c.) If Google were to pay $20 billion as a special dividend, what would be the effect on market value? On the share price? On net income? On earnings per share? What if Google repurchased shares instead? Assume a 1% rate of interest on any cash balance and a 3% interest rate on the debt. Also assume that the deal takes place in early October 2014. Estimate the impact on the Sept. 30, 2014 balance sheet and the income statement for the next 12 months. (HINT: Solve this problem in the Modigliani-Miller setting, and think qualitatively about what would change in the real world.)

Payout Policy at Google

?Decades ago, we used to be worried about companies taking on too much debt,? said Ryan Jacob, manager of the $45 million Jacob Internet Fund, which includes Google shares. ?Now, we?re worried about companies taking on too much cash.?^[1]

In November 2014, Google Chief Financial Officer Patrick Pichette pondered recent payout decisions by some of his competitors, including Apple. Google was sitting on over $60 billion in cash and marketable securities, an amount exceeding 17% of firm market capitalization. Should he consider following in Apple?s footsteps, and start a payout plan for Google?

Google Inc.

Headquartered in Mountain View, California, Google is a technology company focused on products and services to organize information. According to the company website:^[2]

Larry Page, our co-founder and CEO, once described the ?perfect search engine? as something that ?understands exactly what you mean and gives you back exactly what you want.? Since he spoke those words Google has grown to offer products beyond search, but the spirit of what he said remains. With all our technologies?from search to Chrome to Gmail?our goal is to make it as easy as possible for you to find the information you need and get the things you need to do done.

Google was founded in 1995, when founders Larry Page and Sergey Brin met as doctoral computer science students at Stanford University. Incorporated in 1998 in California, the ?Google Guys? started with $1 million in seed capital from family and friends such as Sun Microsystems co-founder Andy Bechtolsheim. Subsequent private equity investors included the well-known Silicon Valley venture capital firms of Kleiner Perkins and Sequoia Capital, who each invested about $13 million in 1999.

Google went public in August 2004 at a price of $85 per share. Stock price performance since then has been exceptional, with total returns approaching 500%, relative to about 125% for the NASDAQ index (see Exhibit 1).

Since its IPO, Google?s financial performance has also been stellar. From a base total revenue of $3.2 billion in 2004, sales have grown at a compound annual rate of almost 40% a year, approaching $60 billion by the end of 2013. (See Exhibit 2 for summary historical financials.) Net profit margins exceeded 20% for most of the last decade. By Sept. 30, 2014, Google?s total net assets had grown to $126 billion, of which $62 billion, or 49%, was cash and marketable securities. Analysts expect Google?s growth to continue, with earnings before interest and taxes (EBIT) for the next 12 months reaching $15.2 billion.

Google has 678.3 million shares outstanding.^[3] With a stock price of $535 per share, its total equity market capitalization exceeds $360 billion. To date, Google has never paid a dividend, although it has modestly repurchased shares (generally in connection with either acquisitions or employee compensation).

Payout Policy

Dividends come in and out of fashion. Total payout (dividends and share repurchases) decreased substantially during the dot.com bubble. Since 2001, however, total payout as a percent of assets more than doubled, from 1.7% in 2001 to over 4.4% in 2007 (see Exhibit 3). Payout declined during the recent financial crisis, but has since recovered close to its 2007 levels.

Repurchases are usually much more variable, and depend strongly on market conditions. Stock buybacks totaled $116.2 billion in the second quarter of 2014, down from almost $160 billion in the first quarter (the second highest level on record).^[4]

Dividend-paying firms have traditionally been larger, more profitable firms with slower growth and fewer internal investment opportunities. As Exhibit 4 shows, dividend yields are lowest for companies in riskier industries such as biotech, internet services and healthcare. Yields for utilities and commodity-based industries are much higher, averaging over 4% in some industries.

Investment Opportunities

Google has been accumulating cash at the rate of $2 to $3 billion per quarter. Before deciding on any payout, Pichette wanted to make sure Google retained the cash it needs to grow Google?s existing businesses. Google historically reinvested a substantial portion of its cash flows in its operations. For example, research and development spending at Apple recently amounted to about 3% of sales, and capital expenditures were about 5%. At Google, both numbers were much higher, closer to 13%.

Google has also acquired over 170 firms since 2001 (and more than 30 so far in 2014).^[5] Notable acquisitions (those of about $1 billion or more) include home automation firm Nest Labs for $4.3 billion in January 2014, GPS navigation software company Waze in June 2013, $12.5 billion for Motorola Mobility in August 2011, the $3.1 billion acquisition DoubleClick in 2007, and $1.65 billion for YouTube in 2006.

Analyst reaction to Google?s acquisitions was generally favorable:

Google has been ?pretty successful? with acquisitions, says Jason Helfstein, an analyst at Oppenheimer & Co. For example, the company has emerged as a dominant force in mobile software thanks to its purchase of Android in 2005. It?s also benefitted in display advertising and user growth from its acquisition of video-sharing site YouTube in 2006.^[6]

Excess cash sometimes tempts managers to make bad acquisitions, or overpay for good ones.

