Payout Policies

1
Payout Policies
2
Payout Policies

• Introduction
• MM irrelevance theorem
• Personal taxation and dividend policy
• Signaling and dividends
• Dividend smoothing
• Disappearing dividends
• Agency costs and dividends
• Stock repurchases

3
Introduction

• Cash dividends and stock repurchases are the two
  principal means by which firms distribute cash to
  shareholders.
• Cash dividends are paid to all shareholders on a
  pro rata basis.
• In an ideal market, the firms stock price falls
  by the per-share amount of the dividend.

4
Introduction

• In a stock repurchase, the firm uses cash to
  retire some outstanding shares, buying shares
  from any investors who choose to sell.
• In a perfect capital market, a stock repurchase
  reduces the number of shares outstanding as well
  as the firms assets (cash), but should have no
  effect on stock prices.

5
Introduction

• Dividends are the traditional means of
  distributing cash to shareholders, but stock
  repurchases have become increasingly more common,
  especially in the U.S.
• Should firms pay dividends?
• Does dividend policy affect firm value?
• What is the optimal dividend policy?

6
Payout Policies

• Introduction
• MM irrelevance theorem
• Personal taxation and dividend policy
• Signaling and dividends
• Dividend smoothing
• Disappearing dividends
• Agency costs and dividends
• Stock repurchases

7
MM irrelevance theorem

• Is the value of the firm affected by a firms
  dividend policy?
• MM 1961
• In the absence of taxes, agency costs or
  information asymmetry, dividend policy is
  irrelevant.
• Dividend policy does not affect the value of the
  firm.

8
MM irrelevance theorem

• In MM world - the availability of external
  financing that makes the value of the firm
  independent of dividend policy. Why?
• Assuming perfect capital markets, two firms which
  are identical in every fashion except for the
  current dividend payout must have the same value
• A firms value will be the same whether it pays a
  high, low or no dividend.

9
MM irrelevance theorem

• In the MM world, firm values are determined
• solely by real considerations such as the
  earning power of the firms assets and its
  investment policy
• and NOT by how the firms earnings are packaged
  for distribution.

10
MM irrelevance theorem

• MM (1961) - irrelevance of dividend policy
• It doesnt matter what sort of dividend a firm
  pays - it has no impact on firm value.
• MM assume (amongst other things)
• no personal taxes
• no asymmetric information
• no agency costs

11
Payout Policies

• Introduction
• MM irrelevance theorem
• Personal taxation and dividend policy
• Signaling and dividends
• Dividend smoothing
• Disappearing dividends
• Agency costs and dividends
• Stock repurchases

12
Personal taxation and dividend policy

• Firm A earns 10m per year
• it can retain this 10m and invest
• it can pay out the 10m as div. And issue equity
  to fund investment
• no personal taxes - MM result
• personal taxes of 40 - ? value of SHs payout to
  6m
• Would S/Hs prefer capital gains income rather
  than dividend income?

13
Personal taxation and dividend policy

• Capital gains tax lt income tax
• prefer capital gains or dividend?
• Capital gains tax income tax
• prefer capital gains or dividend?
• capital gains taxes are taxed upon realization
• a tax payment delayed is a tax payment rendered
  less valuable

14
Personal taxation and dividend policy

• Stock repurchase
• firm itself makes an offer to repurchase shares
  from investors at an above-market price
• Stock repurchases are taxed as capital gains

15
Personal taxation and dividend policy

• So why arent share repurchase schemes used
  instead of dividends?
• Potential threat from tax authorities to tax
  income received from share repurchase program at
  a higher rate
• they discourage specialists from making a market
  in the firms stock because they would be forced
  to trade with the company (with superior
  information advantages)

16
Personal taxation and dividend policy

• Dividend policy is no longer irrelevant!
• Firms should pay no dividends because of the tax
  disadvantage of ordinary income over capital
  gains.
• Theoretical work - Farrar and Selwyn (1967)
  Brennan (1970)

