Chapter 16

Report
Chapter 17
Payout Policy
Chapter Outline
17.1 Cash Distributions to Shareholders
17.2 Dividends Versus Share Repurchase in a
Perfect Capital Market
17.3 The Tax Disadvantage of Dividends
17.4 Payout Versus Retention of Cash
17.5 Signaling with Payout Policy
17.6 Stock Dividends, Splits, and Spin-offs
17.7 Advice for the Financial Manager
Learning Objectives



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
Learning Objectives (cont’d)



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
17.1 Cash Distributions to
Shareholders

Payout Policy

The way a firm chooses between the alternative
ways to pay cash out to shareholders
Figure 17.1 Uses of Free Cash Flow
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
17.1 Cash Distributions to
Shareholders

Dividends


Special Dividend
Accounting Implications


Return of Capital
Liquidating Dividend
Figure 17.3 Dividend History for GM
Stock, 1983-2008
17.1 Cash Distributions to
Shareholders

Share Repurchases


Open Market Repurchase
Tender Offer


Dutch Auction
Targeted Repurchase

Greenmail
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. If
Genron’s unlevered cost of capital is 12%,
then the enterprise value of its ongoing
operations is:
$48 million
Enterprise Value  PV (Future FCF) 
 $400 million
12%
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Genron’s board is meeting to decide how to
pay out its $20 million in excess cash to
shareholders

The board is considering three options:
1.
2.
3.
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
Raise additional cash to pay an even larger dividend
today and in the future
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 1: Pay Dividend with Excess
Cash

With 10 million shares outstanding, Genron will
be able to pay a $2 dividend immediately

Because the firm expects to generate future free cash
flows of $48 million per year, it anticipates paying a
dividend of $4.80 per share each year thereafter
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 1: Pay Dividend with Excess
Cash

Genron’s share price just before the stock pays
its dividend (cum-dividend):
4.80
Pcum  Current Dividend  PV (Future Dividends)  2 
 2  40  $42
0.12

Genron’s share price just after the stock goes exdividend:
4.80
Pex  PV (Future Dividends) 
0.12
 $40
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

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 exdividend
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

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

How will the repurchase affect the share price?
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)

With an initial share price of $42, Genron will
repurchase $20 million ÷ $42 per share = 0.476
million shares, leaving only 10 – 0.476 = 9.524
million shares outstanding
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)

The market value of Genron’s assets falls when
the company pays out cash, but the number of
shares outstanding also falls from 10 million to
9.524 million

The two changes offset each other, so the share price
remains the same at $42
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)

Genron’s Future Dividends

In future years, Genron expects to have $48 million in
free cash flow, which can be used to pay a dividend of
$48 million ÷ 9.524 million shares = $5.04 per share
each year. Thus, Genron’s share price today is:
Prep
5.04

 $42
0.12
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)

Genron’s Future Dividends

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
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)

Investor Preferences

Would an investor prefer that Genron issue a dividend
or repurchase its stock?


Assume an investor holds 2000 shares of Genron Stock
The investor’s holdings after a dividend or share repurchase
are:
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)

Investor Preferences

Would an investor prefer that Genron issue a dividend
or repurchase its stock?

In either case, the value of the investor’s portfolio is $84,000
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)

Investor Preferences

What if the firm repurchases shares but investor
wants cash?

The investor could sell shares to raise cash (aka homemade
dividend)
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)

Investor Preferences

What if the firm pays a dividend and the investor does
not want cash?

