Session 5
Payout Policy
FIN 625: Corporate Finance
Learning Objectives
LO 1: Explain the general terminologies and
price behavior with regard to corporate
payout.
LO 2: Explain the conditions under which
payout policies matter or do not matter.
LO 3: Explain the benefits and drawbacks of
share purchase vs. dividend.
LO 4: Explain the dividend “smoothing”
mechanism by corporations.
Outline
1.
2.
3.
4.
5.
6.
Importance of Corporate Payout
General Terminology and Price Behavior
The Irrelevance of Payout Policy
The Relevance of Payout Policy
What Do We Know About Corporate
Payout
Stock Dividend
1. Importance of Corporate Payout

Taken from Servaes and Tufano (2006): CFO Views on the Importance and Execution of the
Finance Function.
Importance of Corporate Payout
2. General Terminology and Price
Behavior
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Many companies pay a regular cash dividend.
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Firms often repurchase their own shares back.
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Open market
Tender offer
Targeted repurchase (“Greenmail”)
Companies will often declare stock dividends.
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Public companies often pay quarterly.
Sometimes firms will pay an extra cash dividend.
Terms: dividend per share, dividend yield (div/P),
dividend payout ratio (div/NI)
No cash leaves the firm.
The firm increases the number of shares outstanding.
Some companies declare a dividend in kind.

Wrigley’s Gum sends a box of chewing gum.
Survey Evidence on Different Types of
Payout
93%
Regular dividends
Share repurchases
39%
25%
Special dividend
13%
Split or reverse split
Stock dividend
8%
Taken from Servaes and Tufano (2006): The Theory and Practice of Corporate Payout Policy
Procedure for Cash Dividend
25 Oct.
2 Nov.
3 Nov.
5 Nov.
7 Dec.
…
Declaration
Date
ExCumdividend dividend
Date
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 of the firm.
Price Behavior

In a perfect world, the stock price will fall by the
amount of dividend on the ex-dividend date.
-t
…
-2
-1
0
+1
+2
…
$P
$P - div
The price
ex-dividend
drops by the
Date
amount of the Taxes complicate things a bit. Prices drop by
dividend.
div (1-TP), where TP is the personal tax rate.
3. The Irrelevance of Payout Policy
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Key assumptions for M&M Dividend
Irrelevance Proposition:
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Fixed investment policy
No transactions costs
No (personal) taxes
Rationality
The interests of managers and shareholders
are aligned
No asymmetric information (managers do not
know more about the firm than shareholders)
Homemade Dividend

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Dividend Inc. is a $42 stock which is about
to pay a $2 cash dividend.
Bob owns 80 shares and prefers a $3
dividend. Let’s compare how Bob fares if
the firm pays $3 cash dividend instead, or
he simply follows the “homemade”
dividend strategy.
Homemade Dividend

Bob’s homemade dividend strategy:

Sell _2__ shares ex-dividend
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
Dividend Policy is Irrelevant