17
Personal taxation and dividend policy

• Masulis and Trueman (1986)
• important assumptions
• personal tax rates on dividend income differ
  across individuals
• there is a large dividend exclusion from taxes on
  all dividends paid by one corporation to another

18
Personal taxation and dividend policy

• High tax bracket SHs will prefer more earnings to
  be retained and invested.
• Low tax bracket SHs (espec. firms) will prefer
  less investment and more dividends
• investors self-select into clienteles
• low tax bracket individuals buy shares of high
  dividend firms
• vice versa

19
Personal taxation and dividend policy
20
Personal taxation and dividend policy

• Pettit found that low dividend stocks are
  preferred by
• investors with high income
• younger investors
• investors whose ordinary tax and CGT rates differ
  substantially
• investors whose portfolios have high systematic
  risk

21
Payout Policies

• Introduction
• MM irrelevance theorem
• Personal taxation and dividend policy
• Signaling and dividends
• Dividend smoothing
• Disappearing dividends
• Agency costs and dividends
• Stock repurchases

22
Signaling and Dividends

• If firm ? dividend payout - signaling that it has
  expected future CFs that are large enough to meet
  debt payments dividends payments without ? risk
  of bankruptcy
• ? ? VL
• it is expensive for less successful firms to
  mimic the signal.

23
Signaling and Dividends

• Optimal dividend policy
• The signaling value of dividends is ve and can
  be traded off against the tax loss associated
  with dividend income as opposed to capital gains.
• Signaling theories explain how an optimal
  dividend policy may arise.
• However, they do not explain differences in
  dividend payouts across industries or countries.

24
Signaling and Dividends

• Empirical evidence
• initiation or ? of dividend ? ? share price
• Recently, initiations of dividends by high-tech
  firms has resulted in ? share price . Why?
• ? dividend ? ? share price (and sometimes very
  large ?)
• How do these findings tie in with theory?

25
Signaling and Dividends

• Ross (1977)
• in the MM world - market knows the return stream
  of the firm
• in reality, there is asymmetric information
• managers (but not the market) know the return
  stream

26
Payout Policies

• Introduction
• MM irrelevance theorem
• Personal taxation and dividend policy
• Signaling and dividends
• Dividend smoothing
• Disappearing dividends
• Agency costs and dividends
• Stock repurchases

27
Dividend smoothing

• Almost all firms maintain constant nominal
  dividend payments per share for long periods of
  time
• smoothing of dividend payments
• dividends only ? when permanent income ?
• Why?

28
Dividend smoothing

• Lintner (1956) - seminal paper on dividends
• firms have a target dividend payout
• most mgt avoid making changes to divs. that will
  be reversed in short-term
• ? permanent income ? ? dividend payment (and vice
  versa)
• investment requirements have little impact on
  dividend behaviour

29
Payout Policies

• Introduction
• MM irrelevance theorem
• Personal taxation and dividend policy
• Signaling and dividends
• Dividend smoothing
• Disappearing dividends
• Agency costs and dividends
• Stock repurchases

30
Disappearing dividends

• Fama and French (2001)
• Find for the U.S. that
• proportion of firms paying cash dividends falls
  from 66.5 in 1978 to 20.8 in 1999
• Disappearing dividends!
• Could this be due to increased usage of stock
  repurchases?

31
Disappearing dividends

• Changing firm characteristics
• there is a greater proportion amongst traded
  firms of small firms with low profitability and
  strong growth opportunities
• These are characteristics of firms that have
  never paid dividends

32
Disappearing dividends

• Why are small firms more likely to pay no
  dividends?
• Pecking order model
• high transactions costs of issuing securities
• Why are high profitability firms more likely to
  pay dividends?
• Controls the agency costs of free cash flow -
  Jensen (1986)
• Why are firms with good investment opportunities
  more likely to pay no dividends?
• Pecking order model

33
Disappearing dividends

• Lower propensity to pay
• Why?
• A. lower transactions cost for selling stock for
  consumption purposes (clientele effect)
• B. larger holdings of stock by managers who
  prefer capital gains to dividends (personal tax
  reason)
• C. better corporate governance technologies that
  lower the benefits of dividends in controlling
  agency problems between stockholders and managers.

