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Chapter 17

Payout Policy

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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

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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.

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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.
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17.1 Distribution to Shareholders

Payout Policy
The way a firm chooses between the
alternative ways to distribute free cash flow to
equity holders

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Figure 17.1 Uses of Free Cash Flow

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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.

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Dividends (cont'd)

Ex-dividend Date
A date, two days prior to a dividends 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

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Figure 17.2 Important Dates for
Microsofts Special Dividend

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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

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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 liquidation of assets

Liquidating Dividend
A return of capital to shareholders from a
business operation that is being terminated

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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.

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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.

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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.

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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

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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

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17.2 Comparison of Dividends
and Share Repurchases
Consider Genron Corporation. The firms
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%.

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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.

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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


4.80
Pcum Current Dividend PV (Future Dividends) 2 2 40 $42
0.12

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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

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Alternative Policy 1: Pay Dividend with
Excess Cash (cont'd)

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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.

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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

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Alternative Policy 2: Share Repurchase
(No Dividend) (cont'd)

The net effect is that the share price


remains unchanged.

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Alternative Policy 2: Share Repurchase
(No Dividend) (cont'd)

Genrons 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
Genrons share price is
5.04
Prep $42
0.12

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Alternative Policy 2: Share Repurchase
(No Dividend) (cont'd)

Genrons 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.

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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.

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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.

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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.

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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.

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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.

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ModiglianiMiller
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.

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Table 17.1 Genrons Dividends per Share
Each Year Under the Three Alternative Policies

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ModiglianiMiller and Dividend
Policy Irrelevance (cont'd)
MM Dividend Irrelevance
In perfect capital markets, holding fixed the
investment policy of a firm, the firms choice of
dividend policy is irrelevant and does not affect
the initial share price.

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Dividend Policy
with Perfect Capital Markets
A firms 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 firms payout policy.

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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.

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Table 17.2 Long-Term Capital Gains Versus
Dividend Tax Rates in the United States,
19712009

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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.

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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.

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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.

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Optimal Dividend Policy
with Taxes (cont'd)
Dividend Puzzle
When firms continue to issue dividends despite
their tax disadvantage

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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.

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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.

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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.

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Table 17.3 Differing Dividend Policy
Preferences Across Investor Groups

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Clientele Effects (cont'd)

Dividend-Capture Theory
The theory that in absence of 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 ex-
dividend 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 ex-
dividend date.

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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.

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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.

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Retaining Cash with Perfect Capital
Markets (cont'd)

Thus, with perfect capital markets, the retention


versus payout decision is irrelevant.

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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 firms choice of payout
versus retention is irrelevant and does not affect the
initial share price.

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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.

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