Corporate Payout Policy Select three publicly listed companies. Analyse their recent dividend decisions and use these to support your critical assessment of the main theories of corporate payout policies. Dividend policy is one of the most important decisions that a manager of a firm makes in order to achieve the goal of the firm, maximising shareholder wealth. Determining a company's corporate payout policy is a question of "how much, when, and how", that is, the value of the payouts, when to deliver the surplus cash to investors, and in what form should the payouts be delivered. Corporate payout policy is also one of the most polarising topics in finance. Theorists such as DeAngelo and DeAngelo (2006a, 2006b, 2008), and Fama and French advance a theory on the financial life-­‐cycle of the firm determining dividend policy. Other academics are less sanguine about how dividends affect the value of a firm's shares, Miller and Modigliani (1961) (hereafter MM) express in their dividend-­‐irrelevance theory that in a frictionless market, the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power of their investment decisions. These corporate payout policy theories can be supported through the recent dividend decisions of publicly listed companies. Analysing the dividend payout policies of Microsoft, TFS Corporation and Berkshire Hathaway Inc it is evident that dividend policy decisions made by firms are largely based around theory but can often be restricted by macroeconomic factors and external financing arrangements.

The firm life cycle theory of dividends contends that the optimal dividend policy of a firm depends on the firm’s stage in its life cycle. The underlying premise is that firms generally follow a life-­‐cycle trajectory from origin to maturity that is associated with a shrinking investment opportunity set, declining growth rate, and decreasing cost of raising external capital. The optimal dividend policy, derived from a trade-­‐off between the costs and benefits of raising capital for new investments, evolves with these life-­‐cycle-­‐related changes (DeAngleo, DeAngelo, 2006a, 2006b, 2008). As the firm becomes more mature the optimal payout ratio increases. Dividend payers are mature firms, with a high ratio of earned to

contributed capital, while young, high growth firms do not pay dividends (Bulan, Subramian 2009). The dividend policy of Microsoft Corporation supports the life-­‐cycle theory of the firm to a modest degree, Microsoft announced its first dividend when it was mature, however, the event of maturation did not coincide with its dividend initiation. On 16 January 2004, 18 years after their initial public offering in 1986, Microsoft Corporation announced its first cash dividend. This policy illustrated actions of a firm who had just reached its maturity, however since 1995, Microsoft had grown slower and spent less on capital expenditure than the industry average whilst maintaining its profit and cash holdings above the industry average (Bulan, Subramian 2009). According to the life-­‐cycle theory, Microsoft was in a position to return earnings to investors for many years prior to when they announced a dividend; they had the characteristics of a dividend payer and yet weren't. One possible explanation for the timing of Microsoft’s initiation is the reduction in the tax rate on dividends (Bulan, Subramian 2009). In 2003, the tax rate on dividends decreased to 15% (bankrate.com) and Microsoft paid out its 32 billion dollar special dividend (Morngingstar). Whilst supporting another theory of dividend policy; taxes and the radical left (Brealy et al. 2011) this dividend decision of Microsoft demonstrates payout policy could not only be determined by life-­‐cycle theory, there are macroeconomic factors such as the tax rate that needed to be considered by the firm's managers when setting the dividend policy. Analysing the case of Microsoft, it is fair to assume that in a frictionless market without taxes, Microsoft's dividend initiation would have coincided with its maturation however due to taxes imposed on dividends, the optim (Baker 2009) (Miller 1961) (NASDAQ 2013) (Bankrate 2004)al time for Microsoft to announce its initial dividend was delayed. The dividend decision of Microsoft can be explained to a large degree by the life-­‐cycle theory put forward by DeAngelo and DeAngelo, however consideration also needs to be given to macroeconomic factors such as taxes in order to have a complete analysis.

Adding further validation to the life-­‐cycle theory is TFS Corporation's (TFS) decision in 2012 to stop paying a dividend. TFS owns and manages the world's largest Indian Sandalwood plantation and receives revenue through fees it charges to manage the plantations on behalf of their investors and also through revenue earned through selling the company owned trees at harvest. TFS was listed on the Australian Stock Exchange on December 4

2004 and within a matter of months paid an interim dividend on 30 June 2005. With first commercial harvest to be conducted this year, where TFS expects to generate the majority of its future earnings, TFS was clearly still yet to reach maturity as a company when it announced its initial dividend. Prior to the Global Financial Crisis and subsequent Managed Investment Scheme industry capitulation of 2011 TFS had believed it had enough cash flow generated from grower fees to justify paying a dividend (Morne Wagener, pers. comm.), however when there was a market downturn and the number of investors decreased, they no longer had sufficient free cash flow (FCF) to pay dividends. TFS had not yet reached a point where earnings could be generated from the harvesting of trees and should have waited to release a dividend. TFS Chief Financial Officer Morne Wagener explained that "[TFS] should have waited till maintainable and more predictable earnings were available to issue a dividend." The views expressed by the company CFO adds credence to the life-­‐cycle theory that young, high growth firms should not pay a dividend. The fact that the company was forced to stop paying a dividend in 2012 demonstrates that they were not mature enough to start paying a dividend as their ability to meet their payout policy obligations were reliant upon the same year's earnings and not surplus cash characterised by mature firms.

