Pós-graduação
Master inem
Finance
4. Payout Policy
Corporate Financing Planning
Bibliography
- Berk and DeMarzo (2011) Ch 17 pages 551-590
Outline Learning Objectives
4.1 Distributions to Shareholders 1. List two ways a company can distribute cash to its shareholders.
4.2 Comparison of Dividends and Share Repurchases 2. Describe the dividend payment process and the open-market
repurchase process.
4.3 The Tax Disadvantage of Dividends
3. Define stock split, reverse stock split, and stock dividend;
4.4 Dividend Capture and Tax Clienteles describe the effect of those actions on stock price.
4.5 Payout Versus Retention of Cash 4. Discuss the effect of dividend payment or share repurchase in a
perfect world.
4.6 Signaling with Payout Policy 5. Assuming perfect capital markets, describe what Modigliani and
4.7 Stock Dividends, Splits and Spin-offs Miller (1961) found about payout policy.
6. Discuss the effect of taxes on dividend policy; compute the
effective dividend tax rate.
Learning Objectives 4.1 Distributions to Shareholders
7. Provide reasons why firms might accumulate cash balances The way a firm chooses between the alternative ways to
rather than pay dividends. distribute free cash flow to equity holders
8. Describe the effect of agency costs on payout policy.
9. Assess the impact of information asymmetry on payout policy.
A) Cash Dividends: Procedure A) Cash Dividends: Procedure
Example: M c special dividend Example: M c special dividend
Declaration Date: The date on which the board of directors Record Date: When a firm pays a dividend, only shareholders on
authorizes the payment of a dividend. record on this date receive the dividend.
Ex-Dividend Date: A da e, da a d de d ec d Payable Date (Distribution Date): A date, generally within a month
date, on or after which anyone buying the stock will not be eligible after the record date, on which a firm mails dividend checks to its
for the dividend. registered stockholders.
B) Cash Dividends: Type of Dividends C) Share Repurchases
Regular Dividend An alternative way to pay cash to investors is through a
Special Dividend: a one-time dividend payment a firm makes, share repurchase or buyback.
which is usually much larger than a regular dividend
The firm uses cash to buy shares of its own
Stock Split (Stock Dividend): when a company issues a
outstanding stock.
dividend in shares of stock rather than cash to its
shareholders
Dividend in Kind:(e. ., W e G e d ab c e
gum, Dundee Crematoria offers shareholders discounted
cremations)
Liquidating Dividend: a return of capital to shareholders from
a business operation that is being terminated
C) Share Repurchases 4.2. Dividends versus Share Repurchases: Example
Open Market Repurchase Dutch Auction
• when a firm repurchases shares by • A share repurchase method in which
Consider Genron C a .T e b ad ee dec de
buying shares in the open market the firm lists different prices at which it pay out $20 million in excess cash to shareholders. Genron has no debt,
is prepared to buy shares, and
• represent about 95% of all repurchase shareholders in turn indicate how many its equity cost of capital equals its unlevered cost of capital of 12%. The
transactions. shares they are willing to sell at each firm expects to generate future free cash flows of $48 million per year, and
price. The firm then pays the lowest
Tender Offer price at which it can buy back its it anticipates paying a dividend of $4.80 per share each year thereafter.
desired number of shares
• A public announcement of an offer to all $48million
existing security holders to buy back a Enterprise Value = PV (FutureFCF ) = = $400million
specified amount of outstanding Targeted Repurchase 0.12
securities at a prespecified price (10%- • When a firm purchases shares directly
20% premium to the current market from a specific shareholder Assets Liabilities & Equity
price) over a prespecified period of time
(usually about 20 days) Targeted Repurchase: Greenmail Cash $20 million Debt $0 million
• If shareholders do not tender enough • When a firm avoids a threat of takeover Assets $400 million Equity $420 million
shares, the firm may cancel the offer and removal of its management by a
and no buyback occurs. major shareholder by buying out the Total Assets $420 million Total Debt & Equity $420 million
shareholder, often at a large premium
over the current market price The firm has 10 million shares outstanding with current stock price $42.
