FNCE20005 · Corporate Financial Decision Making
Payout Policy
Payout policy is the decision of how much cash to return to shareholders, in what form (dividend or buyback), and when. In a perfect market Modigliani-Miller say it does not matter at all — paying a dividend simply moves a dollar from inside the firm to the shareholder while the share price drops by the same dollar, a zero-NPV transaction, and an investor who wants a different cash pattern can make a homemade dividend. Half the marks here come from the frictions that revive payout: taxes (above all dividend imputation), signalling (dividends are sticky, so a cut is bad news), and clientele effects. The dividend drop-off ratio — how far the price falls per dollar of dividend — backs out the marginal investor's relative tax rates, and reads above 1 for franked dividends to residents. Imputation grosses up a cash dividend by dividing by (1 − tc) and attaches a franking credit, so a 0% fund gets a cash refund while a top-rate holder still owes a little. The chapter also covers the mechanics of returning or raising equity: the rights issue (ex-rights price and the value of a right) and share buybacks (where EPS accretion is not value).
What this chapter covers
- 012.1 The payout measures — DPS, dividend yield, payout and retention ratios
- 022.2 The dividend drop-off ratio and the implied tax wedge
- 032.3 Modigliani-Miller dividend irrelevance and homemade dividends
- 042.4 Dividend imputation — gross-up, franking credit, and who wins
- 052.5 Rights issues — ex-rights price and the value of a right
- 062.6 Share buybacks — on-market vs off-market, and the EPS illusion
- 072.7 Clientele and signalling effects
Worked example: 1-for-5 rights issue — ex-rights price and the value of a right
- +1Ex-rights price: X = (N·M + S)/(N + 1) = (5 × 3.50 + 2.50)/(5 + 1) = (17.50 + 2.50)/6 = 20.00/6 = $3.33.
- +1Value of a right: R = X − S = 3.33 − 2.50 = $0.83.
- +1Check via the other formula: R = N(M − S)/(N + 1) = 5(3.50 − 2.50)/6 = 5/6 = $0.83.
- +1Wealth check (holder of 5 shares): before = 5 × 3.50 = $17.50.
- +1After exercising one right: pay $2.50 for one new share, now hold 6 shares worth 6 × 3.33 = $20.00; net = 20.00 − 2.50 = $17.50 — unchanged.
Key terms
- Dividend drop-off ratio
- (Pcum − Pex)/Div — how far the price falls per dollar of dividend on the ex-date. Under personal taxes it equals (1 − td)/(1 − tcg), so it backs out the marginal investor's relative tax rates: 1 means equal taxation, below 1 means dividends taxed more heavily, above 1 means franking makes dividends taxed less.
- MM dividend irrelevance
- In a perfect market payout policy cannot change firm value; a dividend is a zero-NPV transfer matched by an equal price drop, and any cash pattern can be replicated with homemade dividends (selling shares or reinvesting). The benchmark from which frictions revive payout.
- Franking credit
- Under imputation, the company tax already paid on a franked dividend, passed to resident shareholders. The cash dividend is grossed up by dividing by (1 − tc); the franking credit is tc times the grossed-up figure and is offset against the holder's own tax (refunded if their rate is below the company rate).
- Rights issue
- An offer letting existing shareholders buy new shares at a discounted subscription price S in proportion to their holding. The theoretical ex-rights price is X = (N·M + S)/(N + 1) and the value of a right is R = X − S = N(M − S)/(N + 1).
- Share buyback
- Returning cash by repurchasing shares instead of paying a dividend. On-market buys contrast with off-market selective buybacks (needing >75% non-seller approval). Reducing the share count raises EPS arithmetically, but EPS accretion is not value creation.
Payout Policy FAQ
What does the dividend drop-off ratio tell you?
How heavily the marginal investor is taxed on dividends relative to capital gains. The ratio equals (1 − td)/(1 − tcg): equal to 1 means dividends and gains are taxed equally (the perfect-market case); below 1 means dividends are taxed more heavily (the classical world), so a dollar of dividend is worth less than a dollar of price; above 1 means dividends are taxed less — exactly what franking credits deliver to Australian residents, who can see a drop bigger than the cash dividend. Read which rate is higher, then read the direction; don't mistake a ratio below 1 for mispricing.
If payout is irrelevant under MM, why does the chapter spend so long on it?
Because MM is the benchmark, not the conclusion. In a perfect market a dividend is a zero-NPV transfer and any investor can manufacture homemade dividends. Payout starts to matter once you re-introduce the real-world frictions: taxes (the imputation system above all), issuance and transaction costs, information asymmetry and signalling (dividends are sticky, so a cut signals trouble), and the agency discipline of forcing cash out of an empire-builder's hands. Every dollar of detail you add back is the exam testing why payout stops being a non-event.
How do franking credits change who prefers dividends?
A fully-franked $70 dividend at tc = 30% grosses up to $100 with a $30 franking credit. A 0% pension fund pays no tax on the $100 and gets the $30 credit refunded in cash, netting $100; a 47% top-rate holder owes $47, offsets the $30 credit, and nets $53. So if the personal rate is below the company rate, residents prefer franked dividends (they pocket the refundable excess credit); if above, it depends, because CGT deferral and the 50% individual discount can tilt the balance toward capital gains.
Does a buyback create value the way the EPS bump suggests?
No. Reducing the share count raises EPS arithmetically even when the firm creates nothing — the same fallacy as EPS bootstrapping in mergers. Judge a buyback on whether shares are bought below intrinsic value, not on the EPS headline. A buyback's real merits are flexibility (a one-off return with no implied commitment, unlike a sticky dividend) and signalling undervaluation. Since late 2023 there is no tax advantage to off-market buybacks in Australia, so the choice is driven by flexibility and signalling, not tax.
Exam move
Three calculation types carry this lecture, so drill each to automatic: the drop-off ratio (compute it, set it equal to (1 − td)/(1 − tcg), solve for the unknown tax rate, then interpret the direction); the imputation gross-up (divide by (1 − tc), find the franking credit, trace the cash for a 0% fund and a top-rate holder); and the rights issue (ex-rights price X, value of a right R against X, and a wealth check). The recurring trap is direction: you divide by (1 − tc) to gross up, never multiply. For the conceptual marks, be able to state the MM benchmark in one line and then name each friction that revives payout — taxes, signalling, clientele, agency — and remember 'bird in the hand' is a discredited reason and EPS accretion is not value.