34
Disappearing dividends

• Many interpret the evidence of Fama and French as
  dividends themselves are disappearing.
• However, Fama and French find that it is dividend
  payers which are disappearing NOT dividends.

35
Disappearing dividends

• DeAngelo et al (2004) find that
• Dividends paid by US industrial firms actually
  increased by 22.7 in real terms over the period
  1978-2000
• Why did aggregate real dividends increase despite
  a 50 fall in the number of payers?
• Large increase in earnings and hence dividends of
  largest payers.
• The largest 25 dividend payers in 2000 supplied
  54.9 of aggregate industrial dividends.

36
Payout Policies

• Introduction
• MM irrelevance theorem
• Personal taxation and dividend policy
• Signaling and dividends
• Dividend smoothing
• Disappearing dividends
• Agency costs and dividends
• Stock repurchases

37
Agency costs and dividends

• Free cash flow and agency costs
• Discipline of capital market
• Agency costs and cross-sectional differences in
  payout ratios
• LLSV (2000)

38
Free cash flow and agency costs

• Dividend policies address agency conflicts
  between
• corporate insiders
• outside shareholders
• unless profits are paid out to SHs they may be
• diverted by insiders for personal use
• committed to projects with -ve NPVs which
  provide personal benefits to insiders

39
Free cash flow and agency costs

• By paying dividends, insiders are giving earnings
  to SHs and ?cant use these earnings for their
  own benefit
• Dividend payments serve as a type of bonding
  mechanism
• They bond insiders to a certain type of behaviour.

40
Lecture outline

• Free cash flow and agency costs
• Discipline of capital market
• Agency costs and cross-sectional differences in
  payout ratios
• LLSV (2000)

41
Discipline of capital markets

• By paying dividends, managers must go to the
  capital market more often to raise funds.
• In doing so, they are subject to the scrutiny and
  disciplining effects of investment professionals
• Shareholders are willing to accept higher
  personal taxes in exchange for this monitoring by
  the investment community

42
Lecture outline

• Free cash flow and agency costs
• Discipline of capital market
• Agency costs and cross-sectional differences in
  payout ratios
• LLSV (2000)

43
Agency costs and cross-sectional differences in
payout ratios

• Rozeff (1982) argues that agency costs may
  explain cross-sectional differences in dividend
  payouts across firms.
• Rozeff argues that insider ownership and dividend
  payments are substitutes. What does this imply?
• Industry patterns (across the world)
• firms in mature industries have higher dividend
  payouts than firms in young, rapidly growing
  industries. Why?
• Utility cos. have very high dividend payouts.
  Why?

44
Agency costs and cross-sectional differences in
payout ratios

• Industry patterns (across the world)
• large firms (on average) have higher dividend
  payouts than small firms. Why?
• regulated companies have higher dividend payouts.
  Why?

45
Lecture outline

• Free cash flow and agency costs
• Discipline of capital market
• Agency costs and cross-sectional differences in
  payout ratios
• LLSV (2000)

46
LLSV (2000)

• Agency explanation rationalises why there are
  differences across industries.
• But why do they differ across countries?
• National differences in dividend policies
• highest in industrialised nations
• developing countries pay low or no dividends
• countries that rely on capital markets pay higher
  dividends
• Socialist economies tend to discourage dividends
  (France)

47
LLSV (2000)

• Why do these differences exist?
• LLSV (2000) argue that agency costs and investor
  protection regimes explain differences in
  dividend policies across the world.

