chapter 16 payout policies

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Chapter 16

Payout Policy

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-

Chapter Outline

16.1 Distributions to Shareholders 16.2 Dividends Versus Share Repurchase in a Perfect

Capital Market16.3 The Tax Disadvantage of Dividends16.4 Payout Versus Retention of Cash16.5 Signaling with Payout Policy16.6 Stock Dividends, Splits, and Spin-offs16.7 Advice for the Financial Manager


Learning Objectives

• Identify the different ways in which corporations can make distributions to shareholders

• Understand why the way in which they distribute cash flow does not affect value absent market imperfections

• Indicate how taxes can create an advantage for share repurchases versus dividends

• Explain how increased payouts can reduce agency problems but potentially reduce financial flexibility

• Describe alternate non-cash methods for payouts


16.1 Distributions to Shareholders

• Many young, rapidly growing firms reinvest 100% of their cash flows. But mature, profitable firms often find that they generate more cash than they need to fund all of their attractive investment opportunities.


Figure 16.1 Uses of Free Cash Flow



• The two possibilities for a company that decides to pay out its free cash flow are 1. Dividends

2. Repurchase shares


Dividends

• Most companies that pay dividends pay them at regular, quarterly intervals.

• Occasionally, a firm may pay a one-time, special dividend that is usually much larger than a regular dividend.



• Payout Policy: The way a firm chooses between repurchasing shares or paying dividends.

• The company’s board of directors sets the amount per share that will be paid and decides when the payment will occur.


Special Dividend

• Occasionally, a firm may pay a one-time, special dividend that is usually much larger than a regular dividend, as was Microsoft’s $3.00 dividend in 2004.


Figure 16.3 Dividend History for GM Stock, 1983-2007


Share Repurchases

• The firm uses cash to buy shares of its own outstanding stock.w These shares are generally held in the corporate

treasury, and they can be resold if the company needs to raise money in the future.


Share Repurchases

• Open Market Repurchase: a firm announces its intention to buy its own shares in the open market, and then proceeds to do so over time like any other investor. w The most common way that firms repurchase shares.

• Tender Offer: it offers to buy shares at a prespecified price during a short time period—generally within 20 days.w Dutch auction: A tender offer method in which the firm lists a range of

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.

• Targeted Repurchase: a major shareholder desires to sell a large number of shares but the market for the shares is not sufficiently liquid to sustain such a large sale without severely affecting the price.


Share Repurchases

• Open Market Repurchase• Tender Offer

w Dutch auction• Targeted Repurchase (not as common):

w The firm repurchases the shares of a major shareholder who desires to sell a large number of shares but the regular market for the shares is not sufficiently liquid to sustain such a large sale without severely affecting the price.


16.2 Dividends Versus Share Repurchases in a Perfect Capital Market

• Genron has $20 million in excess cash and no debt. The firm expects to generate additional free cash flows of $48 million per year in subsequent years. If Genron’s unlevered cost of capital is 12%, then the enterprise value of its ongoing operations is


Policy 1: Pay Dividend with Excess Cash

• With 10 million shares outstanding, Genron will be able to pay a $2 dividend immediately. Because the firm expects to generate future free cash flows of $48 million per year, it anticipates paying a dividend of $4.80 per share each year thereafter.

• Compute Genron’s share price just before and after the stock goes ex-dividend.


Cum-Dividend

• Just before the ex-dividend date, the stock is said to trade cum-dividend

• After the stock goes ex-dividend, new buyers will not receive the current dividend.

• 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.


Policy 2: Share Repurchase (No Dividend)

• Suppose that Genron does not pay a dividend this year, but instead uses the $20 million to repurchase its shares on the open market. How will the repurchase affect the share price?


Policy 2: Share Repurchase (No Dividend)

• With an initial share price of $42, Genron will repurchase $20 million ÷ $42 per share = 0.476 million shares, leaving only 10 – 0.476 = 9.524 million shares outstanding. Once again, we can use Genron’s market value balance sheet to analyze this transaction:

• In this case, the market value of Genron’s assets falls when the company pays out cash, but the number of shares outstanding also falls from 10 million to 9.524 million. The two changes offset each other, so the share price remains the same at $42.