Payout Policy #1: Cash Dividend of $20 million Payout Policy #1: Cash Dividend of $20 million
This corresponds to a $2 dividend per share. When a stock trades before
the ex-dividend date, entitling anyone who buys the stock to the dividend,
we talk about the cum-div price. The cum-dividend price of Genron will
be: Pcum = Current Dividend + PV (Future Dividends) = 2 +
4.80
= 2 + 40 = $42
0.12
4.80
Pex = PV (Future Dividends) = = $40
0.12
After payment, the ex-dividend price is $40:
Assets Liabilities & Equity
Cash $0 million Debt $0 million
Assets $400 million Equity $400 million
Total Assets $400 million Total Debt & Equity $400 million
The number of shares is unchanged (10 million).
Lessons: Price Behavior around Dividend Payments Payout Policy #2: Share Repurchase, spending $20m
In a perfect capital market, when a dividend is paid, the With an initial share price of $42, Genron will repurchase:
share price drops by the amount of the dividend when the
stock begins to trade ex-dividend. $20 million
= 0.476 million shares.
$42
-t -2 -1 0 +1 +2
This leaves the company with 10 - 0.476 = 9.524 million shares
$P Assets Liabilities & Equity
Cash $0 million Debt $0 million
$P - Div Assets $400 million Equity $400 million
Total Assets $400 million Total Debt & Equity $400 million
The price drops by Ex-
the amount of the dividend In future years, the firm expects a FCF of $48 million, or
cash dividend Date $48million/9.524million= $5.04 per share, which corresponds to the
Note: Taxes complicate things a bit. Empirically, the price drop is less than price of $42: P =
5.04
= $42
rep
the dividend and occurs within the first few minutes of the ex-date 0.12
Payout Policy #2: Share Repurchase, spending $20m Lessons: Price Behavior around Stock Repurchases
The net effect is that the share price remains unchanged.
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.
What would investors prefer? Payout Policy #1 or #2? What would investors prefer? Payout Policy #1 or #2?
Investors should be indifferent. Consider an investor currently If the investor is not happy with the amount of cash that she is
holding 2,000 shares of Genron. making, she can sell or buy shares. We call this Homemade
• With the cash dividend, investors get: Dividends.
- $2 *2,000=$4000 in cash; if the firm repurchases shares and the investor wants
- $40*2,000=$80,000 in stock. cash, the investor can raise cash by selling shares.
• With the stock repurchase investors get:
If the firm pays a dividend and the investor would prefer
- $42*2,000=$84,000 either in cash (if sold to firm) or
stock, they can use the dividend to purchase additional
in stock (if held to the stock).
shares
Lesson: Dividend Policy Irrelevance in a Perfect World Payout Policy #3: High Dividend (Equity Issue)
Suppose Genron wants to pay an even larger dividend than $2 per
share right now, $4.8. To be able to spend $48 million right away, the
In perfect capital markets, investors are indifferent firm would need to raise $28 million new equity immediately. Given a
current stock price of $42, the firm would raise:
between the firm distributing funds via dividends or share $28million
= 0.67million shares.
$42
repurchases. By reinvesting dividends or selling shares, The number of shares outstanding would raise to 10.67 million.
they can replicate either payout method on their own.
Assets Liabilities & Equity
Cash $48 million Debt $0 million
Assets $400 million Equity $448 million
Total Assets $448 million Total Debt & Equity $448 million
Payout Policy #3: High Dividend (Equity Issue) Lesson: Dividends and Investment Policy
The amount of Dividend per share each year would be:
$48million
= $4.50
10.67million
In perfect capital markets, holding fixed the investment
We can confirm the cum-dividend share price:
Pcum = $4.50 +
$4.50
= $4.50 + $37.50 = $42 polic of a firm, he firm s choice of di idend polic is
0.12
Assets Liabilities & Equity irrelevant and does not affect the initial share price.
Cash $0 million Debt $0 million
Assets $400 million Equity $400 million
Total Assets $400 million Total Debt & Equity $400 million
and indeed the ex-dividend price per share of
$400million/10.67million = $37.50.
4.3 The Tax Disadvantage of Dividends 4.3 The Tax Disadvantage of Dividends
Shareholders must pay taxes on the dividends they receive and The higher tax rate on dividends makes it undesirable for a firm to
they must also pay capital gains taxes when they sell their raise funds to pay a dividend.
shares. Dividends are typically taxed at a higher rate than When dividends are taxed at a higher rate than capital gains, if a
capital gains. In fact, long-term investors can defer the capital firm raises money by issuing shares and then gives that money
gains tax forever by not selling. back to shareholders as a dividend, shareholders are hurt
because they will receive less than their initial investment.
