Master in Finance

Corporate Financing Planning

4. Payout Policy

Bibliography
- Berk and DeMarzo (2020) Ch 17 pages 635-674
Outline
1. Distributions to Shareholders
2. Comparison of Dividends and Share Repurchases
3. The Tax Disadvantage of Dividends
4. Dividend Capture and Tax Clienteles
5. Payout Versus Retention of Cash
6. Signaling with Payout Policy
7. Stock Dividends, Splits and Spin-offs
4.1 Distributions to Shareholders
The way a firm chooses between the alternative ways to
distribute free cash flow to equity holders
A) Cash Dividends: Procedure

Declaration date: The board of directors declares a payment of

dividends.
Record date: The declared dividends are distributable to shareholders
of record on a specific date.
Ex-dividend date: Seller of the stock retains the dividend.
Payment date: The dividend checks are mailed to shareholders of
record.
5
B) Cash Dividends: Type of Dividends
• Regular Dividend: companies regularly pay cash dividends
• Special Dividend: a one-time dividend payment a firm makes,
which is usually much larger than a regular dividend
• Stock Split (Stock Dividend): when a company issues a
dividend in shares of stock rather than cash to its
shareholders
• Dividend in Kind:(e.g., Wrigley’s Gum sends a box of chewing
gum, Dundee Crematoria offers shareholders discounted
cremations)
• Liquidating Dividend: a return of capital to shareholders from
a business operation that is being terminated
C) Share Repurchases
An alternative way to pay cash to investors is through a
share repurchase or buyback.
– The firm uses cash to buy shares of its own
outstanding stock.

1. Open Market Repurchase

When a firm repurchases shares by buying shares in the open
market
Open market share repurchases represent about 95% of all
repurchase transactions.
2. Tender Offer
A public announcement of an offer to all existing security
holders to buy back a specified amount of outstanding
securities at a prespecified price (typically set at a 10% to 20%
premium to the current market price) over a prespecified
period of time (usually about 20 days).
If shareholders do not tender enough shares, the firm may
cancel the offer, and no buyback occurs.
3. Dutch Auction
A share repurchase method in which the firm lists different 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.
4. Targeted Repurchase
When a firm purchases shares directly from a specific shareholder
5. Greenmail
When a firm avoids a threat of takeover and removal of its
management by a major shareholder by buying out the
shareholder, often at a large premium over the current market
price
4.2. Dividends versus Share Repurchases: Example
Consider Genron Corporation. The firm’s board is meeting to decide how
to pay out $20 million in excess cash to shareholders.
Genron has no debt, its equity cost of capital equals its unlevered cost of
capital of 12%.

Enterprise Value = PV (FutureFC $48million

Assets Liabilities & Equity

Cash $20 million Debt $0 million
Assets $400 million Equity $420 million
Total Assets $420 million Total Debt & Equity $420 million
The firm has 10 million shares outstanding with current stock price $42.
Payout Policy 1: Pay Dividend with Excess
Cash (1 of 4)
With 10 million shares outstanding, Genron will be able to pay
a $2 dividend immediately.
The firm expects to generate future free cash flows of $48
million per year; thus, it anticipates paying a dividend of $4.80
per share each year thereafter.
Payout Policy 1: Pay Dividend with Excess
Cash (2 of 4)
Cum-dividend
When a stock trades before the ex-dividend date, entitling
anyone who buys the stock to the dividend
The cum-dividend price of Genron will be
4.80
Pcum = Current Dividend + PV (Future Dividends) = 2 + = 2 + 40 = $42
0.12
Payout Policy 1: Pay Dividend with Excess
Cash (3 of 4)
After the ex-dividend date, new buyers will not receive the
current dividend and the share price and the price of
Genron will be
4.80
Pex = PV (Future Dividends) = = $40.
0.12
Assets Liabilities & Equity
Cash $0 million Debt $0 million
Assets $400 million Equity $400 million
Total Assets $400 million Total Debt & Equity $400 million

The number of shares is unchanged (10 million).

Payout Policy 1: Pay Dividend with Excess
Cash (4 of 4)
December 11 December 12
(Cum-Dividend) (Ex-Dividend)
Cash 20 0
Other assets 400 400
Total market value 420 400
Shares (millions) 10 10
share price $42 $40

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.
Lessons: Price Behavior around Dividend Payments
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.
-t … -2 -1 0 +1 +2 …

$P

$P - Div
The price drops by Ex-
the amount of the dividend
cash dividend Date
Note: Taxes complicate things a bit. Empirically, the price drop is less than
the dividend and occurs within the first few minutes of the ex-date
Payout Policy #2: Share Repurchase, spending $20m
With an initial share price of $42, Genron will repurchase:
$20 million
= 0.476 million shares.
$42

