Chapter 17 Payout Policy
Chapter Outline 17.1 Distributions to Shareholders 17.2 Comparison of Dividends and Share Repurchases 17.3 The Tax Disadvantage of Dividends 17.4 Dividend Capture and Tax Clienteles 17.5 Payout Versus Retention of Cash 17.6 Signaling with Payout Policy 17.7 Stock Dividends, Splits and Spin-offs 17-2
Learning Objectives 1. List two ways a company can distribute cash to its shareholders. 2. Describe the dividend payment process and the open-market repurchase process. 3. Define stock split, reverse stock split, and stock dividend; describe the effect of those actions on stock price. 4. Discuss the effect of dividend payment or share repurchase in a perfect world. 17-3
Learning Objectives (cont'd) 5. Assuming perfect capital markets, describe what Modigliani and Miller (1961) found about payout policy. 6. Discuss the effect of taxes on dividend policy; compute the effective dividend tax rate. 7. Provide reasons why firms might accumulate cash balances rather than pay dividends. 8. Describe the effect of agency costs on payout policy. 9. Assess the impact of information asymmetry on payout policy. 17-4
17.1 Distribution to Shareholders Payout Policy The way a firm chooses between the alternative ways to distribute free cash flow to equity holders 17-5
Figure 17.1 Uses of Free Cash Flow 17-6
Dividends Declaration Date The date on which the board of directors authorizes the payment of a dividend Record Date When a firm pays a dividend, only shareholders on record on this date receive the dividend. 17-7
Dividends (cont'd) Ex-dividend Date A date, two days prior to a dividend s record date, on or after which anyone buying the stock will not be eligible for the dividend Payable Date (Distribution Date) A date, generally within a month after the record date, on which a firm mails dividend checks to its registered stockholders 17-8
Figure 17.2 Important Dates for Microsoft s Special Dividend 17-9
Dividends (cont'd) Special Dividend A one-time dividend payment a firm makes, which is usually much larger than a regular dividend Stock Split (Stock Dividend) When a company issues a dividend in shares of stock rather than cash to its shareholders 17-10
Figure 17.3 Dividend History for GM Stock, 1983 2008 17-11
Dividends (cont'd) Return of Capital When a firm, instead of paying dividends out of current earnings (or accumulated retained earnings), pays dividends from other sources, such as paid-in-capital or the liquidation of assets Liquidating Dividend A return of capital to shareholders from a business operation that is being terminated 17-12
Share Repurchases An alternative way to pay cash to investors is through a share repurchase or buyback. The firm uses cash to buy shares of its own outstanding stock. 17-13
Share Repurchases (cont'd) Open Market Repurchase When a firm repurchases shares by buying shares in the open market Open market share repurchases represent about 95% of all repurchase transactions. 17-14
Share Repurchases (cont'd) Tender Offer A public announcement of an offer to all existing security holders to buy back a specified amount of outstanding securities at a prespecified price (typically set at a 10%- 20% premium to the current market price) over a prespecified period of time (usually about 20 days) If shareholders do not tender enough shares, the firm may cancel the offer and no buyback occurs. 17-15
Share Repurchases (cont'd) Dutch Auction A share repurchase method in which the firm lists different prices at which it is prepared to buy shares, and shareholders in turn indicate how many shares they are willing to sell at each price. The firm then pays the lowest price at which it can buy back its desired number of shares 17-16
Share Repurchases (cont'd) Targeted Repurchase When a firm purchases shares directly from a specific shareholder Greenmail When a firm avoids a threat of takeover and removal of its management by a major shareholder by buying out the shareholder, often at a large premium over the current market price 17-17
17.2 Comparison of Dividends and Share Repurchases Consider Genron Corporation. The firm s board is meeting to decide how to pay out $20 million in excess cash to shareholders. Genron has no debt, its equity cost of capital equals its unlevered cost of capital of 12%. 17-18
Alternative Policy 1: Pay Dividend with Excess Cash With 10 million shares outstanding, Genron will be able to pay a $2 dividend immediately. The firm expects to generate future free cash flows of $48 million per year, thus it anticipates paying a dividend of $4.80 per share each year thereafter. 17-19
Alternative Policy 1: Pay Dividend with Excess Cash (cont'd) Cum-dividend When a stock trades before the ex-dividend date, entitling anyone who buys the stock to the dividend The cum-dividend price of Genron will be Pcum 4.80 Current Dividend PV (Future Dividends) 2 2 40 $42 0.12 17-20
Alternative Policy 1: Pay Dividend with Excess Cash (cont'd) After the ex-dividend date, new buyers will not receive the current dividend and the share price and the price of Genron will be 4.80 Pex PV (Future Dividends) $40 0.12 17-21
