Payout Policy in Corporate Finance

Payout Policy

Chapter  17

Chapter Outline

17.1  Cash Distributions to Shareholders

17.2  Dividends Versus Share Repurchase in a

Perfect Capital Market

17.3  The Tax Disadvantage of Dividends

17.4  Payout Versus Retention of Cash

17.5  Signaling with Payout Policy

17.6  Stock Dividends, Splits, and Spin-offs

17.7 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:

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:

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:

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:

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

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 per

Share 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 Market

Problem:



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 Market

Solution:

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 Market

Execute:



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 Market

Evaluate:



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 Market

Problem:



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 Market

Solution:

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 Market

Execute:



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 Market

Evaluate:



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 Market

Problem:



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 Market

Solution:

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 Market

Execute:



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 Market

Evaluate:



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 Taxes

Problem:



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 Taxes

Solution:

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 Taxes

Execute:



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 Taxes

Evaluate:



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 Taxes

Problem:



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 Taxes

Solution:

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 Taxes

Execute:



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 Taxes

Evaluate:



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 Taxes

Problem:



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 Taxes

Solution:

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 Taxes

Execute:



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 Taxes

Evaluate:



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

Growth

Problem:



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

Growth

Solution:

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

Growth

Execute:



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

Growth

Execute (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

Growth

Evaluate:



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?