Long-Term Capital
Gains Versus When the tax rate on dividends is greater than the tax rate on capital
Dividend Tax Rates gains, shareholders will pay lower taxes if a firm uses share
in the United repurchases rather than dividends.
States, 1971 2009
This tax savings will increase the value of a firm that uses share
repurchases rather than dividends.
Example Solution
A firm raises $25 million from shareholders and uses this cash On dividends, shareholders will owe:
to pay them $25 million in dividends. 39% × $25 million = $9.75 million in dividend taxes.
Assume that dividends are taxed at a 39% tax rate and capital The value of the firm will fall when the dividend is paid, lowering the
gains are taxed at a 20% tax rate. a e de ca a a . S a e de e e ca a a
taxes by:
How much will shareholders receive after taxes? 20% × $25 million = $5 million
Shareholders will pay a total of $4.75 million in taxes.
$9.75 $5.00 = $4.75
Shareholders will receive back only $20.25 million of their $25 million
investment.
$25 $4.75 = $20.25
4.2 The Tax Disadvantage of Dividends 4.4 Dividend Capture and Tax Clienteles
The optimal dividend policy when the dividend tax rate exceeds the The preference for share repurchases rather than
capital gain tax rate is to pay no dividends at all. dividends depends on the difference between the dividend
The payment of dividends has declined on average over the last tax rate and the capital gains tax rate.
30 years while the use of repurchases has increased. • Tax rates vary by income, investment horizon and by
whether the stock is held in a retirement account.
Given these differences, firms may attract different groups
of investors depending on their dividend policy.
Dividend P le
US firms excluding financials
US data. Source: Compustat and utilities. Source: Compustat
A) Effective Dividend Tax Rate A) Effective Dividend Tax Rate
Consider buying a stock just before it goes ex-dividend and Thus, the effective dividend tax rate is
selling the stock just after. The equilibrium (no arbitrage)
condition must be: *
=
d g
d
(Pcum Pex ) (1 ) = Div(1 ) 1 g
g d
This measures the additional tax paid by the investor per
which can be stated as
dollar of after-tax capital gains income that is instead
1
Pcum Pex = Div
1
d
= Div 1
1
d g
= Div (1 *
d
) received as a dividend.
g g
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.
B) Tax Differences Across Investors B) Tax Differences Across Investors
The effective dividend tax rate differs across investors for a The effective dividend tax rate differs across investors for a
variety of reasons. variety of reasons.
• Income Level: different levels of income fall into different • Type of Investor or Investment Account
tax brackets (US) • Stocks held by individual investors in retirement accounts are not
• Investment Horizon: Capital gains on stocks held less subject to taxes on dividends or capital gains (US)
• Stocks held through pension funds or nonprofit endowment
than 1 year, and dividends on stocks held less than 61 funds are not subject to dividend or capital gains taxes (US)
days are taxed at higher ordinary income tax rates. • Corporations that hold stocks are able to exclude 70% (or even
• Long-term investors can defer payment of capital gains 80% e d e a 20% e e ) of dividends
taxes. they receive from corporate taxes, but are unable to exclude
• Investors who plan to bequeath shares to their heirs capital gains
may avoid capital gains taxes altogether. As a result of their different tax rates investors will have varying
preferences regarding dividends.
Example: C) Clientele Effect
Consider 4 different investors and the maximum U.S. federal tax Clientele Effect: When the dividend policy of a firm reflects the
rates as of 2009. The effective dividend tax rate for each tax preference of its investor clientele.
investor would be: Individuals in the highest tax brackets have a preference for
• Buy and Hold Individual Investor, in a taxable account, stocks that pay no or low dividends, whereas tax-free
planning to leave stock to her heirs: d = 15%; g = 0%; d* = 15% investors and corporations have a preference for stocks with
high dividends.
