Chapter 17 Payout Policy.

Chapter 17 Payout Policy

Chapter Outline 1. Cash Distributions to Shareholders
2. Dividends Versus Share Repurchase in a Perfect Capital Market 3. The Tax Disadvantage of Dividends 4. Payout Versus Retention of Cash 5. Signaling with Payout Policy 6. Stock Dividends, Splits, and Spin-offs 7. Advice for the Financial Manager 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 Demonstrate how taxes can create an advantage for share repurchases versus dividends Explain how increased payouts can reduce agency problems but potentially reduce financial flexibility Understand the role of payout policy in signaling information to the market Describe alternate non-cash methods for payouts 2

DOW 30 Firm Dividend Yields

Dividend Payout Ratios for Selected Industries
Industry Payout ratio Banking 38.29 Computer Software Services 13.70 Drug 38.06 Electric Utilities (Eastern U. S.) 67.09 Internet n/a* Semiconductors 24.91 Steel 51.96 Tobacco 55.00 Water utilities 67.35 Is there any pattern? Utilities (stable-cash-producing) vs. Internet, Utilities company’s beta is very low. cash vs. no cash Limited investment opportunities vs. many opportunities Asset-in-place vs growth options Clientele effect * None of the internet companies included in the Value Line Investment Survey paid a dividend.

Pay Out, or Retain? Payout Policy
The way a firm chooses between the alternative ways to pay cash out to shareholders 5

Dividends versus Capital Gains
Constant Growth Stock Valuation If the company increases the payout ratio, this raises D1  P0 will rise. Then less money will available for reinvestment, that will cause the expected growth rate to decline.  P0 will fall. Finding an optimal level of dividend is critical. Why might a high payout be desirable? Desire for current income Individuals in low tax brackets Uncertainty resolution – no guarantee that the higher future dividends will materialize A mature company sees no new investment opportunities. Why might a low payout be desirable? Individuals in upper income tax brackets might prefer lower dividend payouts, with the immediate tax consequences, in favor of higher capital gains Flotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs A fast growing company needs more investment funds.

Do investors prefer high or low payouts?
Dividend Irrelevance Theory Investors don’t care about payout. Bird-in-the Hand Theory Investors prefer a high payout. Tax Preference Theory Investors prefer a low payout, hence growth.

Stock Repurchases Advantages of Repurchases
Stockholders can have an option (e.g., “tender or not”). Helps avoid setting a high dividend that cannot be maintained. Repurchased stock can be used in takeovers or resold to raise cash as needed. Income received is capital gains rather than higher-taxed dividends. Stockholders may take as a positive signal--management thinks stock is undervalued. Stock repurchase allows investors to decide if they want the current cash flow and associated tax consequences Investors face capital gains taxes instead of ordinary income taxes (lower rate) In our current tax structure, repurchases may be more desirable due to the options provided stockholders The IRS recognizes this and will not allow a stock repurchase for the sole purpose of allowing investors to avoid taxes

Stock Repurchases Disadvantages of Repurchases
May be viewed as a negative signal (firm has poor investment opportunities). May depress the stock price. IRS could impose penalties if repurchases were primarily to avoid taxes on dividends. Firm may have to bid up price to complete purchase, thus paying too much for its own stock.

Cash Distributions to Shareholders

17.1 Cash Distributions to Shareholders
Dividends Declaration Date Ex-Dividend Date Record Date Payable Date FIGURE Important Dates for Microsoft’s Special Dividend

The Ex-Day Price Drop -t -2 -1 +1 +2 t
+1 +2 t $1 is the ex-dividend price drop Price= $10 Price= $9 Generally, the stock price will fall by the amount of the dividend on the ex date (Time 0). If the dividend is $1 per share, the price will be equal to $10 – 1 = $9 on the ex date. Before ex date (Time –1) Dividend = $0 Price = $10 On ex date (Time 0) Dividend = $1 Price = $9 Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

