AppliedCorporateFinance

Week5
PayoutPolicy
References:
BerkandDeMarzo Ch.17

LectureOutline
DistributionstoShareholders
ComparisonofDividendsandShare
Repurchases
TheTaxDisadvantageofDividends
DividendCaptureandTaxClienteles
PayoutVersusRetentionofCash
Signaling withPayoutPolicy
StockDividends,SplitsandSpinoffs

PayoutPolicy
Thewayafirmchoosesbetweenthealternativewaysto
distributefreecashflowtoequityholders
UsesofFreeCashFlow:

Dividends
DeclarationDate
Thedateonwhichtheboardofdirectorsauthorizesthe
paymentofadividend

RecordDate
Whenafirmpaysadividend,onlyshareholdersonrecordon
thisdatereceivethedividend

ExdividendDate
Adate,twodayspriortoadividendsrecorddate,onorafter
whichanyonebuyingthestockwillnotbeeligibleforthe
dividend

PayableDate(DistributionDate)
Adate,generallywithinamonthaftertherecorddate,onwhich
afirmmailsdividendcheckstoitsregisteredstockholders

 SpecialDividend
Aonetimedividendpaymentafirmmakes,which
isusuallymuchlargerthanaregulardividend

StockSplit(StockDividend)
Whenacompanyissuesadividendinsharesof
stockratherthancashtoitsshareholders

ShareRepurchases
Analternativewaytopaycashtoinvestorsis
throughasharerepurchaseorbuyback.
Thefirmusescashtobuysharesofitsown
outstandingstock.

OpenMarketRepurchase
Whenafirmrepurchasessharesbybuyingshares
intheopenmarket
Openmarketsharerepurchasesrepresentabout
95%ofallrepurchasetransactions.

 InAustralia
limitedto10%oftotal[voting]sharesoutstanding
withina12monthperiod
Atapricewhichisnotmorethan5%abovethe
average(overlast5tradingdays)

 TenderOffer
Apublicannouncementofanoffertoallexisting
securityholderstobuybackaspecifiedamountof
outstandingsecuritiesataprespecified price
(typicallysetata10%20%premiumtothe
currentmarketprice)overaprespecified periodof
time(usuallyabout20days)
Ifshareholdersdonottenderenoughshares,the
firmmaycanceltheofferandnobuybackoccurs.

 TargetedRepurchase
Whenafirmpurchasessharesdirectlyfroma
specificshareholder

ComparisonofDividendsandShare
Repurchases
Considerahypotheticalfirm,Genron,which
has$20millioncashandnodebt.
Thefirmexpectstogeneratefreecashflows
of$48millionperyearinsubsequentyears.
Genrons costofcapitalis12%.
Therefore,theenterprisevalueofGenrons
ongoingoperationis:
EnterpriseValue=PV(FutureFCF)=$48m/12%=$400m

 Includingcash,Genrons totalmarketvalueis
$420million.
AssumingGenron has10millionshares
outstanding,eachsharehasapriceof$42.
NowsupposeGenron wantstopayoutallthe
freecashflowtoshareholders,whatwould
thesharepricebe?

 With10millionsharesoutstanding,eachshare
receives$2immediately.
Eachsharewillthenreceive$4.8peryearforever.
ThecumdividendpriceofGenron willbe:
4.80
Pcum Current Dividend PV(Future Dividends) 2
2 40 $42
0.12

Cumdividend
Whenastocktradesbeforetheexdividenddate,
entitlinganyonewhobuysthestocktothedividend

 Aftertheexdividenddate,newbuyerswillnot
receivethecurrentdividendandthesharepriceand
thepriceofGenron willbe
4.80
Pex PV (Future Dividends)
$40
0.12

Inaperfectcapitalmarket,whenadividendispaid,the
sharepricedropsbytheamountofthedividendwhen
thestockbeginstotradeexdividend.

