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Chapter 17 Payout Policy. Chapter Outline  Distributions to Shareholders  Dividends Versus Share Repurchase in a Perfect Capital Market  The Tax Disadvantage.

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Presentation on theme: "Chapter 17 Payout Policy. Chapter Outline  Distributions to Shareholders  Dividends Versus Share Repurchase in a Perfect Capital Market  The Tax Disadvantage."— Presentation transcript:

1 Chapter 17 Payout Policy

2 Chapter Outline  Distributions to Shareholders  Dividends Versus Share Repurchase in a Perfect Capital Market  The Tax Disadvantage of Dividends  Payout Versus Retention of Cash  Signaling with Payout Policy  Stock Dividends, Splits, and Spin-offs  Advice for the Financial Manager

3 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

4 17.1 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.

5 Use of Free Cash Flow Free Cash Flow Retain Pay Out Pay dividends Increase Cash reserve Invest in New Projects

6 17.1 Distributions to Shareholders The two possibilities for a company that decides to pay out its free cash flow are 1.Dividends 2.Repurchase shares

7 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.

8 17.1 Distributions to Shareholders 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. 1.Declaration Date – Board declares the dividend, and it becomes a liability of the firm 2. Ex-dividend Date Occurs two business days before date of record If you buy stock on or after this date, you will not receive the dividend Stock price generally drops by about the amount of the dividend

9 Distributions to Shareholders 3.Date of Record – Holders of record are determined, and they will receive the dividend payment 4. Date of Payment – checks are mailed

10 Cash Dividends Regular cash dividend – cash payments made directly to stockholders, usually each quarter Extra cash dividend – indication that the “extra” amount may not be repeated in the future

11 Cash Dividends Special cash dividend – similar to extra dividend, but definitely will not be repeated Liquidating dividend – some or all of the business has been sold

12 Timing of Dividend Payments

13 Share Repurchases The firm uses cash to buy shares of its own outstanding stock. These shares are generally held in the corporate treasury, and they can be resold if the company needs to raise money in the future.

14 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. 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. 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.

15 Share Repurchases Open Market Repurchase Tender Offer Dutch auction Targeted Repurchase (not as common): 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 17.2 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

17 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.

18 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.

19 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?

20 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) Cash200 Other assets400 Total market value of assets 420400 Shares (millions)109.524 Share price$42

21 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.

22 Investor Preferences An investor starts with 2000 shares If the firm pays the dividend she uses it to buy 100 shares or 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.

23 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.

24 Example 17.1 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. 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. Solution: 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.

25 Example 17.1 Homemade Dividends 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.

26 Dividend Reinvestment Program or DRIP DRIP automatically reinvests any dividends into new shares of the stock. If Genron pays a dividend and the investor does not want the cash, she can use the $4000 proceeds of the dividend to purchase 100 additional shares at the ex-dividend share price of $40 per share. As a result she will hold 2100 shares, worth 2100  $40 = $84,000.

27 Policy 3: High Dividend (Equity Issue) Genron plans to pay $48 million in dividends starting next year. Suppose the firm wants to start paying that amount today. Because it has only $20 million in cash today, Genron needs an additional $28 million to pay the larger dividend now. It could raise cash by scaling back its investments. But if the investments have positive NPV, reducing them would lower firm value. An alternative way to raise more cash is to borrow money or sell new shares. Let’s consider an equity issue. Given a current share price of $42, Genron could raise $28 million by selling $28 million  $42 per share = 0.67 million shares. Because this equity issue will increase Genron’s total number of shares outstanding to 10.67 million, the amount of the dividend per share each year will be

28 Policy 3: High Dividend (Equity Issue) Under this new policy, Genron’s cum-dividend share price is…

29 Example 17.1a Homemade Dividends Problem: Otter Co. plans to pay $50 million in dividends this year. The amount of the dividend per share each year will be $5.25 per year. How many shares outstanding does company Otter Co. have?

30 Example 16.1a Homemade Dividends Solution: Plan: We can use the formula for calculating dividends per share ([Total Dividends / Number of Shares Outstanding] = Dividends per Share) to solve for the number of shares outstanding. $50 million X = $5.25 X = 9,523,810 shares The company has just over 9 ½ million shares outstanding.

31 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.

32 17.3 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 Gains Shareholders typically must pay: Taxes on the dividends they receive Capital gains taxes when they sell their shares

33 17.3 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

34 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.

35 The Declining Use of Dividends Prior to 1980, most firms used dividends exclusively to distribute cash to shareholders By 2006: Only about 25% of firms relied on dividends. 30% of all firms (and more than half of firms making payouts to shareholders) used share repurchases exclusively or in combination with dividends

36 Tax Differences Across Investors Dividend Tax Rate Factors: 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.

37 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.

