copyright © 2012 pearson prentice hall. all rights reserved. chapter 17 payout policy

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Chapter 17

Payout Policy

2

Chapter Outline

1. Cash Distributions to Shareholders 2. Dividends Versus Share Repurchase in a Perfect Capital Market3. The Tax Disadvantage of Dividends4. Payout Versus Retention of Cash5. Signaling with Payout Policy6. Stock Dividends, Splits, and Spin-offs7. Advice for the Financial Manager

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DOW 30 Firm Dividend Yields

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Dividend Payout Ratios forSelected Industries

Industry Payout ratio

Banking 38.29Computer Software Services 13.70Drug 38.06Electric Utilities (Eastern U. S.) 67.09Internet n/a*Semiconductors 24.91Steel 51.96Tobacco 55.00Water utilities 67.35

* None of the internet companies included in the Value Line Investment Survey paid a dividend.

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Pay Out, or Retain?

• Payout Policy– The way a firm chooses between the

alternative ways to pay cash out to shareholders

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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.

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s

DP

r g

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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.

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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.

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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.

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CASH DISTRIBUTIONS TO SHAREHOLDERS

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17.1 Cash Distributions to Shareholders

• Dividends– Declaration Date– Ex-Dividend Date– Record Date– Payable Date FIGURE 17.2 Important Dates

for Microsoft’s Special Dividend

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The Ex-Day Price Drop

-t -2 -1 0 +1 +2 t

$1 is the ex-dividend price drop

Price= $10

Price= $9Generally, 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 = $10On 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.

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• 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

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Figure 17.3 Dividend History for GM Stock, 1983-2008

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• 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.

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DIVIDENDS VS. SHARE REPURCHASES IN A PERFECT CAPITAL MARKET

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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:

1. Use the $20 million to pay a $2 cash dividend for each of Genron’s 10 million outstanding shares

2. Repurchase shares instead of paying a dividend

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• 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

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The Ex-Day Price Drop

-t -2 -1 0 +1 +2 t

$1 is the ex-dividend price drop

Price= $10

Price= $9Generally, 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 = $10On 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.

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• 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.

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• 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

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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.

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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.

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• 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

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• 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.

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THE TAX DISADVANTAGE OF DIVIDENDS

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Taxes and DividendsIn a tax-free world, cash dividends are a wash between the

firm and its shareholders.

FirmStock

Holders

Cash: stock issue

Cash: dividends

In a world with taxes, the government gets a cut.

Gov.

Taxes

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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

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• 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

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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

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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

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Table 17.3 Summary of Dividends Versus Repurchases

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• Tax Differences Across Investors– Dividend Tax Rate Factors

• Income Level• Investment Horizon• Tax Jurisdiction• Type of Investor or Investment Account

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• 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

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• 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

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Figure 17.6 The Changing Composition of Shareholder Payouts

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• 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

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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.

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Table 17.4 Differing Dividend Policy Preferences Across Investor Groups

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PAYOUT VERSUS RETENTION OF CASH

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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

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Example 17.2 Payout Decisions in aPerfect 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.

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• 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

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Example 17.3 Retaining Cash withCorporate Taxes

Problem: • Recall Barston Mining from Example 17.2. 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?

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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.

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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.

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• 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

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• 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

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• 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

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Table 17.5 Selected Firms with Large Cash Balances

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SIGNALING WITH PAYOUT POLICY

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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

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• 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.


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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

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• 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.

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• 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

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STOCK DIVIDENDS, SPLITS, AND SPIN-OFFS

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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

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• 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

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• 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

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• 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

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ADVICE FOR THE FINANCIAL MANAGER

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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

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Table 17.6 Navigating the PayoutDecision

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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

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Factors Influencing Dividend Policy

• 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.

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Factors Influencing Dividend Policy

• Alternative Sources of Capital– Cost of Selling New Stock– Ability to Substitute Debt for Equity– Control

• Management may not want to sell new stock

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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?

copyright © 2012 pearson prentice hall. all rights reserved. chapter 17 payout policy

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