the dividend.
16-7
Dividend Payments
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Stock Splits - Issue of additional shares to
firm’s stockholders.
Stock Repurchase - Firm buys back stock
from its shareholders.
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16-9
The Payout Decision
Dividend Decision Survey (2004)
The cost of external capital is lower than the cost of a
dividend cut
Rather than reducing dividends we would raise new funds
to undertake a profitable project
We consider the change in the dividend
We are reluctant to make a change that may have to be
reversed
We look at the current dividend level
We try to maintain a smooth dividend stream
We try to avoid reducing the dividend
0
10
20
30
40
50
60
70
80
Executives who agree or strongly agree (%)
90
100
The Payout Decision
16-10
Lintner’s “Stylized Facts,”
as updated by Brav, Graham, Harvey, Michaely (2004)
1. Managers are reluctant to make dividend changes that may have to be
reversed. They are particularly worried about having to rescind a
dividend increase and, if necessary, would choose to raise new funds to
maintain the payout.
2. To avoid the risk of a reduction in payout, managers smooth” dividends.
Consequently, dividend changes follow shifts in long-run sustainable
earnings. Transitory earnings changes are unlikely to affect dividend
payouts.
3. Managers focus more on dividend changes than on absolute levels. Thus
paying a $2.00 dividend is an important financial decision if last year’s
dividend was $1.00, but no big deal if last year’s dividend was $2.00.
Information in Payouts
 Dividends and stock repurchase decisions contain
information
 The information contained in the decisions varies
 Asymmetric information may be conveyed
 Dividend increases could mean overpriced stock
or increased future profits
 The signal varies based on prior information about
the company
16-11
Information in Payouts
Attitudes concerning dividend targets vary
DIV1  target dividend
 target ratio  EPS1
Dividend Change
DIV1 - DIV0  target change
 target ratio  EPS1 - DIV0
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Information in Payouts
16-13
Dividend changes confirm the following
DIV1 - DIV0  adjustment rate  target change
 adjustment rate  target ratio  EPS1 - DIV0 
Dividend Policy
Before
Dividend
After
Dividend
Total value of firm
New
stockholders
Each share
worth this
before …
Total number
of shares
… and
worth
this
after
Old
stockholders
Total number
of shares
Example of 1/3rd of worth paid as dividend and raising money via new shares
16-14
16-15
Dividend Policy
Shares
Dividend financed
by stock issue
No dividend, no
stock issue
New stockholders
New stockholders
Cash
Firm
Cash
Shares
Cash
Old stockholders
Old stockholders
Dividend Policy is Irrelevant
Since investors do not need dividends to
convert shares to cash they will not pay
higher prices for firms with higher dividend
payouts. In other words, dividend policy
will have no impact on the value of the firm.
16-16
Dividend Policy is Irrelevant
16-17
Example - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.
Using M&M Theory, and given the following balance sheet information,
show how the value of the firm is not altered when new shares are issued to
pay for the dividend.
Record Date
Cash
1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV
2,000
# of Shares
1,000
price/share
$12
Dividend Policy is Irrelevant
16-18
Example - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.
Using M&M Theory, and given the following balance sheet information,
show how the value of the firm is not altered when new shares are issued to
pay for the dividend.
Record Date
Cash
1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV
2,000
# of Shares
1,000
price/share
$12
Pmt Date
0
9,000
9,000
2,000
1,000
$11
Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.
Using M&M Theory, and given the following balance sheet information,
show how the value of the firm is not altered when new shares are issued to
pay for the dividend.
Record Date
Cash
1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV
2,000
# of Shares
1,000
price/share
$12
Pmt Date
0
9,000
9,000
2,000
1,000
$11
Post Pmt
1,000 (91 sh @ $11)
9,000
10,000
2,000
1,091
$11
NEW SHARES ARE ISSUED
16-19
Dividend Theories
Leftists (M&M) - Dividend does not effect value
Rightists - Dividends increase value
Middle of the roaders - Leftist theory with some
reality thrown in.
Residual Dividend Policy
16-20
Dividends Increase Value
Market Imperfections and Clientele Effect
There are natural clients for high-payout stocks,
but it does not follow that any particular firm can
benefit by increasing its dividends. The high
dividend clientele already have plenty of high
dividend stock to choose from.
These clients increase the price of the stock
through their demand for a dividend paying stock.
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Dividends Increase Value
Dividends as Signals
Dividend increases send good news about cash
flows and earnings. Dividend cuts send bad news.
Because a high dividend payout policy will be
costly to firms that do not have the cash flow to
support it, dividend increases signal a company’s
good fortune and its manager’s confidence in
future cash flows.
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Dividends Decrease Value
Tax Consequences
Companies can convert dividends into capital
gains by shifting their dividend policies. If
dividends are taxed more heavily than capital
gains, taxpaying investors should welcome such a
move and value the firm more favorably.
In such a tax environment, the total cash flow
retained by the firm and/or held by shareholders
will be higher than if dividends are paid.
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Taxes and Dividend Policy
Since capital gains are taxed at a lower rate
than dividend income, companies should
pay the lowest dividend possible.
Dividend policy should adjust to changes in
the tax code.
16-24
Taxes and Dividend Policy
16-25
Firm A
Firm B
Next year' s price
(no dividend)
112.50
(high dividend)
102.50
Dividend
0
10
Total pretax payoff
112.50
112.50
Today' s stock price
100
97.78
Capital gain
12.50
4.72
Pretax rate of return (%)
12.5
100
Tax on div @ 40%
Tax on Cap Gain @ 20%
Total After Tax income
(div  cap gain - taxes)
After tax rate of return (%)
 100  12.5
0
.20  12.50  2.50
(0  12.50)  2.50  10
10
100
 100  10.0
14.72
97.78
 100  15.05
.40  10  4.00
.20  4.72  0.94
(10  4.72)  ( 4  0.94)  9.78
9.78
97.78
 100  10.0
Taxes and Dividend Policy
In U.S., shareholders are taxed twice (figures in dollars)
Cash Flow
Operating Income
Corporate tax at 35%
After Tax income (paid as div)
Income tax paid by investors at 15.0%
Cash to Shareholder
100.00
35.00
65.00
9.75
55.25
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16-27
Taxes and Dividend Policy
Under imputed tax systems, such as that in Australia, Shareholders
receive a tax credit for the corporate tax the firm pays (figures in
Australian dollars)
Rate of Income tax
15%
Operating Income
Corporate tax (Tc=.30)
After Tax income
100
30
70
30%
100
30
70
Grossed up Dividend
Income tax
Tax credit for Corp Pmt
Tax due from shareholder
Cash to Shareholder
100
15
-30
-15
85
100
30
-30
0
70
47%
100
30
70
100
47
-30
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53
Web Resources
Click to access web sites
Internet connection required
www.earnings.com
www.ex-dividend.com
www.dripcentral.com
16-28