This leaves the company with 10 - 0.476 = 9.524 million shares

Assets Liabilities & Equity
Cash $0 million Debt $0 million
Assets $400 million Equity $400 million
Total Assets $400 million Total Debt & Equity $400 million

In future years, the firm expects a FCF of $48 million, or

$48million/9.524million= $5.04 per share, which corresponds to the
price of $42: P =
5.04
= $42
rep
0.12
Payout Policy #2: Share Repurchase, spending $20m
The net effect is that the share price remains unchanged.
Lessons: Price Behavior around Stock Repurchases

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.
What would investors prefer? Payout Policy #1 or #2?
Investors should be indifferent. Consider an investor currently
holding 2,000 shares of Genron.
• With the cash dividend, investors get:
- $2 *2,000=$4000 in cash;
- $40*2,000=$80,000 in stock.
• With the stock repurchase investors get:
- $42*2,000=$84,000 either in cash (if sold to firm) or
in stock (if held to the stock).
What would investors prefer? Payout Policy #1 or #2?
If the investor is not happy with the amount of cash that she is
making, she can sell or buy shares. We call this Homemade
Dividends.
– if the firm repurchases shares and the investor wants
cash, the investor can raise cash by selling shares.
– If the firm pays a dividend and the investor would prefer
stock, they can use the dividend to purchase additional
shares
Lesson: Dividend Policy Irrelevance in a Perfect World

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.
Payout Policy #3: High Dividend (Equity Issue)
Suppose Genron wants to pay an even larger dividend than $2 per
share right now, $4.8. To be able to spend $48 million right away, the
firm would need to raise $28 million new equity immediately. Given a
current stock price of $42, the firm would raise:
28 million
= 0.67 million shares
$42 per share
The number of shares outstanding would raise to 10.67 million.
Assets Liabilities & Equity
Cash $48 million Debt $0 million
Assets $400 million Equity $448 million
Total Assets $448 million Total Debt & Equity $448 million
Payout Policy #3: High Dividend (Equity Issue)
The amount of Dividend per share each year would be:
$48 million
= $4.50 per share.
10.67 million shares
We can confirm the cum-dividend share price:
4.50
Pcum = 4.50 + = 4.50 + 37.50 = $42.
0.12
Assets Liabilities & Equity
Cash $0 million Debt $0 million
Assets $400 million Equity $400 million
Total Assets $400 million Total Debt & Equity $400 million

and indeed the ex-dividend price per share of

$400million/10.67million = $37.50.
Lesson: Dividends and Investment Policy

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.
4.3 The Tax Disadvantage of Dividends
Shareholders must pay taxes on the dividends they receive and
they must also pay capital gains taxes when they sell their
shares. Dividends are typically taxed at a higher rate than
capital gains. In fact, long-term investors can defer the capital
gains tax forever by not selling.

Long-Term Capital
Gains Versus
Dividend Tax Rates
in the United
States, 1971–2009
4.3 The Tax Disadvantage of Dividends
The higher tax rate on dividends makes it undesirable for a firm to
raise funds to pay a dividend.
When dividends are taxed at a higher rate than capital gains, if a
firm raises money by issuing shares and then gives that money
back to shareholders as a dividend, shareholders are hurt
because they will receive less than their initial investment.

When the tax rate on dividends is greater than the tax rate on capital
gains, shareholders will pay lower taxes if a firm uses share
repurchases rather than dividends.
This tax savings will increase the value of a firm that uses share
repurchases rather than dividends.
Example
Assume
▪ A firm raises $25 million from shareholders and uses this
cash to pay them $25 million in dividends.
▪ Dividends are taxed at a 39% tax rate.
▪ Capital gains are taxed at a 20% tax rate.
– How much will shareholders receive after taxes?
Solution
On dividends, shareholders will owe:
39% × $25 million = $9.75 million in dividend taxes.
The value of the firm will fall when the dividend is paid, lowering the
shareholders’ capital gains. Shareholders will lower their capital gains
taxes by:
20% × $25 million = $5 million
Shareholders will pay a total of $4.75 million in taxes.
$9.75 − $5.00 = $4.75 million
Shareholders will receive back only $20.25 million of their $25 million
investment.
$25 − $4.75 = $20.25 million
4.4 Dividend Capture and Tax Clienteles
The preference for share repurchases rather than
dividends depends on the difference between the dividend
tax rate and the capital gains tax rate.
• Tax rates vary by income, investment horizon and by
whether the stock is held in a retirement account.
Given these differences, firms may attract different groups
of investors depending on their dividend policy.
A) Effective Dividend Tax Rate
Consider buying a stock just before it goes ex-dividend and
selling the stock just after. The equilibrium (no arbitrage)
condition must be:
(Pcum − Pex ) (1 −  g ) = Div(1 −  d )
which can be stated as
1 −    d −  g 
Pcum − Pex = Div  d
1 − g 
= Div  1 −
 1 −  
= Div  (1 −  )
*
d
   g 

where Pcum is the cum-dividend price, Pex is the ex-dividend

price, g is the capital gains rate tax, d is the dividend tax
rate.
A) Effective Dividend Tax Rate
Thus, the effective dividend tax rate is
d −  g 
 *
=
d
 1 − g 
 