 Supposethatinsteadofpayingadividendthisyear,
Genron usesthe$20milliontorepurchaseitssharesin
theopenmarket.
Withaninitialsharepriceof$42,thenumberofshares
Genron willrepurchaseis:
$20million $42pershare=0.476millionshares
Consequently,thenumberofsharesoutstandingis:
10million0.476million=9.524million
With$400millionmarketvalue,theshareprice
remainsunchanged:
$400million 9.524millionshares=$42pershare

 Aftertherepurchase,thefuturedividendwouldriseto:
$48million 9.524millionshares=$5.04pershare
Onceagain,Genrons sharepriceis:
5 .0 4
Pr e p

0 .1 2

$42

 Inperfectcapitalmarkets,anopenmarketshare
repurchasehasnoeffectonthestockprice,and
thestockpriceisthesameasthecumdividend
priceifadividendwerepaidinstead.
Inperfectcapitalmarkets,investorsare
indifferentbetweenthefirmdistributingfunds
viadividendsorsharerepurchases.Byreinvesting
dividendsorsellingshares,theycanreplicate
eitherpayoutmethodontheirown.

 Ifthefirmrepurchasessharesandtheinvestor
wantscash,theinvestorcanraisecashby
sellingshares.
Ifthefirmpaysadividendandtheinvestor
wouldpreferstock,theycanusethedividend
topurchaseadditionalshares.
MMDividendIrrelevance
Inperfectcapitalmarkets,holdingfixedthe
investmentpolicyofafirm,thefirmschoiceof
dividendpolicyisirrelevantanddoesnotaffect
theinitialshareprice.

DividendPolicy
withPerfectCapitalMarkets
Afirmsfreecashflowdeterminesthelevelof
payoutsthatitcanmaketoitsinvestors.
Inaperfectcapitalmarket,thetypeofpayout
isirrelevant.
Inreality,capitalmarketsarenotperfectanditis
theseimperfectionsthatshoulddeterminethe
firmspayoutpolicy

TheTaxDisadvantageofDividends
TaxesonDividendsandCapitalGains
Shareholdersmustpaytaxesonthedividends
theyreceiveandtheymustalsopaycapitalgains
taxeswhentheyselltheirshares.
Dividendsaretypicallytaxedatahigherratethan
capitalgains.
Thehighertaxrateondividendsmakesit
undesirableforafirmtoraisefundstopaya
dividend.

Problem
Assume:
Afirmraises$25millionfromshareholdersanduses
thiscashtopaythem$25millionindividends.
Dividendsaretaxedata39%taxrate
Capitalgainsaretaxedata20%taxrate.

Howmuchwillshareholdersreceiveaftertaxes?

 Ondividends,shareholderswillowe:
39% $25 million=$9.75millionindividendtaxes.

Shareholderswilllowertheircapitalgainstaxesby:
20% $25million=$5million

Shareholderswillpayatotalof$4.75millionintaxes.
$9.75$5.00=$4.75million

Shareholderswillreceivebackonly$20.25millionof
their$25millioninvestment.
$25$4.75=$20.25million

 Whenthetaxrateondividendsisgreaterthanthetax
rateoncapitalgains,shareholderswillpaylowertaxes
ifafirmusessharerepurchasesratherthandividends.
Thistaxsavingswillincreasethevalueofafirmthatuses
sharerepurchasesratherthandividends.

Theoptimaldividendpolicywhenthedividendtaxrate
exceedsthecapitalgaintaxrateistopaynodividends
atall.
DividendPuzzle
Whenfirmscontinuetoissuedividendsdespitetheirtax
disadvantage

DividendCaptureandTaxClienteles
Thepreferenceforsharerepurchasesrather
thandividendsdependsonthedifference
betweenthedividendtaxrateandthecapital
gainstaxrate.
Taxratesareaffectedbyanumberoffactorssuch
asincome,jurisdiction,andinvestmenthorizon
etc.
Giventhesedifferences,firmswithdifferent
dividendpoliciesmayattractdifferentgroupsof
investors.

 Letsassumewebuyastockjustbeforeitgoes
exdividendandsellthestockjustafter.
DenotePcum asthepriceatwhichwebuy,and
Pex asthepriceatwhichwesell.
Denote asthecapitalgainstaxrate,and
asthedividendtaxrate.

 Atequilibrium,weshouldhave:
(Pcum Pex ) (1 g ) Div(1 d )

Whichcanbewrittenas:
Pcum Pex

1 d

d g
Div
Div 1
1

1 g
g

Wherewedefine
taxrate

*
Div 1 d

tobetheeffectivedividend

 Thus,theeffectivedividendtaxrate is

*
d

d g

1
g

Thismeasurestheadditionaltaxpaidbythe
investorperdollarofaftertaxcapitalgains
incomethatisinsteadreceivedasadividend.