Dividends By Types Regular Dividend: quarterly intervals Special Dividend By Accounting Implications Usually dividends reduce the firm’s retained earnings Return of Capital or Liquidating Dividend: Paying from paid-in-capital

Figure 17.3 Dividend History for GM Stock, 1983-2008

Share Repurchases Open Market Repurchase Tender Offer It offers to buy shares at a pre-specified price during a short timer period Dutch Auction: The firm lists different prices at which it is prepared to buy shares, and shareholders in turn indicate how many shares they are willing to sell at each price. Targeted Repurchase Greenmail: The firm decides to buy out shares from the existing shareholders at a premium to fight against a takeover threat.

Dividends Vs. Share Repurchases in a Perfect Capital Market

17.2 Dividends Versus Share Repurchases in a Perfect Capital Market
Assume 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. Genron’s board is meeting to decide how to pay out its $20 million in excess cash to shareholders The board is considering two options: Use the $20 million to pay a $2 cash dividend for each of Genron’s 10 million outstanding shares Repurchase shares instead of paying a dividend 17

Alternative Policy 1: Pay Dividend with Excess Cash 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 18

The Ex-Day Price Drop -t -2 -1 +1 +2 t
+1 +2 t $1 is the ex-dividend price drop Price= $10 Price= $9 Generally, the stock price will fall by the amount of the dividend on the ex date (Time 0). If the dividend is $1 per share, the price will be equal to $10 – 1 = $9 on the ex date. Before ex date (Time –1) Dividend = $0 Price = $10 On ex date (Time 0) Dividend = $1 Price = $9 Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

Alternative 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 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 (“with the dividend”) price if a dividend were paid instead The rationale: Once the firm uses its assets to repurchase the existing shares, there will be less assets in balance sheets to be used on positive NPV projects. Therefore, increase stock price due to repurchase will be offset because of a fall in stock price due to less assets deployed for profitable investments. 20

Investor Preferences Would an investor prefer that Genron issue a dividend or repurchase its stock? What if the firm repurchases shares but investor wants cash? The investor could sell shares to raise cash (aka homemade dividend) What if the firm pays a dividend and the investor does not want cash? The investor could use the dividend to purchase additional shares 21

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. 22

Example 17.1 Homemade Dividends
Solution: 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. 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. 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. 23

Modigliani-Miller and Dividend Policy Irrelevance 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 Although dividends do determine share prices, a firm’s choice of dividend policy does not A firm’s free cash flows determine the level of payouts that it can make to its investors In a perfect capital market, whether these payouts are made through dividends or share repurchases does not matter 24

The Bird in the Hand Fallacy Firms choosing to pay higher current dividends will enjoy higher stock prices because shareholders prefer current dividends to future dividends. This can be a misconception. MM shows that with perfect capital markets, shareholders can generate an equivalent homemade dividend at any time by selling shares. 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. Thus, the dividend choice of the firm should not matter. However, it may not be a misconception. In the real world, buying and selling securities entail a transaction cost as well as tax consequences. Thus, a homemade dividend is not free of market friction. 25

The Tax Disadvantage of Dividends

Taxes and Dividends In a tax-free world, cash dividends are a wash between the firm and its shareholders. Cash: stock issue Firm Stock Holders Cash: dividends Taxes In a world with taxes, the government gets a cut. Gov.

