Distributions

Dr. C. Bulent Aybar

Professor of International Finance
 Comparison of Dividends and Share Repurchases

• Consider ABC Corporation. The firm’s board is meeting to

decide how to pay out $20 million in excess cash to
shareholders.
• ABC has no debt, its equity cost of capital equals its
unlevered cost of capital of 12%.
• With 10 million shares outstanding, ABC 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.

© Dr. C. Bulent Aybar

 Alternative 1: Pay Dividend with Excess Cash

• Cum-dividend (Stock price with dividend)

– When a stock trades before the ex-dividend date, entitling anyone
who buys the stock to the dividend

• The cum-dividend price of ABC will be

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

• After the ex-dividend date, new buyers will not receive the
current dividend and the share price and the price of ABC
will be
4.80
Pex  PV (Future Dividends)   $40
0.12
© Dr. C. Bulent Aybar
 Dividends and Value Implications in Perfect Markets

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.

© Dr. C. Bulent Aybar

 Alternative 2: Share Repurchase (No Dividend)

• Suppose that instead of paying a dividend this year, ABC

uses the $20 million to repurchase its shares on the open
market.
– With an initial share price of $42, ABC 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

© Dr. C. Bulent Aybar

 Alternative 2: Share Repurchase

After the repurchase, the future dividend would rise to $5.04 per
share.
$48 million ÷ 9.524 million shares = $5.04 per share
ABC’s share price is
5.04
Prep   $42
0.12
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.
 Investor Preferences in Perfect Markets

• 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.
• Investor Preferences
– In the case of ABC, 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.

© Dr. C. Bulent Aybar

 MM Dividend Irrelevance Argument

• MM Dividend Irrelevance Proposition:

– 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.

• In other words, in a perfect capital market, the type of payout

is irrelevant.
• In reality, capital markets are not perfect and imperfections
such as taxes and transaction costs determine the firm’s
payout policy.

© Dr. C. Bulent Aybar

 Repurchases and The Supply of Shares

• There is a misconception that share repurchases decrease the

supply of shares and therefore lead to increasing share
prices. Note that when the firm repurchase shares, two things
happen:
– Supply of Shares Reduced
– The value of the firm’s assets decline because of expenditure to
purchase the sales

• These two effects offset each other leaving the share price
unchanged. This is similar to the dilution fallacy. When
firm issues new shares the share price does not decline
because cash raised as a result of issue increases the value of
the assets.
© Dr. C. Bulent Aybar
 Tax Disadvantage of Dividends

• 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.
• The optimal dividend policy when the dividend tax
rate exceeds the capital gain tax rate is to pay no
dividends at all.

© Dr. C. Bulent Aybar

Capital Gains and Dividend Taxes
Capital Gains and Dividend Taxes in the US
1971-2008
 Taxes and Investor Preferences

• Consider the case where $20m excess cash was distributed

as dividends. In the absence of taxes, we concluded that the
stock price declines by the size of the dividend.
• Now let’s consider this when investors pay dividend and
capital gains taxes. Dividend payment has two implications:
– Dividend received will create a tax liability and net dividend will be
equal to D x(1-Td).
– The investor will experience a capital loss because of the decline in
the share price which is equal to (PCum-PEx). Because of capital gains
taxes the net loss is : (PCum-PEx)x(1-TG)

• If the net dividend exceeds capital loss, investors will prefer

to receive dividends.
© Dr. C. Bulent Aybar
 Taxes and Arbitrage

• Indeed, in that case an arbitrage will take place. The

investors will buy shares Cum-Dividend, sell Ex-Dividend
and incur a capital loss. However provided that net dividends
exceed this loss, they will generate a profit.
• This arbitrage activity will ensure that the Ex-dividend price
will conform to a specific level.

© Dr. C. Bulent Aybar

 Arbitrage and Ex-Dividend Price

• Consider buying a stock just before it goes ex-dividend and

selling the stock just after.
– The equilibrium condition must be:

(Pcum  Pex ) (1   g )  Div(1   d )

– Where Pcum is the cum-dividend price, Pex is the ex-dividend price, g

is the capital gains rate tax, d is the dividend tax rate.
– Which leads to an Ex-Dividend price of:

 (1   d ) 
PEx = PCum - Div  
 (1   g ) 
© Dr. C. Bulent Aybar
 The Effective Dividend Tax Rate
• We can express the wedge between the cum and ex dividend prices as
follows:

1  d   d  g 
Pcum  Pex  Div    Div  1 
 1     1  g

 g   

Pcum  Pex  
 Div  1   *d 
d  g 
  
 1   
*
d
 g 

• Where τd* is the effective dividend tax rate ,The effective dividend tax
rate indicates that given the dividend and capital gains taxes every dollar
of dividend income is equivalent to (1-τd*) dollar of capital gains.
© Dr. C. Bulent Aybar
 Example

• Assume that dividend tax rate is 39% and Capital gains tax
rate is 20%. Calculate and interpret the effective dividend
tax rate?
• Solution:
  d   g  0.39-0.20
    0.2375
 1   
*
d =
 g  (1-0.2)

– Given the effective dividend tax rate of 23.75%, every dollar of

dividend income is effectively equal to (1-0.2375)=$0.7625 of capital
gains.