38 Clientele Effects The dividend policy of a firm is optimized for the tax preference of its investor clientele Individuals in the highest tax brackets have a preference for stocks that pay no or low dividends. Tax-free investors and corporations have a preference for stocks with high dividends.

39 16.4 Payout Versus Retention of Cash Retaining Cash with Perfect Capital Markets 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.

40 Example 16.2 Payout Decisions in a Perfect Capital Market Problem: Barston Mining has $100,000 in excess cash. Barston 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?

41 Example 16.2 Payout Decisions in a Perfect Capital Market Solution: Plan: 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 Barston invested the cash.

42 Example 16.2 Payout Decisions in a Perfect Capital Market Execute: If Barston 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.

43 Example 16.2 Payout Decisions in a Perfect Capital Market Evaluate: Because Barston is not doing anything that the investors could not have done on their own, it does not create any value by retaining the cash and investing it for the shareholders versus simply paying it to them immediately. As we showed in Example 16.1, if Barston retains the cash, but investors prefer to have the income today, they can sell $100,000 worth of shares.

44 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.

45 Payout Versus Retention of Cash Retaining Cash with Imperfect Capital Markets Based on MM’s payout irrelevance, the decision of whether to retain cash depends on market imperfections

46 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.

47 Investor Tax Adjustments In essence, the interest on retained cash is taxed twice: When a firm retains cash, it must pay corporate tax on the interest it earns. The investor will owe capital gains tax on the increased value of the firm. 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.

48 Issuance and Distress Costs Firms retain cash balances to cover potential future cash shortfalls. Allows a firm to avoid the transaction costs of raising new capital (through new debt or equity issues). 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.

49 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. 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.

50 Example 16.4 Cutting Negative-NPV Growth Problem: Rexton Oil is an all-equity firm with 100 million shares outstanding. Rexton has $150 million in cash and expects future free cash flows of $65 million per year. Management plans to use the cash to expand the firm’s operations, which will in turn increase future free cash flows to $72.8 million per year. If the cost of capital of Rexton’s investments is 10%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price?

51 Example 17.4 Cutting Negative-NPV Growth Solution: Plan: We can use the perpetuity formula to value Rexton under the two scenarios. The repurchase will take place at market prices, so the repurchase itself will have no effect on Rexton’s share price. The main question is whether spending $150 million now (instead of repurchasing) to increase cash flows by $7.8 million per year is a positive-NPV project.

52 Example 17.4 Cutting Negative-NPV Growth Execute: Invest: Using the perpetuity formula, if Rexton invests the $150 million to expand, its market value will be: $72.8 million  10% = $728 million, or $7.28 per share with 100 million shares outstanding. Repurchase: If Rexton does not expand, the value of its future free cash flows will be $65 million  10% = $650 million. Adding the $150 million in cash it currently has, Rexton’s market value is $800 million, or $8.00 per share.

53 Example 17.4 Cutting Negative-NPV Growth Execute (cont’d): If Rexton repurchases shares, there will be no change to the share price: It will repurchase $150 million  $8.00 / share = 18.75 million shares, so it will have assets worth $650 million with 81.25 million shares outstanding, for a share price of $650 million  81.25 million shares = $8.00 / share. In this case, cutting investment and growth to fund a share repurchase increases the share price by $0.72 per share ($8.00 - $7.28).

54 Example 17.4 Cutting Negative-NPV Growth Evaluate: The share price is higher with the repurchase because the alternative of expansion has a negative NPV: It costs $150 million, but increases future free cash flows by only $7.8 million, for an NPV of –$150 million + $7.8 million / 10% = –$72 million, or –$0.72 per share. Thus, the repurchase, by avoiding the expansion, keeps the shares from suffering the $0.72 loss.

55 The Managerial Entrenchment Theory of Payout Policy Managers pay out cash only when pressured to do so by the firm’s investors. 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.

56 17.5 Signaling with Payout Policy Asymmetric information: When managers have better information than investors regarding the future prospects of the firm, their payout decisions may signal this information.

57 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.

58 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.

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

60 Dividend Signaling Interpret dividends as a signal in the context of the type of new information managers are likely to have. 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. 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.

61 Signaling and Share Repurchases Share repurchases, like dividends, may also signal managers’ information to the market. Share repurchases may signal that managers believe the firm to be under- valued (or at least not over-valued). 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.

62 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.

63 17.6 Stock Dividends, Splits, and Spin-offs In a stock split or stock dividend, the company issues additional shares rather than cash to its shareholders. 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 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. A 100% stock dividend is equivalent to a 2:1 stock split.

64 Stock Dividends and Splits The firm does not pay out any cash to shareholders. 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. 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. 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.

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

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

67 17.7 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. 1-67

68 17.7 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. 1-68

69 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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