Chapter 16

Payout PolicyChapter 17Chapter Outline17.1 Cash Distributions to Shareholders 17.2 Dividends Versus Share Repurchase in a Perfect Capital Market17.3 The Tax Disadvantage of Dividends17.4 Payout Versus Retention of Cash17.5 Signaling with Payout Policy17.6 Stock Dividends, Splits, and Spin-offs17.7 Advice for the Financial Manager22Learning ObjectivesIdentify the different ways in which corporations can make distributions to shareholdersUnderstand why the way in which they distribute cash flow does not affect value absent market imperfectionsDemonstrate how taxes can create an advantage for share repurchases versus dividends

33Learning Objectives (contd)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 payouts4417.1 Cash Distributions to ShareholdersPayout PolicyThe way a firm chooses between the alternative ways to pay cash out to shareholders

55Figure 17.1 Uses of Free Cash Flow

6617.1 Cash Distributions to ShareholdersDividendsDeclaration DateEx-Dividend DateRecord DatePayable Date

FIGURE 17.2 Important Dates for Microsofts Special Dividend717.1 Cash Distributions to ShareholdersDividendsSpecial DividendAccounting ImplicationsReturn of CapitalLiquidating Dividend8Figure 17.3 Dividend History for GM Stock, 1983-2008

917.1 Cash Distributions to ShareholdersShare RepurchasesOpen Market RepurchaseTender OfferDutch AuctionTargeted RepurchaseGreenmail1017.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAssume 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 Genrons unlevered cost of capital is 12%, then the enterprise value of its ongoing operations is:

111117.2 Dividends Versus Share Repurchases in a Perfect Capital MarketGenrons board is meeting to decide how to pay out its $20 million in excess cash to shareholdersThe board is considering three options:Use the $20 million to pay a $2 cash dividend for each of Genrons 10 million outstanding sharesRepurchase shares instead of paying a dividendRaise additional cash to pay an even larger dividend today and in the future121217.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 1: Pay Dividend with Excess CashWith 10 million shares outstanding, Genron will be able to pay a $2 dividend immediatelyBecause 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

131317.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 1: Pay Dividend with Excess CashGenrons share price just before the stock pays its dividend (cum-dividend):

Genrons share price just after the stock goes ex-dividend:

141417.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 1: Pay Dividend with Excess CashIn 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

151517.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative 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 marketHow will the repurchase affect the share price?161617.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative 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 171717.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 2: Share Repurchase (No Dividend)

181817.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 2: Share Repurchase (No Dividend)The market value of Genrons assets falls when the company pays out cash, but the number of shares outstanding also falls from 10 million to 9.524 millionThe two changes offset each other, so the share price remains the same at $42191917.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 2: Share Repurchase (No Dividend)Genrons Future DividendsIn 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, Genrons share price today is:

202017.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 2: Share Repurchase (No Dividend)Genrons Future DividendsIn 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 instead212117.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 2: Share Repurchase (No Dividend)Investor PreferencesWould an investor prefer that Genron issue a dividend or repurchase its stock?Assume an investor holds 2000 shares of Genron StockThe investors holdings after a dividend or share repurchase are:

222217.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 2: Share Repurchase (No Dividend)Investor PreferencesWould an investor prefer that Genron issue a dividend or repurchase its stock?In either case, the value of the investors portfolio is $84,000

232317.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 2: Share Repurchase (No Dividend)Investor PreferencesWhat if the firm repurchases shares but investor wants cash?The investor could sell shares to raise cash (aka homemade dividend)

242417.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 2: Share Repurchase (No Dividend)Investor PreferencesWhat if the firm pays a dividend and the investor does not want cash?The investor could use the dividend to purchase additional shares

252517.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 2: Share Repurchase (No Dividend)Investor Preferences

In either case, the value of the investors portfolio is $84,000In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchasesBy reinvesting dividends or selling shares, they can replicate either payout method on their own

262617.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 3: High Dividend (Equity Issue)Assume Genron plans to pay $48 million in dividends starting next yearSuppose the firm wants to start paying that amount todayBecause it has only $20 million in cash today, Genron needs an additional $28 million to pay the larger dividend now

272717.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative 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

282817.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 3: High Dividend (Equity Issue)Because this equity issue will increase Genrons total number of shares outstanding to 10.67 million, the amount of the dividend per share each year will be:

292917.2 Dividends Versus Share Repurchases in a Perfect Capital MarketAlternative Policy 3: High Dividend (Equity Issue)Under this new policy, Genrons cum-dividend share price is:

The initial share value is unchanged by this policy, and increasing the dividend has no benefit to shareholders

3030Example 17.1 Homemade DividendsProblem: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.3131Example 17.1 Homemade DividendsSolution: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.3232Example 17.1 Homemade DividendsExecute: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.3333Example 17.1 Homemade DividendsEvaluate:Again, the policy that the firm chooses is irrelevantthe investor can transact in the market to create a homemade dividend policy that suits her preferences.3434Example 17.1a Homemade DividendsProblem: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.3535Example 17.1a Homemade DividendsSolution: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.3636Example 17.1a Homemade DividendsExecute: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.3737Example 17.1a Homemade DividendsEvaluate:Again, the policy that the firm chooses is irrelevantthe investor can transact in the market to create a homemade dividend policy that suits her preferences.383817.2 Dividends Versus Share Repurchases in a Perfect Capital MarketModigliani-Miller and Dividend Policy IrrelevanceIn perfect capital markets, holding fixed the investment policy of a firm, the firms choice of dividend policy is irrelevant and does not affect the initial share price

3939Table 17.1 Genrons Dividends perShare Each Year Under the Three Alternative Policies

4017.2 Dividends Versus Share Repurchases in a Perfect Capital MarketDividend Policy and Perfect Capital MarketsAlthough dividends do determine share prices, a firms choice of dividend policy does notA firms free cash flows determine the level of payouts that it can make to its investorsIn a perfect capital market, whether these payouts are made through dividends or share repurchases does not matter414117.3 The Tax Disadvantage of DividendsTaxes on Dividends and Capital GainsShareholders typically must pay: Taxes on the dividends they receive Capital gains taxes when they sell their shares 424217.3 The Tax Disadvantage of DividendsTaxes on Dividends and Capital GainsWhen a firm pays a dividend, shareholders are taxed according to the dividend tax rateIf dividends are taxed at a higher rate than capital gains shareholders will prefer share repurchases to dividendsBecause long-term investors can defer the capital gains tax until they sell, there is still a tax advantage for share repurchases over dividends

4343Table 17.2 Long-Term Capital Gains Versus Dividend Tax Rates in the United States, 19712010

444417.3 The Tax Disadvantage of DividendsOptimal Dividend Policy with TaxesThe optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all

4545Figure 17.4 Dividend and Capital Gains Tax Rates Around the World

4617.3 The Tax Disadvantage of DividendsOptimal Dividend Policy with TaxesDividends in PracticePrior to 1980, most firms used dividends exclusively to distribute cash to shareholders By 2009 about 30% of firms relied exclusively on dividendsAt 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 dividends474717.3 The Tax Disadvantage of DividendsOptimal Dividend Policy with TaxesDividends in PracticeDividend PuzzleWhen firms continue to issue dividends despite their tax disadvantage4848Figure 17.5 The Rise of Repurchases

4949Table 17.3 Summary of Dividends Versus Repurchases

505017.3 The Tax Disadvantage of DividendsTax Differences Across InvestorsDividend Tax Rate FactorsIncome LevelInvestment HorizonTax JurisdictionType of Investor or Investment Account

515117.3 The Tax Disadvantage of DividendsTax Differences Across InvestorsDividend Tax Rate FactorsLong-term investors are more heavily taxed on dividends, so they would prefer share repurchases to dividend payments. One-year investors, pension funds, and other non-taxed investors have no tax preference for share repurchases over dividends; they would prefer a payout policy that most closely matches their cash needs

525217.3 The Tax Disadvantage of DividendsTax Differences Across InvestorsDividend Tax Rate FactorsCorporations enjoy a tax advantage associated with dividends due to the 70% exclusion ruleA corporation that chooses to invest its cash will prefer to hold stocks with high dividend yields5353Figure 17.6 The Changing Composition of Shareholder Payouts

545417.3 The Tax Disadvantage of DividendsTax Differences Across InvestorsClientele EffectsWhen the dividend policy of a firm reflects the tax preferences of its investor clienteleIndividuals in the highest tax brackets have a preference for stocks that pay no or low dividendsTax-free investors and corporations have a preference for stocks with high dividendsThe dividend policy of a firm is optimized for the tax preference of its investor clientele5555Table 17.4 Differing Dividend Policy Preferences Across Investor Groups

