Corporate Financial Policy

Semester A 2012-13
City University of Hong Kong
AC4331 Week 11
1. Financial Management : Core Principles and Applications, 3
rd
Edition
Ross Westerfield Faffe and Jordan (2011)
2. Financial Management, 3
rd
Edition Megginson, Smart , Graham (2010)
Topic 10
.
1-2
Introduction to Financial Management
Free Cash Flow
Financial Planning and Forecasting
Financial Assets and Time Value of Money
Risk and Return
Bond and Stock Valuation
Cost of Capital
Cash Flow Estimation and Risk Analysis
Capital Structure and Leverage
Treasury and Valuation
Enterprise Risk Management
Dividends and Share Repurchase
Merger and Acquisitions

Extra Ref:
Financial Management, Theory and Practice, 12e Eugene and
Brigham
Distributions to shareholders
Chapter 16

Investor Preferences on
Dividends
Signaling Effects
Residual Dividend Model
Dividend Reinvestment Plans
Stock Repurchases
Stock Dividends and Stock Splits
16-5
The decision to pay out earnings versus
retaining and reinvesting them.
Dividend policy includes
High or low dividend payout?
Stable or irregular dividends?
How frequent to pay dividends?
Announce the policy?
16-6
Investors are indifferent between dividends
and retention-generated capital gains.
Investors can create their own dividend
policy
If they want cash, they can sell stock.
If they dont want cash, they can use dividends to
buy stock.
Proposed by Modigliani and Miller and based
on unrealistic assumptions (no taxes or
brokerage costs), hence may not be true.
Need an empirical test.
16-7
May think dividends are less risky than
potential future capital gains.
If so, investors would value high-payout
firms more highly, i.e., a high payout would
result in a high P
0
.
16-8
May want to avoid transactions costs
Maximum tax rate is the same as on
dividends, but
Taxes on dividends are due in the year they are
received, while taxes on capital gains are due
whenever the stock is sold.
If an investor holds a stock until his/her death,
beneficiaries can use the date of the death as the
cost basis and escape all previously accrued capital
gains.
16-9
Investors view dividend increases as signals
of managements view of the future.
Since managers hate to cut dividends, they wont
raise dividends unless they think the raise is
sustainable.
However, a stock price increase at time of a
dividend increase could reflect higher
expectations for future EPS, not a desire for
dividends.
16-10
Different groups of investors, or clienteles,
prefer different dividend policies.
Firms past dividend policy determines its
current clientele of investors.
Clientele effects impede changing dividend
policy. Taxes and brokerage costs hurt
investors who have to switch companies.
16-11
Find the retained earnings needed for the
capital budget.
Pay out any leftover earnings (the residual) as
dividends.
This policy minimizes flotation and equity
signaling costs, hence minimizes the WACC.
16-12
(
(
(

|
|
|
.
|

\
|

|
|
|
.
|

\
|
=
budget
capital
Total

ratio
equity
Target
Income Net Dividends
16-13
Capital budget $800,000
Target capital structure 40% debt, 60%
equity
Forecasted net income $600,000
How much of the forecasted net income
should be paid out as dividends?
14
For a given firm, the optimal payout ratio is
a function of four factors:
Investors preferences for dividends versus
capital gains
The firms investment opportunities
Its target capital structure
The availability and cost of external capital
The last three elements are combined in
what we call the residual dividend model