Alternative Policy 1: Pay Dividend with Excess Cash (cont'd) 17-22
Alternative Policy 1: Pay Dividend with Excess Cash (cont'd) In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend. 17-23
Alternative Policy 2: Share Repurchase (No Dividend) Suppose that instead of paying a dividend this year, Genron uses the $20 million to repurchase its shares on the open market. With an initial share price of $42, Genron will repurchase 476,000 shares. $20 million $42 per share = 0.476 million shares This will leave only 9.524 million shares outstanding. 10 million 0.476 million = 9.524 million 17-24
Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) The net effect is that the share price remains unchanged. 17-25
Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) Genron s Future Dividends It should not be surprising that the repurchase had not effect on the stock price. After the repurchase, the future dividend would rise to $5.04 per share. $48 million 9.524 million shares = $5.04 per share Genron s share price is 5.04 Prep 0.12 $42 17-26
Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) Genron s Future Dividends In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the cum-dividend price if a dividend were paid instead. 17-27
Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) Investor Preferences In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate either payout method on their own. 17-28
Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) Investor Preferences In the case of Genron, if the firm repurchases shares and the investor wants cash, the investor can raise cash by selling shares. This is called a homemade dividend. If the firm pays a dividend and the investor would prefer stock, they can use the dividend to purchase additional shares. 17-29
Textbook Example 17.1 17-30
Textbook Example 17.1 (cont'd) 17-31
Alternative Policy 3: High Dividend (Equity Issue) Suppose Genron wants to pay dividend larger than $2 per share right now, but it only has $20 million in cash today. Thus, Genron needs an additional $28 million to pay the larger dividend now. To do this, the firm decides to raise the cash by selling new shares. 17-32
Alternative Policy 3: High Dividend (Equity Issue) (cont'd) Given a current share price of $42, Genron could raise $28 million by selling 0.67 million shares. $28 million $42 per share = 0.67 million shares This will increase the total number of shares to 10.67 million. 17-33
Alternative Policy 3: High Dividend (Equity Issue) (cont'd) The new dividend per share will be $48 million $4.50 per share 10.67 million shares And the cum-dividend share price will be 4.50 Pcum 4.50 4.50 37.50 $42 0.12 Again, the share value is unchanged. 17-34
Modigliani Miller and Dividend Policy Irrelevance There is a trade-off between current and future dividends. If Genron pays a higher current dividend, future dividends will be lower. If Genron pays a lower current dividend, future dividends will be higher. 17-35
Table 17.1 Genron s Dividends per Share Each Year Under the Three Alternative Policies 17-36
Modigliani Miller and Dividend Policy Irrelevance (cont'd) MM Dividend Irrelevance In perfect capital markets, holding fixed the investment policy of a firm, the firm s choice of dividend policy is irrelevant and does not affect the initial share price. 17-37
Dividend Policy with Perfect Capital Markets A firm s free cash flow determines the level of payouts that it can make to its investors. In a perfect capital market, the type of payout is irrelevant. In reality, capital markets are not perfect and it is these imperfections that should determine the firm s payout policy. 17-38
17.3 The Tax Disadvantage of Dividends Taxes on Dividends and Capital Gains Shareholders must pay taxes on the dividends they receive and they must also pay capital gains taxes when they sell their shares. Dividends are typically taxed at a higher rate than capital gains. In fact, long-term investors can defer the capital gains tax forever by not selling. 17-39
Table 17.2 Long-Term Capital Gains Versus Dividend Tax Rates in the United States, 1971 2009 17-40
17.3 The Tax Disadvantage of Dividends (cont'd) Taxes on Dividends and Capital Gains The higher tax rate on dividends makes it undesirable for a firm to raise funds to pay a dividend. When dividends are taxed at a higher rate than capital gains, if a firm raises money by issuing shares and then gives that money back to shareholders as a dividend, shareholders are hurt because they will receive less than their initial investment. 17-41
Textbook Example 17.2 17-42
Textbook Example 17.2 (cont'd) 17-43
Alternative Example 17.2 Problem Assume: A firm raises $25 million from shareholders and uses this cash to pay them $25 million in dividends. Dividends are taxed at a 39% tax rate Capital gains are taxed at a 20% tax rate. How much will shareholders receive after taxes? 17-44
Alternative Example 17.2 Solution On dividends, shareholders will owe: 39% $25 million = $9.75 million in dividend taxes. Shareholders will lower their capital gains taxes by: 20% $25 million = $5 million Note: The value of the firm will fall when the dividend is paid, lowering the shareholders capital gains. 17-45