Google could make an argument for holding on to its cash, by saying it needs the money for deals or investing in new businesses. Still, a dividend or buyback could assuage investor concerns that Google might instead make an unneeded, large acquisition, said Tim Ghrisky, who as co-founder of Solaris Group helps oversee about $2 billion in assets, including Google shares.^[7]

Pichette was also aware of other issues at neighboring Silicon Valley firms. Venture capital had been pouring into startups during 2014. This trend was causing concern among venture capitalists about wasteful expenses such as luxurious office spaces, high salaries and extravagant, catered lunches. ?Andreessen Horowitz co-founder Marc Andreessen has warned entrepreneurs about overspending, punctuating a string of tweets with the word, ?Worry.??^[8] Similar problems can easily occur at larger, more established companies with high free cash flows.

Pichette wondered whether he should be concerned about these issues at Google. Google?s perquisites for employees, such as the well-stocked cafeteria at many of its locations, were famous. Pichette was convinced that these benefits helped Google attract and retain the skilled technical employees who are in such high demand in its industry. He also understood that dividends represented a stronger pledge:

?Dividends are reliable,? notes Robert Arnott, chairman of Research Affiliates, a money manager in Newport Beach, Calif. ?You cut them at your peril. But you can cut a buyback and hardly anybody notices.?^[9]

If he really wanted to let analysts know that Google had no intention of wasting cash, committing to a large dividend payout would be a stronger way to send his message.

Signaling

Although dividends used to be rare for technology companies, they have become increasingly more common.

Technology companies for years resisted paying dividends on the theory that their earnings growth would reward shareholders with higher stock prices. But share price appreciation ended for many companies after the stock market bubble burst in 2000.^[10]

How would the market react to announcement by Google of a dividend or stock repurchase? Many investors and analysts worry that returning cash to investors means that the company does not have good growth opportunities within the firm, or that management isn?t reinvesting as much as it should to sustain long-term growth. On the other hand, the decision to repurchase company stock would signal that management views the stock as undervalued, and therefore a good investment opportunity.

Dividend Taxation

Pichette also considered the tax consequences of potential payouts for Google?s shareholders. (Exhibit 5 has a list of Google?s 10 largest shareholders as of year-end 2013). In the U.S., corporate profits are taxed twice. Payout is made from after-corporate-tax dollars, and investors must pay taxes on the income. Historically, tax rates on dividends have been higher than tax rates on capital gains (see Exhibit 6).^[11]

In 2003, tax reform passed under President George Bush reduced tax rates on both capital gains and dividends to 15%. Although the Bush tax cuts were originally set to expire at the end of 2010, they were temporarily extended in 2010 and made permanent by the American Taxpayer Relief Act of 2012. Uncertainty leading up to the 2012 act prompted a flurry of last-minute special dividends by companies trying to take advantage of the lower tax rates before they expired. For example, discount retailer Costco sold $3.5 billion of bonds in November 2012 to finance a $3 billion special dividend. Although the 2012 Act made favorable tax treatment permanent for qualified dividends, it raised tax rates on both dividends and capital gains to 20%.

Google has not previously paid a dividend. Pichette imagined that many Google?s major investors bought Google stock precisely because it was a non-dividend paying, high growth company. He worried about the impact of a large change in payout policy on the portfolios of his investors.

Executive Compensation

As was common at technology companies, many Google executives and employees had equity-based compensation. Google founders Larry Page and Sergey Brin each owned over 46 million shares of Google?s Class B stock.

Companies regularly repurchase stock to offset new shares issued as part of employee compensation. ?Many buyback programs appear to be prompted less by a company?s enthusiasm for its own shares and more by a desire to offset the dilution caused by executives exercising stock options.? ^[12]

Employee options are typically not adjusted for dividends, to the detriment of employees who own options rather than actual shares. Also, ?there?s an incentive for companies to buy back stock, rather than pay dividends. Buybacks can push up share prices, making management?s stock options more valuable.?^[13]

Cash Balances and Repatriation Taxes

Many companies, including technology companies, have accumulated large cash balances in part because of successful overseas operations. (Exhibit 7 lists the top 6 in terms of cash and equivalents as of fiscal-year-end 2013.) In early 2013, shortly before it announced a large payout, Apple had $145 billion in cash, only $45 billion of which was in the U.S.^[14] About 50% of Google?s cash is overseas.^[15]

Given current tax laws, companies pay taxes on foreign earnings at the tax rate of the country in which they earn the profits. However, if they bring the cash back to the U.S. (for example, to use it to pay a dividend), they will owe ?repatriation taxes? on these profits equal to the difference in taxes owed at the U.S. corporate rate (now 35% for most large companies) and the typically lower rate in the foreign country. Companies with large overseas operations often choose to leave the cash abroad and avoid paying the repatriation tax penalty. They may use their overseas cash to invest overseas (such as Microsoft?s $8.5 billion deal to acquire Skype in 2011 or its $7 billion purchase of Nokia?s core cellphone business in September 2013). Also, ?overseas? cash need not be invested abroad; it may be held in U.S. assets. But it must be repatriated before it can be used to fund a payout.