15
Using the Residual Model to Calculate
Dividends Paid
Dividends = .
Net
income
Target
equity
ratio
Total
capital
budget
[ ] ) ) ( (
16
Capital budget: $800,000. Given.
Target capital structure: 40% debt, 60%
equity. Want to maintain.
Forecasted net income: $600,000.
How much of the $600,000 should we
pay out as dividends?
17
NI = $400,000: Need $480,000 of
equity, so should retain the whole
$400,000. Dividends = 0.
NI = $800,000: Dividends = $800,000
- $480,000 = $320,000. Payout =
$320,000/$800,000 = 40%.
If NI = $400,000
Dividends = $400,000 (0.6)($800,000) =
-$80,000.
Since the dividend results in a negative number,
the firm must use all of its net income to fund its
budget, and probably should issue equity to
maintain its target capital structure.
Payout = $0/$400,000 = 0%.
If NI = $800,000
Dividends = $800,000 (0.6)($800,000) =
$320,000.
Payout = $320,000/$800,000 = 40%.
16-18
19
Of the $800,000 capital budget, 0.6($800,000) = $480,000 must
be equity to keep at target capital structure. [0.4($800,000) =
$320,000 will be debt.]
With $600,000 of net income, the residual is $600,000 -
$480,000 = $120,000 = dividends paid.
Payout ratio = $120,000/$600,000
= 0.20 = 20%.
Calculate portion of capital budget to be
funded by equity.
Of the $800,000 capital budget, 0.6($800,000) =
$480,000 will be funded with equity.
Calculate excess or need for equity capital.
There will be $600,000 $480,000 = $120,000
left over to pay as dividends.
Calculate dividend payout ratio.
$120,000/$600,000 = 0.20 = 20%.
16-20
Fewer good investments would lead to
smaller capital budget, hence to a higher
dividend payout.
More good investments would lead to a
lower dividend payout.
16-21
Advantage
Minimizes new stock issues and flotation costs.
Disadvantages
Results in variable dividends
Sends conflicting signals
Increases risk
Doesnt appeal to any specific clientele.
Conclusion Consider residual policy when
setting long-term target payout, but dont
follow it rigidly from year to year.
16-22
Shareholders can automatically reinvest their
dividends in shares of the companys
common stock. Get more stock than cash.
There are two types of plans:
Open market
New stock
16-23
Dollars to be reinvested are turned over to
trustee, who buys shares on the open
market.
Brokerage costs are reduced by volume
purchases.
Convenient, easy way to invest, thus useful
for investors.
16-24
Firm issues new stock to DRIP enrollees
(usually at a discount from the market price),
keeps money and uses it to buy assets.
Firms that need new equity capital use new
stock plans.
Firms with no need for new equity capital use
open market purchase plans.
Most NYSE listed companies have a DRIP.
Useful for investors.
16-25
Forecast capital needs over a planning
horizon, often 5 years.
Set a target capital structure.
Estimate annual equity needs.
Set target payout based on the residual
model.
Generally, some dividend growth rate
emerges. Maintain target growth rate if
possible, varying capital structure somewhat
if necessary.
16-26
Buying own stock back from stockholders
Reasons for repurchases:
As an alternative to distributing cash as dividends.
To dispose of one-time cash from an asset sale.
To make a large capital structure change.

16-27
Stockholders can tender or not.
Helps avoid setting a high dividend that
cannot be maintained.
Repurchased stock can be used in takeovers
or resold to raise cash as needed.
Income received is capital gains rather than
higher-taxed dividends.
Stockholders may take as a positive
signalmanagement thinks stock is
undervalued.
16-28
May be viewed as a negative signal (firm has
poor investment opportunities).
IRS could impose penalties if repurchases
were primarily to avoid taxes on dividends.
Selling stockholders may not be well
informed, hence be treated unfairly.
Firm may have to bid up price to complete
purchase, thus paying too much for its own
stock.
16-29
Stock dividend: Firm issues new shares in
lieu of paying a cash dividend. If 10%, get 10
shares for each 100 shares owned.
Stock split: Firm increases the number of
shares outstanding, say 2:1. Sends
shareholders more shares.
16-30
Both stock dividends and stock splits
increase the number of shares outstanding,
so the pie is divided into smaller pieces.
Unless the stock dividend or split conveys
information, or is accompanied by another
event like higher dividends, the stock price
falls so as to keep each investors wealth
unchanged.
But splits/stock dividends may get us to an
optimal price range.
16-31
Theres a widespread belief that the optimal
price range for stocks is $20 to $80. Stock
splits can be used to keep the price in this
optimal range.
Stock splits generally occur when
management is confident, so are interpreted
as positive signals.
On average, stocks tend to outperform the
market in the year following a split.
16-32
Eugene textbook

Questions:16-1, 16-3, 16-5, 16-6

Problems: 16-1, 16-2,16-3,16-6, 16-9
33
Dividends and Other Payouts
Supplementary Notes
for Advanced Learners

Ref: Ross Westerfield Jaffe Jordan
Core Principles and Applications
of Corporate Finance

Chapter 16

Differentiate and explain various dividend
types and how they are paid
Grasp and apply the issues surrounding
dividend policy decisions
Comprehend and explain why share
repurchases are an alternative to dividends
Distinguish the difference between cash and
stock dividends
35
16.1 Different Types of Dividends
16.2 Standard Method of Cash Dividend Payment
16.3 The Benchmark Case: An Illustration of the
Irrelevance of Dividend Policy
16.4 Repurchase of Stock
16.5 Personal Taxes, Issuance Costs, and Dividends
16.6 Real World Factors Favoring a High-Dividend
Policy
16.7 The Clientele Effect: A Resolution of Real World
Factors?
16.8 What We Know and Do Not Know About Dividend
Policy
16.9 Stock Dividends and Stock Splits
Appendix: Supplementary Materials
36
Many companies pay a regular cash dividend.
Public companies often pay quarterly.
Sometimes firms will pay an extra cash dividend.
The extreme case would be a liquidating dividend.
Companies will often declare stock dividends.
No cash leaves the firm.
The firm increases the number of shares outstanding.
Some companies declare a dividend in kind.
Wrigleys Gum sends a box of chewing gum.
Dundee Crematoria offers shareholders discounted
cremations.
37