© Dr. C. Bulent Aybar

 Example

• The JRN Corp. will pay constant dividend of $3 per share per year
to perpetuity. Assume that all investors pay a 20% dividend tax, but
no capital gains tax. The required return for JRN stock is 12%.
• What is the JRN stock price?
– P=D x (1-Td)/re= 3.00 x (1-0.2)/0.12=$20
• Assume that JRN announces that it will not pay any dividends, but will
use the cash to repurchase stock instead. The price of JRN shares should
be:
– P=D x (1-Td)/re= 3.00 /0.12=$25
• In a perfect market repurchase decision should not affect the firm value.
Since the tax rate in the case of repurchases in zero, the stock price
would be the same as if dividends were not taxed.

© Dr. C. Bulent Aybar

 Declining Use of Dividends

The payment of dividends has declined on average over the last 30

years. By 2006 only 25% of the firms relied on dividends.
Payouts in the form of Repurchases Increased

By 2006, 30% of all firms (and more than half of firms making
payouts to shareholders) used share repurchases exclusively or in
combination with dividends
 Dividend Puzzle

• Firms continue to issue dividends despite their tax

disadvantage. Despite the growing importance of share
repurchases as a part of firms’ payout policies, dividends
remain a key form of payouts to shareholders.
• 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.
© Dr. C. Bulent Aybar
Effective Dividend Tax Rate Varies across Investors Groups
– Income Level. Investors with different levels of income fall into
different tax brackets and face different tax rates.
– Investment Horizon. Capital gains on stocks held less than one year,
and dividends on stocks held for less than 61 days, are taxed at
higher ordinary income tax rates
– Tax Jurisdiction. U.S. investors are subject to state taxes that differ
by state.
– Type of Investor or Investment Account. Stocks held by individual
investors in a retirement account are not subject to taxes on dividends
or capital gains. Similarly, stocks held through pension funds or
nonprofit endowment funds are not subject to dividend or capital
gains taxes.
– Corporations that hold stocks are able to exclude 70% of dividends
they receive from corporate taxes, but are unable to exclude capital
gains. Corporations can exclude 80% if they own more than 20% of
the shares of the firm paying the dividend.

© Dr. C. Bulent Aybar

 Taxes and Preferences

1. Long-term investors are more heavily taxed on dividends, so

they would prefer share repurchases to dividend payments.
2. One-year investors, pension funds, and other non-taxed
investors have no tax preference for share repurchases over
dividends; they would prefer a payout policy that most
closely matches their cash needs. For example, a non-taxed
investor who desires current income would prefer high
dividends so as to avoid the brokerage fees and other
transaction costs of selling the stock.
3. Corporations enjoy a tax advantage associated with
dividends due to the 70% exclusion rule. For this reason, a
corporation that chooses to invest its cash will prefer to hold
stocks with high dividend yields.
© Dr. C. Bulent Aybar
 Investor Preferences and Dividend Policy

• The presence of different group of investors sometimes

shapes the dividend policy of the firm.
• So called “Clientele Effect” suggest that 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.

© Dr. C. Bulent Aybar

 Implications of Cash Retention in Perfect Markets

• In perfect capital markets, once a firm has taken all positive-

NPV investments, it is indifferent between saving excess
cash and paying it out.
• Buying and selling securities is a zero-NPV transaction, so it
should not affect firm value.
• Shareholders can make any investment a firm makes on their
own if the firm pays out the cash.
• The retention versus payout decision is irrelevant in the
Perfect Markets!

© Dr. C. Bulent Aybar

 This conclusion changes in imperfect markets!!

• 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.
• 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.

© Dr. C. Bulent Aybar

 Example

• XYZ Mining has $100,000 in excess cash. XYZ is

considering investing the cash in one-year Treasury bills
paying 6% interest, and then using the cash to pay a dividend
next year.
• 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?