• One-Year Individual Investor, in a taxable account,
planning to sell in 1 year: d = 15%; g = 15%; d* = 0%
• Pension Fund: d
= 0%; g
= 0%; *
d
= 0%
• Corporation: d
= (1 70%) 35% = 10.5%; g
= 35%; *
d
= 38%
D) Dividend-Capture Theory 4.5 Payout versus Retention of Cash
Absent transaction costs, investors can trade shares at the time In perfect capital markets, once a firm has taken all
of the dividend so that non-taxed investors receive the dividend. positive-NPV investments, it is indifferent between saving
An implication of this theory is that we should see large trading volume in a stock
around the ex-dividend day, as high-tax investors sell and low-tax investors buy excess cash and paying it out.
the stock in anticipation of the dividend, and then reverse those trades just after
the ex-dividend date.
With market imperfections, there is a tradeoff: Retaining
cash can reduce the costs of raising capital in the future,
Volume and Share
but it can also increase taxes and agency costs.
Price Effects of Value
Line Special
Dividend
A) Retaining Cash with Perfect Capital Markets Example
With perfect capital markets, the retention versus payout Payne Enterprises has $20,000,000 in excess cash.
decision is irrelevant.
If a firm has already taken all positive-NPV projects, any a) Payne is considering investing the cash in one-year
additional projects it takes on are zero or negative-NPV Treasury bills paying 5% interest, and then using the cash
investments. Rather than waste excess cash on negative- to pay a dividend next year.
NPV projects, a firm can use the cash to purchase
financial assets. b) Alternatively, the firm can pay a dividend immediately
In perfect capital markets, buying and selling securities is and shareholders can invest the cash on their own.
a zero-NPV transaction, so it should not affect firm value.
In a perfect capital market, which option will shareholders
prefer?
Solution Lesson: MM Payout Irrelevance
a) If Payne pays an immediate dividend, the shareholders
receive $20,000,000 today. If shareholders invest the
$20,000,000 in Treasury bills themselves, they would have In perfect capital markets, if a firm invests excess cash flows in
$21,000,000 at the end of 1 year. financial securities, he firm s choice of pa o ers s re en ion
$20,000,000 × (1.05) = $21,000,000
is irrelevant and does not affect the initial share price.
b) If Payne retains the cash, at the end of one year the
company will be able to pay a dividend of $21,000,000.
$20,000,000 × (1.05) = $21,000,000
Thus shareholders are indifferent about whether the firm
pays the dividend immediately or retains the cash.
B) Retaining Cash with Imperfect Markets (Taxes) Example
Corporate taxes make it costly for a firm to retain excess Suppose that Payne has a marginal tax rate of 39%.
cash.
Would a tax-exempt endowment
Cash is equivalent to negative leverage, so the tax a) prefer that Payne use its excess cash to pay the dividend
advantage of leverage implies a tax disadvantage to immediately
holding cash. b) or invest the cash in a Treasury bill paying 5% interest
and then pay out a dividend?
Solution C) Adjusting for Investor Taxes
a) If Payne pays a dividend today, shareholders receive The decision to pay out versus retain cash may also affect
$20,000,000. the taxes paid by shareholders.
• When a firm retains cash, it must pay corporate tax on the
b) If Payne retains the cash for one year, it will earn an interest it earns. In addition, the investor will owe capital
after-tax return on the Treasury bills of: 5% × (1 0.39) = gains tax on the increased value of the firm. In essence,
3.05% At the end of the year, Payne will pay a dividend of the interest on retained cash is taxed twice.
$20,000,000 × (1.0305) = $20,610,000.
• If the firm paid the cash to its shareholders instead, they
This amount is less than the $21,000,000 the endowment could invest it and be taxed only once on the interest that
would have earned if they had invested the $20,000,000 they earn.
in the Treasury bills themselves.
C) Adjusting for Investor Taxes D) Issuance and Distress Costs
The effective tax disadvantage of retaining cash therefore Generally, firms retain cash balances to cover potential
depends on the combined effect of the corporate and capital future cash shortfalls, despite the tax disadvantage to
gains taxes, compared to the single tax on interest income. retaining cash:
• a firm might accumulate a large cash balance if
there is a reasonable chance that future earnings
(1 c ) (1 g ) will be insufficient to fund future positive-NPV
investment opportunities.
*
= 1
retain
(1 i ) 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.