December 11 (Before Repurchase) December 12 (After Repurchase)

Cash 20 0Other assets 400 400

Total market value of assets 420 400

Shares (millions) 10 9.524

Share price $42 $42


Investor Preferences

• In future years, Genron expects to have $48 million in free cash flow, which can be used to pay a dividend of $48 million ÷ 9.524 million shares = $5.04 per share each year.

• 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

• An investor starts with 2000 sharesw If the firm pays the dividend she uses it to buy 100 shares orw If the firm repurchases, she sells 95 shares

• In either case, the value of the investor’s portfolio is $84,000 immediately after the transaction. The only difference is the distribution between cash and stock holdings. Thus it might seem the investor would prefer one approach or the other based on whether she needs the cash.


Homemade Dividend

• If Genron repurchases shares and the investor wants cash, she can raise cash by selling shares. For example, she can sell $4000 ÷ $42 per share = 95 shares to raise about $4000 in cash. She will then hold 1905 shares, or 1905 × $42 ≈ $80,000 in stock.


Example 16.1 Homemade Dividends

Problem:• Suppose Genron does not adopt the third

alternative policy, and instead pays a $2 dividend per share today. Show how an investor holding 2000 shares could create a homemade dividend of $4.50 per share × 2000 shares = $9000 per year on her own.



Solution:Plan:• If Genron pays a $2 dividend, the investor

receives $4000 in cash and holds the rest in stock. She can raise $5000 in additional cash by selling 125 shares at $40 per share just after the dividend is paid.



Execute:• The investor creates her $9000 this year by

collecting the $4000 dividend and then selling 125 shares at $40 per share. In future years, Genron will pay a dividend of $4.80 per share. Because she will own 2000 – 125 = 1875 shares, the investor will receive dividends of 1875 × $4.80 = $9000 per year from then on.



Evaluate:• Again, the policy that the firm chooses is

irrelevant—the investor can transact in the market to create a homemade dividend policy that suits her preferences.


Dividend Policy with Perfect Capital Markets

• By using share repurchases or equity issues a firm can easily alter its dividend payments.

• While dividends do determine share prices, a firm’s choice of dividend policy does not.

• The value of a firm ultimately derives from its underlying free cash flow which pays the dividends.

• It is the imperfections in capital markets that should determine the firm’s payout policy.


16.3 The Tax Disadvantage of Dividends

• Taxes are an important market imperfection that influence a firm’s decision to pay dividends or repurchase shares

• Taxes on Dividends and Capital Gainsw Shareholders typically must pay:

§ Taxes on the dividends they receive § Capital gains taxes when they sell their shares


Table 16.2 Long-Term Capital Gains Versus Dividend Tax Rates in the United States, 1971–2008


16.3 The Tax Disadvantage of Dividends

• Do taxes affect investors’ preferences for dividends versus share repurchases?1. When a firm pays a dividend, shareholders are taxed according to the

dividend tax rate.2. If the firm repurchases shares instead, and shareholders sell shares to

create a homemade dividend, the homemade dividend will be taxed according to the capital gains tax rate.

3. If dividends are taxed at a higher rate than capital gains shareholders will prefer share repurchases to dividends.

4. Recent changes to the tax code have equalized the tax rates on dividends and capital gains.§ Microsoft starting paying dividends shortly after these changes.

5. Because long-term investors can defer the capital gains tax until they sell, there is still a tax advantage for share repurchases over dividends


Optimal Dividend Policy with Taxes

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


The Declining Use of Dividends

• Prior to 1980, most firms used dividends exclusively to distribute cash to shareholders

• By 2006: w Only about 25% of firms relied on dividends. w 30% of all firms (and more than half of firms

making payouts to shareholders) used share repurchases exclusively or in combination with dividends


Figure 16.5 The Declining Use of Dividends


Figure 16.6 The Changing Composition of Shareholder Payouts


The Dividend Puzzle

• Firms continue to issue dividends despite their tax disadvantage

• Figure 16.6 indicates the growing importance of share repurchases as a part of firms’ payout policies, however it also shows that dividends remain a key form of payouts to shareholders.


Table 16.3 Summary of Dividends Versus Repurchases


Tax Differences Across Investors

• Dividend Tax Rate Factors:w Income Level. Investors with different levels of income fall into different

tax brackets and face different tax rates.w 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

w Tax Jurisdiction. U.S. investors are subject to state taxes that differ by state.

w 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.