38
Record Date Date on which company
determines existing shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock immediately
before this date is entitled to a dividend.
Cash Dividend - Payment of cash by the firm
to its shareholders.
39
25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec.
Declaration
Date
Cum-
dividend
Date
Ex-
dividend
Date
Record
Date
Payment
Date

Declaration Date: The Board of Directors declares a payment
of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 5 November.
In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
40
$P
$P - div
Ex-
dividend
Date
The price drops
by the amount of
the cash
dividend.
-t

-2 -1 0 +1 +2

Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
A compelling case can be made that 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 dividends.
In other words, dividend policy will have no
impact on the value of the firm because
investors can create whatever income stream
they prefer by using homemade dividends.

41
Bianchi Inc. is a $42 stock about to pay a $2 cash
dividend.
Bob Investor owns 80 shares and prefers a $3
dividend.
Bobs homemade dividend strategy:
Sell 2 shares ex-dividend
42

homemade dividends
Cash from dividend $160
Cash from selling stock $80
Total Cash $240
Value of Stock Holdings $40 78 =
$3,120

$3 Dividend
$240
$0
$240
$39 80 =
$3,120
True or False: Dividends are irrelevant

True or False: Dividend policy is irrelevant
43
In the above example, Bob Investor began
with a total wealth of $3,360:
44
share
42 $
shares 80 360 , 3 $ =
240 $
share
39 $
shares 80 360 , 3 $ + =
80 $ 160 $
share
40 $
shares 78 360 , 3 $ + + =
- After a $3 dividend, his total wealth is still $3,360:
- After a $2 dividend and sale of 2 ex-dividend shares, his
total wealth is still $3,360:
Firms should never forgo positive NPV
projects to increase a dividend (or to pay a
dividend for the first time).
Recall that one of the assumptions underlying
the dividend-irrelevance argument is: The
investment policy of the firm is set ahead of
time and is not altered by changes in
dividend policy.
45
Instead of declaring cash dividends, firms
can rid themselves of excess cash through
buying shares of their own stock.
Recently, share repurchase has become an
important way of distributing earnings to
shareholders.
During the financial crisis of 2007 and 2008
share repurchases and dividends exceeded
reported earnings
46
47

$10 = /100,000 $1,000,000
=
Price per share
100,000
=
outstanding Shares
1,000,000 Value of Firm 1,000,000 Value of Firm
1,000,000 Equity 850,000 Assets Other
0 Debt $150,000 Cash
sheet balance Original A.
Equity & Liabilities Assets
Consider a firm that wishes to distribute $100,000 to its
shareholders.
48
$9 = 00,000 $900,000/1 = share per Price
100,000 = g outstandin Shares
900,000 Firm of Value 900,000 Firm of Value
900,000 Equity 850,000 Assets Other
0 Debt $50,000 Cash
dividend cash share per $1 After B.
Equity & s Liabilitie Assets
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:
49
Assets Li abilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 90,000
Price per share = $900,000 / 90,000 = $10
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
Flexibility for shareholders
Keeps stock price higher
Good for insiders who hold stock options
As an investment of the firm
Tax benefits
50
To get the result that dividend policy is
irrelevant, we needed three assumptions:
No taxes
No transactions costs
No uncertainty
In the United States, both cash dividends
and capital gains are taxed at a maximum
rate of 15 percent (at least through 2010).
Since capital gains can be deferred, the tax
rate on dividends is greater than the
effective rate on capital gains.

51
In a world of personal
taxes, firms should not
issue stock to pay a
dividend.
52
Firm
Stock
Holders
Cash: stock issue
Cash: dividends
Gov.
Taxes
Investment Bankers The direct costs of
stock issuance will
add to this effect.
The above argument does not necessarily
apply to firms with excess cash.
Consider a firm that has $1 million in cash
after selecting all available positive NPV
projects.
Select additional capital budgeting projects (by
assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares
53
In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative
uses for funds to reduce dividends.
3. Though personal taxes mitigate against the
payment of dividends, these taxes are not
sufficient to lead firms to eliminate all dividends.
4. Under current tax law, shareholders generally
prefer a repurchase to a dividend.
54
Desire for Current Income
Behavioral Finance
It forces investors to be disciplined.
Do investors have sufficient discipline to optimize
their position?
Agency Costs
High dividends reduce free cash flow.
55
Empirically, stock prices increase after
dividend increase announcements
Dividend increases are a signal that the firm
is expected to do well
It is the expectation of good times, or
information content effect, that raises the
price of the stock on dividend increases, not
the increase in the dividend itself
56
Clienteles for various dividend payout policies
are likely to form in the following way:

57
Group Stock Type
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Zero-to-Low payout
Low-to-Medium payout
Medium payout
High payout
Once the clienteles have been satisfied, a corporation is unlikely
to create value by changing its dividend policy.
Stated differently, a firm can boost its stock price by paying
higher dividends only if an unsatisfied clientele exists
58
Stability of dividends is important.
Reducing dividends to make funds available
for capital investment could send incorrect
signals to investors, who might push down
the stock price.

Dividend stability has 2 components:
How dependable is the growth rate
Can we count on at least receiving the current
dividend in the future
Dividends are large in the aggregate
Number of companies that pays has declined
Many newly listed firms; less likely to pay dividends
Tax policies matter; not a major deterrent
Corporations smooth dividends.
Dividends provide information to the market.
Firms should follow a sensible dividend policy:
Dont forgo positive NPV projects just to pay a
dividend.
Avoid issuing stock to pay dividends.
Consider share repurchase when there are few better
uses for the cash.
59
Aggregate payouts are massive and have
increased over time.
Dividends are concentrated among a small
number of large, mature firms.
Managers are reluctant to cut dividends.
Managers smooth dividends.
Stock prices react to unanticipated changes in
dividends.
60
Pay additional shares of stock instead of
cash
Increases the number of outstanding
shares
Small stock dividend
Less than 20 to 25%
If you own 100 shares and the company declared a
10% stock dividend, you would receive an
additional 10 shares.
Large stock dividend more than 20 to
25%

61
Stock splits essentially the same as a stock
dividend except it is expressed as a ratio
For example, a 2 for 1 stock split is the same as a
100% stock dividend.
Stock price is reduced when the stock splits.
Common explanation for split is to return
price to a more desirable trading range.
62
1. What is Dividend Policy?
2. Do investors prefer High or Low payout?
Three theories
3. What is information content or signaling
hypothesis?
4. What is a Residual Dividend Model?
63
64
Its the decision to pay out earnings versus
retaining and reinvesting them. Includes
these elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
65
Dividends are irrelevant: Investors dont
care about payout.
Bird-in-the-hand: Investors prefer a high
payout.
Tax preference: Investors prefer a low
payout, hence growth.
66
Firms value is determined only by its basic
earning power and its business risk.
Investors are indifferent between dividends
and retention-generated capital gains. If
they want cash, they can sell stock. If they
dont want cash, they can use dividends to
buy stock.
Modigliani-Miller support irrelevance.
Theory is based on unrealistic assumptions
(no taxes or brokerage costs), hence may
not be true. Need empirical test.
67
Investors think dividends are less risky
than potential future capital gains, hence
they like dividends.

If so, investors would value high payout
firms more highly, i.e., a high payout
would result in a high P
0
.
68
Retained earnings lead to capital gains,
which are taxed at lower rates than
dividends: 28% maximum vs. up to
39.6%. Capital gains taxes are also
deferred.

This could cause investors to prefer
firms with low payouts, i.e., a high
payout results in a low P
0
.
69
Theory Implication
Irrelevance Any payout OK
Bird-in-the-hand Set high payout
Tax preference Set low payout
But which, if any, is correct???
70
Stock Price ($)
Payout 50% 100%
40
30
20
10
Bird-in-Hand
Indifference
Tax preference
0
71
Cost of equity (%)
Payout 50% 100%
15
20
10
Tax Preference
Indifference
Bird-in-Hand
0
72
Empirical testing has not been able to
determine which theory, if any, is correct.
Thus, managers use judgment when
setting policy.
Analysis is used, but it must be applied
with judgment.
73
Managers hate to cut dividends, so wont
raise dividends unless they think raise is
sustainable. So, investors view dividend
increases as signals of managements view
of the future.

Therefore, a stock price increase at time of a
dividend increase could reflect higher
expectations for future EPS, not a desire for
dividends.
What are the different types of dividends,
and how is a dividend paid?
What is the clientele effect, and how does
it affect dividend policy irrelevance?
What is the information content of
dividend changes?
What are stock dividends, and how do
they differ from cash dividends?
How are share repurchases an alternative
to dividends, and why might investors
prefer them?
74