TFS's decision to abandon their dividend in 2012 validates another theory of corporate payout policy; the information content of dividends. The information content of dividends theory suggests that investors don't get excited about the level of a company's dividend, they worry about the change (Watts 1973). Lintner (1956) also indicates that managers are reluctant to increase dividends when the chances are good that they will later be forced to reverse that decision. An increased dividend signals increased profitability which in-­‐tern can cause the share price to increase, the opposite applies to a decreased dividend. It is therefore no surprise that the company share price fell from 44c to 33c around the time when the announcement was made in August 2012 (ASX 2013). This example validates the information content of dividend theory as the abandonment of the dividend led to a 25% reduction in the company share price. Company CEO and Chairman, Frank Wilson, described the decision to terminate the dividend in 2012 as "very difficult" as the board's intentions are to keep shareholders happy but ultimately paying a dividend in 2012 would have

jeopardised the company moving forward (Frank Wilson, pers. comm.). It is also interesting to note that restrictions under a bond TFS issued into the US debt market in 2011 prevented them from paying a dividend in 2012 as they did not meet certain FCF requirements outlined in the bond agreement. Although the bond restrictions prevented TFS from issuing a dividend, TFS were reluctant to pay one as it would have been imprudent given the company's current position (Frank Wilson, pers. comm.). The dramatic fall in the share price of TFS demonstrates that shareholders do respond to the change in dividend level as suggested by Lintner (1956) and Watts (1973). Once the company reaches maturity it will have to adopt a more conservative approach when setting its payout policy to make sure that they issue a dividend that can be maintained and avoid being forced into abandoning their dividend in the future.

The theories covered so far have emphasised the importance of corporate payout policy in maximising shareholder wealth, however not all theories suggest that dividend policy is relevant in achieving the goal of the firm. MM's Dividend Irrelevance theorem expresses that in frictionless markets, payout policy is irrelevant in determining the value of the firm and investment policy is the sole determinant of firm value (MM 1961). The MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be offset by the reduction in the market value of the shares. Applying this to a real world situation, where Watts (1973) and Lintner (1956) would describe the decrease in the TFS share price in August 2012 as a consequence of the stock market reacting to the information about the dividend increase, MM argue that the market reacted to the information about future earnings, which is implicitly revealed to investors by the payout decrease. As managers generally set stable target payout ratios, investors have good reason interpret a change in the dividend rate as a change in management’s views of future profit prospects for the firm (MM 1961). In cases such as TFS’s dividend abandonment, it explains the stock market reaction as primarily reflecting news about investment policy (as measured by future earnings), rather than news about payout policy per se.

The question of “how” when setting corporate payout policy refers to how the company distributes it’s FCF to its investors. As an alternative to offering a cash or stock dividend to its shareholders a firm can repurchase stock, this is known as a “stock repurchase” or “share buyback”. As real world markets are imperfect, a stock repurchase can be a favoured method to a cash dividend as it is taxed as a capital gain as opposed to ordinary income. The theory of taxes and the radical left (Brealey, Myers, Allen 2011) suggests that whenever dividends are taxed greater than capital gains, the firm should retain the cash or use the surplus cash to repurchase shares. This distribution policy can transmute dividends into capital gains and can theoretically increase returns for investors. Berkshire Hathaway is a US based conglomerate that subscribe to this theory; they only distribute cash through share repurchases. Berkshire Hathaway display the characteristics of a mature firm yet unlike Microsoft, do not pay a cash dividend. Company CEO, Warren Buffet expresses that if investors are looking to extract money, they should sell shares, leaving the company to pump all earnings back into it’s operations and not rely on a dividend (Woodhead 2013). Buffet expressed that the share buyback approach lets each shareholder make his own choice between cash receipts and capital build-­‐up (Woodhead 2013). As well as this greater flexibility, the tax advantages of capital gains allow only a portion of the realisation of the asset to be taxed as opposed to dividends, which are fully taxable. The theory of taxes and the radical left demonstrates why a company such as Berkshire Hathaway would have a share buyback policy as opposed to a conventional cash dividend. The recent dividend decisions of Microsoft, TFS and Berkshire Hathaway are supported by the life-­‐cycle theory of the firm, the information content of dividends and also taxes and the radical left. Whilst the ideas perpetuated by DeAngelo, DeAngelo, Lintner and Watts are successful in explaining the rationale behind modern day corporate payout policy to a large degree, Modigliani and Miller’s propose a sound argument that dividends are irrelevant if the firm focuses on investment policy. Through the analysis of the recent payout policies of the aforementioned firms, it is clear that the main theories are useful for conducting a well informed assessment of contemporary payout policy, however, in real markets there is also macroeconomic variables such as taxes and financing arrangements that also dictate the payout decisions of managers.

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