17.3 The Tax Disadvantage of Dividends
Taxes on Dividends and Capital Gains Shareholders typically must pay: Taxes on the dividends they receive Capital gains taxes when they sell their shares 28

Taxes on Dividends and Capital Gains When a firm pays a dividend, shareholders are taxed according to the dividend tax rate If dividends are taxed at a higher rate than capital gains shareholders will prefer share repurchases to dividends 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 29

Table 17.2 Long-Term Capital Gains Versus Dividend Tax Rates in the United States, 1971–2010
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Figure 17.4 Dividend and Capital Gains Tax Rates Around the World

Figure 17.5 The Rise of Repurchases
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Optimal Dividend Policy with Taxes Dividends in Practice Prior to 1980, most firms used dividends exclusively to distribute cash to shareholders By 2009 about 30% of firms relied exclusively on dividends At the same time, 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 When firms continue to issue dividends despite their tax disadvantage 33

Table 17.3 Summary of Dividends Versus Repurchases
34

Tax Differences Across Investors Dividend Tax Rate Factors Income Level Investment Horizon Tax Jurisdiction Type of Investor or Investment Account 35

Tax Differences Across Investors Dividend Tax Rate Factors 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 36

Tax Differences Across Investors Dividend Tax Rate Factors Corporations enjoy a tax advantage associated with dividends due to the 70% exclusion rule A corporation that chooses to invest its cash will prefer to hold stocks with high dividend yields 37

Figure 17.6 The Changing Composition of Shareholder Payouts
38

Tax Differences Across Investors Clientele Effects When the dividend policy of a firm reflects the tax preferences 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 The dividend policy of a firm is optimized for the tax preference of its investor clientele Different groups of investors, or clienteles, prefer different dividend policies. Michael Jordan vs. Eddie Murphy Investors who want current income would prefer high dividend payout firms (like utilities stocks), while investors with no need for current income would prefer low dividend payout firms (like tech stocks). Investors would sell off their stocks to switch to other stocks which fits investors’ desire. Therefore, clientele effects impede changing dividend policy because investors may have a discretion. (i.e., maintain stable dividend policy.) However, taxes & brokerage costs hurt investors who have to switch companies. 39

Clientele Effect Different groups of investors, or clienteles, prefer different dividend policies. Investors who want current income would prefer high dividend payout firms (like utilities stocks), while investors with no need for current income would prefer low dividend payout firms (like tech stocks). Investors would sell off their stocks to switch to other stocks which fits investors’ desire. Therefore, clientele effects impede changing dividend policy because investors may have a discretion. (i.e., maintain stable dividend policy.) However, taxes & brokerage costs hurt investors who have to switch companies. Retired individual vs. investors with good earnings Switching behavior

Table 17.4 Differing Dividend Policy Preferences Across Investor Groups

Payout Versus Retention of Cash

17.4 Payout Versus Retention of Cash
Retaining Cash with Perfect Capital Markets MM Payout Irrelevance 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 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 43

Example 17.2 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 2% 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? 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 17.1, if Barston retains the cash, but investors prefer to have the income today, they can sell $100,000 worth of shares. Solution: 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. If Barston retains the cash, at the end of one year the company will be able to pay a dividend of $100,000  (1.02) = $102,000. 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 $102,000  (1.02) = $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. 44

Retaining Cash with Imperfect Capital Markets Taxes and Cash Retention Cash can be thought of as equivalent to negative leverage so the tax advantage of leverage implies a tax disadvantage to holding cash 45

Example 17.3 Retaining Cash with Corporate Taxes
Problem: Recall Barston Mining from Example Suppose Barston must pay corporate taxes at a 35% rate on the interest it will earn from the one-year Treasury bill paying 2% interest. Would pension fund investors (who do not pay taxes on their investment income) prefer that Barston use its excess cash to pay the $100,000 dividend immediately or retain the cash for one year? Solution: Plan: As in the original example, the comparison is between what shareholders could generate on their own and what shareholders will receive if Barston retains and invests the funds for them. The key question then is: what is the difference between the after-tax return that Barston can earn and distribute to shareholders versus the pension fund’s tax-free return on investing the $100,000? 46

Execute: 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 2% to receive a total of $102,000 in one year. If Barston retains the cash for one year, it will earn an after-tax return on the Treasury bills of 2%  (1 – 0.35) = 1.3% Thus, at the end of the year, Barston will pay a dividend of $100,000  (1.013) = $101,300. 47

