SW9: Payout Policy Definition: the way a firm chooses the alternative ways to distribute free cash flow to equity Dividends: - - Declaration Date: The date on which the board of directors authorizes the payment of a dividend Record Date: When a firm pays a dividend, only shareholders on record on this date receive the dividend Ex-dividend Date: A date, two days prior to a dividend’s record date, on or after which anyone buying the stock will not be eligible for the dividend Payable Date (Distribution Date): A date, generally within a month after the record date, on which a firm mails dividend checks to its registered stockholders Special Dividend: one time payment a firm makes much larger than a regular dividend Stock Split: when a company issues a dividend in shares of stock rather than cash to its shareholders Share repurchases: - - - - The firm uses cash to buy shares of its own outstanding stock. Open Market Repurchase: When a firm repurchases shares by buying shares in the open market o Open market share repurchases represent about 95% of all repurchase transactions. Tender Offer: A public announcement of an offer to all existing security holders to buy back a specified amount of outstanding securities at a prespecified price (typically set at a 10% to 20% premium to the current market price) over a prespecified period of time (usually about 20 days) If shareholders do not tender enough shares, the firm may cancel the offer, and no buyback occurs. Dutch Auction: A share repurchase method in which 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. The firm then pays the lowest price at which it can buy back its desired number of shares Targeted Repurchase: When a firm purchases shares directly from a specific shareholder – Greenmail: When a firm avoids a threat of takeover and removal of its management by a major shareholder by buying out the shareholder, often at a large premium over the current market price Comparison of Dividends and Share Repurchases(Example) Modigliani-Miller and Dividend Policy Irrelevance - Trade off between current and future dividens. Current higher dividend= future dividends are lower Dividend irrelevance: in a perfect capital markets, the firms choice of dividend policy is irrelevant and doesn’t affect the initial share price Tax Disadvantage of Dividends: - Shareholders pay taxes on dividends they receive and pay capital gains taxes when they sell their shares - Dividend taxes are normally higher than capital gains - Taxes on Dividends and Capital Gains o The higher tax rate on dividends makes it undesirable for a firm to raise funds to pay a dividend When dividends are taxed at a higher rate than capital gains, if a firm raises money by issuing shares and then gives that money back to shareholders as a dividend, shareholders are hurt because they will receive less than their initial investment. - Optimal Dividend Policy with Taxes If tax rate on dividends is greater than tax rate on capital gains, shareholders will pay lower taxes if a firm uses share repurchases tax savings increase the value of the firm then Optimal dividend policy: dividend tax rate exceeds the capital gain tax rate is to pay no dividends payments of dividends has declined Tax rates very by income, jurisdiction etc maybe different investor groups are attracted Effective Dividend Tax rate: - Consider buying a stock just before it goes ex-dividend and selling the stock just after. The equilibrium condition must be - The effective dividend tax rate is: Clientele Effects When the dividend policy of a firm reflects the tax preference of its investors clientele Dividend Capture Theory: - Investors can trade shares at the time of the dividend so that non-taxed investors receive the dividend large trading volume in a stock around the ex-dividend day Payout vs Retention of Cash - Perfect capital markets: Once a firm has all positive NPV investments, it is indifferent between saving excess cash and paying it out Market imperfections: trade-off, retaining cash can reduce costs of raising capital in the future but can also increase taxes and agency costs Retaining Cash with Perfect Capital Markets - - If a firm has already taken all positive NPV projects, any additional projects are zero or negative NPV investments the firm should use the cash to purchase financial assets In a perfect capital market, buying and selling securities is a zero NPV transaction so it shouldn’t affect the firm value retention versus payout decision is irrelevant Corporate taxes make it costly for a firm to retain excess cash equal to negative leverage Adjusting for Investor Taxes - - Decision to pay out vs retain may also affect the taxes paid by shareholders o 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. In essence, the interest on retained cash is taxed twice If the firm paid the cash to its shareholders instead, they could invest it and be taxed only once on the interest that they earn. o The cost of retaining cash therefore depends on the combined effect of the corporate and capital gains taxes, compared to the single tax on interest income. Issuance and Distress Costs - Firms retain cash balances to cover potential future cash shortfalls, despite tax disadvantage Cost of holding cash to cover future potential needs should be compared to the reduction in transaction, agency and selection costs of raising new capital through new debt Agency (buying or selling for the account and risk of customer) costs of retaining cash - Firms should choose to retain to help with future growth opportunities to avoid distress costs - Dividend smoothing o Practice of maintaining relatively constant dividends infrequent dividend changes Dividend Signaling - - Signaling hypothesis: o Idea that dividend changes reflects managers’ views about a firm’s future earning prospects if dividends are smoothed, the choice will contain info regarding management’s expectations of future earnings Increased dividends= positive signals to investors and vice versa Share repurchases: credible signal that shares are underpriced because if they are overpriced, a share repurchase is costly for current shareholders Stock Dividends, Splits and Spin offs - Stock dividends and Splits: o With a stock dividend, a firm does not pay out any cash to shareholders. o As a result, the total market value of the firm’s equity is unchanged. The only thing that is different is the number of shares outstanding. The stock price will therefore fall because the same total equity value is now divided over a larger number of shares - Stock dividends aren’t taxed no real consequence Number of shares is increased, and price is proportionally reduced—> no change in value Share price is in a range thought to be attractive to small investors On average, announcements of stock splits are associated with a 2% increase in the stock price reverse split: when stock falls to low so company reduces the number of outstanding shares Spin off: when a firm sells a subsidiary by selling shares in the subsidiary alone avoids transaction costs and special dividend is not taxed as a cash distribution -