Impact of Tax Rates on Investor Preferences Regarding Dividends

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.


Clientele Effects

• The dividend policy of a firm is optimized for the tax preference of its investor clientelew Individuals in the highest tax brackets have a

preference for stocks that pay no or low dividends.w Tax-free investors and corporations have a

preference for stocks with high dividends.


Table 16.4 Differing Dividend Policy Preferences Across Investor Groups


16.4 Payout Versus Retention of Cash

• Retaining Cash with Perfect Capital Marketsw Buying and selling securities is a zero-NPV

transaction, so it should not affect firm value. w Shareholders can make any investment a firm makes

on their own if the firm pays out the cash.w The retention versus payout decision is irrelevant.


Modigliani and Miller

• 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 value of the firm.


Payout Versus Retention of Cash

• Retaining Cash with Imperfect Capital Marketsw Based on MM’s payout irrelevance, the decision of

whether to retain cash depends on market imperfections


Taxes and Cash Retention

• Corporate taxes make it costly for a firm to retain excess cash.

• Cash can be thought of as equivalent to negative leverage (review Chap. 15), so the tax advantage of leverage implies a tax disadvantage to holding cash.


Investor Tax Adjustments

• In essence, the interest on retained cash is taxed twice:w When a firm retains cash, it must pay corporate tax on the interest it earns. w The investor will owe capital gains tax on the increased value of the firm. w 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 depends on the combined effect of the corporate and capital gains taxes, compared to the single tax on interest income.

• Under most tax regimes there remains a substantial tax disadvantage for the firm to retaining excess cash even after adjusting for investor taxes.


Issuance and Distress Costs

• Firms retain cash balances to cover potential future cash shortfalls.w Allows a firm to avoid the transaction costs of raising new

capital (through new debt or equity issues).w Used to avoid financial distress during temporary periods of

operating losses.• A firm must balance the tax costs of holding cash with

the potential benefits of not having to raise external funds in the future.


Agency Costs of Retaining Cash

• There are likely to be agency costs associated with having too much cash in the firm.

• Paying out excess cash through dividends or share repurchases can boost the stock price by reducing managers’ ability and temptation to waste resources. w Example:

§ 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.


Table 16.5 Selected Firms with Large Cash Balances


The Managerial Entrenchment Theory of Payout Policy

• Managers pay out cash only when pressured to do so by the firm’s investors.w Retained cash can be used to fund investments that

are costly for shareholders but have benefits for managers (for instance, pet projects and excessive salaries), or it can simply be held as a means to reduce leverage and the risk of financial distress that could threaten managers’ job security.


16.5 Signaling with Payout Policy

• Asymmetric information:w When managers have better information than

investors regarding the future prospects of the firm, their payout decisions may signal this information.


Dividend Smoothing

• Dividend Smoothing: The practice of maintaining relatively constant dividends.

• Firms adjust dividends relatively infrequently, and dividends are much less volatile than earnings.

• 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.


Figure 16.7 GM’s Earnings and Dividends per Share, 1985–2006


How can firms keep dividends smooth as earnings vary?

• Firms can maintain almost any level of dividend in the short run by adjusting the number of shares they repurchase or issue and the amount of cash they retain.

• Firms generally set dividends at a level they expect to be able to maintain based on the firm’s earnings prospects.


Dividend Signaling

• Dividend signaling hypothesis: The idea that dividend changes reflect managers’ views about a firm’s future earnings prospects.w 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.

w When managers cut the dividend, it may signal that they have given up hope that earnings will rebound in the near term and so need to reduce the dividend to save cash.


Dividend Signaling

• Interpret dividends as a signal in the context of the type of new information managers are likely to have.w An increase of a firm’s dividend may be signal of a lack of

investment opportunities.§ Example:

○ Microsoft’s move to initiate dividends in 2003 was largely seen as a result of its declining growth prospects as opposed to a signal about its increased future profitability.

w A firm might cut its dividend to exploit new positive-NPV investment opportunities. § The dividend decrease might lead to a positive—rather than negative

—stock price reaction.