Evaluate: This amount is less than the $102,000 the investors would have earned if they had invested the $100,000 in Treasury bills themselves. Because Barston must pay corporate taxes on the interest it earns, there is a tax disadvantage to retaining cash. Pension fund investors will therefore prefer that Barston pays the dividend now. 48

Retaining Cash with Imperfect Capital Markets Investor Tax Adjustments 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 The net result is that the interest on retained cash is taxed twice Under most tax regimes there remains a substantial tax disadvantage for the firm to retaining excess cash even after adjusting for investor taxes 49

Retaining Cash with Imperfect Capital Markets Issuance and Distress Costs Firms retain cash balances to cover potential future cash shortfalls, which allows a firm to avoid the transaction costs of selling 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 50

Retaining Cash with Imperfect Capital Markets Agency Costs of Retaining Cash There is no benefit to shareholders when a firm holds cash above and beyond its future investment or liquidity needs 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 51

Table 17.5 Selected Firms with Large Cash Balances
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Signaling with Payout Policy

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 Dividend Smoothing The practice of maintaining relatively constant dividends 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 54

Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. (“Sticky Dividends”) So, investors view dividend increases as signals of management’s view of the future. Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends. Stock prices generally rise with unexpected increases in dividends and fall with unexpected decreases in dividends Does this mean that the average investor prefers a high dividend payout ratio? No – changes in the dividend send a signal about management’s view concerning future prospects

Figure 17.7 GM’s Earnings and Dividends per Share, 1985–2008
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Dividend Signaling 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 57

Dividend Signaling Changes in dividends should be viewed 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 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. 58

Signaling and Share Repurchases 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 Differences Between Share Repurchases and Dividends Managers are much less committed to share repurchases than to dividend payments Unlike with dividends, firms do not smooth their repurchase activity from year to year The cost of a share repurchase depends on the market price of the stock 59

Stock Dividends, Splits, and Spin-offs

17.6 Stock Dividends, Splits, and Spin-offs
Stock Dividends and Splits 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 61

Stock Dividends and Splits The firm does not pay out any cash to shareholders The total market value of the 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 62

Stock Dividends and Splits 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 63

Stock Dividends and Splits Spin-Offs When a firm sells a subsidiary by selling shares as a non-cash special dividend in the subsidiary alone Advantages of a Spin-Off It avoids the transaction costs associated with such a sale The special dividend is not taxed as a cash distribution 64

Advice for the Financial Manager

17.7 Advice for the Financial Manager
Overall, as a financial manager, you should consider the following when making payout policy decisions: For a given payout amount, try to maximize the after-tax payout to the shareholders Repurchases and special dividends are useful for making large, infrequent distributions to shareholders Starting and increasing a regular dividend is seen by shareholders as an implicit commitment to maintain this level of regular payout indefinitely 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 Be mindful of future investment plans

Table 17.6 Navigating the Payout Decision

Factors Influencing Dividend Policy
Constraints Bond Indentures Preferred Stock Restrictions Impairment of Capital Rule Dividends cannot exceed retained earnings Availability of Cash Penalty Tax on Improperly Accumulated Earnings Generally applicable to private corporations Limiting maximum on dividend not exceeding balance sheet retained earnings

Investment Opportunities Number of Profitable Opportunities Possibility or Accelerating or Delaying Projects How would a change in investment opportunities affect dividend under the residual policy? Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout. More good investments would lead to a lower dividend payout.

Alternative Sources of Capital Cost of Selling New Stock Ability to Substitute Debt for Equity Control Management may not want to sell new stock

Chapter Quiz What is an open-market share repurchase?
In a perfect capital market, how important is the firm’s decision to pay dividends versus repurchase shares? What is the dividend puzzle? What possible signals does a firm give when it cuts its dividend? What are some advantages of a spinoff as opposed to selling the division and distributing the cash? 71

Chapter 17 Payout Policy.

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