Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

KEY TERMS

agency cost/contracting

model, 548

announcement date, 537

asymmetric information, 549

bonus share issue, 540

constant dollar payment policy,

539

constant payout ratio policy, 539

cum dividend, 537

date payable, 537

dividend payout ratio, 537

dividend yield, 537

ex-dividend date, 537

extra dividend, 539

low-regular and extra payout

policy, 539

payout policy, 535

record date, 537

residual theory of dividends, 553

reverse share split, 540

share repurchase program, 535

share split, 540

signalling model, 549

special dividend, 539

target dividend payout ratio, 539

SELF-TEST PROBLEMS

Answers to Self-test problems and the Concept review questions throughout the chapter appear on

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not affect the value of a company. However,

the fact that many companies pay dividends

is something of a puzzle, because most real

market imperfections (such as taxes) argue

against paying cash dividends.

■ One theory of dividend policy assumes

that dividend payments serve to reduce

agency costs between corporate managers

and external investors by committing the

company to pay out excess profits. Managers

are prevented from spending the profits on

perquisites or wasting them on unwise capital

investments. Most of the empirical evidence

supports this agency cost model over the

competing signalling model, which predicts

that managers use dividend payments to

convey information to investors about the

company’s expected future earnings.

■ In addition to ownership considerations,

several other aspects of a company’s

operating and regulatory environment seem

to influence dividend payouts. Other things

being equal, closely held corporations,

which operate in a high-growth industry

where large ongoing capital investments are

needed to compete, have lower dividend

payouts than do widely held companies in

slow-growing or highly regulated industries.

■ In countries where personal income tax

rates on dividend payments are higher than

capital gains tax rates, companies may prefer

to distribute cash to shareholders via share

repurchases.

■ High transaction costs can affect potential

shareholders’ share purchases, since it may be

more cost effective to hold shares with regular

dividend payments, than to try to sell share to

receive income. This can influence companies

(wishing to attract shareholders and boost

their share price) to maintain regular dividend

payments.

■ The residual theory of dividends suggests

that dividends are simply a residual,

the cash left over after corporations

have funded all positive-NPV projects.

This theory explains why high-growth

companies retain most of their profits and

pay no or low dividends, whereas mature,

slow-growing companies tend to have high

dividend payouts. Although appealing,

actual dividend payments are not as

variable as they would be if companies

viewed them purely as residuals from cash

flow.

■ Companies tend to take a conservative

approach to dividend payments, generally

preferring a long-term, dividend-smoothing

approach over an approach that fluctuates

greatly with earning cycles. In contrast, share

repurchases tend to be more flexible.

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