Signaling and Share Repurchases

• Share repurchases, like dividends, may also signal managers’ information to the market.w Share repurchases may signal that managers believe

the firm to be under-valued (or at least not over-valued).

w 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.


Important differences between share repurchases and dividends

1. Managers are much less committed to share repurchases than to dividend payments.

2. Unlike with dividends, firms do not smooth their repurchase activity from year to year.

3. The cost of a share repurchase depends on the market price of the stock.


16.6 Stock Dividends, Splits, and Spin-offs

• In a stock split or stock dividend, the company issues additional shares rather than cash to its shareholders.w If a company declares a 10% stock dividend, each

shareholder will receive one new share of stock for every 10 shares already owned.

• Stock Splits: Stock dividends of 50% or higher w With a 50% stock dividend, each shareholder will receive one

new share for every two shares owned.§ Also called a 3:2 (“3-for-2”) stock split.

w A 100% stock dividend is equivalent to a 2:1 stock split.


Stock Dividends and Splits

• The firm does not pay out any cash to shareholders.w The total market value of the firm’s assets and liabilities, and therefore of

its equity, is unchanged.

• There is an increase in the number of shares outstanding. w The stock price will fall because the same total equity value is now

divided over a larger number of shares.

• Stock dividends are not taxed. w There is no real consequence to a stock dividend. w The number of shares is proportionally increased and the price per share is

proportionally reduced so that there is no change in value.


Stock Splits and Share Price

• The typical motivation for a stock split is to keep the share price in a range thought to be attractive to small investors. w Making the stock more attractive to small investors can increase the

demand for and the liquidity of the stock, which may in turn boost the stock price.

w On average, announcements of stock splits are associated with a 2% increase in the stock price.

w Most firms use splits to keep their share prices from exceeding $100. § Example:

○ From 1990 to 2000, Cisco Systems split its stock nine times, so that one share purchased at the IPO split into 288 shares. Had it not split, Cisco’s share price at the time of its last split in March 2000 would have been 288 × $72.19, or $20,790.72.


Spin-offs

• Spin-off: When non-cash special dividends are used to spin off assets or a subsidiary as a separate company.w Example:

§ After selling 15% of Monsanto Corporation in an IPO in October 2000, Pharmacia Corporation announced in July 2002 that it would spin off its remaining 85% holding of Monsanto Corporation. The spin-off was accomplished through a special dividend in which each Pharmacia shareholder received 0.170593 share of Monsanto per share of Pharmacia owned. After receiving the Monsanto shares, Pharmacia shareholders could trade them separately from the shares of the parent firm.

§ Advantages of the spin-off in comparison to selling the shares of Monsanto and distributing cash to shareholders as a cash dividend.

1. It avoids the transaction costs associated with such a sale.2. The special dividend is not taxed as a cash distribution. Instead, Pharmacia

shareholders who received Monsanto shares are liable for capital gains tax only at the time they sell the Monsanto shares.


16.7 Advice for the Financial Manager

• Overall, as a financial manager, you should consider the following when making payout policy decisions:1. For a given payout amount, try to maximize the after-tax payout to the

shareholders. Repurchases and dividends are often taxed differently and one can have an advantage over the other.

2. Repurchases and special dividends are useful for making large, infrequent distributions to shareholders. Neither implies any expectation of repeated payouts.

3. Starting and increasing a regular dividend is seen by shareholders as an implicit commitment to maintain this level of regular payout indefinitely. Only set regular dividend levels that you are confident the firm can maintain.

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16.7 Advice for the Financial Manager

4. Because regular dividends are seen as an implicit commitment, they send a stronger signal of financial strength to shareholders than do infrequent distributions such as repurchases. However, this signal comes with a cost because regular payouts reduce a firm’s financial flexibility.

5. Be mindful of future investment plans. There are transaction costs associated with both distributions and raising new capital, so it is expensive to make a large distribution and then raise capital to fund a project. It would be better to make a smaller distribution and fund the project internally.

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Chapter Quiz

1. What is an open-market share repurchase?2. In a perfect capital market, how important is the firm’s

decision to pay dividends versus repurchase shares?3. What is the dividend puzzle?4. What possible signals does a firm give when it cuts its

dividend?5. What are some advantages of a spinoff as opposed to

selling the division and distributing the cash?

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