 Example:
Consideraninvestorwhofacesadividendtax
rateof39%,acapitalgaintaxrateof20%.

=0.390.20=23.75%
10.20

Thatis,each$1receivedasdividendsisworthonly
$0.7625ascapitalgains.

ClienteleEffects
Thedividendpolicyofafirmreflectsthetax
preferenceofitsinvestorclientele.
Individualsinthehighesttaxbracketshavea
preferenceforstocksthatpaynoorlow
dividends.
Taxfreeinvestorsandcorporationshavea
preferenceforstockswithhighdividends.
Thedividendpolicyofafirmisoptimizedfor
thetaxpreferenceofitsinvestorclientele.

DividendCaptureTheory
Absenttransactioncosts,investorscantradesharesatthe
timeofthedividendsothatnontaxedinvestorsreceivethe
dividend.
Weshouldseelargetradingvolumeinastockaroundtheexdividend
day,ashightaxinvestorssellandlowtaxinvestorsbuythestockin
anticipationofthedividend.

 Forasmallordinarydividend,thetransaction
costsandrisksoftradingthestockprobably
offsetthebenefitsassociatedwithdividend
capture.
Onlylargespecialdividendstendtogenerate
largeincreasesinvolume.
Thus,whileclienteleeffectsanddividendcapture
strategiesreducetherelativetaxdisadvantageof
dividends,theydonoteliminateit.

PayoutVersusRetentionofCash
MMPayoutIrrelevance
Inperfectcapitalmarkets,ifafirminvestsexcess
cashflowsinfinancialsecurities,thefirmschoice
ofpayoutversusretentionisirrelevantanddoes
notaffecttheinitialshareprice.
BuyingandsellingsecuritiesisazeroNPV
transaction,soitshouldnotaffectfirmvalue.
Shareholderscanmakeanyinvestmentafirm
makesontheirownifthefirmpaysoutthecash.

 Example1:Supposeafirmhas$100,000in
excesscash,willthefollowing2optionslead
toanydifferencesinaperfectcapitalmarket?
Option1:Investthecashin1yearTreasurybills
paying6%interest,andthenusethecashtopay
dividendsnextyear.
Option2:Paydividendsimmediatelyandlet
shareholdersinvestthecashontheirown.

 Example2:SupposethefirminExample1nowfaces
corporatetaxesof35%ontheinterestitwillearnfrom
theTreasurybill,willthe2optionsleadtoany
differencesforpensionfundinvestors(whodonotpay
taxesontheirinvestmentincome)?
Withperfectcapitalmarkets,nodifferencesexist.
Withoutperfectcapitalmarkets,factorssuchastaxes
makeitcostlyforafirmtoretainexcesscash.
Cashisequivalenttonegativedebt,sothetaxadvantage
ofdebtimpliesataxdisadvantagetoholdingcash.

AgencyCostsofRetainingCash
Whenfirmshaveexcessivecash,managersmay
usethefundsinefficientlybypayingexcessive
executiveperks,overpayingforacquisitions,etc.
Payingoutexcesscashthroughdividendsor
sharerepurchases,ratherthanretainingcash,can
boostthestockpricebyreducingmanagers
abilityandtemptationtowasteresources.
Letsseehowpayingthecashoutcansometimes
helpavoidreducingfirmvalue.

 SupposeExamExpertCorpisanallequityfirmthathas
10,000sharesoutstanding.
Thankstothoseterriblyhardexams,thefirmcurrently
has$12,000incashandwillgeneratefuturefreecash
flowof$5,000eachyear.
ItscurrentCEOandCFO,Ms.ExamandMr.Rocks,are
decidingonwhattodowiththe$12,000cash.
Theirfirstoptionistousethecashtorepurchase
shares.
Alternatively,theycanretainthecashandexpandthe
firmbytryingtopredictthemidtermexamin
FINS3625

 Ifthecashisretainedandreinvested,theyexpectthe
firmtogenerateFCFof$6,000peryear.
Thecostofcapitalis10%.
Whichoptionisoptimal?
Usingtheperpetuityformula,ifExamExpertexpands
andreinvests,itsmarketvaluewillbe:
$6,000 10%=$60,000
With10,000sharesoutstanding,eachsharewillbe
worth$6.