© Dr. C. Bulent Aybar

Solution: Perfect Markets/No Taxes and Transaction Costs
• We need to compare what shareholders would receive from
an immediate dividend ($100,000), to the present value of
what they would receive in one year if XYZ invested the
cash.
– If XYZ retains the cash, at the end of one year the company will be
able to pay a dividend of $100,000  (1.06) = $106,000.
– Note that this payoff is the same as if shareholders had invested the
$100,000 in Treasury bills themselves.
– In other words, the present value of this future dividend is exactly
$106,000  (1.06) = $100,000, which is the same as the $100,000
shareholders would receive from an immediate dividend.

• Thus shareholders are indifferent about whether the firm

pays the dividend immediately or retains the cash.
© Dr. C. Bulent Aybar
 Introduce Corporate Taxes
• Suppose XYZ must pay corporate taxes at a 35% rate on the interest it
will earn from the one-year Treasury bill paying 6% interest. Evaluate
retention and immediate dividend options from pension fund investors
perspective:
– Because the pension fund investors do not pay taxes on investment income,
the results from the prior example still hold: they would get $100,000, invest
it, and earn 6% to receive a total of $106,000 in one year.
– If XYZ retains the cash for one year, it will earn an after-tax return on the
Treasury bills of
6%  (1 – 0.35) = 3.90%
– Thus, at the end of the year, XYZ will pay a dividend of $100,000  (1.039)
= $103,900.
• In this case, investors prefer immediate dividends over retention.

© Dr. C. Bulent Aybar

 Example: Microsoft Special Dividend

• In 2004, Microsoft declared a $3 special dividend. At the

time outstanding number of shares were 10.666 billion. The
total amount of cash to be returned to investors is $32bn.
• What would have been the tax implications of retention of
this amount?
– If MSFT corporate tax is assumed to be 35%, the PV of the tax
payments would be:
– (32bn x Rf x 0.35 )/Rf=$11.2bn
– On a per share basis tax savings from paying out the cash rather than
retaining is $3x0.35=$1.05 per share.

© Dr. C. Bulent Aybar

 Implications of Retention and Payment

• 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.

• 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.

© Dr. C. Bulent Aybar

 Effective Cost of Retention

• Since retention of cash may have negative implications for

shareholders, the expected price of the shares should also be
affected from this.
• Combining the implications of corporate, dividend and
individual income taxes we can develop the following
decision rule for retention:

  p   d  
c <  
 1   d  

• When corporate tax rate complies with the above condition,

it may be beneficial to retain cash.

© Dr. C. Bulent Aybar

 Why Retain Cash Despite its Tax Disadvantages

• Reducing 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.
– 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.

© Dr. C. Bulent Aybar

 Large Cash Balances by Technology Firms
Firms with Large Cash Holdings

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.
 Agency Cost of Cash Retention

• When firms have excessive cash, managers may use the

funds inefficiently by paying excessive executive perks,
over-paying 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.
– On April 23, 2004 Value Line announced it would use its
accumulated cash to pay a special dividend of $17.50 per share.
Value Line’s stock increased by roughly $10 on the announcement of
its special dividend, very likely due to the perceived tax benefits and
reduced agency costs that would result from the transaction.

© Dr. C. Bulent Aybar

 Other Explanations to Distribution Policies

• Dividend Smoothing
– The practice of maintaining relatively constant dividends: Firm
change dividends infrequently and dividends are much less volatile
than earnings.
– 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.

© Dr. C. Bulent Aybar

GM’s Earnings and Dividends
 Signaling Theory

• The idea that dividend changes reflect managers’ views

about a firm’s future earning prospects:
• 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.

© Dr. C. Bulent Aybar

 Other Side of the Coin

• 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.

© Dr. C. Bulent Aybar

 Repurchases Signaling and Market Timing

• 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.

© Dr. C. Bulent Aybar

 Stock Dividends

• 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.
• 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.

© Dr. C. Bulent Aybar

 Value Implications of Stock Dividends

• Suppose ABC paid a 50% stock dividend. In this case each

shareholder will receive one share per two shares they hold.
This is equivalent to a 3:2 stock split.
• A shareholder who owns 100 shares before the dividend has
a portfolio worth $4,200 at $42 per share price.
– $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 or (42 x 2/3=$28)

© Dr. C. Bulent Aybar

 Stock 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.
• 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.
• Reverse Splits are used when the price of a company’s stock falls too low and
the company reduces the number of outstanding shares

© Dr. C. Bulent Aybar

Distribution of Stock Prices for NYSE Firms

© Dr. C. Bulent Aybar

 Spin-offs

• 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.
• 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.

© Dr. C. Bulent Aybar