FIN 413
Corporate Financial Policy
Clifford W. Smith, Jr.
Spring 2007
Handout 8
* Covers readings on course outline through Barclay/Smith/Watts (1997)
Payouts to Stockholders
Can Take a Number of Forms
 Regular cash dividends
 Open market repurchases
 Intra-firm tender offers
 Targeted repurchases
 Specially designated dividends
Payouts to Shareholders by
NYSE Firms (1983 - 1986)
Total Payout
($Billions)
Percent of
Firms
Percent of
Equity
Regular Cash
Dividends
67.40
80.65
4.26
Open Market
Repurchases
19.27
10.67
1.15
Intra-Firm
Tender Offers
3.46
0.76
0.21
3.51
2.81
0.21
0.34
2.22
0.02
Targeted
Repurchases
Specially
Designated
Dividends
(Barclay/Smith, JFE 1988)
The Dividend Payout Process
1
2
3
(1) Adoption Date
(2) Announcement Date
(3) Ex-Dividend Date
(4) Record Date
(5) Payment Date
4
5
Time
Questions About Payout Policy

How does payout policy affect firm value?

How have dividends varied over time?

What determines the level of payouts?

What determines the form of payouts?

How does the market react to announcements
about changes in payouts?

What is the behavior of the stock price at the exdividend date?
Dividend Policy

What do we mean by the question, "Does a firm's
dividend policy affect firm value?"

Cash flow identity sources of funds = uses of funds
NCFt + St + Bt = DIVt + Rt + Pt + It

It is not possible to change dividend payments and
hold everything else constant
Why Do Firms Pay Dividends?
 The bird-in-the-hand fallacy
– Consider two alternatives
 A 50/50 chance at $100 or $105
 $1 for sure and a 50/50 chance at $99 or
$104
– Holding real investments constant, dividend
payments do not make the firm less risky
– Absent taxes and transaction costs, investors can
manufacture any dividend level they desire
Historical Evidence
Barclay, Smith, and Watts (1995) JACF, Vol. 7, pp. 4-19.
Miller/Modigliani II
 If the choice of payout policy affects
current firm value, then it does so by
– Changing tax liabilities
– Changing contracting costs
– Changing investment incentives
Why Do Firms Pay Dividends?
 Dividends reduce transaction costs for some
investors
–
Some investors consume from their portfolios and
dividend payments save them the costs selling
stock to generate income.
–
Other investors are saving and have increased
transaction costs associated with reinvesting the
dividends.
–
Paying dividends and raising external capital
creates additional transaction costs for the firm.
Why Do Firms Pay Dividends?
 Dividends payments can provide better
investment incentives by reducing the
conflicts between managers and
shareholders.
–
Monitoring management and the free cash
flow problem.
–
The role of investment bankers in the capital
acquisition process.
Corporate Bonding Mechanisms
 Bond Ratings
 Audited Financial
Statements
 Insurance Purchases
 External Board Members
 Investment Bankers
Investment Opportunity Set
Assets in
Place
Cost of Dividends
(Flotation Costs)
Benefits of Dividends
(Free Cash Flow)
Predicted Dividend Yield
Growth
Opportunities
Low
High
High
Low
High
Low
Barclay, Smith, Watts (1995) JACF, Vol. 7, p 4-19
Firm Characteristics
Growth Options (Merck)
Payout Policy
Lower
Credence Goods (Eastern)
–
Product Warranties (Yugo)
–
Future Product Support (Yugo/Wang)
–
Supplier Financing (Campeau)
–
Closely Held Firm
Size
Regulation
Lower
–
Higher
Firm Specific Assets
–
Investment Tax Credits
–
Marginal Corporate Tax Rate
–
Marginal Personal Tax Rate
–
Investment Opportunity Set
Assets in
Place
Growth
Opportunities
Capital Structure
Leverage
High
Low
Maturity
Long
Short
Priority
Diffuse
Leasing
High
Low
Level of Pay
Low
High
Conditional Pay
Low
High
Hedging
Low
High
Dividends
High
Low
Concentrated
Compensation
The Investment Opportunity Set and
Corporate Financing, Dividend and
Compensation Policies
Correlation Matrix
E/V
D/P
Log (Salary)
D/P
-0.49*
Use of Stock
Options
Log (Salary)
0.70**
0.73**
-0.19
-0.64
0.70**
(Smith/Watts, 1992)
Why Do Firms Pay Dividends?
 Managers use dividend payments to
"signal" their private information to the
market.
– Dividend changes contain information, but
the quality of the signal is poor.
– Signaling related to dividend changes and
provides little insight about optimal
dividend levels.
The Information Content
of Dividend Changes
Unexpected Change
in Dividends
Unexpected Change
in Earnings in the
Following Year
Positive
Negative
+
53
47
–
49
51
(Watts)
The Information Content
of Dividend Changes

There is strong empirical evidence that changes in
dividend levels are associated with changes in firm value.
– Charest
Div.  
Div.  
– Asquith/Mullens
Div. initiation
– Brickley
Stock price 1.3%
Stock price  3.8%

