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Payout Policy

Payout Policy. Advanced Corporate Finance 2 October 2007. Does payout policy affect firm value?. Perfect capital markets analysis: Miller and Modigliani (1961) – Dividend policy is irrelevant! Investor taxation theories Signaling theories Agency cost arguments Clientele effect

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Payout Policy

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  1. Payout Policy Advanced Corporate Finance 2 October 2007

  2. Does payout policy affect firm value? • Perfect capital markets analysis: Miller and Modigliani (1961) – Dividend policy is irrelevant! • Investor taxation theories • Signaling theories • Agency cost arguments • Clientele effect • Is payout policy really irrelevant? • Role of repurchases in payout policy

  3. Dividend Irrelevance • Perfect capital markets • Investment decision is all that matters to firm value. • Investors are indifferent between capital gains and dividends. • Any “excess” dividends would have to be financed with new financing.

  4. Basic example of dividend irrelevance • Next period net income = $5 per share. • Cost of equity = 10% and no economic profits. • Decision: how much to pay to shareholders during period? • Suppose 100% of NI • Suppose 50% of NI • Suppose none of it • Value is equivalent regardless of payout.

  5. Investor taxation • Suppose dividends are taxed at a different rate than are capital gains. • Assume 40% tax rate on dividends and 0% on capital gains. • Investors prefer less payout. • 100% payout: investor earns 6% after taxes. • 50% payout: 8% after taxes. • 0% payout: 10% after taxes.

  6. Empirical implication of tax story • Brennan (1970): If dividends are taxed at higher rate than capital gains, expected returns on stocks with higher dividend yields need to be higher. • Equation 16.15 adds a “dividend yield” factor to CAPM. • Mixed empirical support for the tax theory (see discussion in Section G…pp. 676 - 679).

  7. Are dividends a signaling mechanism? • Asymmetric information environment (remember pecking order?) • Issuing securities is “bad” news. • Reverse argument: paying off investors signals “good” news (i.e., positive announcement effect). • Unexpected dividend increase is associated with greater earnings surprise (in theory). • Is dividend increase really predictive of future earnings increases?

  8. Agency costs, investment opportunities, and dividends • Agency costs of free cash flow argument as benefit of dividends. • Cost of dividends = flotation costs of raising new capital. • Firms choose a dividend payout ratio in which the marginal benefits = marginal costs. • Firms with more growth opportunities, higher risk, and fewer potential agency problems optimally pay lower dividend

  9. Dividend clientele effect • Elton and Gruber (1970) • Another tax argument • Investors in higher tax brackets choose stocks with lower dividend yields. • Estimating tax bracket of average investor • Equation 16.29

  10. Irrelevance of dividend irrelevance – DeAngelo & DeAngelo working paper • Based on DeAngelo and DeAngelo (2006) • Miller and Modigliani model includes implicit assumption that 100% of FCFE is paid out every period. • Highly restrictive assumption that guarantees “irrelevance” result. • Recall definition of FCFE from class session on valuation.

  11. Irrelevance of dividend irrelevance (cont’d) • Define “investment value” of stock. • Define “distribution value” of stock. • Distribution value (DV) <= Investment value (IV) • Optimal payout policy results in DV = IV • Optimal payout policy = full PV of FCFE over stock’s life. • Miller & Modigliani assumed payout is included in set of optimal payout policy. • Timing and form (div vs. repurchase) do not affect value as long as optimal payout policy is followed.

  12. Irrelevance of dividend irrelevance (cont’d) • Firms trade off benefits vs. costs of retaining FCFE to determine payout level at any point in time. • Factors that encourage retention. • Factors that discourage retention. • DeAngelo, DeAngelo, and Stulz (2006) life-cycle theory: • Young firms largely face issues that encourage retention while mature firms face higher marginal costs of retaining cash flow.

  13. Repurchases • Offer alternative means to distribute cash flow to shareholders (Recall definition of FCFE). • Have taken much larger role in payout policy in last 20 years. • Often misunderstood effect on value: • Relation between EPS and stock price • Does the act of repurchasing stock cause higher stock price?

  14. Basic valuation examples • All-equity company with zero expected economic profits and cost of equity = 10% • Next year’s expected EBIT = 100 • Tax rate = 40% • 12 shares of stock outstanding. • Examples: • Use existing cash to repurchase stock. • Issue debt to repurchase stock. • Cuts dividend to repurchase stock.

  15. “Payout Policy in the 21st Century” • Brav et al. (2005): Survey of 384 financial execs. • Maintenance of dividend level of similar priority to making good investments. • Dividends are paid “conservatively.” • Repurchases reflect residual cash flow after investment. • Managers increasingly favor repurchases as payout mechanism because of greater flexibility. • Many managers would prefer to reduce current dividend payout.

  16. Repurchases: Differences from dividend increases • Evidence suggests that firms use repurchases as a substitute for increased dividends – Grullon and Michaely (2002). • Other differences: • Role of market regulation (SEC in US). • Role of employee stock options – Kahle (2002). • Effect on value of exec stock options – Fenn and Liang (2001). • Timing (valuation issues). • Effect on EPS – Bens et al. (2003).

  17. References • Bens, D.A., V. Nagar, D.J. Skinner, and M.H.F. Wong, 2003, “Employee stock options, EPS dilution, and stock repurchases,” Journal of Accounting and Economics 36, 51-90. • Brav, A., J.R. Graham, C.R. Harvey, and R. Michaely, 2005, “Payout policy in the 21st century,” Journal of Financial Economics 77, 483-527. • Brennan, M., 1970, “Taxes, market valuation and corporate financial policy,” National Tax Journal, December, 417-427. • DeAngelo, H., and L. DeAngelo, 2006, “The irrelevance of the MM dividend irrelevance theorem,” Journal of Financial Economics 79, 293-315. • DeAngelo, H., and L. DeAngelo, 2006, “Payout policy pedagogy: What matters and why,” unpublished working paper. • DeAngelo, H., L. DeAngelo, and R.M. Stulz, 2006, “Dividend policy and the earned/contributed capital mix: A test of the life-cycle theory,” Journal of Financial Economics 81, 227-254. • Elton, E.J., and M.J. Gruber, 1970, “Marginal stockholders’ tax rates and the clientele effect,” Review of Economics and Statistics, February, 68-74. • Fenn, G.W., and N. Liang, 2001, “Corporate payout policy and managerial stock incentives,” Journal of Financial Economics 60, 45-72. • Grullon, G., and R. Michaely, 2002, “Dividends, share repurchases, and the substitution hypothesis,” Journal of Finance 62, 1649-1684. • Kahle, K.M., 2002, “When a buyback isn’t a buyback: Open market repurchases and employee stock options,” Journal of Financial Economics 63, 235-261. • Miller, M.H., and F. Modigliani, 1961, “Dividend policy, growth, and the valuation of shares,” Journal of Business 34, 411-433.

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