48
LLSV (2000)

• Outcome model
• Dividends are an outcome of legal protection of
  shareholders.
• Not necessarily legal rights to dividends.
• Minority shareholders can force companies to pay
  out cash using legal powers e.g. voting for
  directors, takeovers, suing company.
• Firms cant rip off minority shareholders ? they
  will return cash to them

49
LLSV (2000)

• Predictions of outcome model
• dividend payout ratios are higher in countries
  with good legal protection of shareholders
• companies with good investment opportunities
  will have lower dividend payout ratios

50
Dividends / Earnings
High investor protection
Low investor protection
Investment Opportunities
51
LLSV (2000)

• Substitute model
• Dividends serve as a substitute for legal
  protection of S/Hs
• This view rests on the need for firms to come
  occasionally to the market to raise capital.
• Firms need a good reputation to raise money
  continually.

52
LLSV (2000)

• Paying dividends gives a firm a reputation for
  not expropriating SHs
• Firms want this reputation so that they can raise
  further equity finance.
• When does reputation become of no value?

53
LLSV (2000)

• Predictions of substitute model
• dividend payout ratios are lower in countries
  with good legal protection of shareholders
• companies with good investment opportunities may
  pay out more to maintain their reputations

54
Dividends / Earnings
Low investor protection
High investor protection
Investment Opportunities
55
LLSV (2000)

• Examine dividend payouts of 4,104 firms from 33
  countries
• Classify countries into
• High and Low protection economies
• Common and Civil law economies
• Common law countries typically have high investor
  protection regimes

56
LLSV (2000)

• Common law countries typically have higher payout
  ratios than civil law countries
• High investor protection countries have higher
  payout ratios than low investor protection
  countries

57
LLSV (2000)

• Evidence supports outcome agency model of
  dividends.
• Why?
• Firms appear to pay cash out to investors
  because the opportunities to steal or misinvest
  it are in part limited by law, and because
  minority shareholders have enough power to
  extract it

58
Payout Policies

• Introduction
• MM irrelevance theorem
• Personal taxation and dividend policy
• Signaling and dividends
• Dividend smoothing
• Disappearing dividends
• Agency costs and dividends
• Stock repurchases

59
Stock repurchases

• What are stock repurchases?
• The equivalence of dividends and stock
  repurchases
• Why do companies repurchase shares?
• Why increased usage of stock repurchases?

60
What are stock repurchases?

• aka Corporate Equity Repurchases
• Average cash distribution is usually large - 20
  of firms market value
• A firm can use 2 methods to repurchase
  outstanding shares.
• Open market stock repurchase scheme
• Shares are purchased on the open market gradually
  over time.
• Most used method

61
What are stock repurchases?

• Tender offer
• Shares are repurchased on a one-time basis
• leads to sudden and dramatic changes in the
  number of issued shares
• NB shareholders are NOT forced to sell their
  shares.

62
What are stock repurchases?

• By repurchasing shares, the number of outstanding
  shares is reduced.
• These shares are held by the firm and can be
• Resold later e.g. in conjunction with exercise of
  employee or executive stock options
• Reissued as compensation in a acquisition

63
What are stock repurchases?

• Stock repurchases have at least five practical
  effects
• Firms assets are reduced as cash is paid out.
  Who might this affect?
• Leverage is increased.
• Firm is adding substantially to the demand for
  its stock driving up stock price
• The firms active involvement in the secondary
  market may enhance liquidity.
• The liquidity of shares decreases either because
  the number of free-floating shares falls or the
  dealers increase their bid-ask spread as they
  face the firm as an ongoing informed trader

64
What are stock repurchases?

• Have become increasingly common
• US firms
• Average repurchase payout ratio
• 1974 3.7 1998 13.6
• Average dividend payout ratio
• 1974 22.3 1998 13.8
• Firms that have repurchased shares
• 1974 27 1998 81

65
Lecture outline

• What are share buybacks?
• The equivalence of dividends and stock
  repurchases
• Why do companies repurchase shares?
• Why increased usage of stock repurchases?