This measures the additional tax paid by the investor per
dollar of after-tax capital gains income that is instead
received as a dividend.
Changes in the Effective Dividend Tax Rate

Problem
Consider an individual investor in the highest U.S. tax
bracket who plans to hold a stock for more than one year.
What was the effective dividend tax rate for this investor
in 2002? How did the effective dividend tax rate change
in 2003? (Ignore state taxes.)
Solution
In 2002 we have
d = 39% and  g = 20%. Thus

0.39 − 0.20
*d = = 23.75%
1 − 0.20
This indicates a significant tax disadvantage of dividends; each $1 of
dividends is worth only $0.7625 in capital gains. However, after the
2003 tax cut, τ d = 15% and τ g = 15%, and
0.15 − 0.15
 =
*
= 0%
1 − 0.15
d

Therefore, the 2003 tax cut eliminated the tax disadvantage of

dividends for a one-year investor.
B) Tax Differences Across Investors
The effective dividend tax rate differs across investors for a
variety of reasons.
• Income Level: different levels of income fall into different
tax brackets (US)
• Investment Horizon: Capital gains on stocks held less
than 1 year, and dividends on stocks held less than 61
days are taxed at higher ordinary income tax rates.
• Long-term investors can defer payment of capital gains
taxes.
• Investors who plan to bequeath shares to their heirs
may avoid capital gains taxes altogether.
B) Tax Differences Across Investors
The effective dividend tax rate differs across investors for a
variety of reasons.
• Type of Investor or Investment Account
• Stocks held by individual investors in retirement accounts are not
subject to taxes on dividends or capital gains (US)
• Stocks held through pension funds or nonprofit endowment
funds are not subject to dividend or capital gains taxes (US)
• Corporations that hold stocks are able to exclude 70% (or even
80% if they hold more than 20% of the firm’s equity) of dividends
they receive from corporate taxes, but are unable to exclude
capital gains
As a result of their different tax rates investors will have varying
preferences regarding dividends.
C) Clientele Effect
Clientele Effect: When the dividend policy of a firm reflects the
tax preference of its investor clientele.
Individuals in the highest tax brackets have a preference for
stocks that pay no or low dividends, whereas tax-free
investors and corporations have a preference for stocks with
high dividends.
D) Dividend-Capture Theory
Absent transaction costs, investors can trade shares at the time
of the dividend so that non-taxed investors receive the dividend.
An implication of this theory is that we should see large trading volume in a stock
around the ex-dividend day, as high-tax investors sell and low-tax investors buy
the stock in anticipation of the dividend, and then reverse those trades just after
the ex-dividend date.

Volume and Share

Price Effects of Value
Line’s Special
Dividend
4.5 Payout versus Retention of Cash
In perfect capital markets, once a firm has taken all
positive-NPV investments, it is indifferent between saving
excess cash and paying it out.

With 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.
A) Retaining Cash with Perfect Capital Markets
With perfect capital markets, the retention versus payout
decision is irrelevant.
– If a firm has already taken all positive-NPV projects, any
additional projects it takes on are zero or negative-NPV
investments. Rather than waste excess cash on negative-
NPV projects, a firm can use the cash to purchase
financial assets.
– In perfect capital markets, buying and selling securities is
a zero-NPV transaction, so it should not affect firm value.
Delaying Dividends with Perfect Markets
Problem
Barston Mining has $100,000 in excess cash. Barston is
considering investing the cash in one-year Treasury bills
paying 6% 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?
Solution
If Barston pays an immediate dividend, the shareholders receive
$100,000 today. If Barston retains the cash, at the end of one year
the company will be able to pay a dividend of

$100,000  (1.06) = $106,000

This payoff is the same as if shareholders had invested the

$100,000 in Treasury bills themselves. In other words, the present
$106,000
value of this future dividend is exactly = $100,000.Thus,
(1.06)
shareholders are indifferent about whether the firm pays the
dividend immediately or retains the cash.
Lesson: 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 share price.
B) Retaining Cash with Imperfect Markets (Taxes)
Corporate taxes make it costly for a firm to retain excess
cash.