Alternative Example 17.2 Solution (continued) Shareholders will pay a total of $4.75 million in taxes. $9.75 $5.00 = $4.75 million Shareholders will receive back only $20.25 million of their $25 million investment. $25 $4.75 = $20.25 million 17-46
Optimal Dividend Policy with Taxes When the tax rate on dividends is greater than the tax rate on capital gains, shareholders will pay lower taxes if a firm uses share repurchases rather than dividends. This tax savings will increase the value of a firm that uses share repurchases rather than dividends. 17-47
Optimal Dividend Policy with Taxes (cont'd) The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all. The payment of dividends has declined on average over the last 30 years while the use of repurchases has increased. 17-48
Figure 17.4 The Decline in Payouts and the Use of Dividends Source: Compustat. 17-49
Figure 17.5 The Changing Composition of Shareholder Payouts Source: Compustat data for U.S. firms, excluding financial firms and utilities. 17-50
Optimal Dividend Policy with Taxes (cont'd) Dividend Puzzle When firms continue to issue dividends despite their tax disadvantage 17-51
17.4 Dividend Capture and Tax Clienteles The preference for share repurchases rather than dividends depends on the difference between the dividend tax rate and the capital gains tax rate. Tax rates vary by income, by jurisdiction, and by whether the stock is held in a retirement account. Given these differences, firms may attract different groups of investors depending on their dividend policy. 17-52
The Effective Dividend Tax Rate Consider buying a stock just before it goes exdividend and selling the stock just after. The equilibrium condition must be: ( P P ) (1 ) Div(1 ) cum ex g d Which can be stated as 1 d d g * Pcum Pex Div Div 1 Div 1 d 1 g 1 g Where P cum is the cum-dividend price, P ex is the ex-dividend price, g is the capital gains rate tax, d is the dividend tax rate. 17-53
The Effective Dividend Tax Rate (cont'd) Thus, the effective dividend tax rate is * d d 1 g g This measures the additional tax paid by the investor per dollar of after-tax capital gains income that is instead received as a dividend. 17-54
Textbook Example 17.3 17-55
Textbook Example 17.3 (cont'd) 17-56
Tax Differences Across Investors The effective dividend tax rate differs across investors for a variety of reasons. Income Level Investment Horizon Tax Jurisdiction Type of Investor or Investment Account As a result of their different tax rates investors will have varying preferences regarding dividends. 17-57
Clientele Effects Clientele Effect When the dividend policy of a firm reflects the tax preference of its investor clientele Individuals in the highest tax brackets have a preference for stocks that pay no or low dividends, whereas tax-free investors and corporations have a preference for stocks with high dividends. 17-58
Table 17.3 Differing Dividend Policy Preferences Across Investor Groups 17-59
Clientele Effects (cont'd) Dividend-Capture Theory The theory that absent transaction costs, investors can trade shares at the time of the dividend so that non-taxed investors receive the dividend An implication of this theory is that we should see large trading volume in a stock around the exdividend day, as high-tax investors sell and low-tax investors buy the stock in anticipation of the dividend, and then reverse those trades just after the exdividend date. 17-60
Figure 17.6 Volume and Share Price Effects of Value Line s Special Dividend 17-61
17.5 Payout Versus Retention of Cash In perfect capital markets, once a firm has taken all positive-npv investments, it is indifferent between saving excess cash and paying it out. With market imperfections, there is a tradeoff: Retaining cash can reduce the costs of raising capital in the future, but it can also increase taxes and agency costs. 17-62
Retaining Cash with Perfect Capital Markets If a firm has already taken all positive-npv projects, any additional projects it takes on are zero or negative-npv investments. Rather than waste excess cash on negative- NPV projects, a firm can use the cash to purchase financial assets. In perfect capital markets, buying and selling securities is a zero-npv transaction, so it should not affect firm value. 17-63
Retaining Cash with Perfect Capital Markets (cont'd) Thus, with perfect capital markets, the retention versus payout decision is irrelevant. 17-64
Textbook Example 17.4 17-65
Textbook Example 17.4 (cont'd) 17-66
Alternative Example 17.4 Problem Payne Enterprises has $20,000,000 in excess cash. Payne is considering investing the cash in oneyear Treasury bills paying 5% interest, and then using the cash to pay a dividend next year. 17-67
Alternative Example 17.4 Problem (continued) Alternatively, the firm can pay a dividend immediately and shareholders can invest the cash on their own. In a perfect capital market, which option will shareholders prefer? 17-68