66
The equivalence of dividends and stock repurchases

• Goo.com earned 4m in 2005 and decides to payout
  50 either as dividends or share repurchase.
• The company has 1m shares outstanding with a
  market value of 10 per share.
• It can
• pay dividends of 2 per share
• repurchase shares at 10/share

67

• Current value of firm 10m.
• For 2m, it can repurchase 200,000 shares
• ?after repurchase, value of firm
• 10m - 2m 8m
• share price 8m / 800,000 10 (no price
  effect from repurchase)

68

• Comparison of shareholders wealth before tax
• Pay dividends
• 2 dividend ex-div share price 8 (8m / 1m
  shares)
• Share repurchase
• Share price 10 (whether shareholder sold
  shares to company or not)

69
Lecture outline

• What are share buybacks?
• The equivalence of dividends and stock
  repurchases
• Why do companies repurchase shares?
• Why increased usage of stock repurchases?

70
Why do companies repurchase shares? Tax
avoidance hypothesis

• Managers use share repurchases instead of
  dividends to minimise shareholders taxes.
• Capital gains are taxed less heavily than
  dividend income
• What impact will the elimination of taxes on
  dividends in the US have on corporate behaviour?

71
Why do companies repurchase shares? Signalling
hypothesis

• Managers are better informed about the future
  prospects of the firm than outside shareholders.
• A share repurchase could signal that
• Firm has exhausted all profitable investment
  opportunities
• Expect future cash flows to increase
• But why choose repurchases rather than dividends
  to do this?

72
Why do companies repurchase shares? Agency costs
of free cash flow hypothesis

• If firms no longer have profitable investment
  opportunities they may make a share repurchase to
  reduce the amount of free cash they have.
• This prevents managers expropriating it.
• Studies have shown that the market reacts
  favourably to share buyback programs whose
  investment opportunities have declined.

73
Why do companies repurchase shares? Leverage tax
shield hypothesis

• If repurchase is financed by issuing debt ?
  leverage ? and if gain to leverage, SHs benefit
• Usually via a tender offer leads to dramatic
  and sudden changes in capital structure compared
  to a debt-financed dividend payout or open market
  repurchase

74
Why do companies repurchase shares? Bondholder
expropriation hypothesis

• Repurchase may unexpectedly reduce the amount of
  collateral backing bond issues.
• However, this only applies to unsecured lenders,
  and the ability of firms to repurchase should be
  factored into the interest rate charged by the
  lender.

75
Why do companies repurchase shares? Stock option
hypothesis

• Executive compensation over the past 20 years has
  contained more and more stock options.
• As share prices increase, stock options become
  more valuable.
• What happens share prices if firms retain
  earnings rather than pay out dividends?
• Once options are exercised, firms then repurchase
  shares.

76
Why do companies repurchase shares? Stock option
hypothesis

• However, firms may repurchase shares after
  options are exercised to offset the increase in
  common equity resulting from the option being
  exercised.
• This may only be the case for employee stock
  options.

77
Lecture outline

• What are share buybacks?
• The equivalence of dividends and stock
  repurchases
• Why do companies repurchase shares?
• Why increased usage of stock repurchases?

78
Why increased usage of share buybacks?

• Firms have now reached the stage where they
  distribute more cash via repurchases than
  dividends. Why has this arisen?
• Regulatory changes less regulatory hostility to
  buybacks.
• Tax efficiency reasons less likely to explain
  changes
• Increasing use of stock options most likely
  explanation.

79
Reading

• Baker, H., Powell, G. and Veit, E. (2002),
  Revisiting the Dividend Puzzle Do All of the
  Pieces Now Fit, Review of Financial Economics,
  11 241-261.
• Fama, E. F. and French, K. R. (2001),
  Disappearing Dividends Changing Firm
  Characteristics or Lower Propensity to Pay?,
  Journal of Financial Economics, 60 3-43.
• La Porta, R., Lopez-De-Silanes, F., Shleifer, A.
  and Vishny, R. W. (2000), Agency Problems and
  Dividend Policies Around the World, Journal of
  Finance, 551-33.
• Relevant Chapters in 1) Arnold
• 2) Brearly Myres