Chapter 17 (Finance)

In our analysis we considered three possible dividend policies for the firm this year:

(1) pay out all cash as a dividend, (2) pay no dividend and use the cash instead to repurchase shares, or (3) issue equity to finance a larger dividend.

The effective dividend tax rate t*d for an investor depends on the tax rates the investor faces on dividends and capital gains. These rates differ across investors for a variety of reasons

1. income level 2. investment horizon 3. tax jurisdiction 4. type of investor or investment account

The date on which the board authorizes the dividend is the declaration date.

After the board declares the dividend, the firm is legally obligated to make the payment

The firm will pay the dividend to all shareholders of record on a specific date, set by the board, called the record date. Because it takes three business days for shares to be registered, only shareholders who purchase the stock at least three days prior to the record date receive the dividend. As a result, 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, on the payable date (or distribution date), which is generally about a month after the record date, the firm mails dividend checks to the registered shareholders.

several important differences distinguish share repurchases and dividends.

First, managers are much less committed to share repurchases than to dividend payments Second, unlike with dividends, firms do not smooth their repurchase activity from year to year. A third key difference between dividends and share repurchases is that the cost of a share repurchase depends on the market price of the stock.

If there is a tax disadvantage to retaining cash, why do some firms accumulate large cash balances?

Generally, they retain cash balances to cover potential future cash shortfalls.

When a firm's investments generate free cash flow, the firm must decide how to use that cash.

If the firm has new positive-NPV investment opportunities, it can reinvest the cash and increase the value of the firm.

MM Dividend Irrelevance:

In perfect capital markets, holding fixed the investment policy ofa firm, the firm's choice of dividend policy is irrelevant and does not affect the initial share

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 fir

By selling shares or reinvesting dividends, the investor can create any combination of cash and stock desired. As a result, the investor is indifferent between the various payout methods the firm might employ:

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

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.

once a firm has taken all positive-NPV investments, it is indifferent between saving excess cash and paying it out. But once we consider market imperfections, there is a tradeoff:

Retaining cash can reduce the costs of raising capital in the future, but it can also increase taxes and agency costs

What are the advantages and disadvantages of retaining cash and investing in financial securities? In perfect capital markets, buying and selling securities is a zero-NPV transac-tion, 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. Thus, it should not be surprising that with perfect capital markets, the retention versus payout decision—just like the dividend versus share repurchase decision—is irrelevant to total firm value

If taxes are the only important market imperfection, when the tax rate on dividends exceeds the tax rate on capital gains, the optimal dividend policy is for

firms to pay no dividends. Firms should use share repurchases for all payout

if a major shareholder is threatening to take over the firm and remove its management, the firm may decide to eliminate the threat by buying out the shareholder—often at a large pre-mium over the current market price. This type of transaction is called .

greenmail

Thus, in the case of a share repurchase, by selling shares an investor can create a

homemade dividend.

a stock price that is very low raises transaction costs for

investors.

Share repurchases are therefore a credible signal that

management believes its shares are underpriced.

If firms smooth dividends, the firm's dividend choice will contain information regarding

management's expectations of future earnings.

a stock dividend. In this case, each shareholder who owns the stock before it goes ex-dividend receives additional shares of stock of the firm itself (a stock split) or

of a subsidiary (a spin-off).

Firms that use dividends will have to pay a higher pre-tax return to offer their investors the same after-tax return as firms that use share repurchases. 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

The way a firm chooses be-tween these alternatives is referred to as its

payout policy

Ultimately, firms should choose to retain cash for the same reasons they would use low leverage—to

preserve financial slack for future growth opportunities and to avoid financial distress costs

A firm can repurchase shares through a tender offer in which it offers to buy shares at a

prespecified price during a short time period

a firm may pay a one-time, special dividend that is usually much larger than a

regular dividend

Most companies that pay dividends pay them at

regular, quarterly intervals.

An open market repurchase is the most common way that firms

repurchase shares

Dividends are a cash outflow for the firm. From an accounting perspective, dividends generally reduce the firm's current (or accumulated) retained earnings. In some cases, divi-dends are attributed to other accounting sources, such as paid-in capital or the liquida-tion of assets. In this case, the dividend is known as a

return of capital or a liquidating dividend.

the investor earns a profit by trading to capture the dividend if the after-tax dividend exceeds the after-tax capital loss. Conversely, if the after-tax capital loss exceeds the after-tax dividend, the investor benefits by

selling the stock just before it goes ex-dividend and buying it afterward, thereby avoiding the dividend.