Cash is equivalent to negative leverage, so the tax

advantage of leverage implies a tax disadvantage to
holding cash.
Retaining Cash with Corporate Taxes
Problem
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?
Solution
If Barston pays an immediate dividend, shareholders receive
$100,000 today. If barston retains the cash for one year, it will earn
an after-tax return on the Treasury bills of

6%  (1 − 0.35 ) = 3.90%
Thus, at the end of the year, Barston will pay a dividend of $100,000
× (1.39) = $103,900.
This amount is less than the $106,000 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 in earns, there is a tax disadvantage to retaining cash.
Pensin fund investors will therefore prefer that Barston pays the
dividend now.
C) Adjusting for Investor Taxes
The decision to pay out versus retain cash may also affect
the taxes paid by shareholders.
• 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. In essence,
the interest on retained cash is taxed twice.

• If the firm paid the cash to its shareholders instead, they

could invest it and be taxed only once on the interest that
they earn.
D) Issuance and Distress Costs
Generally, firms retain cash balances to cover potential
future cash shortfalls, despite the tax disadvantage to
retaining cash:
• a firm might accumulate a large cash balance if
there is a reasonable chance that future earnings
will be insufficient to fund future positive-NPV
investment opportunities.
The cost of holding cash to cover future potential cash
needs should be compared to the reduction in transaction,
agency, and adverse selection costs of raising new capital
through new debt or equity issues.
E) Agency Costs of Retaining Cash
When firms have excessive cash, managers may use the
funds inefficiently by paying excessive executive perks,
over-paying for acquisitions, etc.
• Paying out excess cash through dividends or share
repurchases, rather than retaining cash, can boost
the stock price by reducing managers’ ability and
temptation to waste resources.

Firms should choose to retain cash to preserve financial

slack for future growth opportunities and to avoid financial
distress costs.
4.6 Signaling with Payout Policy
Dividend Smoothing: The practice of maintaining relatively
constant dividends. Firm change dividends infrequently
and dividends are much less volatile than earnings

GM’s Earnings
and Dividends
per Share,
1985–2008

Management desires to maintain a long-term target level of

dividends as a fraction of earnings.
A) 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 An increase of a firm’s dividend
sends a positive signal to investors might also signal a lack of
that management expects to be able investment opportunities.
to afford the higher dividend for the
foreseeable future.
Conversely, a firm might cut its
• When a firm decreases its dividend, dividend to exploit new positive-NPV
it may signal that management has investment opportunities. In this
given up hope that earnings will case, the dividend decrease might
rebound in the near term and so lead to a positive, rather than
need to reduce the dividend to save negative, stock price reaction.
cash.
B) Signalling and Share Repurchases
Share repurchases are a credible signal that the shares are
undervalued, because if they are over-priced a share
repurchase is costly for long-term shareholders.
If investors believe that managers have better information
regarding the firm’s prospects and act on behalf of long-
term shareholders, then investors will react favorably to
share repurchase announcements.
Example
Clark Industries has 200 million shares outstanding, a current
share price of $30, and no debt. Management believes that the
shares are underpriced, and the true value is $35. Clark plans to
pay $600 million in cash to its shareholders by repurchasing at the
current market price. After the transaction new information comes
out that confirms the manager’s initial perception of total equity
value

What is Clark’s share price after the new information comes out?
Solution
Clark’s initial market cap= $30x200m=$6billion
Clark will repurchases: $600m/$30 = 20 million shares.

After the new information, total equity value is 200million*$35= $7,000 million, of
which $600 million was spent in the repurchase. The current equity value would then
be: $7billion-$600 million=$6.4 billion. On a per share basis this corresponds to a
stock price increase to $6.4 billion/180 million shares = $35.56.
4.7 Stock Dividends, Splits and Spin-offs
A firm can pay a type of dividend that does not involve
cash: Stock Dividend. A shareholder who holds the stock
before the ex-dividend date receives:
• additional shares of the stock itself (called a Stock Split
if higher than 50%)
• Example: a stock dividend of 50% means that each
shareholder receives 1 new share for every two
shares owned - also known as a 3:2 (“3 for 2”) stock
split.
• or shares of a subsidiary (Spin-Off).
A) Stock Dividends
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 equity is unchanged.
• The only thing that is different is 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.
A) Stock Dividends
Why firms pay stock dividends or split their stocks?
To keep price in a range attractive to small investors. Firms
try to keep their shares not:
• too high to increase the demand and liquidity of
the stock and in the end boost the stock price
• too low because of transaction costs (e.g., for
NYSE and NASDAQ the minimum size of one tick
is $0.01, which is larger for stocks with a low
price, in percentage terms.). If the price falls too
low, a firm can engage in a reverse split.
B) Spin-Offs
When a firm sells a subsidiary by selling shares in the
subsidiary alone
• Non-cash special dividends are commonly used to
spin off assets or a subsidiary as a separate
company.

Spin-offs offer two advantages over cash distribution:

– It avoids the transaction costs associated with a
subsidiary sale.
– The special dividend is not taxed as a cash
distribution.