E) Agency Costs of Retaining Cash 4.6 Signaling with Payout Policy
When firms have excessive cash, managers may use the Dividend Smoothing: The practice of maintaining relatively
funds inefficiently by paying excessive executive perks, constant dividends. Firm change dividends infrequently
over-paying for acquisitions, etc. and dividends are much less volatile than earnings
• Paying out excess cash through dividends or share
repurchases, rather than retaining cash, can boost GM Earning
and Dividends
the stock price by reducing a a e ability and per Share,
temptation to waste resources. 1985 2008
Firms should choose to retain cash to preserve financial
slack for future growth opportunities and to avoid financial Management desires to maintain a long-term target level of
distress costs. dividends as a fraction of earnings.
A) Dividend Signaling Hypothesis B) Signalling and Share Repurchases
If firms smooth dividends, the dividend choice will Share repurchases are a credible signal that the shares are
contain information regarding a a e e expectations of undervalued, because if they are over-priced a share
future earnings. repurchase is costly for long-term shareholders.
• When a firm increases its dividend, it An increase of a dividend
sends a positive signal to investors might also signal a lack of If investors believe that managers have better information
that management expects to be able investment opportunities. regarding the prospects and act on behalf of long-
to afford the higher dividend for the
foreseeable future. term shareholders, then investors will react favorably to
Conversely, a firm might cut its
• When a firm decreases its dividend, dividend to exploit new positive-NPV
share repurchase announcements.
it may signal that management has investment opportunities. In this
given up hope that earnings will case, the dividend decrease might
rebound in the near term and so lead to a positive, rather than
need to reduce the dividend to save negative, stock price reaction.
cash.
Example Solution
Ca a a e ca = $30 200 =$6b
Clark Industries has 200 million shares outstanding, a current
Clark will repurchases: $600m/$30 = 20 million shares.
share price of $30, and no debt. Management believes that the
shares are underpriced, and the true value is $35. Clark plans to
pay $600 million in cash to its shareholders by repurchasing at the
current market price. After the transaction new information comes
a c e a a e a e ce a e After the new information, total equity value is 200million*$35= $7,000 million, of
value which $600 million was spent in the repurchase. The current equity value would then
be: $7billion-$600 million=$6.4 billion. On a per share basis this corresponds to a
W a Ca ae ce a e e e a c e ? stock price increase to $6.4 billion/180 million shares = $35.56.
4.7 Stock Dividends, Splits and Spin-offs A) Stock Dividends
A firm can pay a type of dividend that does not involve With a stock dividend, a firm does not pay out any cash to
cash: Stock Dividend. A shareholder who holds the stock shareholders. As a result, the total market value of the
before the ex-dividend date receives: equity is unchanged.
• The only thing that is different is the number of
• additional shares of the stock itself (called a Stock Split shares outstanding: the stock price will fall because
if higher than 50%) the same total equity value is now divided over a
• Example: a stock dividend of 50% means that each larger number of shares.
shareholder receives 1 new share for every two • Stock dividends are not taxed.
shares owned - also known as a 3:2 ( 3 for 2 ) stock
split.
• or shares of a subsidiary (Spin-Off).
A) Stock Dividends B) Spin-Offs
Why firms pay stock dividends or split their stocks? When a firm sells a subsidiary by selling shares in the
subsidiary alone
To keep price in a range attractive to small investors. Firms • Non-cash special dividends are commonly used to
try to keep their shares not: spin off assets or a subsidiary as a separate
• too high to increase the demand and liquidity of company.
the stock and in the end boost the stock price
• too low because of transaction costs (e.g., for Spin-offs offer two advantages over cash distribution:
NYSE and NASDAQ the minimum size of one tick It avoids the transaction costs associated with a
is $0.01, which is larger for stocks with a low subsidiary sale.
price, in percentage terms.). If the price falls too The special dividend is not taxed as a cash
low, a firm can engage in a reverse split. distribution.
Quiz Quiz (cont.)
1. What is a targeted repurchase? 6. What possible signals does a firm give when it cuts its
2. H a e dec a d de d dividend?
versus repurchase shares, assuming perfect capital 7. What is the difference between a stock dividend and a
markets? stock split?
3. W a e d de d e ?
8. Why would a firm initiate a reverse stock split?
4. Why would investors have a tax preference for share
repurchases rather than dividends?
5. Is there an advantage for a firm to retain its cash
instead of paying it out to shareholders in perfect
capital markets? What if capital markets are not
perfect?