The investor could use the dividend to purchase additional
shares
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 2: Share Repurchase (No
Dividend)

Investor Preferences

In either case, the value of the investor’s portfolio is
$84,000


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
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 3: High Dividend (Equity
Issue)



Assume Genron plans to pay $48 million in
dividends starting next year
Suppose the firm wants to start paying that
amount today
Because it has only $20 million in cash today,
Genron needs an additional $28 million to pay
the larger dividend now
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 3: High Dividend (Equity
Issue)


One was way to raise more cash is to borrow
money or sell new shares
Given a current share price of $42, Genron could
raise $28 million by selling $28 million  $42
per share = 0.67 million shares
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 3: High Dividend (Equity
Issue)

Because this equity issue will increase Genron’s
total number of shares outstanding to 10.67
million, the amount of the dividend per share
each year will be:
$48 million
 $4.50 per share
10.67 million shares
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Alternative Policy 3: High Dividend (Equity
Issue)

Under this new policy, Genron’s cum-dividend
share price is:
4.50
Pcum  4.50 
 4.50  37.50  $42
0.12

The initial share value is unchanged by this policy, and
increasing the dividend has no benefit to
shareholders
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.
Example 17.1 Homemade
Dividends
Solution:
Plan:

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.
Example 17.1 Homemade
Dividends
Execute:

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.
Example 17.1 Homemade
Dividends
Evaluate:

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.
Example 17.1a 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 6,000
shares could create a homemade dividend of $4.50 per share  6,000
shares = $27,000 per year on her own.
Example 17.1a Homemade
Dividends
Solution:
Plan:

If Genron pays a $2 dividend, the investor receives $12,000 in cash and
holds the rest in stock. She can raise $15,000 in additional cash by
selling 375 shares at $40 per share just after the dividend is paid.
Example 17.1a Homemade
Dividends
Execute:

The investor creates her $27,000 this year by collecting the $12,000
dividend and then selling 375 shares at $40 per share. In future years,
Genron will pay a dividend of $4.80 per share. Because she will own
6,000 – 375 = 5,625 shares, the investor will receive dividends of
5,625  $4.80 = $27,000 per year from then on.
Example 17.1a Homemade
Dividends
Evaluate:

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.
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

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
Table 17.1 Genron’s Dividends per
Share Each Year Under the Three Alternative Policies
17.2 Dividends Versus Share Repurchases in a Perfect
Capital Market

Dividend Policy and Perfect Capital Markets

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
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
17.3 The Tax Disadvantage of
Dividends

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
Table 17.2 Long-Term Capital Gains Versus Dividend
Tax Rates in the United States, 1971–2010
17.3 The Tax Disadvantage of
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
Figure 17.4 Dividend and Capital
Gains Tax Rates Around the World
17.3 The Tax Disadvantage of
Dividends

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
17.3 The Tax Disadvantage of
Dividends

Optimal Dividend Policy with Taxes

Dividends in Practice

Dividend Puzzle

When firms continue to issue dividends despite their tax
disadvantage
Figure 17.5 The Rise of
Repurchases
Table 17.3 Summary of Dividends
Versus Repurchases
17.3 The Tax Disadvantage of
Dividends

Tax Differences Across Investors

Dividend Tax Rate Factors




Income Level
Investment Horizon
Tax Jurisdiction
Type of Investor or Investment Account
17.3 The Tax Disadvantage of
Dividends

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 nontaxed investors have no tax preference for share
repurchases over dividends; they would prefer a
payout policy that most closely matches their cash
needs
17.3 The Tax Disadvantage of
Dividends

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
Figure 17.6 The Changing
Composition of Shareholder
Payouts
17.3 The Tax Disadvantage of
Dividends

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
Table 17.4 Differing Dividend
Policy Preferences Across Investor
Groups
17.4 Payout Versus Retention of
Cash

Retaining Cash with Perfect Capital Markets



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
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?
Example 17.2 Payout Decisions in
a
Perfect Capital Market
Solution:
Plan:

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.
Example 17.2 Payout Decisions in
a
Perfect Capital Market
Execute:

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.
Example 17.2 Payout Decisions in
a
Perfect Capital Market
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.
Example 17.2a Payout Decisions in
a
Perfect Capital Market
Problem:

Hershey Co. has $100,000 in excess cash. Hershey is considering
investing the cash in one-year Treasury bills paying 4% 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?
Example 17.2a Payout Decisions in
a
Perfect Capital Market
Solution:
Plan:

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 Hershey invested the cash.
Example 17.2a Payout Decisions in
a
Perfect Capital Market
Execute:

If Hershey retains the cash, at the end of one year the
company will be able to pay a dividend of $100,000  (1.04)
= $104,000. 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 $104,000  (1.04) = $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.
Example 17.2a Payout Decisions in
a
Perfect Capital Market
Evaluate:

Because Hershey 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 17.1a, if Hershey retains the
cash, but investors prefer to have the income today, they can sell
$100,000 worth of shares.
Example 17.2b Payout Decisions in
a
Perfect Capital Market
Problem:

GoodBuy Co. has $375,000 in excess cash. GoodBuy is considering
investing the cash in one-year Treasury bills paying 3.25% 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?
Example 17.2b Payout Decisions in
a
Perfect Capital Market
Solution:
Plan:

We need to compare what shareholders would receive from an
immediate dividend ($375,000), to the present value of what they would
receive in one year if GoodBuy invested the cash.
Example 17.2b Payout Decisions in
a
Perfect Capital Market
Execute:

If GoodBuy retains the cash, at the end of one year the
company will be able to pay a dividend of $375,000 
(1.0325) = $387,187.50. Note that this payoff is the same
as if shareholders had invested the $375,000 in Treasury
bills themselves. In other words, the present value of this
future dividend is exactly $387,187.50  (1.0325) =
$375,000, which is the same as the $375,000
shareholders would receive from an immediate dividend.
Thus shareholders are indifferent about whether the firm
pays the dividend immediately or retains the cash.
Example 17.2b Payout Decisions in
a
Perfect Capital Market
Evaluate:

Because GoodBuy 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 GoodBuy retains
the cash, but investors prefer to have the income today, they can sell
$375,000 worth of shares.
17.4 Payout Versus Retention of
Cash

Retaining Cash with Perfect Capital Markets

MM Payout Irrelevance

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
17.4 Payout Versus Retention of
Cash

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
Example 17.3 Retaining Cash with
Corporate 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 oneyear 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?
Example 17.3 Retaining Cash with
Corporate Taxes
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?
Example 17.3 Retaining Cash with
Corporate Taxes
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 aftertax 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.
Example 17.3 Retaining Cash with
Corporate Taxes
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.
Example 17.3a Retaining Cash
with
Corporate Taxes
Problem:

Recall Hershey Co. from Example 17.2a. Suppose Hershey must pay
corporate taxes at a 35% rate on the interest it will earn from the oneyear Treasury bill paying 4% interest. Would pension fund investors (who
do not pay taxes on their investment income) prefer that Hershey use its
excess cash to pay the $100,000 dividend immediately or retain the
cash for one year?
Example 17.3a Retaining Cash
with
Corporate Taxes
Solution:
Plan:

As in the original example, the comparison is between what
shareholders could generate on their own and what
shareholders will receive if Hershey retains and invests the
funds for them. The key question then is: what is the
difference between the after-tax return that Hershey can
earn and distribute to shareholders versus the pension
fund’s tax-free return on investing the $100,000?
Example 17.3a Retaining Cash
with
Corporate Taxes
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 4% to
receive a total of $104,000 in one year.
If Hershey retains the cash for one year, it will earn an aftertax return on the Treasury bills of
4%  (1 – 0.35) = 2.60%
Thus, at the end of the year, Hershey will pay a dividend of
$100,000  (1.026) = $102,600.
Example 17.3a Retaining Cash
with
Corporate Taxes
Evaluate:

This amount is less than the $104,000 the investors would have earned
if they had invested the $100,000 in Treasury bills themselves. Because
Hershey must pay corporate taxes on the interest it earns, there is a tax
disadvantage to retaining cash. Pension fund investors will therefore
prefer that Hershey pays the dividend now.
Example 17.3b Retaining Cash
with
Corporate Taxes
Problem:

Recall GoodBuy Co. from Example 17.2b. Suppose GoodBuy must pay
corporate taxes at a 39% rate on the interest it will earn from the oneyear Treasury bill paying 3.25% interest. Would pension fund investors
(who do not pay taxes on their investment income) prefer that GoodBuy
use its excess cash to pay the $375,000 dividend immediately or retain
the cash for one year?
Example 17.3b Retaining Cash
with
Corporate Taxes
Solution:
Plan:

As in the original example, the comparison is between what
shareholders could generate on their own and what
shareholders will receive if GoodBuy retains and invests the
funds for them. The key question then is: what is the
difference between the after-tax return that GoodBuy can
earn and distribute to shareholders versus the pension
fund’s tax-free return on investing the $375,000?
Example 17.3b Retaining Cash
with
Corporate Taxes
Execute:



Because the pension fund investors do not pay taxes on
investment income, the results from the prior example still
hold: they would get $375,000, invest it, and earn 3.25% to
receive a total of $387,187.50 in one year.
If GoodBuy retains the cash for one year, it will earn an aftertax return on the Treasury bills of
3.25%  (1 – 0.39) = 1.9825%
Thus, at the end of the year, GoodBuy will pay a dividend of
$375,000  (1.019825) = $382,434.38.
Example 17.3b Retaining Cash
with
Corporate Taxes
Evaluate:

This amount is less than the $ 387,187.50 the investors would have
earned if they had invested the $375,000 in Treasury bills themselves.
Because GoodBuy must pay corporate taxes on the interest it earns,
there is a tax disadvantage to retaining cash. Pension fund investors will
therefore prefer that GoodBuy pays the dividend now.
17.4 Payout Versus Retention of
Cash

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
17.4 Payout Versus Retention of
Cash

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
17.4 Payout Versus Retention of
Cash

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
Example 17.4 Cutting NegativeNPV
Growth
Problem:

Rexton Oil is an all-equity firm with 100 million shares
outstanding. Rexton has $150 million in cash and expects
future free cash flows of $65 million per year. Management
plans to use the cash to expand the firm’s operations, which
will in turn increase future free cash flows to $72.8 million
per year. If the cost of capital of Rexton’s investments is
10%, how would a decision to use the cash for a share
repurchase rather than the expansion change the share
price?
Example 17.4 Cutting NegativeNPV
Growth
Solution:
Plan:

We can use the perpetuity formula to value Rexton under the two
scenarios. The repurchase will take place at market prices, so the
repurchase itself will have no effect on Rexton’s share price. The main
question is whether spending $150 million now (instead of
repurchasing) to increase cash flows by $7.8 million per year is a
positive-NPV project.
Example 17.4 Cutting NegativeNPV
Growth
Execute:

Repurchase: If Rexton does not expand, the value of its future free cash
flows will be $65 million  10% = $650 million. Adding the $150 million
in cash it currently has, Rexton’s market value is $800 million, or $8.00
per share.
Example 17.4 Cutting NegativeNPV
Growth
Execute (cont’d):

Repurchase: If Rexton does not expand, the value of its future free cash
flows will be $65 million  10% = $650 million. Adding the $150 million
in cash it currently has, Rexton’s market value is $800 million, or $8.00
per share.


If Rexton repurchases shares, there will be no change to the share price: It
will repurchase $150 million  $8.00 / share = 18.75 million shares, so it
will have assets worth $650 million with 81.25 million shares outstanding,
for a share price of $650 million  81.25 million shares = $8.00 / share.
In this case, cutting investment and growth to fund a share repurchase
increases the share price by $0.72 per share ($8.00 - $7.28).
Example 17.4 Cutting NegativeNPV
Growth
Evaluate:
The share price is higher with the repurchase because the alternative of
expansion has a negative NPV: It costs $150 million, but increases
future free cash flows by only $7.8 million, for an NPV of:
–$150 million + $7.8 million / 10% = –$72 million, or –$0.72 per share.

