Chapter 14 Payout Policy. Copyright ©2015 Pearson Education, Inc. All rights reserved.14-2 The Basics of Payout Policy: Elements of Payout Policy The

Chapter 14

Payout Policy

Copyright ©2015 Pearson Education, Inc. All rights reserved. 14-2

The Basics of Payout Policy:Elements of Payout Policy

• The term payout policy refers to the decisions that a firm makes regarding whether to distribute cash to shareholders, how much cash to distribute, and the means by which cash should be distributed.

• Cash can be distributed as a dividend or through stock repurchase plans.


The Basics of Payout Policy:General Lessons

1. Rapidly growing firms generally do not pay out cash to shareholders.

2. Slowing growth, positive cash flow generation, and favorable tax conditions can prompt firms to initiate cash payouts to investors.

3. Cash payouts can be made through dividends or share repurchases.

4. When business conditions are weak, firms are more willing to reduce share buybacks than to cut dividends.


Figure 14.1 Per Share Earnings and Dividends of the S&P 500 Index


Matter of Fact

P&G’s Dividend History

Few companies have replicated the dividend achievements of the consumer products giant, Procter & Gamble (P&G). P&G has paid dividends every year for more than a century, and it increased its dividend in every year from 1956–2010.


Figure 14.2 Aggregate Dividends and Repurchases for All U.S.-Listed Companies


Matter of Fact

Share Repurchases Gain Worldwide Popularity– In most of the world’s largest economies, repurchases have

been on the rise in recent years, eclipsing dividend payments at least some of the time in countries as diverse as Belgium, Denmark, Finland, Hungary, Ireland, Japan, Netherlands, South Korea, and Switzerland.

– A recent study of payout policy at firms from 25 different countries found that share repurchases rose at an annual rate of 19% from 1999–2008.


Focus on Ethics

Are Buybacks Really a Bargain?– In addition to simply returning cash to shareholders,

companies also typically say they repurchase stock because they believe their stock is undervalued.

– Yet new research shows that companies often use creative financial reporting to push earnings downward before buybacks, making the stock seem undervalued and causing its price to bounce higher after the buyback.

Do you agree that corporate managers would manipulate their stock’s value prior to a buyback, or do you believe that corporations are more likely to initiate a buyback to enhance shareholder value?


The Mechanics of Payout Policy:Cash Dividend Payment Procedures

• At quarterly or semiannual meetings, a firm’s board of directors decides whether and in what amount to pay cash dividends.

• If the firm has already established a precedent of paying dividends, the decision facing the board is usually whether to maintain or increase the dividend, and that decision is based primarily on the firm’s recent performance and its ability to generate cash flow in the future.

• Boards rarely cut dividends unless they believe that the firm’s ability to generate cash is in serious jeopardy.


Figure 14.3 U.S. Public IndustrialFirms Increasing, Decreasing, or Maintaining Dividends


Figure 14.4 Dividend Payment Time Line


The Mechanics of Payout Policy: Cash Dividend Payment Procedures (cont.)

On August 21, 2013, the board of directors of Best Buy announced that the firm’s next quarterly cash dividend would be $0.17 per share, payable October 1, 2013 to shareholders of record on Tuesday, September 10, 2013.The stock would begin trading ex-dividend on Friday, September 6, 2013. At the time, Best Buy had 340,967,179 shares of common stock outstanding, so the total dividend would be $57,964,420. Before the dividend was declared, the key accounts of the firm were as follows (dollar values quoted in thousands):

– Cash: $680,000– Dividends payable: $0– Retained earnings: $3,395,000



When the dividend was announced by the directors, almost $58 million of the retained earnings ($0.17 per share 341 million shares) was transferred to the dividends payable account. The key accounts thus became:

– Cash: $680,000– Dividends payable: $57,964– Retained earnings: $3,337,036



When Best Buy actually paid the dividend on October 26, this produced the following balances in the key accounts of the firm:

– Cash: $622,036– Dividends payable: $0– Retained earnings: $3,337,036

The net effect of declaring and paying the dividend was to reduce the firm’s total assets (and stockholders’ equity) by almost $58 million.


The Mechanics of Payout Policy: Share Repurchase Procedures

• Common methods for repurchasing shares include:– An open-market share repurchase is a share repurchase

program in which firms simply buy back some of their outstanding shares on the open market.

– A tender offer repurchase is a repurchase program in which a firm offers to repurchase a fixed number of shares, usually at a premium relative to the market value, and shareholders decide whether or not they want to sell back their shares at that price.

– A Dutch Auction repurchase is a repurchase method in which the firm specifies how many shares it wants to buy back and a range of prices at which it is willing to repurchase shares. Investors specify how many shares they will sell at each price in the range, and the firm determines the minimum price required to repurchase its target number of shares. All investors who tender receive the same price.