A firm 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 sufficiently liquid to sustain such a large sale without

several affecting the price

The Dutch Auction

share repurchase, in which the firm lists differ-ent 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.

If a corporation decides to pay cash to shareholders, it can do so through either dividend payments or

share repurchases.

in a stock split or stock dividend, the company issues additional

shares rather than cash to its shareholders

Rather than pay a dividend using cash or shares of its own stock, a firm can also dis-tribute shares of a subsidiary in a transaction referred to as a

spin-off

Thus, paying out excess cash through dividends or share repurchases can boost the

stock price by reducing waste or the transfer of the firm's resources to other stakeholders.

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 ifa dividend were paid instea

Corporate taxes make it costly for a firm to retain excess cash. Even after adjusting for investor taxes, retaining excess cash brings a

substantial tax disadvantage for a firm.

If the price of the stock falls too low, a company can engage in a reverse split and reduce

the number of shares outstanding

firms can maintain almost any level of dividend in the short run by adjusting

the number of shares they repurchase or issue and the amount of cash they retain.

Even though there is potential tax disadvantage to retaining cash, some firms accumulate cash balances. Cash balances help firms minimize the

transaction costs of raising new capital when they have future potential cash needs

Dividends and share repurchases help minimize the agency problem of wasteful spending when a firm has excess cash. They also reduce the

transfer of value to debt holders or other stakeholders

With a stock dividend, a firm does not pay out any cash to shareholders. As a result, the total market value of the firm's assets and liabilities, and therefore of its equity, is

unchanged

As Modigliani and Miller make clear, the value of a firm ultimately derives from its

underlying free cash flow. A firm's free cash flow determines the level of payouts that it can make to its investors.

No arbitrage implies 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.

The fact that firms continue to issue dividends despite their tax dis-advantage is often referred to as the

dividend puzzle

The idea that dividend changes reflect managers' views about a firm's future earnings prospects is called the

dividend signaling hypothesis

This practice of maintaining relatively constant dividends is called

dividend smoothing.

While many investors have a tax preference for share repurchases rather than dividends, the strength of that preference depends on the difference between the dividend tax rate and the capital gains tax rate that they face.

Tax rates vary by income, jurisdiction, investment horizon, and whether the stock is held in a retirement account.

Why, then, do companies pay stock dividends or split their stock?

The typical motivation for a stock split is to keep the share price in a range thought to be attractive to small investors.

While open market share repurchases represent about 95% of all repurchase transactions, other methods are available to a firm that wants to buy back its stock.

These methods are used when a firm wishes to repurchase a substantial portion of its shares, often as part of a recapitalization.

asymmetric information

When managers have better information than investors regarding the future prospects of the firm, their payout decisions may signal this information

the dividend-capture theory. This theory states that

absent transaction costs, investors can trade shares at the time of the dividend so that non-taxed investors receive the dividend.

The effective dividend tax rate t*d measures the

additional tax paid by the investor per dol-lar of after-tax capital gains income that is instead received as a dividend.

There is no benefit to shareholders when a firm 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 firm.

Just before the ex-dividend date, the stock is said to trade cum-dividend ("with the dividend") because

anyone who buys the stock will be entitled to the dividend

The advantage of holding cash to cover future potential cash needs is that this strategy allows a firm to

avoid the transaction costs of raising new capital

An alternative way to pay cash to investors is through a share repurchase or buyback. In this kind of transaction, the firm uses cash to

buy shares of its own outstanding stock.

When a firm pays interest, it receives a tax deduction for that interest, whereas when a firm receives interest, it owes taxes on the interest.

cash is equivalent to negative leverage, so the tax advantage of leverage implies a tax disadvantage to holding cash.

To compare investor preferences, we must quantify the

combined effects of dividend and capital gains taxes to determine an effective dividend tax rate for an investor.

Differences in tax preferences across investor groups create clientele effects, in which the

dividend policy of a firm is optimized for the tax preference of its investor clientele.