Alternative Example 17.4 Solution If Payne pays an immediate dividend, the shareholders receive $20,000,000 today. If Payne retains the cash, at the end of one year the company will be able to pay a dividend of $21,000,000. $20,000,000 (1.05) = $21,000,000 17-69
Alternative Example 17.4 Solution (continued) If shareholders invest the $20,000,000 in Treasury bills themselves, they would have $21,000,000 at the end of 1 year. $20,000,000 (1.05) = $21,000,000 The present value in either scenario is: $21,000,000 1.05 = $20,000,000 Thus shareholders are indifferent about whether the firm pays the dividend immediately or retains the cash. 17-70
Retaining Cash with Perfect Capital Markets (cont'd) MM Payout Irrelevance In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm s choice of payout versus retention is irrelevant and does not affect the initial share price. 17-71
Taxes and Cash Retention Corporate taxes make it costly for a firm to retain excess cash. Cash is equivalent to negative leverage, so the tax advantage of leverage implies a tax disadvantage to holding cash. 17-72
Textbook Example 17.5 17-73
Textbook Example 17.5 (cont'd) 17-74
Alternative Example 17.5 Problem What if Payne, from Alternative Example 17.4, has a marginal tax rate of 39%. Would a taxexempt endowment prefer that Payne use its excess cash to pay the dividend immediately or invest the cash in a Treasury bill paying 5% interest and then pay out a dividend? 17-75
Alternative Example 17.5 (cont d) Solution If Payne pays a dividend today, shareholders receive $20,000,000. If Payne retains the cash for one year, it will earn an after-tax return on the Treasury bills of: 5% (1 0.39) = 3.05% At the end of the year, Payne will pay a dividend of $20,000,000 (1.0305) = $20,610,000. This amount is less than the $21,000,000 the endowment would have earned if they had invested the $20,000,000 in the Treasury bills themselves. 17-76
Textbook Example 17.6 17-77
Textbook Example 17.6 17-78
Alternative Example 17.6 Problem What if Payne, from Alternative Examples 17.4 and 17.5, were to pay a special dividend of $20,000,000. How would this affect the present value of the taxes Payne must pay? 17-79
Alternative Example 17.6 (cont d) Solution If Payne retains the $20,000,000 and invests in Treasury Bills, the interest will be taxed at 39%. The present value of the tax payments on Payne s additional interest income will be: $20,000,000 5% 39% $7,800,000 5% 17-80
Adjusting for Investor Taxes The decision to pay out versus retain cash may also affect the taxes paid by shareholders. When a firm retains cash, it must pay corporate tax on the interest it earns. In addition, the investor will owe capital gains tax on the increased value of the firm. In essence, the interest on retained cash is taxed twice. 17-81
Adjusting for Investor Taxes (cont'd) If the firm paid the cash to its shareholders instead, they could invest it and be taxed only once on the interest that they earn. The cost of retaining cash therefore depends on the combined effect of the corporate and capital gains taxes, compared to the single tax on interest income. 1 1 * c retain 1 1 i g 17-82
Issuance and Distress Costs Generally, firms retain cash balances to cover potential future cash shortfalls, despite the tax disadvantage to retaining cash. A firm might accumulate a large cash balance if there is a reasonable chance that future earnings will be insufficient to fund future positive-npv investment opportunities. 17-83
Issuance and Distress Costs (cont'd) The cost of holding cash to cover future potential cash needs should be compared to the reduction in transaction, agency, and adverse selection costs of raising new capital through new debt or equity issues. 17-84
Agency Costs of Retaining Cash When firms have excessive cash, managers may use the funds inefficiently by paying excessive executive perks, overpaying for acquisitions, etc. Paying out excess cash through dividends or share repurchases, rather than retaining cash, can boost the stock price by reducing managers ability and temptation to waste resources. 17-85
Textbook Example 17.7 17-86
Textbook Example 17.7 (cont'd) 17-87
Agency Costs of Retaining Cash (cont'd) Firms should choose to retain to help with future growth opportunities and to avoid financial distress costs. It is not surprising that high-tech and biotechnology firms tend to retain and accumulate large amounts of cash. 17-88
Table 17.4 Firms with Large Cash Balances (April 2009) 17-89
17.6 Signaling with Payout Policy Dividend Smoothing The practice of maintaining relatively constant dividends Firm change dividends infrequently and dividends are much less volatile than earnings. 17-90
Figure 17.7 GM s Earnings and Dividends per Share, 1985 2008 Source: Compustat and CapitalIQ. 17-91
17.6 Signaling with Payout Policy (cont'd) Research has found that Management believes that investors prefer stable dividends with sustained growth. Management desires to maintain a long-term target level of dividends as a fraction of earnings. Thus, firms raise their dividends only when they perceive a long-term sustainable increase in the expected level of future earnings, and cut them only as a last resort. 17-92
