PAYOUT POLICY Outline Past two decade trend in payout policy Stylized facts about dividend payouts and share repurchases Why dividends are irrelevant Why dividends are not irrelevant Tax treatment of dividends vs share repurchases 2 Payout Policy The firm s choice of how much and in what form to distribute its free cash flow to shareholders Dividends Dividends are regular typically quarterly payments to shareholders Firms sometimes pay additional often larger than usual extra or special dividends Timing of dividends 1 Declaration Announcement date 2 Cum Dividend Date Last trading day that includes right to receive the dividend 3 Ex Dividend Date First trading day without the right to receive the dividend i e the day after the Cum Dividend date 4 Payment Date Share Repurchases An alternative way to pay cash to investors is through a share repurchase The firm buys back some of its own shares from shareholders Types of repurchases Open Market Repurchase 95 of all repurchase transactions Targeted Repurchase Firm buys shares directly from a specific shareholder Tender Offer Trends in Payout Policy Most firms make some type of cash payout three quarters of S P 500 firms using dividends repurchases or both Dollar amount of dividends have gradually increased over time but have not kept pace with stock prices Dividend yield fell from about 5 to around 2 over past 2 decades Share Repurchases grew from 1 10 of dividends in 1980 for S P 500 to overtaking dividend payments from 1998 onwards Level of repurchases is more volatile and pro cyclical than dividends 6 The Rise of Repurchases The Rise of Repurchases Modigliani Miller and Payout Policy Irrelevance M M In perfect capital markets payout policy is irrelevant All that matters for value is a firm s free cash flows When payouts are made and whether they are made through dividends or share repurchases does not matter Example Dividends Versus Share Repurchases in a Perfect Capital Market Genron has 20 million in excess cash and no debt The firm expects to generate additional FCF of 48 million per year in subsequent years Genron s unlevered cost of capital is 12 Thus the enterprise value of its ongoing operations is EV 48 million 12 400 million The firm current has 10 million shares outstanding Genron s board is meeting to decide how to pay out the 20 million in excess cash to shareholders The board is considering the following options 1 2 Pay a 2 cash dividend per share 10 million shares Repurchase shares Alternative 1 Pay 2 Dividend per Share Genron s share price just before the stock pays its dividend cumdividend Current Dividend PV Future dividends 4 80 2 2 40 42 0 12 Genron s share price ex dividend 4 80 PV Future dividends 40 0 12 Alternative 2 Share Repurchase 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 Alternative 2 Share Repurchase With an initial share price of 42 Genron will repurchase 20 million 42 0 476 million shares This leaves 10 0 476 9 524 million shares outstanding The market value of Genron s assets falls when the company pays out cash but the number of shares outstanding also falls These two changes offset each other so the share price remains at 42 Alternative 2 Share Repurchase Would an investor prefer that Genron issues a dividend or repurchases stock Suppose an investor holds 2000 shares of Genron Stock The investor s holdings after a dividend or share repurchase are The investor has the same amount of wealth regardless Homemade dividends What if the firm repurchases shares but investor wants some cash The investor could sell some of his her shares to raise cash a homemade dividend What if the firm pays a dividend but the investor does not want any cash The investor could use the dividend to purchase additional shares Objections to M M Why Payout Policy Might Matter Dividends are good Agency problems If managers are not maximizing firm value then it is better to get cash out of the firm Transaction costs If people want cash flow to live on it is easier to receive dividends than to sell shares Dividends are bad Loss of flexibility If it is difficult to cut dividends they reduce financial flexibility Taxes If dividends are taxed more heavily than capital gains firms should substitute repurchases for dividends Taxes on Dividends and Capital Gains Individual shareholders typically must pay taxes on dividends paid and also on the capital gain when they sell their shares If firms do share repurchases instead of dividends the share price will increase so the capital gain will be higher But the tax rate on dividends and capital gains often differs Long Term Capital Gains Versus Dividend Tax Rates in the United States 1971 2010 Optimal Payout Policy with Taxes If dividends are taxed at a higher rate than capital gains then shareholders will prefer share repurchases to dividends Even if the tax rates are the same there is still a tax advantage for share repurchases over dividends because long term investors can defer the capital gains tax until they sell Optimal Payout Policy with Taxes When the dividend tax rate exceeds the capital gain tax rate the firm s optimal payout policy is to pay no dividends at all A Dividend Puzzle The Puzzle Firms continue to pay dividends despite their tax disadvantage Don t firms realize that this is a bad idea from a tax perspective Tax Differences Across Investors Not all investors face the same tax rates on dividends and capital gains Investors tax rates for dividends and capital gains differ based on their 1 2 3 Income Level Investment Horizon Type of Investor e g pensions funds vs individual investor Dividend Clientele Effect When the payout policy of a firm reflects the tax preferences of its investors Payout vs Retention Before choosing between dividends and repurchases a firm must decide how much cash to pay out in the first place Paying out vs Retaining cash in Perfect Capital Markets MM Payout Irrelevance In perfect capital markets and if a firm invests excess cash flows in financial securities the retention vs payout decision is irrelevant Buying and selling securities is a zero NPV transaction so it should not affect firm value Shareholders can make the same investment the firm makes on their own On the other hand if the firm s would otherwise take a positive or negative NPV investment with retained cash the payout vs retention decision will matter