 Ifthecashisnotreinvested,withannualFCFof$5,000the
presentvalueofExamExpertsfutureFCFwillbe:
$5,000 10%=$50,000
Withcashof$12,000,themarketvaluewillbe$62,000,
leadingtoasharepriceof$6.2.
AfterExamExpertrepurchasesshares,therewillbeno
changetotheshareprice.
Itwillrepurchase$12,000 $6.2/share=1,935shares
Inotherwords,therewillbe8,065sharesremaininginthe
firm(10,000 1,935=8,065)
SincePV(FCF)=$50,000,eachshareshouldbeworth$6.2
($50,000 8,065=$6.2)

 ObviouslyExamExpertisbetteroffnot
attemptingtopredicttheexaminFINS3625.
Thisconclusioncanalsobedrawnuponrealising
thattheprojecthasanegativeNPV.
NPV=Initialcost+PV(Futurebenefits)
=$12,000+($1,000 10%)=$2,000
Therefore,byavoidingtheunprofitable
expansion,therepurchasepreventstheshare
fromsufferinga$0.2reduction.

SignalingwithPayoutPolicy
Managersmighthaveprivateinformation
regardingthefutureprospectsofthefirm.
Ifthisinformationispositive,managersmayuse
theirpayoutdecisionstosignalsuchinformation
DividendSmoothing
Thepracticeofmaintainingrelativelyconstant
dividends
Firmchangedividendsinfrequentlyanddividendsaremuch
lessvolatilethanearnings.

 Researchhasfoundthat
Managementbelievesthatinvestorspreferstable
dividendswithsustainedgrowth.
Managementdesirestomaintainalongtermtarget
levelofdividendsasafractionofearnings.
Thus,firmsraisetheirdividendsonlywhentheyperceivea
longtermsustainableincreaseintheexpectedlevelof
futureearnings,andcutthemonlyasalastresort.

 DividendSignaling Hypothesisreferstotheideathat
dividendchangesreflectmanagersviewsabouta
firmsfutureearningprospects
Whenafirmincreasesitsdividend,itsendsapositive
signaltoinvestorsthatmanagementexpectstobeable
toaffordthehigherdividendfortheforeseeable
future;andviceversa.
Anincreasemightalsosignalalackofinvestment
opportunities.
Conversely,afirmmightcutitsdividendtoexploitnew
positiveNPVinvestmentopportunities.
Inthiscase,thedividenddecreasemightleadtoapositive,
ratherthannegative,stockpricereaction.

 Sharerepurchasesareacrediblesignalthat
thesharesareunderpriced,becauseifthey
areoverpricedasharerepurchaseiscostly
forcurrentshareholders.
Ifinvestorsbelievethatmanagershavebetterinformation
regardingthefirmsprospectsandactonbehalfofcurrent
shareholders,theninvestorswillreactfavorablytoshare
repurchaseannouncements.

StockDividends,Splits,andSpinoffs
Withastockdividend,afirmdoesnotpayoutanycash
toshareholders.
Asaresult,thetotalmarketvalueofthefirmsequityis
unchanged.Theonlythingthatisdifferentisthe
numberofsharesoutstanding.
Thestockpricewillthereforefallbecausethesame
totalequityvalueisnowdividedoveralargernumber
ofshares.
Stockdividendsof50%ormorearegenerallyreferred
toasstocksplits.
A50%stockdividendisessentiallyequaltoa3:2stock
split

 Thetypicalmotivationforastocksplitistokeepthe
sharepriceinadesiredrangetoattractsmallinvestors.
Ifthesharepriceistoohigh,itmightbedifficultfor
smallinvestorstoinvestinthestock.
Thismaylimitthedemandforthestock,whichwill
thenreducethestockliquidity.
Onaverage,announcementsofstocksplitsare
associatedwitha2%increaseinthestockprice.
Ontheotherhand,firmscanalsodoreversesplitsto
reducethenumberofsharesoutstanding,andthereby
increasingshareprices.

Homework
Chapter 17:6,11,19,24,32