PAYOUT POLICY2Outline• 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 repurchasesPayout Policy• The firm’s choice of how much and in what form to distribute its free cash flow to shareholdersDividends• 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 date2. Cum-Dividend Date: Last trading day that includes right to receive the dividend3. Ex-Dividend Date: First trading day without the right to receive the dividend (i.e. the day after the Cum-Dividend date)4. Payment DateShare Repurchases• An alternative way to pay cash to investors is through a share repurchase— The firm buys back some of its own shares from shareholdersTypes of repurchases:• Open Market Repurchase — 95% of all repurchase transactions• Targeted Repurchase— Firm buys shares directly from a specific shareholder• Tender Offer6Trends 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 dividendsThe Rise of RepurchasesThe Rise of RepurchasesModigliani-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 matterExample: 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. Pay a $2 cash dividend per share (10 million shares)2. Repurchase sharesAlternative 1: Pay $2 Dividend per ShareGenron’s share price just before the stock pays its dividend (cum-dividend): = CurrentDividend + PV Futuredividends= 2 +4.800.12= 2 + 40 = $42Genron’s share price ex-dividend:= PV Futuredividends =4.800.12= $40Alternative 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 $42Alternative 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 sharesObjections 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 sharesDividends 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 dividendsTaxes 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, 1971–2010Optimal 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 allA 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. Income Level2. Investment Horizon3. 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 investorsPayout 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