5617.4 Payout Versus Retention of CashRetaining Cash with Perfect Capital MarketsBuying and selling securities is a zero-NPV transaction, so it should not affect firm valueShareholders can make any investment a firm makes on their own if the firm pays out the cashThe retention versus payout decision is irrelevant5757Example 17.2 Payout Decisions in aPerfect Capital MarketProblem: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?5858Example 17.2 Payout Decisions in aPerfect Capital MarketSolution: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.5959Example 17.2 Payout Decisions in aPerfect Capital MarketExecute: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.6060Example 17.2 Payout Decisions in aPerfect Capital MarketEvaluate: 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.6161Example 17.2a Payout Decisions in aPerfect Capital MarketProblem: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?6262Example 17.2a Payout Decisions in aPerfect Capital MarketSolution: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.6363Example 17.2a Payout Decisions in aPerfect Capital MarketExecute: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.6464Example 17.2a Payout Decisions in aPerfect Capital MarketEvaluate: 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.6565Example 17.2b Payout Decisions in aPerfect Capital MarketProblem: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?6666Example 17.2b Payout Decisions in aPerfect Capital MarketSolution: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.6767Example 17.2b Payout Decisions in aPerfect Capital MarketExecute: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.6868Example 17.2b Payout Decisions in aPerfect Capital MarketEvaluate: 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.696917.4 Payout Versus Retention of CashRetaining Cash with Perfect Capital MarketsMM Payout IrrelevanceIn perfect capital markets, if a firm invests excess cash flows in financial securities, the firms choice of payout versus retention is irrelevant and does not affect the initial value of the firm

707017.4 Payout Versus Retention of CashRetaining Cash with Imperfect Capital MarketsTaxes and Cash RetentionCash can be thought of as equivalent to negative leverage so the tax advantage of leverage implies a tax disadvantage to holding cash

7171Example 17.3 Retaining Cash withCorporate TaxesProblem: 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 one-year 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?7272Example 17.3 Retaining Cash withCorporate TaxesSolution: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 funds tax-free return on investing the $100,000?7373Example 17.3 Retaining Cash withCorporate TaxesExecute: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 after-tax return on the Treasury bills of2% (1 0.35) = 1.3%Thus, at the end of the year, Barston will pay a dividend of $100,000 (1.013) = $101,300.7474Example 17.3 Retaining Cash withCorporate TaxesEvaluate: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.7575Example 17.3a Retaining Cash withCorporate TaxesProblem: 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 one-year 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?7676Example 17.3a Retaining Cash withCorporate TaxesSolution: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 funds tax-free return on investing the $100,000?7777Example 17.3a Retaining Cash withCorporate TaxesExecute: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 after-tax return on the Treasury bills of4% (1 0.35) = 2.60%Thus, at the end of the year, Hershey will pay a dividend of $100,000 (1.026) = $102,600.7878Example 17.3a Retaining Cash withCorporate TaxesEvaluate: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.7979Example 17.3b Retaining Cash withCorporate TaxesProblem: 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 one-year 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?8080Example 17.3b Retaining Cash withCorporate TaxesSolution: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 funds tax-free return on investing the $375,000?8181Example 17.3b Retaining Cash withCorporate TaxesExecute: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 after-tax return on the Treasury bills of3.25% (1 0.39) = 1.9825%Thus, at the end of the year, GoodBuy will pay a dividend of $375,000 (1.019825) = $382,434.38.8282Example 17.3b Retaining Cash withCorporate TaxesEvaluate: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.838317.4 Payout Versus Retention of CashRetaining Cash with Imperfect Capital MarketsInvestor Tax AdjustmentsWhen a firm retains cash, it must pay corporate tax on the interest it earnsIn addition, the investor will owe capital gains tax on the increased value of the firmThe net result is that the interest on retained cash is taxed twiceUnder most tax regimes there remains a substantial tax disadvantage for the firm to retaining excess cash even after adjusting for investor taxes

848417.4 Payout Versus Retention of CashRetaining Cash with Imperfect Capital MarketsIssuance and Distress CostsFirms retain cash balances to cover potential future cash shortfalls, which allows a firm to avoid the transaction costs of selling new debt or equity issuesUsed to avoid financial distress during temporary periods of operating lossesA firm must balance the tax costs of holding cash with the potential benefits of not having to raise external funds in the future

858517.4 Payout Versus Retention of CashRetaining Cash with Imperfect Capital MarketsAgency Costs of Retaining CashThere is no benefit to shareholders when a firm holds cash above and beyond its future investment or liquidity needsThere are likely to be agency costs associated with having too much cash in the firmPaying out excess cash through dividends or share repurchases can boost the stock price by reducing managers ability and temptation to waste resources

