Dividend Payout Policy

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• Part 10
• Dividend Payout Policy
• Organisation
• Empirical Observations of Dividend Policy
• MM Proposition on Dividend
• Agency costs and signaling issues
• Clienteles effect
• Stock Repurchase

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10.1 Empirical Evidence of Dividend Decisions

• Most companies have a long-term target dividend
  payout ratio.
• Managers focus more on the change in payout than
  on the absolute level of payout.
• Dividends are smoothed relative to profits.
• Most managers are reluctant to make changes in
  dividends that are likely to have to be reversed
  in the near future.

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10.2 The MM Theorem on Dividend Policy

• Given the investment plan, without taxes, and
  under a perfectly competitive capital market,
  then a companys dividend policy has no effect on
  shareholders wealth.
• X cash from operation ?S cash raised from new
  share issues I investment and nD dividends.
• Since sources and uses of funds must be equal
  X ?S I nD.

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10.3 MM on Dividend

• In a perfect capital market, dividend policy has
  no effect on shareholders wealth because any
  cash paid out as dividends can be costlessly
  replaced by issuing additional shares. So
  shareholders have higher dividends but lower
  capital gains.
• Overall, this wont change the total returns to
  the shareholders.

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10.4 Dividends and Taxes

• In the classical tax system, the dividends are
  taxed twice (at both the company level and the
  personal level). In addition, the capital gains
  are taxed at a lower rate at the personal level.
• Therefore, investors prefer a lower dividend
  payout rate.
• In the imputation tax system (Australia),
  dividends are taxed only once. If the tax rates
  for the dividend income and capital gains are the
  same, then shareholders should be indifferent to
  the payout policy.

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10.5 Dividend as a credible signal

• Share price changes around the dividend
  announcement are positively related to the change
  in dividend.
• Management can use dividend policy to signal
  information to investors. To make the signal
  credible, the signaling costs have to be
  inversely related to the quality of the firm.
• Overall, it is more costly for a weaker firm to
  increase dividend payout, since it has to reverse
  its payout ratio when things turn out to be bad.
  The market tends to penalize those firms who
  reverse their payout policy.

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10.6 Clienteles Effect

• Investors choose to invest in certain companies
  which meet their particular requirements (for
  income sources or tax status). For example,
  retirees may prefer to have regular dividend
  payments instead of periodorically selling a few
  shares in the market.
• The existence of investor clienteles suggests
  that companies should follow a stable dividend
  policy.

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10.7 Stock Repurchase vs. Dividends

• Share repurchase (buy-back) is a form of cash
  payout policy.
• Share repurchase is used to distribute cash in
  special occasions. Firm can maintain a stable
  dividend policy with occasional buy backs or
  special dividend payouts.
• Market response to share repurchase is positive.

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10.8 Share Repurchase

• In the ideal (MM) world, share repurchase does
  not affect the total return to shareholders.
• It involves the tradeoff between dividend income
  and capital gains.
• However, if capital gains is taxed at a lower
  rate, then shareholders prefer repurchase over
  dividend.

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10.9 An Example

• A firm has 1 per share in cash, which it will
  use either to repurchase shares or to pay a cash
  dividend. Share price (cum-dividend) is 20.
• Other things equal, the share price after a
  repurchase will still be 20.
• P (20 -1)/(1 1/20) 20.

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10.10 Leveraged Recapitalisation

• Share repurchase program is often associated with
  a change in the companys capital structure
  policy.
• Issuing more debt to buy back shares is called
  leveraged repurchase.
• Sometimes, leveraged repurchase is used as a
  defense tactic against takeover.