Principles of
Corporate Finance
Chapter 16
Eighth Edition
Payout Policy
Slides by
Matthew Will
McGraw-Hill/Irwin
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Topics Covered
The Choice of Payout Policy
Dividend Payments and Stock Repurchases
How Do Companies Decide on The Payout?
Information in Dividends and Stock
Repurchases
The Payout Controversy
The Rightists
Taxes and the Radical Left
The Middle of the Roaders
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Payout Policies
McGraw-Hill/Irwin
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Dividend & Stock Repurchases
U.S. Data 1980 - 2002
600
Earnings less repurchases & dividends
Repurchases
500
$ Billions
Dividends
400
300
200
100
McGraw-Hill/Irwin
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
19
80
0
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Types of Dividends
Cash Div
Regular Cash Div
Special Cash Div
Stock Div
Stock Repurchase (4 methods)
1. Buy shares on the market
2. Tender Offer to Shareholders
3. Dutch Auction
4. Private Negotiation (Green Mail)
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Dividend Payments
Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.
Record Date - Person who owns stock on this
date received the dividend.
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Dividend Payments
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Stock Splits - Issue of additional shares to
firm’s stockholders.
Stock Repurchase - Firm buys back stock
from its shareholders.
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The Dividend Decision
Lintner’s “Stylized Facts”
(How Dividends are Determined)
1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on absolute
levels.
3. Dividends changes follow shifts in long-run, sustainable
levels of earnings rather than short-run changes in earnings.
4. Managers are reluctant to make dividend changes that might
have to be reversed.
5. Firms repurchase stock when they have accumulated a large
amount of unwanted cash or wish to change their capital
structure by replacing equity with debt.
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The Dividend Decision
Attitudes concerning dividend targets vary
DIV1  target dividend
 target ratio  EPS1
Dividend Change
DIV1 - DIV0  target change
 target ratio  EPS1 - DIV0
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The Dividend Decision
Dividend changes confirm the following
DIV1 - DIV0  adjustment rate  target change
 adjustment rate  target ratio  EPS1 - DIV0 
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Dividend Policy
Impact of Dividend Changes on EPS
Change EPS/Price at t = 0 as %
15
10
5
0
-5
Div Rise
Div Cut
-10
-15
Year
Source: Healy & Palepu (1988)
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Dividend Policy
Before
Dividend
After
Dividend
Total value of firm
New
stockholders
Each share
worth this
before …
Total number
of shares
… and
worth
this
after
Old
stockholders
Total number
of shares
Example of 1/3rd of worth paid as dividend and raising money via new shares
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Dividend Policy
Shares
Dividend financed
by stock issue
No dividend, no
stock issue
New stockholders
New stockholders
Cash
Firm
Cash
Shares
Cash
Old stockholders
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Old stockholders
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Dividend Policy is Irrelevant
Since investors do not need dividends to
convert shares to cash they will not pay
higher prices for firms with higher dividend
payouts. In other words, dividend policy
will have no impact on the value of the firm.
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Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.
Using M&M Theory, and given the following balance sheet information,
show how the value of the firm is not altered when new shares are issued
to pay for the dividend.
Record Date
Cash
1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV
2,000
# of Shares
1,000
price/share
$12
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Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.
Using M&M Theory, and given the following balance sheet information,
show how the value of the firm is not altered when new shares are issued
to pay for the dividend.
Record Date
Cash
1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV
2,000
# of Shares
1,000
price/share
$12
McGraw-Hill/Irwin
Pmt Date
0
9,000
9,000
2,000
1,000
$11
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Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.
Using M&M Theory, and given the following balance sheet information,
show how the value of the firm is not altered when new shares are issued
to pay for the dividend.
Record Date
Cash
1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV
2,000
# of Shares
1,000
price/share
$12
Pmt Date
0
9,000
9,000
2,000
1,000
$11
Post Pmt
1,000 (91 sh @ $11)
9,000
10,000
2,000
1,091
$11
NEW SHARES ARE ISSUED
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Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Stock
Cash
Record
12,000
0
Total Value
12,000
Stock = 1,000 sh @ $12 = 12,000
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Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Stock
Cash
Record
12,000
0
Pmt
11,000
1,000
Total Value
12,000
12,000
Stock = 1,000sh @ $11 = 11,000
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Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Stock
Cash
Record
12,000
0
Pmt
11,000
1,000
Post
12,000
0
Total Value
12,000
12,000
12,000
Stock = 1,091sh @ $115 = 12,000
 Assume stockholders purchase the new issue with the cash
dividend proceeds.
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Dividends Increase Value
Market Imperfections and Clientele Effect
There are natural clients for high-payout stocks,
but it does not follow that any particular firm can
benefit by increasing its dividends. The high
dividend clientele already have plenty of high
dividend stock to choose from.
These clients increase the price of the stock
through their demand for a dividend paying stock.
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Dividends Increase Value
Dividends as Signals
Dividend increases send good news about cash
flows and earnings. Dividend cuts send bad news.
Because a high dividend payout policy will be
costly to firms that do not have the cash flow to
support it, dividend increases signal a company’s
good fortune and its manager’s confidence in
future cash flows.
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Dividends Decrease Value
Tax Consequences
Companies can convert dividends into capital
gains by shifting their dividend policies. If
dividends are taxed more heavily than capital
gains, taxpaying investors should welcome such a
move and value the firm more favorably.
In such a tax environment, the total cash flow
retained by the firm and/or held by shareholders
will be higher than if dividends are paid.
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Taxes and Dividend Policy
Since capital gains are taxed at a lower rate
than dividend income, companies should
pay the lowest dividend possible.
Dividend policy should adjust to changes in
the tax code.
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Taxes and Dividend Policy
Firm A
Firm B
Next year' s price
(no dividend)
112.50
(high dividend)
102.50
Dividend
0
10
Total pretax payoff
112.50
112.50
Today' s stock price
100
97.78
Capital gain
12.50
4.72
Pretax rate of return (%)
12.5
100
Tax on div @ 50%
Tax on Cap Gain @ 20%
Total After Tax income
(div  cap gain - taxes)
After tax rate of return (%)
McGraw-Hill/Irwin
 100  12.5
0
.20  12.50  2.50
(0  12.50)  2.50  10
10
100
 100  10.0
14.72
97.78
 100  15.05
.40  10  4.00
.20  4.72  0.94
(10  4.72)  (4  0.94)  9.78
9.78
97.78
 100  10.0
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Taxes and Dividend Policy
In U.S., shareholders are taxed twice (figures in dollars)
Cash Flow
Operating Income
Corporate tax at 35%
After Tax income (paid as div)
Income tax paid by investors at 15.0%
Cash to Shareholder
McGraw-Hill/Irwin
100.00
35.00
65.00
9.75
55.25
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Taxes and Dividend Policy
Under imputed tax systems, such as that in Australia, Shareholders
receive a tax credit for the corporate tax the firm pays (figures in
Australian dollars)
Rate of Income tax
15%
Operating Income
Corporate tax (Tc=.30)
After Tax income
100
30
70
30%
100
30
70
Grossed up Dividend
Income tax
Tax credit for Corp Pmt
Tax due from shareholder
Cash to Shareholder
100
15
-30
-15
85
100
30
-30
0
70
McGraw-Hill/Irwin
47%
100
30
70
100
47
-30
17
53
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Web Resources
Click to access web sites
Internet connection required
www.taxsites.com.
www.fulldisclosure.com
www.ex-dividend.com
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