In the above example, Bob began with a total
wealth of $3,360:
$42
$3,360  80 shares 
share
 After a $3 dividend, his total wealth is still $3,360:
$39
$3,360  80 shares 
 $240
share
 After a $2 dividend and sale of 2 ex-dividend shares,
his total wealth is still $3,360:
$40
$3,360  78 shares 
 $160  $80
share
Repurchase Policy is Irrelevant
In an ideal word, consider a firm that wishes to
distribute $100,000 to its shareholders.
Assets
Liabilities & Equity
A. Original balance sheet
Cash
$150,000
Other Assets
850,000
Value of Firm
1,000,000
Debt
0
Equity
1,000,000
Value of Firm
1,000,000
Shares outstanding = 100,000
Price per share = $1,000,000 /100,000 = $10
Stock Repurchase versus Dividend
If they distribute the $100,000 as a cash dividend, the
balance sheet will look like this:
Assets
Liabilities & Equity
B. After $1 per share cash dividend
Cash
$_50,000_ Debt
Other Assets
$_850,000_Equity
$_900,000_
Value of Firm
$_900,000_Value of Firm
$_90,0000_
Shares outstanding = _100,000_
Price per share = $_9_
0
Stock Repurchase versus Dividend
If they distribute the $100,000 through a stock
repurchase, the balance sheet will look like this:
Assets
Li abilities & Equity
C. After stock repurchase
Cash
$50,000
Debt
Other Assets
$850,000 Equity
$900,000
Value of Firm
$900,000 Value of Firm
$900,000
Shares outstanding = _90,000_
Price per share = _$10_
0
4. The Relevance of Payout Policy
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The irrelevance of the payout policy
hinges on the “perfect market”
assumptions.
Violations of these assumptions may lead
to the result that payout policy is relevant.
If investment policy is not held constant,
then firms should never forgo positive
NPV projects to increase payout (or to
initiate payout), because while investment
policy can increase firm value, payout
policy cannot.
When Is Payout Policy Relevant?
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Issuance costs
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This implies firms should avoid paying dividends or
repurchasing shares, to reduce the need to go to
external capital market to raise funds and incur such
costs.
Personal taxes
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Firms should avoid payout if they do not have
sufficient cash flows to pay.
When cash flows are ample, repurchase is better
than dividend, because “effective” tax rate under
repurchase is lower.
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Repurchase is taxed on the profit of the trade, while
dividend is taxed on the total cash receipts.
Capital gains tax under repurchase can be deferred.
When Is Payout Policy Relevant?
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Irrationality - Behavioral Finance
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Agency costs
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Corporate payout, especially dividend solves the
self-control problem.
Corporate payout, especially dividends reduce free
cash flows.
Asymmetric information - signaling
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Payout increase or initiation signals good prospect
of the firm.
Companies often cite “depressed” stock price as a
reason for repurchase.
Dividend may have a stronger signaling effect,
because cutting dividend is very costly.
Other Factors Favoring Repurchase vs.
Dividend
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Flexibility for firms
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Executive compensation
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Cutting dividend is more costly than cutting
repurchase.
Executives favor a higher stock price
associated with repurchase because of their
stocks and options.
Offset to dilution
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Increase earnings-per-share (EPS)
Survey Evidence on Repurchase
Vs. Dividend
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Taken from Brav at al. (2005): Payout Policy in the 21st Centrary.
Survey Evidence on Rationale for
Repurchase
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Taken from Brav at al. (2005): Payout Policy in the 21st Centrary.
Time Trend for Dividend and
Repurchase in the U.S.
5. What Do We Know About Corporate
Payout
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Aggregate payouts are massive and have
increased over time.
Corporate payouts are heavily concentrated among
a relatively small number of large, mature firms.
Stock prices react to unanticipated changes in
dividends and repurchases.
Managers are reluctant to cut dividends, even if this
means bypassing positive NPV projects.
Repurchases vary with transitory earnings.
Taxes and issuance costs matter for dividend
policy, but only of a second degree.
Corporations “smooth” dividends.
Time Trend for Fraction of Dividend
Payers
Lintner Dividend Model (1956)
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Dividend changes=Div1-Div0=s*(t*EPS1Div0)
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Div1 (Div0) is the dividend next year (this
year). s is the speed of adjustment to the
target. t is the target payout ratio.
Example
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Suppose Orange Inc. currently pays a
dividend of $2/share. Earnings are
expected to be $5/share next year, and
target payout ratio is 80%. Suppose the
speed of adjustment, s is 0.5. What will
the dividend next year be? What if s=0,
s=1?
Example
Div0=$2, EPS1=$5/share, t=80%, s=0.5.
So Div1-Div0 = s*(t*EPS1-Div0),
Div1 = Div0 + s*(t*EPS1-Div0)
= $2 + 0.5*(80%*$5-$2)
= $3
If s=0, there’s no adjustment, so Div will stay
at the original level, Div1 = Div0 = $2.
If s=1, there’s full adjustment, Div1 =
t*EPS1 = $4.
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6. Stock Dividend
Pay additional shares of stock instead of
cash.
 Increases the number of shares outstanding
and reduce the price per share.
 Small stock dividend

Less than 20 to 25%
 If you own 100 shares and the company
declares a 10% stock dividend, you would
receive an additional 10 shares.
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Large stock dividend – more than 20 to 25%
Stock Split
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Stock split – essentially the same as a
stock dividend except it is expressed as a
ratio
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For example, a 2 for 1 stock split is the same
as a 100% stock dividend.
Common explanation for split is to return
price to a “more desirable trading range.”
Readings
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Chapter 16