CHAPTER 5

PAYOUT POLICY

Nguyen Thu Hang

 Chapter Outline
1. Distributions to Shareholders
1.1. Dividends
1.2. Share repurchases
2. Dividends and Share repurchases
2.1. Pay Dividend with Excess Cash
2.2. Share Repurchase
2.3. High Dividend
2.4. Modigliani–Miller and Dividend Policy Irrelevance
3. Tax Disadvantage of Dividends
3.1. Do taxes affect investors’ preferences for dividends versus
share repurchases?
3.2. Optimal Dividend Policy with taxes
3.3. Effective Dividend Tax rate
4. Payout Versus Retention of Cash
 Outline
• Types of dividend
• Dividend Theory
• Dividend policy
Distributions to Shareholders
 Types of dividend

 Cash dividend.
 Stock dividend.
 Share repurchase.
Important dates
 I. Important dates

Declaration Ex-dividend day Record day Payment

day day

2 – 4 weeks 2 - 3 days 2 – 4 weeks

How does share price change after dividend payout?
 I
 D/P

Phương Xuân Mai Linh

Dividend 1.000 VND 800 VND
Price 33.300 VND 22.600 VND
D/P 3,00% 3,54%
 IStock
I Dividend

 Tuấn Bách Company

USD
Paid-in capital (Common stocks) 10.000
Share premium 210.000
Undistributed earnings 290.000
Total Equity 500.000
Price per share 66
 I Stock Dividend
 Tuấn Bách announces stock dividend 10%.

USD
Book Cal. Price
Paid-in capital($1par) 11.000 10.000×1,1
Share premium 200.000 66/1.1
Undistributed 290.000 = 60
289.000
earnings -10.000*0.1 USD
Total Equity 500.000
 Stock split
 Tuấn Bách announces stock split 2:1

Book (USD)
Paid-in capital($0,5 par, 20.000 shares) 10.000
Share premium 200.000
Undistributed earnings 290.000
Total Equity 500.000
 ICash dividend
 Diệu Lê Company: 100,000 shares outstanding,
price $10. Net income $49000.

Assets (‘000USD) Liabilities (‘000USD)

Cash 300 Liabilities 200
Other 900 Equity 1.000
Total 1.200 Total 1.200
 Cash dividend
 Diệu Lê pays 300.000 USD cash dividend, (3
USD per share).

Assets Liabilities
Cash 0 Liabilities 200
Other 900 Equity 700
Total 900 Total 900
 IRepurchase
 Diệu Lê uses 300.000 USD to buy back shares.
Price: $10 per share => 300.000/10 = 30.000
shares.

Assets Liabilities
Cash 0 Liabilities 200
Other 900 Equity 700
Total 900 Total 900
 Share Repurchases
• An alternative way to pay cash to investors.
• The firm uses cash to buy shares of its own
outstanding stock.
• These shares are generally held in the
corporate treasury, and they can be resold if
the company needs to raise money in the
future.
 Example: Dividend Policy
• Genron Corporation 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.
• Unlevered cost of capital is 12%,
• The enterprise value of its ongoing operations is
$48 million/12%= $400 million.
• Including the cash, Genron’s total market value is
$420 million.
 Dividend Policy
Using the $20 million to pay a $2 cash dividend
Repurchasing shares instead of paying a
dividend.
Raising additional cash and pay an even larger
dividend today, in anticipation of the high
future free cash flows it expects to receive.
 Will the amount of the current dividend
affect Genron’s share price?
 Which policy would shareholders prefer?
 Pay Dividend with Excess Cash
• Record date: December 14, Ex-dividend date:
December 12.
• Just before the ex-dividend date, cum-dividend-
price(“with the dividend”):
Pcum = Current Dividend + PV(Future Dividends)
= 2 + 4.80/0.12 = 2 + 40 = $42
• After the stock goes ex-dividend, new buyers will
not receive the current dividend. Ex-dividend
price:
Pex = PV (Future Dividends) =4.80/0.12= $40
 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.
Share Repurchase
 High Dividend (Equity Issue)
• Genron raises $28 million by selling 0.67
million shares to pay high dividend this year.
• The amount of the dividend per share each
year: $48 million/10.67 million shares=$4.50
per share.
• Genron’s cum-dividend share price is
Pcum = 4.50 +4.50/0.12= 4.50 + 37.50 = $42
 Modigliani–Miller and Dividend Policy
Irrelevance
• 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.