8686Example 17.4 Cutting Negative-NPVGrowthProblem: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 firms operations, which will in turn increase future free cash flows to $72.8 million per year. If the cost of capital of Rextons investments is 10%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price?8787Example 17.4 Cutting Negative-NPVGrowthSolution: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 Rextons 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.8888Example 17.4 Cutting Negative-NPVGrowthExecute: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, Rextons market value is $800 million, or $8.00 per share.8989Example 17.4 Cutting Negative-NPVGrowthExecute (contd):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, Rextons 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).9090Example 17.4 Cutting Negative-NPVGrowthEvaluate: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.9191Example 17.4a Cutting Negative-NPV GrowthProblem: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 firms operations, which will in turn increase future free cash flows to $6 million per year. If the cost of capital of Aarons investments is 8%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price?9292Example 17.4a Cutting Negative-NPV GrowthSolution: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 Aarons 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.9393Example 17.4a Cutting Negative-NPV GrowthExecute: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, Aarons market value is $76.5 million, or $5.10 per share.9494Example 17.4a Cutting Negative-NPV GrowthExecute (contd):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, Aarons 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).95Example 17.4a Cutting Negative-NPV GrowthEvaluate: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.9696Table 17.5 Selected Firms with Large Cash Balances

979717.5 Signaling with Payout PolicyAsymmetric InformationWhen managers have better information than investors regarding the future prospects of the firm, their payout decisions may signal this information

989817.5 Signaling with Payout PolicyDividend SmoothingThe practice of maintaining relatively constant dividendsFirms 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 resort9999Figure 17.7 GMs Earnings and Dividends per Share, 19852008

10010017.5 Signaling with Payout PolicyDividend SignalingThe idea that dividend changes reflect managers views about a firms future earnings prospectsWhen 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 cash10110117.5 Signaling with Payout PolicyDividend SignalingChanges in dividends should be viewed in the context of the type of new information managers are likely to haveAn increase of a firms dividend may be signal of a lack of investment opportunitiesA firm might cut its dividend to exploit new positive-NPV investment opportunitiesThe dividend decrease might lead to a positive, rather than negative, stock price reaction.10210217.5 Signaling with Payout PolicySignaling and Share RepurchasesShare repurchases are a credible signal that the shares are under-priced, because if they are over-priced a share repurchase is costly for current shareholders10310317.5 Signaling with Payout PolicySignaling and Share RepurchasesDifferences Between Share Repurchases and DividendsManagers are much less committed to share repurchases than to dividend paymentsUnlike with dividends, firms do not smooth their repurchase activity from year to yearThe cost of a share repurchase depends on the market price of the stock10410417.6 Stock Dividends, Splits, and Spin-offsStock Dividends and SplitsIn 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 ownedAlso called a 3:2 (3-for-2) stock splitA 100% stock dividend is equivalent to a 2:1 stock split10510517.6 Stock Dividends, Splits, and Spin-offsStock Dividends and SplitsThe firm does not pay out any cash to shareholdersThe total market value of the is unchangedThere is an increase in the number of shares outstandingThe stock price will fall because the same total equity value is now divided over a larger number of sharesStock dividends are not taxedThere is no real consequence to a stock dividend10610617.6 Stock Dividends, Splits, and Spin-offsStock Dividends and SplitsStock Splits and Share PriceThe typical motivation for a stock split is to keep the share price in a range thought to be attractive to small investorsMaking 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 priceOn average, announcements of stock splits are associated with a 2% increase in the stock priceMost firms use splits to keep their share prices from exceeding $10010710717.6 Stock Dividends, Splits, and Spin-offsStock Dividends and SplitsSpin-OffsWhen a firm sells a subsidiary by selling shares as a non-cash special dividend in the subsidiary aloneAdvantages of a Spin-OffIt avoids the transaction costs associated with such a saleThe special dividend is not taxed as a cash distribution10810817.7 Advice for the Financial ManagerOverall, 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 shareholdersRepurchases and special dividends are useful for making large, infrequent distributions to shareholders

10917.7 Advice for the Financial ManagerOverall, 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 indefinitelyBecause regular dividends are seen as an implicit commitment, they send a stronger signal of financial strength to shareholders than do infrequent distributions such as repurchases11017.7 Advice for the Financial ManagerOverall, as a financial manager, you should consider the following when making payout policy decisions:Be mindful of future investment plans

111Table 17.6 Navigating the PayoutDecision

112Chapter QuizWhat is an open-market share repurchase?In a perfect capital market, how important is the firms 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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