Dividend Signaling Dividend Signaling Hypothesis The idea that dividend changes reflect managers views about a firm s future earning prospects If firms smooth dividends, the firm s dividend choice will contain information regarding management s expectations of future earnings. 17-93
Dividend Signaling (cont'd) When a firm increases its dividend, it sends a positive signal to investors that management expects to be able to afford the higher dividend for the foreseeable future. When a firm decreases its dividend, it may signal that management has given up hope that earnings will rebound in the near term and so need to reduce the dividend to save cash. 17-94
Dividend Signaling (cont'd) While an increase of a firm s dividend may signal management s optimism regarding its future cash flows, it might also signal a lack of investment opportunities. Conversely, a firm might cut its dividend to exploit new positive-npv investment opportunities. In this case, the dividend decrease might lead to a positive, rather than negative, stock price reaction. 17-95
Signaling and Share Repurchases Share repurchases are a credible signal that the shares are under-priced, because if they are over-priced a share repurchase is costly for current shareholders. If investors believe that managers have better information regarding the firm s prospects and act on behalf of current shareholders, then investors will react favorably to share repurchase announcements. 17-96
Textbook Example 17.8 17-97
Textbook Example 17.8 (cont'd) 17-98
17.7 Stock Dividends, Splits, and Spin-offs Stock Dividends and Splits With a stock dividend, a firm does not pay out any cash to shareholders. As a result, the total market value of the firm s equity is unchanged. The only thing that is different is the number of shares outstanding. The stock price will therefore fall because the same total equity value is now divided over a larger number of shares. 17-99
17.7 Stock Dividends, Splits, and Spin-offs (cont'd) Stock Dividends and Splits Suppose Genron paid a 50% stock dividend (a 3:2 stock split) rather than a cash dividend. A shareholder who owns 100 shares before the dividend has a portfolio worth $4,200. $42 100 = $4,200. After the dividend, the shareholder owns 150 shares. Since the portfolio is still worth $4,200, the stock price will fall to $28. $4,200 150 = $28 17-100
Table 17.5 Cum- and Ex-Dividend Share Price for Genron with a 50% Stock Dividend ($ million) 17-101
17.7 Stock Dividends, Splits, and Spin-offs (cont'd) Stock Dividends and Splits Stock dividends are not taxed, so from both the firm s and shareholders perspectives, there is no real consequence to a stock dividend. The number of shares is proportionally increased and the price per share is proportionally reduced so that there is no change in value. 17-102
17.7 Stock Dividends, Splits, and Spin-offs (cont'd) Stock Dividends and Splits The typical motivation for a stock split is to keep the share price in a range thought to be attractive to small investors. If the share price rises too high, it might be difficult for small investors to invest in the stock. 17-103
17.7 Stock Dividends, Splits, and Spin-offs (cont'd) Stock Dividends and Splits Keeping the price low may make the stock more attractive to small investors and can increase the demand for and the liquidity of the stock, which may in turn boost the stock price. On average, announcements of stock splits are associated with a 2% increase in the stock price. 17-104
17.7 Stock Dividends, Splits, and Spin-offs (cont'd) Stock Dividends and Splits Reverse Split When the price of a company s stock falls too low and the company reduces the number of outstanding shares 17-105
Figure 17.8 Distribution of Stock Prices for NYSE Firms (June 2009) 17-106
Spin-offs Spin-off When a firm sells a subsidiary by selling shares in the subsidiary alone Non-cash special dividends are commonly used to spin off assets or a subsidiary as a separate company. 17-107
Spin-offs (cont'd) Spin-offs offer two advantages It avoids the transaction costs associated with a subsidiary sale. The special dividend is not taxed as a cash distribution. 17-108
Discussion of Data Case Key Topic If Congress were to pass legislation eliminating the capital gains tax, what would be the impact on your analysis? What if taxes on dividends were eliminated instead? How would your analysis change if capital gains and dividends were both taxed at the same rate as ordinary income? 17-109
Chapter Quiz 1. What is a targeted repurchase? 2. How important is the firm s decision to pay dividends versus repurchase shares, assuming perfect capital markets? 3. What is the dividend puzzle? 4. Why would investors have a tax preference for share repurchases rather than dividends? 5. Is there an advantage for a firm to retain its cash instead of paying it out to shareholders in perfect capital markets? What if capital markets are not perfect? 17-110
Chapter Quiz 6. What possible signals does a firm give when it cuts its dividend? 7. What is the difference between a stock dividend and a stock split? 8. Why would a firm initiate a reverse stock split? 17-111