SDD

Stock price 3.7%
Stock price 2.1%
(Size adjusted, the SDDs have smaller stock price effects than
regular dividend increases.)
The Information Content
of Dividend Changes
 The association between stock price
changes and dividend changes is most
easily interpreted in conjunction with the
cash-flow identity.
sources of funds = uses of funds
NCFt + St + Bt = DIVt + Rt + Pt + It
DIVt = NCFt + St + Bt - Rt - Pt - It
Securities Issuance Process
1
2
3
4
5 6 7
8
Time
(1) Management contacts investment banker/
investment banker begins evaluation of the firm's
demand for capital
(2) Firm begins to contact others to assist in preparation
of the registration statement (public accounting
firm, law firm, consulting engineers, etc.)
- Investment banker begins to contact other investment
bankers to form syndicate
Securities Issuance Process
1
2
3
4
5 6 7
8
Time
(3) File registration statement with the SEC
- Make public announcement of the offering
 while issue is in registration only tombstone ads and red
herring prospectus can be distributed
 syndicate begins to solicit indication of interest
(4) SEC notifies the firm that the registration statement
is effective
- Due diligence meeting is schedule
- All major parties to the offering meet to certify that all
required activities have been completed
- Offering date (6) is set
Securities Issuance Process
1
2
3
4
5 6 7
8
Time
(5) Offer price is set
–
Typically after the close of business the day before the
offering - but sometimes after the open on the offer date
–
Under US securities laws, shares cannot be sold for more
than the offer price
–
Shares cannot be sold below the offer price unless the
syndicate breaks
UBS strengthens protection against
Gulf war for underwriters
By Tracy Corrigan
UNION Bank of Switzerland added a specific
reference to the Middle East in the
documentation of a new issue launched in the
Swiss bond market yesterday, to tighten legal
protection for underwriters in the event of war in
the Gulf.
The reference was added to the standard 'force
majeure' clause in the documentation of a
SFr50m private placement for the Japanese
company Tokyo Tatemono. This clause, in UBS
documentation, typically refers to political,
economic or monetary crisis in Switzerland, the
borrower's country or elsewhere. At the end of
this definition, arranger UBS added the words 'in
particular the Middle East'. According to an
official at UBS, the addition was made as an
'extra precaution' to ensure the issue could be
cancelled quickly should war break out.
FINANCIAL TIMES WEDNESDAY JANUARY 9 1991
Many underwriters believe that existing 'force
majeure' clauses are adequate, but because the
wording of most clauses is general rather than
specific, there has been some uncertainty about
the level of protection provided. The issue was
discussed at a meeting of the legal committee of
the International Primary Markets Association
last month, but no formal position was agreed.
The Tokyo Tatemono deal, launched
yesterday by UBS, will be signed on January 16.
The 'force majeure' protection expires on the
closing date, January 23, when the issue goes
from the primary to the secondary market. By
this stage, all the paper would normally be sold,
so underwriters would no longer be exposed.
However, with investors adopting a cautious
stance, underwriters are likely to be more than
usually careful to participate only in deals which
they are confident can be placed within the
primary period.
Securities Issuance Process
1
2
3
4
5 6 7
8
Time
(6) Offer date -- securities offered to the public
(7) Offering sold -- frequently within the hour
(8) Settlement date -- net proceeds are paid to
the issuer
Smith, C.W. (1986) Midland Corporate Finance Journal, Vol. 4, (No.1), p 7
Generalizations about Relative
Magnitudes Suggested in Table 1

Average abnormal returns are non-positive

Abnormal returns associated with announcements of
common stock are negative and larger in absolute value
than those observed with debt or preferred stock

Abnormal returns associated with announcements of
convertible securities are negative and larger in absolute
value than those for the corresponding non-convertible
securities.

Abnormal returns associated with sales of securities by
industrials are negative and larger in absolute value than
those for utilities
Potential Explanations of the Pattern
of Stock Price Effects in Table 1
 Optimal capital structure theories
 Implied cash flow changes
 Degree to which announcements were
unanticipated
 Information asymmetry hypotheses
 Ownership changes
Optimal Financial Policy
Let's assume that we are learning about an optimal capital
structure. The relation between firm value and leverage is convex.
Thus, if the function is stable and firms maximize value,
announcements of new security sales imply firm value increases.
Firm Value
New Value
Old Value
Old
Leverage
New
Leverage
Leverage
Optimal Financial Policy
If the announcement releases new information to the market, then
the relation between firm value and leverage shifts and there is no
prediction about the sign of the value change.
Firm Value
Old Value
New Value
Old New
Leverage Leverage
Leverage
Implied Cash Flow Changes
DT + RT + PT + IT = NCFT + ST + BT
where for the period T:
DT
= the dividend paid
RT
= interest paid
PT
= debt principal paid
IT
= new investment
NCFT
= the firm's net operating cash flow
ST
= the proceeds from the sale of new equity net of
transactions costs
BT
= the proceeds from the sale of bonds net of
transactions costs
Therefore
NCFT = DT - ST + RT - BT + PT + IT
Smith, C.W. (1986) Midland Corporate Finance Journal, Vol. 4, (No.1), p 11
Smith, C.W. (1986) Midland Corporate Finance Journal, Vol. 4, (No.1), p 13
Smith, C.W. (1986) Midland Corporate Finance Journal, Vol. 4, (No.1), p 15
Toward a Unified Theory
of Corporate Financial Policy:
Integration of Stocks and Flows
 Determine the optimal capital structure for
the economic balance sheet.
 Look at the trajectory of capital structure.
 Whenever the costs of deviating from target
exceed the cost of adjustment - adjust.
Adjustment Costs
 Differ by transaction

─
Costs of share issues are higher than that for debt
─
Costs of share issues are higher than that of share
repurchases
Exhibit fixed costs and scale economics
─
Equity offers are rare while bank loans are common
─
Optimal adjustment frequently involves overshooting
─
Most companies spend considerable time away from their
target
"You got to be careful if you
don't know where you're going,
because you might not get there"
Yogi Berra