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Chapter 17. Payout Policy


  1. When a firm wants to distribute cash to its shareholders, it can pay a cash dividend or it can repurchase shares.
    1. Most companies pay regular, quarterly dividends. Sometimes firms announce onetime, special dividends.
    2. Firms repurchase shares using an open market repurchase, a tender offer, a Dutch auction repurchase, or a targeted repurchase.

  2. On the declaration date, firms announce that they will pay dividends to all shareholders of record on the record date. The ex-dividend date is the first day on which the stock trades without the right to an upcoming dividend; it is usually two trading days prior to the record date. Dividend checks are mailed on the payment date.
  3. In a stock split or a stock dividend, a company distributes additional shares rather than cash to shareholders.
  4. In perfect capital markets, the stock price falls by the amount of the dividend when a dividend is paid. An open market share repurchase has no effect on the stock price, and the stock price is the same as the cum-dividend price if a dividend were paid instead.
  5. The Modigliani-Miller dividend irrelevance proposition states that in perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price.
  6. In reality, capital markets are not perfect, and market imperfections affect firm dividend policy.
  7. Taxes are an important market friction that affects dividend policy.
    1. Considering taxes as the only market imperfection, when the tax rate on dividends exceeds the tax rate on capital gains, the optimal dividend policy is for firms to pay no dividends. Firms should use share repurchases for all payouts.
    2. The effective dividend tax rate, τ*d, measures the net tax cost to the investor per dollar of dividend income received.
      Equation 17.3
      The effective dividend tax rate varies across investors for several reasons, including income level, investment horizon, tax jurisdiction, and type of investment account.
    3. Different investor taxes create clientele effects, in which the dividend policy of a firm suits the tax preference of its investor clientele.

  8. Modigliani-Miller payout policy irrelevance says that, in perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s choice of payout versus retention is irrelevant and does not affect the initial share price.
  9. Corporate taxes make it costly for a firm to retain excess cash. Even after adjusting for investor taxes, retaining excess cash brings a substantial tax disadvantage for a firm.
  10. Even though there is a tax disadvantage to retaining cash, some firms accumulate cash balances. Cash balances help firms minimize the transaction costs of raising new capital when they have future potential cash needs. However, there is no benefit to shareholders from firms holding cash in excess of future investment needs.
  11. In addition to the tax disadvantage of holding cash, agency costs may arise, as managers may be tempted to spend excess cash on inefficient investments and perks. Without pressure from shareholders, managers may choose to horde cash to spend in this way or as a means of reducing a firm’s leverage and increasing their job security.
  12. Dividends and share repurchases help minimize the agency problem of wasteful spending when a firm has excess cash.
  13. Firms typically maintain relatively constant dividends. This practice is called dividend smoothing.
  14. The idea that dividend changes reflect managers’ views about firms’ future earnings prospects is called the dividend signaling hypothesis.
    1. Managers usually increase dividends only when they are confident the firm will be able to afford higher dividends for the foreseeable future.
    2. When managers cut the dividend, it may signal that they have lost hope that earnings will improve.

  15. Share repurchases may be used to signal positive information, as repurchases are more attractive if management believes the stock is under-valued at its current price.
  16. With a stock dividend, shareholders receive either additional shares of stock of the firm itself (a stock split) or shares of a subsidiary (a spin-off). The stock price generally falls proportionally with the size of the split.
  17. A reverse split decreases the number of shares outstanding, and therefore results in a higher share price.

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