The Mechanics of Payout Policy:Share Repurchase Procedures (cont.)

In July 2013, Fidelity National Information Services announced a Dutch auction repurchase for 86 million common shares at prices ranging from $29 to $31.50 per share.

At a price of $31.25, shareholders are willing to tender a total of 86 million shares, exactly the amount that Fidelity wants to repurchase.


The Mechanics of Payout Policy: Tax Treatment of Dividends and Repurchases

For many years, dividends and share repurchases had very different tax consequences.

– The dividends that investors received were generally taxed at ordinary income tax rates.

– On the other hand, when firms repurchased shares, the taxes triggered by that type of payout were generally much lower.

•That is now different.– Currently capital gains taxes and dividend taxation are

identical.• There is a distinction between long-term and short-term

capital gains.


The Mechanics of Payout Policy: Dividend Reinvestment Plans

Dividend reinvestment plans (DRIPs) are plans that enable stockholders to use dividends received on the firm’s stock to acquire additional shares—even fractional shares—at little or no transaction cost.

– Some companies even allow investors to make their initial purchases of the firm’s stock directly from the company without going through a broker.

– With DRIPs, plan participants typically can acquire shares at about 5 percent below the prevailing market price.


The Mechanics of Payout Policy: Stock Price Reactions to Corporate Payouts

What happens to the stock price when a firm pays a dividend or repurchases shares?

– In theory, when a stock begins trading ex dividend, the stock price should fall by exactly the amount of the dividend.

– In theory, when a firm buys back shares at the going market price, the market price of the stock should remain the same.

– In practice, taxes and a variety of other market imperfections may cause the actual change in share price in response to a dividend payment or share repurchase to deviate from what we expect in theory.



Relevance of Payout Policy

• The financial literature has reported numerous theories and empirical findings concerning payout policy.

• Although this research provides some interesting insights about payout policy, capital budgeting and capital structure decisions are generally considered far more important than payout decisions.

• In other words, firms should not sacrifice good investment and financing decisions for a payout policy of questionable importance.

• The most important question about payout policy is this: Does payout policy have a significant effect on the value of a firm?


Relevance of Payout Policy: Residual Theory of Dividends

The residual theory of dividends is a school of thought that suggests that the dividend paid by a firm should be viewed as a residual—the amount left over after all acceptable investment opportunities have been undertaken.


Relevance of Payout Policy: Residual Theory of Dividends (cont.)

Using the residual theory of dividends, the firm would treat the dividend decision in three steps, as follows:

– Determine its optimal level of capital expenditures, which would be the level that exploits all of a firm’s positive NPV projects.

– Using the optimal capital structure proportions, estimate the total amount of equity financing needed to support the expenditures generated in Step 1.

– Because the cost of retained earnings, rr, is less than the cost of new common stock, rn, use retained earnings to meet the equity requirement determined in Step 2. If retained earnings are inadequate to meet this need, sell new common stock. If the available retained earnings are in excess of this need, distribute the surplus amount—the residual—as dividends.


Relevance of Payout Policy: The Dividend Irrelevance Theory

The dividend irrelevance theory is Miller and Modigliani’s theory that in a perfect world, the firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value.

– In a perfect world (certainty, no taxes, no transactions costs, and no other market imperfections), the value of the firm is unaffected by the distribution of dividends.

– Of course, real markets do not satisfy the “perfect markets” assumptions of Modigliani and Miller’s original theory.


Relevance of Payout Policy: The Dividend Irrelevance Theory (cont.)

The clientele effect is the argument that different payout policies attract different types of investors but still do not change the value of the firm.

– Tax-exempt investors may invest more heavily in firms that pay dividends because they are not affected by the typically higher tax rates on dividends.

– Investors who would have to pay higher taxes on dividends may prefer to invest in firms that retain more earnings rather than paying dividends.

– If a firm changes its payout policy, the value of the firm will not change—what will change is the type of investor who holds the firm’s shares.


Relevance of Payout Policy: Arguments for Dividend Relevance

• Dividend relevance theory is the theory, advanced by Gordon and Lintner, that there is a direct relationship between a firm’s dividend policy and its market value.

• The bird-in-the-hand argument is the belief, in support of dividend relevance theory, that investors see current dividends as less risky than future dividends or capital gains.


Relevance of Payout Policy: Arguments for Dividend Relevance (cont.)

Studies have shown that large changes in dividends do affect share price.

– Informational content is the information provided by the dividends of a firm with respect to future earnings, which causes owners to bid up or down the price of the firm’s stock.

– The agency cost theory says that a firm that commits to paying dividends is reassuring shareholders that managers will not waste their money.

– Although many other arguments related to dividend relevance have been put forward, empirical studies have not provided evidence that conclusively settles the debate about whether and how payout policy affects firm value.