Thus, the repurchase, by avoiding the expansion, keeps the shares from
suffering the $0.72 loss.

Example 17.4a Cutting NegativeNPV Growth
Problem:

Aaron Corp. is an all-equity firm with 15 million shares
outstanding. Aaron has $14 million in cash and expects
future free cash flows of $5 million per year. Management
plans to use the cash to expand the firm’s operations, which
will in turn increase future free cash flows to $6 million per
year. If the cost of capital of Aaron’s investments is 8%, how
would a decision to use the cash for a share repurchase
rather than the expansion change the share price?
Example 17.4a Cutting NegativeNPV Growth
Solution:
Plan:

We can use the perpetuity formula to value Aaron under the two
scenarios. The repurchase will take place at market prices, so the
repurchase itself will have no effect on Aaron’s share price. The main
question is whether spending $14 million now (instead of repurchasing)
to increase cash flows by $1 million per year is a positive-NPV project.
Example 17.4a Cutting NegativeNPV Growth
Execute:
Invest: Using the perpetuity formula, if Aaron invests the $14
million to expand, its market value will be:
$6 million  8% = $75 million, or $5.00 per share with 15
million shares outstanding.
 Repurchase: If Aaron does not expand, the value of its
future free cash flows will be $5 million  8% = $62.5
million. Adding the $14 million in cash it currently has,
Aaron’s market value is $76.5 million, or $5.10 per share.

Example 17.4a Cutting NegativeNPV Growth
Execute (cont’d):

Repurchase: If Aaron does not expand, the value of its future free cash
flows will be $5 million  8% = $62.5 million. Adding the $14 million in
cash it currently has, Aaron’s market value is $76.5 million, or $5.10 per
share.


If Aaron repurchases shares, there will be no change to the share price: It
will repurchase $14 million  $5.10/ share = 2.75 million shares, so it will
have assets worth $62.5 million with 12.25 million shares outstanding, for a
share price of $62.5 million  12.25 million shares = $5.10 / share.
In this case, cutting investment and growth to fund a share repurchase
increases the share price by $0.10 per share ($5.10 - $5.00).
Example 17.4a Cutting NegativeNPV Growth
Evaluate:
The share price is higher with the repurchase because the alternative of
expansion has a negative NPV: It costs $14 million, but increases future
free cash flows by only $1 million, for an NPV of
–$14 million +($1 million ÷ 8%) = -$1.5 million, or –$0.10 per share.

Thus, the repurchase, by avoiding the expansion, keeps the shares from
suffering the $0.10 loss.

Table 17.5 Selected Firms with
Large Cash Balances
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
17.5 Signaling with Payout Policy

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
Figure 17.7 GM’s Earnings and
Dividends per Share, 1985–2008
17.5 Signaling with Payout Policy

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
17.5 Signaling with Payout Policy

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 positiveNPV investment opportunities

The dividend decrease might lead to a positive, rather than
negative, stock price reaction.
17.5 Signaling with Payout Policy

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
17.5 Signaling with Payout Policy

Signaling and Share Repurchases

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
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
17.6 Stock Dividends, Splits, and
Spin-offs

Stock Dividends and Splits

The firm does not pay out any cash to
shareholders


There is an increase in the number of shares
outstanding


The total market value of the is unchanged
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
17.6 Stock Dividends, Splits, and
Spin-offs

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
17.6 Stock Dividends, Splits, and
Spin-offs

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
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
17.7 Advice for the Financial
Manager

Overall, as a financial manager, you should
consider the following when making payout
policy decisions:


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
17.7 Advice for the Financial
Manager

Overall, as a financial manager, you should
consider the following when making payout
policy decisions:

Be mindful of future investment plans
Table 17.6 Navigating the Payout
Decision
Chapter Quiz
1.
2.
3.
4.
5.
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?

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