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Terms in this set (45)
the way a firm chooses between the alternative ways to pay cash out to shareholders
alternative uses of free cash flow
retain the cash flow or distribute it to the firm's capital providers as a return on their investment
driver of payout policy decision
whether the firm could better employ the cash flow than could its investors: same as asking whether the firm has enough positive-NPV projects to use the free cash flow, because positive-NPV projects are those that are expected to generate value relative to what investors could generate elsewhere in the capital markets.
retain FCF: invest in new projects or increase cash reserves
payout FCF: repurchase shares or pay dividends
the date on which a public company's board of directors authorizes the payment of a dividend. firm is then legally obligated to make payment.
the specific date set by a public company's board of directors such that the firm will pay a dividend to all shareholders of record on this date. Only shareholders who purchase the stock at least three days prior to (term) receive dividend.
a date, two days prior to a dividend's record date, on or after which anyone buying the stock will not be eligible for the dividend.
payable date (distribution date)
a date, generally within a month after the record date, on which a firm mails dividend checks to its registered stockholders.
a one-time dividend payment a firm makes that is usually much larger than a regular dividend.
return of capital
when a firm, instead of paying dividends out of current earnings (or accumulated retained earnings), pays dividends from other sources, such as paid-in capital or the liquidation of assets.
taxed as a capital gain rather than as a dividend for the investor.
a return of capital to shareholders from a business operation that is being terminated.
the firm uses cash to buy shares of its own outstanding stock.
open market repurchase
when a firm repurchases its own shares by buying them on the open market over time. most common method.
a public announcement of an offer to all existing security holders to buy back a specified amount of outstanding securities at a prespecified price over a short time period, generally twenty days.
price is usually set at a substantial premium (10-20% typically) to the current market price.
offer often depends on shareholders tendering a sufficient number of shares. if shareholders do not (term) enough shares, the firm may cancel the offer and no buyback occurs.
a share repurchase method in which shareholders 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.
when a firm purchases shares directly from a specific shareholder; the purchase price is negotiated directly with the seller.
why targeted repurchase?
a targeted repurchase may occur if a major shareholder desires to sell a large number of shares but the market for shares is not sufficiently liquid to sustain such a large sale without severely affecting the price. under these circumstances, the shareholder may be willing to sell shares back to the firm at a discount to the current market price. alternatively, targeted repurchases may be used if a major shareholder is threatening to take over the firm and remove its management.
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.
alternative 1: pay a dividend with excess cash
in a perfect capital market: no debt. equity cost of capital equals its unlevered cost of capital.
cum dividend --> ex-dividend. after the stock goes ex-dividend, new buyers will not receive the current dividend.
share price will drop on ex-dividend date. the amount of the price drop is equal to the amount of the current dividend.
the share price falls when a dividend is paid because the reduction in cash decreases the market value of the firm's assets.
although the stock price falls, stockholders do not incur a loss overall. ex: stock worth $42 before dividend. after dividend, stock worth $40 and hold $2 in cash dividend = $42.
***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.
when a stock trades before the ex-dividend date, entitling anyone who buys the stock to the dividend.
alternative 2: share repurchase (no dividend)
the market value of the firm's assets falls when the company pays out cash, but the number of shares outstanding also falls. the two changes off-set each other, so the share price remains the same.
by not paying a dividend today and repurchasing shares instead, the firm is able to raise its dividends per share in the future. this increase in future dividends compensates shareholders for the dividends they give up today.
***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.
would an investor prefer that a firm issue a dividend or repurchase its stock?
same initial share price. same portfolio value -- only difference is the distribution between cash and stock holdings. repurchase = all stock. dividends = stock + cash.
***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.
alternative 3: high dividend (equity issue)
initial share value is unchanged by this policy and increasing the dividend has no benefit to shareholders.
if the firm pays a higher current dividend per share, it will pay lower future dividends per share.
ex: if a firm raises the current dividend by issuing equity, it will have more shares and therefore smaller free cash flows per share to pay dividends in the future.
if a firm lowers the current dividend and repurchases its shares, it will have fewer shares in the future, so it will be able to pay a higher dividend per share. the net effect of this trade off is to leave the total present value of all future dividends, and hence the current share price, unchanged.
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.
*in perfect capital markets, buying and selling equity and debt are zero-NPV transactions that do not affect firm value. any choice of leverage by a firm could be replicated by investors using homemade leverage. as a result, the firm's choice of capital structure is irrelevant. regardless of the amount of cash the firm has on hand, it can pay a smaller dividend (and use the remaining cash to repurchase shares) or a larger dividend (by selling equity to raise cash). because buying or selling shares is a zero-NPV transaction, such transactions have no effect on the initial share price. furthermore, shareholders can create a homemade dividend of any size by buying or selling shares themselves.
dividend policy w/perfect capital markets
by using share repurchases or equity issues, a firm can easily alter its dividend payments. because these transactions do not alter the value of the firm, neither does dividend policy.
a firm's choice of dividend today affects the dividends it can afford to pay in the future in an offsetting fashion. although dividends do determine share prices, a firm's choice of dividend policy does not.
as MM made clear, the value of a firm ultimately derives from its underlying free cash flows. a firm's FCFs determine the level of payouts that it can make to investors. in a perfect capital market, whether these payouts are made through dividends or share repurchases does not matter.
taxes on dividends and capital gains
shareholders typically must pay taxes on the dividends they receive. they must also pay capital gains taxes whenever they sell their shares.
when a firm pays a dividend, shareholders are taxed according to the dividend tax rate. if the firm repurchases shares instead, and 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, which has been true until the most recent change to the tax code, 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.
optimal dividend policy with taxes
when 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.
can also express the tax savings in terms of a firm's equity cost of capital.
the optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all.
when firms continue to issue dividends despite their tax disadvantage
dividend tax rate factors
tax rates on dividends and capital gains differ across investors for a variety of reasons:
income level, investment horizon, tax jurisdiction, type of investor or investment account.
