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Payout Policy
Chapter 17
Chapter Outline
17.1 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 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:
Enterprise Value PV (Future FCF)
$48 million
12%$400 million
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. Use the $20 million to pay a $2 cash dividend for each of Genron’s 10 million outstanding shares
2. Repurchase shares instead of paying a dividend
3. 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):
Genron’s share price just after the stock goes ex-dividend:
Pcum Current Dividend PV (Future Dividends) 2
4.80
0.122 40 $42
Pex PV (Future Dividends)
4.80
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 ex-dividend
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
0.12$42
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 either payout method on their own
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
10.67 million shares$4.50 per share
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:
The initial share value is unchanged by this policy, and increasing the dividend has no benefit to shareholders
Pcum 4.50
4.50
0.124.50 37.50 $42
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 perShare 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 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
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 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?
Example 17.2 Payout Decisions in a
Perfect 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.
Example 17.2 Payout Decisions in a
Perfect 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.
Example 17.2 Payout Decisions in a
Perfect 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.
Example 17.2a Payout Decisions in a
Perfect 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?
Example 17.2a Payout Decisions in a
Perfect 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.
Example 17.2a Payout Decisions in a
Perfect 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.
Example 17.2a Payout Decisions in a
Perfect 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.
Example 17.2b Payout Decisions in a
Perfect 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?
Example 17.2b Payout Decisions in a
Perfect 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.
Example 17.2b Payout Decisions in a
Perfect 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.
Example 17.2b Payout Decisions in a
Perfect 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.
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 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?
Example 17.3 Retaining Cash with
Corporate 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 fund’s tax-free return on investing the $100,000?
Example 17.3 Retaining Cash with
Corporate 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 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 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.
Example 17.3a Retaining Cash with
Corporate 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?
Example 17.3a Retaining Cash with
Corporate 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 fund’s tax-free return on investing the $100,000?
Example 17.3a Retaining Cash with
Corporate 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 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 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.
Example 17.3b Retaining Cash with
Corporate 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?
Example 17.3b Retaining Cash with
Corporate 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 fund’s tax-free return on investing the $375,000?
Example 17.3b Retaining Cash with
Corporate 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 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 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.
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 Negative-NPV
GrowthProblem: 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 Negative-NPV
GrowthSolution: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 Negative-NPV
GrowthExecute: 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 Negative-NPV
GrowthExecute (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 Negative-NPV
GrowthEvaluate: 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 Negative-NPV 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 Negative-NPV 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 Negative-NPV 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 Negative-NPV 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 Negative-NPV 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 positive-NPV 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 The total market value of the is unchanged
There is an increase in the number of shares outstanding
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. What is an open-market share repurchase?2. In a perfect capital market, how important is the
firm’s decision to pay dividends versus repurchase shares?
3. What is the dividend puzzle?4. What possible signals does a firm give when it
cuts its dividend?5. What are some advantages of a spinoff as
opposed to selling the division and distributing the cash?