PAY OUT

POLICY
 PAY OUT

Repurchase Pay
Shares Dividends
CASH DIVIDEND PAYMENT
PROCEDURES (Relevant Date)

• DECLARATION DATE- the date upon which the dividend

formally declared by B.O.D

• EX-DIVIDEND DATE- the date which stock brokerage companies

have uniformly decide to terminate the right of ownership to the
dividend, which is 4 days prior from the record date

• DATE OF RECORD - the date on which all names are recorded as

stockholders receive a declared dividend at specified future time

• PAYMENT DATE - the actual date by which the firm mails the holder
of record
 RELEVANT DATE

JUNE 10 JUNE 27 JULY 1 AUGUST 1

Declaration Ex- dividend Payment

Record date date
date date
 LIMITATION ON
DIVIDENDS
• A provision in some bond indentures placing a
maximum amount on what a company can pay out in
dividends.
• Design to protect bondholders but has the possibility to
scare away the potential shareholders.
 STOCK DIVIDENDS AND
STOCK SPLITS
• In a stock dividends and in a stock split, the
company issues additional shares rather
than cash to its shareholders.
• The total shareholders equity is unchanged.
 COMPARISON BETWEEN STOCK
DIVIDEND AND STOCK SPLIT
STOCK DIVIDEND STOCK SPLIT
Par value of stock not changed Par value of stock changed according to
fraction
The number of shares increased by the The number of shares increased by fraction
percentage of stocks in dividends

Part of reserves are capitalized No changes in reserves

The ratio of shareholders' ownership does The ratio of shareholders' ownership does
not changed not changed

Book value per share and declining prices Book value per share and declining prices
• REVERSE STOCK SPLIT - a method used to raise the market price of the firms'
stock by exchanging certain number of share outstanding to one new share.

• 2-FOR-1 - each stock should be divided into 2 units of shares; par value went down
half of the original

• 4-FOR-1 - each stock will be divided into 4 units of shares; par value will be reduced
by fraction

• 3-FOR-2 - each unit of shares will be multiplied by 1.5 and the price will be divided by
1.5
EXAMPLE:
CAM CO. has 200,000 shares of RM 2. CAM Co. stock is
selling for RM 25 per share. Because the stock is selling at
high market price, the firm has declared a 2-for-1 stock split.
The total SHE is shown in the following:
Common stock(200,000 shares x RM 2) 400,000
Paid in Capital in excess of par 4,000,000
Retained Earnings 2,000,000
Total SHE 6, 400,000
SOLUTION:
Common stock(400,000 shares x RM 1) 400,000
Paid in Capital in excess of par 4,000,000
Retained Earnings 2,000,000
Total SHE 6, 400,000
 STOCK REPURCHASE
 Therepurchase by the firm of outstanding
common stock in the market place.
 FOUR MAIN WAYS TO IMPLEMENT
STOCK REPURCHASE

 OPEN MARKET REPURCHASE - firm announces that it plans to buy stock in the secondary market just
like other investors; most common method

 TENDER OFFER- the firm offer to buy buck a stated number of shares at a fixed price

 AUCTION - firms state a range of prices which it is prepared to repurchase

 DIRECT NEGOTIATION- firms may negotiate repurchase of a block of shares from a major shareholder
*GREENMAIL- shares are repurchased at a generous price that makes the bidder happy to leave the
target alone.
STOCK REPURCHASE: EXAMPLE

Imagine a firm has 100,000 shares outstanding, worth $1M in total.

If the firm buys back 10,000 shares at $ 10 each, how is
shareholders’ wealth affected?

Cash $150,000
Other assets 850,000
Before Dividend: Value of firm 1,000,000
Shares outstanding = 100,000
Price per share = $1,000,000/100,000 = $10

Cash $50,000
Other assets 850,000
After Dividend: Value of firm 900,000
Shares outstanding = 90,000
Price per share = $900,000/90,000 = $10

After the cash dividend, the market value of the firm falls to
$900,00 yet shareholders retain equal ownership in the firm
 After repurchase, shareholders can sell 10% of their
shares and earn $100,000 in cash, yet still retain ownership
equal to that which they had before.

The shareholders’ position is exactly the same with

the share repurchase as with the cash dividend:

• Total share worth $900,000

• Cash worth $100,000

 INFORMATION CONTENT OF DIVIDEND
AND REPURCHASE

 Dividend increase convey managers' confidence about

future cash flow and earnings. Dividend cuts convey lack of
confidence and therefore bad news.
Dividend increase – good news
Dividend cuts- bad news
DIVIDENDS OR REPURCHASE

 A repurchase avoids the fall in stock price that would

otherwise occur on the ex-dividend date if the company
used the cash to pay dividends rather than to repurchase
stock. Repurchase also reduce the number of outstanding
shares so future earning per share though total earnings
are unaffected.
 An Example of Dividend
Versus Buyback

