Professional Documents
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Payout policy
Chapter 15
Finance T3 2017
Department of Finance
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Recap – Topic 10
• The effect of financial leverage on the company’s
risk and return
• Modigliani-Miller propositions I & II with no taxes
and with taxes
• Trade-off model (with financial distress cost, and
agency cost)
• Pecking-order theory
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Recap
• What is financial leverage?
• Uses more debt in capital structure, magnifies company’s
both upside gains and downside losses, earnings become
risker with leverage.
• So, financial leverage increases financial risk, increases firm
beta, and increases return on equity.
• This model describes the optimal level of debt for a given company as a
trade-off between the benefits of corporate borrowing and the increasing 6
agency and insolvency costs that come from additional borrowing.
• The optimal debt B is chosen to maximise company value.
Learning outcomes
After studying this topic, you will be able to
• Discuss the fundamentals of payout policy
• Discuss why payout policy is irrelevant in a world
with perfect capital markets
• Discuss dividend relevance in the imperfect world,
including agency and signaling models
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Payout policy fundamentals
• Payout policy describes the choice about
distributing cash to a company’s shareholders
considering:
• The level of cash distribution
• The form of the distribution
• The stability of the distribution
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Major Types of Dividends
Cash dividends (a.k.a ordinary or regular dividends):
• By far the most popular.
• Dividends are “sticky” in that they are relatively insensitive to changes
in profitability.
• In Australia they are typically payed half yearly, in some other
countries they are paid quarterly.
Special Dividends:
• Just like ordinary dividends except not expected to continue.
• The small difference has major signalling impacts.
• It has the opposite signaling effect compared to share buybacks
Scrip/Stock Dividends:
• Rather than paying cash, companies sometimes award bonus shares,
small stock dividends, large stock dividends and share splits
• Economically they are equivalent to cash dividends.
Types of dividend payout policies
Constant payout • The ratio indicates the percentage of each
ratio policy dollar earned that is distributed to the owners.
• The value of the two firms with different policies is the same.
15.3 M&M meet the real
(imperfect) world
• In perfect capital markets, payout decisions do not
affect company value.
• M&M state that operational and investment decisions,
not financial decisions, create value.
• Dividends matter: Stock price = PV of future dividends
• Several academic theories explain why dividend
decisions matter in the real world.
• Certain market imperfections, for example taxes or 13
agency costs, affect payout decisions in general.
Tax reasons
• High dividend preference
• Tax-exempt investors don’t have to worry about
differential treatment between dividends and capital
gains
• Low dividend preference
• Dividends are taxed immediately but capital gains
are not taxed until the share is sold (potentially,
indefinite deferral)
• Individuals in upper income tax brackets might
prefer lower dividend payouts, in favor of higher
capital gains with the deferred tax liability 14
Agency costs
Paying dividends reduces Agency Costs.
between managers and shareholders.
Happy
shareholder
External Financing puts
a company under the
scrutiny of the ASIC
Lots of
dividends
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HIGH dividends add to the value of a firm.
Signalling model
• Addresses asymmetric information – managers have more
information about a company's prospects than investors.
• Raising the dividend usually causes the share price to rise
and decreasing the dividend causes the share price to fall
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Dividend changes may signal information to the
market concerning the firm’s future prospects
Other reasons
• Accumulated Earning Tax:
• In US, companies pay a tax penalty when they have too much
retained earnings (because it is deemed that they are giving their
investors a tax break)
• Cash Flow Needs:
• Small investors transaction costs may be too high and therefore they
might prefer dividends
• Transfer Wealth from creditors:
• Transfer wealth from bondholders to shareholders
• Some reasons to not pay dividends:
• Corporate taxes: Unlike interest payments, dividends aren’t tax
deductible for companies. Further, stockholders have to pay taxes on
dividend income. In Australia, the dividend imputation section limits
this disadvantage
• Personal income taxes: income taxes on capital gain are lower than 17
on dividend income. Also, individuals can time capital gains
15.3 M&M meet the real
(imperfect) world
Several competing theories have been advanced to explain
observed patterns in dividend policies:
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Scope of
Valuation
corporate Capital
(Topics 3 & 4), Capital Structure
finance (Topic 1) Budgeting
Risk and return Topics 10 & 11
Time value of Topics 7, 8 & 9
(Topics 5 & 6)
money (Topic 2)
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Exam format
• The final exam is a 2-hour, closed-book exam
• 15 minutes reading time allowed before the start
• The exam is worth 60% of your assessment for the unit
• There are two parts and you must attempt ALL questions
• Part A – 30 marks
• 5 Short-answer questions (6 marks each)
• Consists of both theories and calculations
• Part B – 30 marks
• 3 Long-answer questions (10 marks each)
• 1 theory and 2 numerical questions
• A formula sheet will be provided. 20
• Hurdle requirement: Students are required to gain 50%
or more on the exam in order to pass the unit!
…The End.
THANK YOU & GOOD LUCK
FOR YOUR FINAL EXAM!
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