Factors Affecting Dividend Policy

Dividend policy represents the firm’s plan of action to be followed whenever it makes a dividend decision.First consider five factors in establishing a dividend policy:

1. legal constraints2. contractual constraints3. the firm’s growth prospects4. owner considerations5. market considerations


Factors Affecting Dividend Policy: Legal Constraints

• Most states prohibit corporations from paying out as cash dividends any portion of the firm’s “legal capital,” which is typically measured by the par value of common stock.

• Other states define legal capital to include not only the par value of the common stock, but also any paid-in capital in excess of par.

• These capital impairment restrictions are generally established to provide a sufficient equity base to protect creditors’ claims.


Factors Affecting Dividend Policy: Contractual Constraints

• Often the firm’s ability to pay cash dividends is constrained by restrictive provisions in a loan agreement.

• Generally, these constraints prohibit the payment of cash dividends until the firm achieves a certain level of earnings, or they may limit dividends to a certain dollar amount or percentage of earnings.

• Constraints on dividends help to protect creditors from losses due to the firm’s insolvency.


Factors Affecting Dividend Policy: Growth Prospects

• A growth firm is likely to have to depend heavily on internal financing through retained earnings, so it is likely to pay out only a very small percentage of its earnings as dividends.

• A more established firm is in a better position to pay out a large proportion of its earnings, particularly if it has ready sources of financing.


Factors Affecting Dividend Policy: Owner Considerations

Tax status of a firm’s owners:– If a firm has a large percentage of wealthy stockholders

who have sizable incomes, it may decide to pay out a lower percentage of its earnings to allow the owners to delay the payment of taxes until they sell the stock.

Owners’ investment opportunities:– If it appears that the owners have better opportunities

externally, the firm should pay out a higher percentage of its earnings.

Potential dilution of ownership:– If a firm pays out a high percentage of earnings, new

equity capital will have to be raised with common stock. The result of a new stock issue may be dilution of both control and earnings for the existing owners.


Factors Affecting Dividend Policy: Market Considerations

Catering theory is a theory that says firms cater to the preferences of investors, initiating or increasing dividend payments during periods in which high-dividend stocks are particularly appealing to investors.


Types of Dividend Policies: Constant-Payout-Ratio Dividend Policy

• A firm’s dividend payout ratio indicates the percentage of each dollar earned that a firm distributes to the owners in the form of cash. It is calculated by dividing the firm’s cash dividend per share by its earnings per share.

• A constant-payout-ratio dividend policy is a dividend policy based on the payment of a certain percentage of earnings to owners in each dividend period.


Types of Dividend Policies: Regular Dividend Policy

• Regular dividend policy is a dividend policy based on the payment of a fixed-dollar dividend in each period.

• A regular dividend policy is often build around a target dividend-payout ratio, which is a dividend policy under which the firm attempts to pay out a certain percentage of earnings as a stated dollar dividend and adjusts that dividend toward a target payout as proven earnings increases occur.


Types of Dividend Policies: Low-Regular-and-Extra Dividend Policy

• A low-regular-and-extra dividend policy is a dividend policy based on paying a low regular dividend, supplemented by an additional (“extra”) dividend when earnings are higher than normal in a given period.

• An extra dividend is an additional dividend optionally paid by the firm when earnings are higher than normal in a given period.


Other Forms of Dividends

A stock dividend is the payment, to existing owners, of a dividend in the form of stock.

– In a stock dividend, investors simply receive additional shares in proportion to the shares they already own.

– No cash is distributed, and no real value is transferred from the firm to investors.

– Instead, because the number of outstanding shares increases, the stock price declines roughly in line with the amount of the stock dividend.

– In an accounting sense, the payment of a stock dividend is a shifting of funds between stockholders’ equity accounts rather than an outflow of funds.


Other Forms of Dividends (cont.)

A stock split is a method commonly used to lower the market price of a firm’s stock by increasing the number of shares belonging to each shareholder.

– Stock splits are often made prior to issuing additional stock to enhance that stock’s marketability and stimulate market activity.

– It is not unusual for a stock split to cause a slight increase in the market value of the stock, attributable to its informational content and to the fact that total dividends paid commonly increases slightly after a split.

– A reverse stock split is a method used to raise the market price of a firm’s stock by exchanging a certain number of outstanding shares for one new share.


Other Forms of Dividends (cont.)

Delphi Company, a forest products concern, had 200,000 shares of $2-par-value common stock and no preferred stock outstanding. Because the stock is selling for a high market price, the firm declared a 2-for-1 stock split.

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Chapter 14 Payout Policy. Copyright ©2015 Pearson Education, Inc. All rights reserved.14-2 The Basics of Payout Policy: Elements of Payout Policy The