Let's use the example of a hypothetical consumer products

company that we will call Footloose & Fancy Free Inc. (symbol FLUF),
that has 500 million shares out in Year 1. The shares are trading at $20,
giving FLUF a market capitalization of $10 billion. Assume that FLUF
had revenues of $10 billion in Year 1 and a net income margin of 10%,
for net income (or after-tax profit) of $1 billion or $2 per share. This
means that the stock is trading at a price-to-earnings multiple (P/E) of
10 (in other words, $20 / $2 = $10).
Suppose that FLUF is feeling particularly generous toward its
shareholders and decides to return its entire net income of $1 billion to
them. This could play out in one of two simplified scenarios.
• Scenario 1: Dividend. FLUF pays out $1 billion as a special dividend, which
amounts to $2 per share. Assume you are a FLUF shareholder and you own 1,000
shares of FLUF purchased at $20 a share. You therefore receive (1,000 shares x
$2/share) or $2,000 as the special dividend. At tax time you pay $300 as tax (at
15%), for an after-tax dividend income of $1,700, or an after-tax yield of 8.5%
($1700 / $20,000 = 8.5%).
• Scenario 2: Buyback. FLUF spends the $1 billion buying back FLUF
shares. Although a company will execute its share buyback over a period of
many months and at different prices, to keep things simple, we assume that
FLUF buys back a huge share block at $20, which amounts to 50 million shares
bought back or repurchased. This reduces its share count from 500 million shares
to 450 million shares.
• The 1,000 shares of FLUF that you purchased at $20 will now be worth more
over time because the reduced share count will boost the value of the shares.
Assume that in Year 2, the company's revenues and net income are unchanged
from Year 1 at $10 billion and $1 billion respectively. However, because the
number of shares outstanding is now down to 450 million, earnings-per-share
would be $2.22 instead of $2. If the stock trades at an unchanged price-to-
earnings ratio of 10, FLUF shares should now be trading at $22.22 ($2.22 x 10)
instead of $20.
 REPURCHASES AND THE
DIVIDEND DISCOUNT MODEL
Example:

• If a stock dividend in this year is $4, the dividend

has been growing 6% annually, what will be the
intrinsic value of the stock assuming a required rate
of return of 12%.

P = D $4.24
= = $70.66
1
0

r–g 12% - 6%
WHY DIVIDEND MAY INCREASE
VALUE

Once we relax the assumptions of perfect and efficient

capital markets, many investors claim dividends may actually
increase value.

• Attracts natural clientele

• Leverage behavioral psychology

• Prevents manager from wasting funds

 WHY DIVIDEND MAY DECREASE VALUE

• All other things being equal, investors are willing to pay more for a stock whose
returns come in the form of low- taxed capital gains. Firms should pay the lowest
cash dividend they can get away.

ILLUSTRATION:
Assumed that dividends are taxed at 40% but capital gains are taxed at 20%
only. The stocks of firm A and B are equally risky and investors demand an after-tax
rate of return of 10% on each. Investors expected A to be worth $112.5 next year
while B be only $102.5, but a $10 is forecast so the total pretax is the same $112.50.
But to provide the same after-tax return, B must sell for less than A, $97.78
rather than $100. The reason obvious; investors are willing to pay more for stock A
because its return comes from a lo-taxed capital gains.
 Effect of shift in dividend policy when dividend are
taxed more heavily than capital gains.

FIRM A FIRM B
Next years’ price $112.50 $102.5

Dividend 0 $10.00

Total pre-tax pay off $112.50 $112.50

Todays stock price $100 $97.78

Capital gain 12.5 $4.72

Before tax rate of return (12.5/100)=.125 or 12.5% (14.72/97.78)=15.05 or 15.05%

Tax on dividend at 40% 0 .40 x 10 = $4

Tax on capital gain ta 20% .20 x $12.50=2.50 .20 x $4.72 =$.94

Total after-tax income (dividend (0 + 12.50) – 2.5 = $10 (10+4.71) – (4+.94) = $9.78
+capital gain – taxes)
After tax rate of return 10 / 100 = .10 or 10% 9.78/97.78=.10 or 10%
TAXATION OF DIVIDENDS AND CAPITAL
GAINS UNDER CURRENT TAX LAW

• Tax law still favors capital gains. Taxes on dividends have to

be paid immediately, but taxes on capital gains can be
deferred until shares are sold and capital gains are realized.
Stockholders can choose when to sell their shares thus, when
to pay their capital gain tax. The longer they wait the less the
present value of the capital gain tax liability.
 TAXATION

• One advantage to investors:

Capital gain taxes are deferrable.

• One advantage to corporations:

• Corporation pay income taxon only 30% of any dividends
received from investments in other corporations.
PAYOUT POLICY AND THE LIFE
CYCLE OF THE FIRM

• MM said that payout policy does not affect shareholder value. Shareholder value
is driven by investment policy, including exploitation of growth opportunities,
and to some extent by debt policy. If payout is a residual, then payout decision
should evolve over the life cycle of the firm.

• The life cycle of the firm is not always predictable. It’s not always obvious when
firm is “mature” and ready to start paying cash back to shareholders The
following three questions can help the manager to decide:
1. Is the company generating positive cash flow after making all investment with positive
NPV’s and is the positive cash flow likely to continue?
2. Is the firm’s debt ratio prudent?
3. Are the company’s holding of cash sufficient cushion for unexpected setbacks and a
sufficient war chest for unexpected opportunities?