1. Dr. C. Bulent Aybar Professor of International Finance
Distributions
Dr. C. Bulent Aybar
Professor of International Finance

2. 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.

3. 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
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. 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.

5. 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 = million shares
This will leave only million shares outstanding.
10 million − million = million

6. Alternative 2: Share Repurchase
After the repurchase, the future dividend would rise to $5.04 per share.
$48 million ÷ million shares = $5.04 per share
ABC’s share price is
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.

7. 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.

8. 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.

9. 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.

10. 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.

11. Capital Gains and Dividend Taxes
Capital Gains and Dividend Taxes in the US

12. 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.

13. 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.

14. 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:
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:

15. The Effective Dividend Tax Rate
We can express the wedge between the cum and ex dividend prices as follows:
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.

16. Example
Assume that dividend tax rate is 39% and Capital gains tax rate is 20%. Calculate and interpret the effective dividend tax rate?
Solution:
Given the effective dividend tax rate of 23.75%, every dollar of dividend income is effectively equal to ( )=$ of capital gains.

17. 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.

18. 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.

19. 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

20. 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.

21. 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.

22. Taxes and Preferences
Long-term investors are more heavily taxed on dividends, so they would prefer share repurchases to dividend payments.
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.
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.

23. 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.

24. 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!

25. 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.

26. 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?

27. 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.

28. 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.

29. Example: Microsoft Special Dividend
In 2004, Microsoft declared a $3 special dividend. At the time outstanding number of shares were 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.

30. 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.

31. 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:
When corporate tax rate complies with the above condition, it may be beneficial to retain cash.

32. 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.

33. 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.

34. 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.

35. 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.

36. GM’s Earnings and Dividends

37. 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.

38. 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.

39. 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.

40. 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.

41. 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)

42. 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

43. Distribution of Stock Prices for NYSE Firms

44. Spin-offs offer two advantages
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.