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.
corporations enjoy a tax advantage associated with dividends due to the 70% exclusion rule.
when the dividend policy of a firm reflects the tax preferences of its investors clientele
retaining cash with perfect capital markets
once a firm has taken all positive-NPV projects, it is left with the question of whether to retain any remaining cash or distribute it to shareholders. if the firm retains the cash, it can hold the cash in the bank or use it to purchase financial assets. the firm can then pay the money to shareholders at a future time or invest it when positive-NPV investment opportunities become available.
in perf. cap mkt - buying and selling securities is a zeo-NPV transaction - should not affect firm's value. doesn't matter if firm retains or pays it out.
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
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 can be thought of as equivalent to negative leverage, so the tax advantage of leverage implies a tax disadvantage to holding tax.
investor tax adjustments
b/c the dividend tax will be paid whether the firm pays the cash immediately or retains the cash and pays the interest over time, the dividend tax rate does not affect the cost of retaining cash. however, 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 cash to its shareholders instead, they could invest it and be taxed only once on the interest they earn.
-remains a substantial tax disadvantage for the firm to retaining excess cash even after adjusting for investor taxes.
issuance and distress costs
firms retain cash balances to cover potential future cash shortfalls.
-advantage of doing this: allows a firm to avoid the transaction costs of raising new capital (thru new debt or equity issues)
-a firm must therefore balance the tax costs of holding cash with the potential benefits of not having to raise external funds in the future. firms with very volatile earnings may also build up cash reserves to enable them to weather temporary periods of operating losses. by holding sufficient cash, these firms can avoid financial distress and its associated costs.
agency costs of retaining cash
no benefit to shareholders when a firm holds cash above and beyond its future investment or liquidity needs.
-likely to be 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 overpaying for acquisitions.
-leverage is one way to reduce a firm's excess cash.
-thus, paying out cash thru dividends or share repurchases can boost the stock price by reducing manger's ability and temptation to waste resources.
the practice of maintaining relatively constant dividends
why dividend smoothing?
John Lintner suggested that these observations resulted from:
1. management's belief that investors prefer stable dividends with sustained growth
2. management's desire to maintain a long-term target level of dividends as a fraction of earnings.
-thus, 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.
-firms generally set dividends at a level they expect to be able to maintain based on the firm's earning prospects
if firms smooth dividends, the firm's dividend choice will contain info regarding management's expectations of future earnings:
1. when a firm increases its dividends, it sends a positive signal to investors that management expects to be able to afford the higher dividend for the foreseeable future.
2. 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 hypothesis
the idea that dividend changes reflect managers' views about a firm's future earnings prospects.
-an increase in dividend may signal management's optimism regarding future cash flows, may also signal a lack of investment opportunities.
-firm may cut its dividends to exploit new positive-NPV investment opportunities. (in this case, the dividend decrease might lead to a positive, rather than negative, stock price reaction)
signaling and share repurchases
1. managers are much less committed to share repurchases than to dividend payments.
2. firms do not smooth their repurchase activity from year to year, as they do with dividends. aka announcing a share repurchase today does not necessarily represent a long-term commitment to repurchase shares. (SRP may be less of a signal that dividends are about future earnings of a firm)
3. the cost of a SRP depends on the market price of the stock.
-if managers believe the stock is currently over-valued, a SRP will be costly -- buying the stock at its current (over-valued) price is a negative-NPV investment.
-repurchasing shares when managers perceive the stock to be undervalued is a positive-NPV investment. managers will clearly be more likely to repurchase shares if they believe the stock to be undervalued.
stock dividend (stock split)
when a company issues a dividend, in shares of stock rather than cash to its shareholders.
ex: 10% (term) -- each shareholder will receive one new share of stock for every ten shares already owned.
stock dividends of 50% or higher are referred to as stock splits. 50% -- each shareholder will receive one new share for each 2 shares owned. (also called a 3 for 2 split). 100% stock dividend = 2:1 split
no cash is paid out.
when a firm sells a subsidiary by selling shares as a non-cash special dividend in the subsidiary alone.
1. for a given payout amount, try to maximize the after-tax payout to the shareholders. repurchases and dividends are often taxed differently and one can have an advantage over the other.
2. repurchases and special dividends are useful for making large, infrequent distributions to shareholders. neither implies any expectation of repeated payouts.
3. starting and increasing a regular dividend is seen by shareholders as an implicit commitment to maintain this level of regular payout indefinitely. only set regular payouts to reduce a firm's financial flexibility.
4. 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 share repurchases. however, this signal comes with a cost because regular payouts reduce a firm's financial flexibility.
5. be mindful of future investment plans. there are transaction costs associated with both distributions and raising new capital to fund a project. it would be better to make a smaller distribution and fund the project internally.
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