• MM Dividend 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.
Taxes on Dividends and Capital gains
 Do taxes affect investors’ preferences for
dividends versus share repurchases?
• Cash dividend: shareholders are taxed
according to the dividend tax rate.
• Share repurchase: shareholders sell shares to
create a homemade dividend, the homemade
dividend will be taxed according to the capital
gains tax rate.
• If dividends are taxed at a higher rate than
capital gains, shareholders will prefer share
repurchases to dividends.
 Do taxes affect investors’ preferences for
dividends versus share repurchases?
• The higher tax rate on dividends also makes it
undesirable for a firm to raise funds to pay a dividend.
• Absent taxes and issuance costs, if a firm raises
money by issuing shares and then gives that money
back to shareholders as a dividend  shareholders
are no better or worse off- they get back the money
they put in.
• When dividends are taxed at a higher rate than capital
gains  Shareholders will receive less than their
initial investment.
 Optimal Dividend Policy with taxes
(The tax rate on dividends exceeds the tax rate on capital gains)

• Shareholders will pay lower taxes if a firm uses

share repurchases for all payouts rather than
dividends.
• This tax savings will increase the value of a firm that
uses share repurchases rather than dividends. 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 
Increase the cost of capital
• The optimal dividend policy is to pay no dividends
at all.
Trends in the Use of Dividends and
Repurchases
The Changing Composition of Shareholder
Payouts
 Problem

1. Suppose a firm raises $10 million from shareholders

and uses this cash to pay them $10 million in
dividends. If the dividend is taxed at a 40% rate, and
if capital gains are taxed at a 15% rate, how much will
shareholders receive after taxes?
 Concept Check

 What is the optimal dividend policy when the

dividend tax rate exceeds the capital gains tax
rate?
 The Effective Dividend Tax Rate
• Consider an investor who buys a stock today just
before it goes ex-dividend, and sells the stock just
after
Her after-tax cash flow from the dividend: Div(1   d )
 The price just before the stock goes ex-dividend, Pcum
exceeds the price just after, Pex Her after-tax loss is
(Pcum –Pex)(1-τg).
 The investor earns a profit by trading to capture the
dividend if the after-tax dividend exceeds the after-
tax capital loss.
 The Effective Dividend Tax Rate
 The investor earns a profit by trading to capture the
dividend if the after-tax dividend exceeds the after-tax
capital loss.
 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.
 There is an arbitrage opportunity unless the price drop and
dividend are equal after taxes:
(Pcum –Pex)(1-τg)= Div(1- τd)
 The Effective Dividend Tax Rate
(Pcum –Pex)(1-τg)= Div(1- τd)

E ffective dividend tax rate:

• The effective dividend tax rate measures the

additional tax paid by the investor per dollar of after-
tax capital gains income that is instead received as a
dividend.
 Payout versus Retention of cash

• How should a firm decide the amount it

should pay out to shareholders and the
amount it should retain?
 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.
 Taxes and Cash Retention
• Suppose Barston must pay corporate taxes at
a 35% rate on the interest it will earn from the
one-year Treasury bill paying 6% 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?
 Case: Tax disadvantage of holding cash

• Microsoft paid special dividend of $3 per

share or $32 billion, during late 2004. If
Microsoft had instead retained that cash
permanently, what would the present value of
the additional taxes be?
 Tax disadvantage of holding cash
• Corporate taxes make it costly for a firm to
retain excess cash.
• 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.
 Agency Costs of Retaining Cash
• No benefit to shareholders when a firm holds cash above
and beyond its future investment or liquidity needs.
• Agency costs associated with having too much cash in the
firm: when firms have excessive cash, managers may use
the funds inefficiently by continuing money-losing pet
projects, paying excessive executive perks, or over-paying
for acquisitions. In addition, unions, the government, or
other entities may take advantage of the firm’s “deep
pockets.”
• Paying out excess cash through dividends or share
repurchases (similar to leverage) can avoid these costs by
reducing waste or the transfer of the firm’s resources to
other stakeholders, boost the stock price.
 Case: Agency Costs of Retaining Cash
• 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 by 12%.
• 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?
• You are the CEO of a company and you are
considering entering into an agreement to
have your company buy another company. You
think the price might be too high, but you will
be the CEO of the combined, much larger
company. You know that when the company
gets bigger, your pay and prestige will
increase. What is your decision?
 Example
Phuong Xuan Corp. (100% equity) has $100 mil.
cash. Corporate tax rate 25%, personal tax rate
15%. Bank-deposit interest rate 5%. No
investment opportunity is viable.
 Should Mai Linh, CEO of Phương Xuân Corp. keep
this amount of cash to deposit it on a bank
account or should he pay out the money to
shareholders (by devidend)?
 Signaling with Payout policy
• When managers have better information than investors
regarding the future prospects of the firm, their payout
decisions may signal this information.
• Firms adjust dividends relatively infrequently, and
dividends are much less volatile than earnings. This
practice of maintaining relatively constant dividends is
called dividend smoothing.
• (1) management’s belief that investors prefer stable
dividends with sustained growth, and (2) management’s
desire to maintain a long-term target level of dividends as
a fraction of earnings.
 Dividend signaling hypothesis
• If firms smooth dividends, the firm’s dividend choice will
contain information regarding management’s
expectations of future earnings.
• 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.
• Dividend signaling is similar to the use of leverage as a
signal.
 Signaling and Share Repurchases
• If managers are acting in the interest of long-term
shareholders and attempting to maximize the firm’s future
share price, they will be more likely to repurchase shares if
they believe the stock to be undervalued.
• Most CFOs believe that they should act in the interests of
the long-term shareholders.
 Share repurchases are a credible signal that management
believes its shares are underpriced.
 If investors believe that managers have better information
regarding the firm’s prospects than they do, then investors
should react favorably to share repurchase
announcements.
• THE END OF CHAPTER 5