Chapter 17

Payout Policy
Ziwei Wang
Wuhan University
Distributions to Shareholders
• When a rm generates free cash ows, it can either retain the cash or pay out
to its shareholders.

• If retained, the cash can be used to fund new investment or put in the cash
reserves.

• If paid out, the rm can either pay a dividend or repurchase shares.

• The way a rm chooses between the alternative uses of free cash ow is
called its payout policy.

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Distributions to Shareholders

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 Dividends
• A public company’s board of directors determines the amount of the rm’s
dividend and when the payment will occur.

• The date on which the board authorizes the dividend is the declaration date,
after which the rm is legally obligated to make the payment.

• The rm will pay the dividend to all shareholders of record on a speci c date,
set by the board, called the record date.

• Due to a three-day registration period, the date two business days prior to the
record date is known as the ex-dividend date. Anyone who purchases the
stock on or after the ex-dividend date will not receive the dividend.

• Finally, the rm mails dividend checks to the registered shareholders on the

payable date (or distribution date).
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Dividends

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Share Repurchases
• Another way to pay cash to investors is through a share repurchase or
buyback.

• In this kind of transaction, the rm uses cash to buy shares of its own
outstanding stock.

• These shares are generally held in the corporate treasury, and they can be
resold if the company needs to raise money in the future.

• We examine three possible transaction types for a share repurchase.

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 Share Repurchases
• An open market repurchase is the most common way that rms repurchase
shares.

• A rm announces its intention to buy its own shares in the open market, and
then proceeds to do so over time like any other investor.

• The rm may take a year or more to buy the shares, and it is not obligated to
repurchase the full amount it originally stated.

• The rm must not buy its shares in a way that might appear to manipulate the
price.

• For example, SEC guidelines recommend that the rm not purchase more than
25% of the average daily trading volume in its shares on a single day, nor
make purchases at the market open or within 30 minutes of the close of trade.

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 Share Repurchases
• A rm can repurchase shares through a tender o er in which it o ers to buy
shares at a pre-speci ed price during a short time period.

• The price is usually set at a substantial premium (10%–20% is typical) to the

current market price.

• The o er often depends on shareholders tendering a su cient number of

shares.

• If shareholders do not tender enough shares, the rm may cancel the o er

and no buyback occurs.

• A related method: Dutch auction.

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 Share Repurchases
• A rm may also purchase shares directly from a major shareholder in a
targeted repurchase.

• In this case the purchase price is negotiated directly with the seller.
• A targeted repurchase may occur if a major shareholder desires to sell a large
number of shares but the market for the shares is not su ciently liquid.

• Under these circumstances, the shareholder may be willing to sell shares

back to the rm at a discount to the current market price.

• Alternatively, if a major shareholder is threatening to take over the rm and

remove its management, the rm may decide to eliminate the threat by buying
out the shareholder—often at a large premium over the current market price.

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 Dividends vs. Share Repurchases
• How do rms choose between dividends and share repurchases?
• In the perfect capital markets setting of Modigliani and Miller, the method of
payment does not matter.

• We compare di erent methods by considering Genron Corp., a hypothetical

rm.

• Genron has $20 million in excess cash and no debt. It has 10 million shares
outstanding.

• The rm expects to generate additional free cash ows of $48 million per year
in subsequent years.

• Its unlevered cost of capital is 12%, which leads to a total market value of
$420 million.
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Dividends vs. Share Repurchases
• Policy 1: Pay dividend with excess cash.
• With 10 million shares outstanding, Genron will be able to pay a $2 dividend
immediately.

• Because the rm expects to generate future free cash ows of $48 million per
year, it anticipates paying a dividend of $4.80 per share each year thereafter.

• Just before the ex-dividend date, the stock is said to trade cum-dividend at
4.80
Pcum = Currend Dividend + PV(Future Dividends) = 2 + = $42.
0.12

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Dividends vs. Share Repurchases
• After the stock goes ex-dividend, new buyers will not receive the current
dividend.

• At this point the share price will re ect only the dividends in subsequent years
4.80
Pex = PV(Future Dividends) = = $40.
0.12
• 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.

• If not, an arbitrage opportunity would arise.

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Dividends vs. Share Repurchases

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Dividends vs. Share Repurchases
• Policy 2: Share repurchase and no dividend.
• With an initial share price of $42, Genron will repurchase $20 million / $42 per
share = 0.476 million shares, leaving only 9.524 million shares outstanding.

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Dividends vs. Share Repurchases
• Let’s double check that the share price does not fall after the repurchase.
• In future years, Genron expects to have $48 million in free cash ow, which
can be used to pay a dividend of $5.04 per share each year.

• The share price today should be

5.04
Prep = = $42.
0.12
• In perfect capital markets, an open market share repurchase has no e ect on
the stock price, and the stock price is the same as the cum-dividend price if a
dividend were paid instead.

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Dividends vs. Share Repurchases
• Would an investor prefer a dividend or a share repurchase?
• Consider an investor who currently holds 2000 shares of Genron stock.
• In either case, the value of the investor’s portfolio is $84,000 immediately after
the transaction.

• The only di erence is the distribution between cash and stock holdings.

