M170 Corporate Finance Handout 3

1. M170 Corporate FinanceHandout 3 • Payout policy, Modigliani and Miller, incentives • Berk and DeMarzo chapter 17

2. Chapter Outline 17.1 Distributions to Shareholders 17.2 Comparison of Dividends and Share Repurchases 17.3 The Tax Disadvantage of Dividends 17.4 Dividend Capture and Tax Clienteles 17.5 Payout Versus Retention of Cash 17.6 Signaling with Payout Policy 17.7 Stock Dividends, Splits and Spin-offs

3. Learning Objectives List two ways a company can distribute cash to its shareholders. Describe the dividend payment process and the open-market repurchase process. Define stock split, reverse stock split, and stock dividend; describe the effect of those actions on stock price. Discuss the effect of dividend payment or share repurchase in a perfect world.

4. Learning Objectives (cont'd) Assuming perfect capital markets, describe what Modigliani and Miller (1961) found about payout policy. Discuss the effect of taxes on dividend policy; compute the effective dividend tax rate. Provide reasons why firms might accumulate cash balances rather than pay dividends. Describe the effect of agency costs on payout policy. Assess the impact of information asymmetry on payout policy.

5. 17.1 Distribution to Shareholders Payout Policy The way a firm chooses between the alternative ways to distribute free cash flow to equity holders

6. Figure 17.1 Uses of Free Cash Flow

7. 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.

8. Dividends (cont'd) 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

9. Figure 17.2 Important Dates for Microsoft’s Special Dividend

10. Dividends (cont'd) Special Dividend A one-time dividend payment a firm makes, which is usually much larger than a regular dividend Stock Split (Stock Dividend) When a company issues a dividend in shares of stock rather than cash to its shareholders

11. Figure 17.3 Dividend History for GM Stock, 1983–2008

12. Dividends (cont'd) Return of Capital When a firm, instead of paying dividends out of current earnings (or accumulated retained earnings), pays dividends from other sources, such as paid-in-capital or the liquidation of assets Liquidating Dividend A return of capital to shareholders from a business operation that is being terminated

13. Share Repurchases An alternative way to pay cash to investors is through a share repurchase or buyback. The firm uses cash to buy shares of its own outstanding stock.

14. Share Repurchases (cont'd) Open Market Repurchase When a firm repurchases shares by buying shares in the open market Open market share repurchases represent about 95% of all repurchase transactions.

15. Share Repurchases (cont'd) 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%-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.

16. Share Repurchases (cont'd) 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

17. Share Repurchases (cont'd) 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

18. 17.2 Comparison of Dividends and Share Repurchases Consider Genron Corporation. The firm’s board is meeting to decide how to pay out $20 million in excess cash to shareholders. Genron has no debt, its equity cost of capital equals its unlevered cost of capital of 12%.

19. Alternative Policy 1: Pay Dividend with Excess Cash With 10 million shares outstanding, Genron will be able to pay a $2 dividend immediately. The firm expects to generate future free cash flows of $48 million per year, thus it anticipates paying a dividend of $4.80 per share each year thereafter.

20. Alternative Policy 1: Pay Dividend with Excess Cash (cont'd) Cum-dividend When a stock trades before the ex-dividend date, entitling anyone who buys the stock to the dividend The cum-dividend price of Genron will be

21. Alternative Policy 1: Pay Dividend with Excess Cash (cont'd) After the ex-dividend date, new buyers will not receive the current dividend and the share price and the price of Genron will be

22. Alternative Policy 1: Pay Dividend with Excess Cash (cont'd)

23. Alternative Policy 1: Pay Dividend with Excess Cash (cont'd) 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.

24. Alternative Policy 2: Share Repurchase (No Dividend) Suppose that instead of paying a dividend this year, Genron uses the $20 million to repurchase its shares on the open market. With an initial share price of $42, Genron will repurchase 476,000 shares. $20 million ÷ $42 per share = 0.476 million shares This will leave only 9.524 million shares outstanding. 10 million − 0.476 million = 9.524 million

25. Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) The net effect is that the share price remains unchanged.

26. Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) Genron’s Future Dividends It should not be surprising that the repurchase had not effect on the stock price. After the repurchase, the future dividend would rise to $5.04 per share. $48 million ÷ 9.524 million shares = $5.04 per share Genron’s share price is

27. Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) 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.

28. Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) Investor Preferences 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 either payout method on their own.

29. Alternative Policy 2: Share Repurchase (No Dividend) (cont'd) Investor Preferences In the case of Genron, if the firm repurchases shares and the investor wants cash, the investor can raise cash by selling shares. This is called a homemade dividend. If the firm pays a dividend and the investor would prefer stock, they can use the dividend to purchase additional shares.

30. Textbook Example 17.1

31. Textbook Example 17.1 (cont'd)

32. Alternative Policy 3: High Dividend (Equity Issue) Suppose Genron wants to pay dividend larger than $2 per share right now, but it only has $20 million in cash today. Thus, Genron needs an additional $28 million to pay the larger dividend now. To do this, the firm decides to raise the cash by selling new shares.

33. Alternative Policy 3: High Dividend (Equity Issue) (cont'd) Given a current share price of $42, Genron could raise $28 million by selling 0.67 million shares. $28 million ÷ $42 per share = 0.67 million shares This will increase the total number of shares to 10.67 million.

34. Alternative Policy 3: High Dividend (Equity Issue) (cont'd) The new dividend per share will be And the cum-dividend share price will be Again, the share value is unchanged.

35. Modigliani–Miller and Dividend Policy Irrelevance There is a trade-off between current and future dividends. If Genron pays a higher current dividend, future dividends will be lower. If Genron pays a lower current dividend, future dividends will be higher.

36. Table 17.1 Genron’s Dividends per Share Each Year Under the Three Alternative Policies

37. Modigliani–Miller and Dividend Policy Irrelevance (cont'd) MM Dividend 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.

38. Dividend Policy with Perfect Capital Markets A firm’s free cash flow determines the level of payouts that it can make to its investors. In a perfect capital market, the type of payout is irrelevant. In reality, capital markets are not perfect and it is these imperfections that should determine the firm’s payout policy.

39. 17.3 The Tax Disadvantage of Dividends Taxes on Dividends and Capital Gains Shareholders must pay taxes on the dividends they receive and they must also pay capital gains taxes when they sell their shares. Dividends are typically taxed at a higher rate than capital gains. In fact, long-term investors can defer the capital gains tax forever by not selling.

40. Table 17.2 Long-Term Capital Gains Versus Dividend Tax Rates in the United States, 1971–2009

41. 17.3 The Tax Disadvantage of Dividends (cont'd) Taxes on Dividends and Capital Gains 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.

42. Textbook Example 17.2

43. Textbook Example 17.2 (cont'd)

44. Alternative Example 17.2 Problem Assume: A firm raises $25 million from shareholders and uses this cash to pay them $25 million in dividends. Dividends are taxed at a 39% tax rate Capital gains are taxed at a 20% tax rate. How much will shareholders receive after taxes?

45. Alternative Example 17.2 Solution On dividends, shareholders will owe: 39% × $25 million = $9.75 million in dividend taxes. Shareholders will lower their capital gains taxes by: 20% × $25 million = $5 million Note: The value of the firm will fall when the dividend is paid, lowering the shareholders’ capital gains.

46. Alternative Example 17.2 Solution (continued) Shareholders will pay a total of $4.75 million in taxes. $9.75 − $5.00 = $4.75 million Shareholders will receive back only $20.25 million of their $25 million investment. $25 − $4.75 = $20.25 million

47. Optimal Dividend Policy with Taxes When the tax rate on dividends is greater than the tax rate on capital gains, shareholders will pay lower taxes if a firm uses share repurchases rather than dividends. This tax savings will increase the value of a firm that uses share repurchases rather than dividends.

48. Optimal Dividend Policy with Taxes (cont'd) The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all. The payment of dividends has declined on average over the last 30 years while the use of repurchases has increased.

49. Figure 17.4 The Decline in Payouts and the Use of Dividends Source: Compustat.

50. Figure 17.5 The Changing Composition of Shareholder Payouts Source: Compustat data for U.S. firms, excluding financial firms and utilities.