Corporate Finance Week 4 — Payout Policy

1) Big-picture framing: how to think about payout

Core decision rule: value maximization.

Invest first in positive NPV projects (clear the hurdle rate).
Choose financing consistent with the assets being financed (linked to capital structure topics later).
If there are not enough value-creating investments, return excess cash to shareholders via dividends or buybacks (best form depends on shareholder characteristics/taxes).

Interpretation: payout is what you do when cash is excess relative to value-creating investment needs.

2) What payout policy is: key definitions you can be tested on

Payout policy = distribution of free cash flow to shareholders via:

Dividends (cash paid pro-rata to shares)
Share buybacks / repurchases (firm buys shares back from shareholders)

Dividend reporting “equivalents”

DPS (dividend per share)
Dividend yield = DPS / share price
Payout ratio = DPS / EPS (or dividends / earnings)

Interpretation to be fluent with: a “payout ratio of 30%” means roughly one-third of earnings per share is paid out as dividends per share; the remainder goes to retained earnings to fund projects.

Regular vs special dividends

Regular dividends: expected to be maintained
Special dividends: one-time, less likely to repeat

3) Dividend mechanics: the dates and who gets the dividend

You should know the timeline and entitlement logic:

Declaration date: board authorizes the dividend.
Ex-dividend date: on/after this trading date, a new buyer does not get the dividend (must own before the ex-date).
Record date: firm checks shareholder register to determine who gets paid.
Payable date: cash is distributed.

High-yield rule: if you buy on the ex-dividend date, it is too late to receive that dividend.

4) Modigliani–Miller dividend irrelevance: the theory anchor

Proposition (perfect capital markets): payout policy is irrelevant. If investment policy/cash flows do not change, firm value cannot change with dividend policy; investors are indifferent between dividends and capital gains.

What “perfect market” means (assumptions)

Investment policy held constant
No tax advantage of dividends vs capital gains
No information asymmetry
No transaction costs / barriers
Managers act in shareholders’ interests
Firms can issue equity at no cost if they “paid out too much”

Cum-dividend vs ex-dividend price (mechanical intuition)

In the MM world, the stock price drops by the dividend on the ex-dividend date.

Example logic: if a $2 dividend is paid, price falls by $2 (timing changes; PV of future dividends unchanged).

Repurchase vs dividend under MM

Under MM logic, special dividends vs repurchases converge to the same implied value (policy choice does not change value).

5) Outside MM: why payout policy can matter (four determinants)

Determinants of payout policy:

Transaction costs
Taxes
Signaling
Agency

(A) Taxes

Often, dividends are taxed more heavily than capital gains → investors may prefer capital gains.
Not universal: cross-country rules differ (some markets treat dividends/capital gains differently).
Lecture emphasis: differences like US vs UK dividend yields can be heavily driven by taxation (“usually about taxes”).

Three framing cases for dividends:

No tax disadvantage + frictionless equity issuance → dividends do not matter.
Dividend tax disadvantage → increasing dividends destroys value.
If shareholders like dividends / dividends signal prospects → increasing dividends can create value.

(B) Clientele effects

Some shareholders prefer dividends (regular cash, no tax disadvantage, policy constraints).
Example: pension funds may like dividends due to steady inflows to fund steady outflows.

(C) Signaling (why dividends are “sticky”)

Dividend policy can convey information about firm quality/prospects.
A weak firm cannot sustain high dividends without future pain (cuts, foregone investments, suspicious equity issuance, creditor pressure).
Practical outcome: firms avoid cuts and raise dividends only when they believe earnings can sustain them → dividend smoothing / stickiness.

Empirical direction (qualitative):

Dividend increases → positive abnormal returns
Dividend decreases/omissions → negative abnormal returns
Dividend initiation → strongly positive
Dividend omission → strongly negative

Numbers may be bonus; direction is high-yield.

(D) Agency (payout as discipline)

Dividends and repurchases reduce free cash flow available for managers to waste on poor acquisitions / negative NPV projects.
Payout can be an alternative to debt as a discipline mechanism.
Shareholders tend to like payout more than managers; stronger shareholder rights correlate with higher dividends.

6) “Bad reasons” for dividends (likely probe points)

Bird-in-hand fallacy

Timing error: comparing dividends today to capital gains sometime later is not apples-to-apples.
Correct comparison is dividends today versus price appreciation today (price drops on the ex-dividend day).

“Excess cash → pay dividends” (why not buy back?)

Excess cash does not automatically imply dividends are optimal.
Repurchases may dominate due to tax efficiency and flexibility.

7) Share buybacks: mechanics, methods, and why firms use them

What happens to repurchased shares (institutional detail)

US: repurchased shares often become treasury stock (issued but not outstanding).
UK: traditionally eliminated; since 2003 can be held as treasury stock with shareholder approval.

Main repurchase methods (qualitative implications)

Fixed-price tender offer
- Company sets price, quantity, duration; public disclosure; shareholders tender; prorated if oversubscribed.
- Typical premium around ~20%; strong positive announcement reaction (strong signal).
Open-market repurchase (most common)
- Firm announces intent; buys gradually; no obligation; can take months/years.
- Constraint noted: cannot buy more than 25% of average daily traded volume (anti-manipulation rule in US context).
- Typically smaller positive announcement reaction than tender offers.
Dutch auction tender offer
- Firm sets share amount + price range; shareholders submit prices; firm buys at the lowest price that clears the quantity (buys from tenders at/below that price).
- Premium typically lower than fixed tender; announcement reaction usually between open-market and fixed tender.

Other effects of repurchases (short answers)

Concentration of ownership: remaining holders’ % increases as shares outstanding fall.
Defense against hostile takeovers: fewer shares outstanding, more committed holders, higher takeover cost (and signaling undervaluation can matter).

8) What is likely to be “exam-shaped” from Week 4

Mechanics: who receives the dividend given declaration/ex-div/record/pay dates; explain why ex-date matters.
MM application: cum-dividend vs ex-dividend pricing differs by the dividend amount; explain dividend irrelevance conceptually and/or numerically.
Short essay: why payout policy can matter in reality → taxes, clientele, signaling, agency.
Dividends vs buybacks: compare (tax efficiency, flexibility/commitment, signaling strength, ownership concentration) and link to investor clientele.
Fallacies: bird-in-hand timing error; “excess cash → dividends” when buybacks could be superior.