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Dividends vs. Share Repurchases
• If Genron repurchases shares but the investor wants cash, she can simply sell
some shares. In other words, the investor can create a homemade dividend.

• Similarly, if Genron pays a dividend and the investor does not want the cash,
she can use the $4000 proceeds of the dividend to purchase new shares.

• Many rms allow investors to register for a dividend reinvestment program

(DRIP) which automatically reinvests dividends into new shares of the stock.

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Dividends vs. Share Repurchases
• Policy 3: High dividend (equity issue).
• Suppose Genron plans to pay $48 million in dividends starting today.
• It needs to raise the additional $28 million by either borrowing or issuing new
shares.

• We consider an equity issue.

• Given a current share price of $42, it can raise $28 million by selling 0.67
million shares.

• The total number of shares outstanding becomes 10.67 million.

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Dividends vs. Share Repurchases
• The amount of the dividend per share each year becomes
$48 million
= $4.50 per share .
10.67 million shares
• Under this new policy, Genron’s cum-dividend share price is
4.50
Pcum = Currend Dividend + PV(Future Dividends) = 4.50 + = $42.
0.12
• The initial share value is unchanged by this policy, and increasing the dividend
has no bene t to shareholders.

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 MM and Dividend Policy Irrelevance
• Di erent dividend policies simply re ect a tradeo : If Genron pays a higher
current dividend per share, it will pay lower future dividends per share.

• MM Dividend Irrelevance (1961): In perfect capital markets, holding xed the

investment policy of a rm, the rm’s choice of dividend policy is irrelevant and
does not a ect the initial share price.
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The Tax Disadvantage of Dividends
• But are dividends and share repurchases really the same in reality?
• If capital markets are imperfect, there is a tax disadvantage of dividends.
• When a rm pays a dividend, shareholders are taxed according to the
dividend tax rate.

• If the rm repurchases shares instead, and shareholders sell shares to create

a homemade dividend, the homemade dividend will be taxed according to the
capital gains tax rate.

• Shareholders should prefer share repurchases to dividends prior to 2003.

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The Tax Disadvantage of Dividends

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The Tax Disadvantage of Dividends
Problem

Suppose a rm raises $10 million from shareholders and uses this cash to pay
them $10 million in dividends. If the dividend is taxed at a 40% rate, and if
capital gains are taxed at a 15% rate, how much will shareholders receive after
taxes?

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The Tax Disadvantage of Dividends
• Even after 2003, because capital gains taxes are deferred until the asset is
sold, there is still a tax advantage for share repurchases over dividends for
long-term investors.

• As a result, the optimal dividend policy when the dividend tax rate exceeds
the capital gain tax rate is to pay no dividends at all.

• However, dividends still remain a key form of payouts to shareholders.

• The fact that rms continue to issue dividends despite their tax disadvantage
is often referred to as the dividend puzzle (read sections 17.4 and 17.6).

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The Tax Disadvantage of Dividends

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The Tax Disadvantage of Dividends

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 Payout vs. Retention of Cash
• If a rm retains cash, it can use those funds to invest in new projects.
• The rm should always invest in positive-NPV projects.
• When all positive-NPV projects have been exhausted, a rm can hold the
cash in the bank or use it to purchase nancial assets.

• The rm can then pay the money to shareholders at a future time or invest it
when positive-NPV investment opportunities become available.

• What are the advantages and disadvantages of retaining cash and investing in
nancial securities?

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 Payout vs. Retention of Cash
• The argument is quite simple:
• In perfect capital markets, buying and selling securities is a zero-NPV
transaction, so it should not a ect rm value.

• Shareholders can make any investment a rm makes on their own if the rm

pays out the cash.

• Therefore, in perfect capital markets, if a rm invests excess cash ows in

nancial securities, the rm’s choice of payout versus retention is irrelevant
and does not a ect the initial value of the rm.

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Payout vs. Retention of Cash
• With taxes, retained cash may have a tax disadvantage.
• The intuition aligns with the tax bene t of leverage: cash holding is just the
opposite of leverage.

Problem

Suppose Barston must pay corporate taxes at a 35% rate on the interest it will
earn from the one-year Treasury bill paying 6% 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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Payout vs. Retention of Cash
• If there is a tax disadvantage to retaining cash, why do some rms
accumulate large cash balances?

• Generally, they retain cash balances to cover potential future cash shortfalls.
• This can help the rm avoid the transaction costs of raising new capital
(through new debt or equity issues).

• The direct costs of issuance range from 1% to 3% for debt issues and from
3.5% to 7% for equity issues.

• There can also be substantial indirect costs of raising capital due to the
agency and adverse selection costs discussed last week.

• By holding cash, rms can also avoid nancial distress and associated costs.
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Payout vs. Retention of Cash
• There is no bene t to shareholders when a rm holds cash above and beyond
its future investment or liquidity needs, however.

• In fact, in addition to the tax cost, there are likely to be agency costs
associated with having too much cash in the rm.

• When rms have excessive cash, managers may use the funds ine ciently.
• Moreover, due to the debt overhang problem, some of the value of the
retained cash will bene t debt holders.

• As a result, equity holders may prefer to “cash out” and increase the rm’s
payouts.

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Payout vs. Retention of Cash

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