Interestingly, cash and ?equivalents? are often invested in very risky securities. In a recent working paper, Duchin, Gilbert, Harford and Hrdlicka (2014) show that risky securities (including assets such as mortgage-backed securities, which are clearly not ?cash equivalents?) comprise 27% of corporate cash holdings.^[16] To manage its substantial cash and short-term investment portfolio, in 2010 Google hired professional investment managers, including bond traders and portfolio managers, to set up a new trading floor in the company?s Mountain View headquarters.^[17]

Payout Policy at Other Tech Companies

Over the past two decades, several other large tech companies initiated dividends (see Exhibit 8). Apple paid dividends in its earlier years, but cancelled them beginning in 1996 as the company went through a difficult financial period. Intel?s dividend dates back to 1992, and Microsoft initiated dividends in 2003, right around the time of the Bush tax cuts. After long resisting dividends, Cisco paid its first-ever quarterly dividend in March 2011. So far, other tech giants including Yahoo, eBay and Amazon have yet to join the dividend party.

Apple?s Payout

In March, 2012, Apple announced plans to initiate a dividend and share repurchase program. The initial quarterly dividend of $2.65/share would begin in July of that year. The repurchase program would consist of $10 billion, executed over the next three years, for a total payout of $45 billion over that period.

In early 2013, Apple increased its quarterly dividend to $3.05 a share, bumping its total payout up to $100 billion. To avoid repatriation taxes on its overseas cash, on April 30, 2013 Apple sold a record-setting $17 billion in corporate bonds. As described by Bloomberg:^[18]

Apple issued $3 billion of floating-rate notes and $14 billion of fixed-rate securities in six parts with maturities from three to 30 years?Proceeds may help the company avoid repatriation taxes on its $102.3 billion of funds held overseas as Chief Executive Officer Tim Cook returns an additional $55 billion to shareholders through 2014 to compensate for a stock that?s been hammered by signs of slowing growth.

Interest rates on the debt ranged from 0.45% on the three-year debt to 3.85% on the 30-year bonds. The bonds were rated AA+/Aa1, despite Apple?s large cash balance of over $145 billion. Rating agencies may be reluctant to give firms full credit for their cash when rating debt, because companies can pay out cash or use it for other purposes such as acquisitions before the maturity of the debt.

Apple again announced in April 2014 that it would increase its share repurchase program by $30 billion, boost its dividend, and split its stock 7 for 1. However, this increase was still not enough to satisfy some of its investors. In an open letter to Apple CEO Tim Cook posted on his website in October 2014, activist investor Carl Icahn (owner of about 1% of Apple stock) urged Apple to increase its payout even further.^[19]

We are simply asking you to help us convince the board to repurchase a lot more, and sooner. We feel compelled to do so because we forecast such impressive earnings growth over the next few years, and therefore we believe Apple is dramatically undervalued in today?s market, and the more shares repurchased now, the more each remaining shareholder will benefit from that earnings growth.

The Decision

After watching recent events at Apple, Pichette pondered Google?s next steps. In 2010, Bloomberg ranked Google as the most well-positioned company in the Standard and Poor?s 500 to initiate a dividend.^[20] Fortunately, Google was not yet on the receiving end of strong activitist-shareholder pressure to increase its payout. But its cash balance had almost doubled since 2010. With current cash and equivalents of over $60 billion and strong operating profits, such pressure could be imminent.

As a first step, Pichette contemplated distributing a third of Google?s cash, or $20 billion. Given Google?s ample cash balances, he should be able to fund that amount without issuing debt or triggering any repatriation taxes. Should Google proceed with a transaction like this? If so, what would be the impact on Google?s financials? And what form should the payout take: dividend, share repurchase, or a combination?

Exhibit 1. Google?s Historical Stock Price Performance Relative to the NASDAQ Index.

Source: Google Finance, accessed Nov. 11, 2014

http://www.google.com/finance?&&&&&&&&&&%3A.IXIC&&%3AGOOG&&&

[1] ?Google Investors Seek Apple-Like Dividend as Cash Piles Up: Tech,? Brian Womack, April 12, 2012, http://www.bloomberg.comews/2012-04-12/google-investors-seek-apple-like-dividend-as-cash-piles-up-tech.html

[2] http://www.google.com/about/company/products/

[3] Google completed a 2 for 1 stock split on April 3, 2014. All per share numbers in this case have been adjusted for the split. Google currently has three classes of common stock outstanding, Classes A, B and C. They differ primarily in their voting rights. For additional information, see http://blogs.wsj.com/moneybeat/2014/04/03/what-googles-stock-split-means-for-you/.

[4] ?Companies Reduced Stock Buybacks in 2^nd Quarter; Buybacks Declined 1.6% from a Year Earlier,? Tess Stynes, The Wall Street Journal, Sept. 23, 2014.

[5] Source: Wikipedia, http://en.wikipedia.org/wiki/List_of_mergers_and_acquisitions_by_Google

[6] ?Google Investors Seek Apple-Like Dividend as Cash Piles Up: Tech,? Brian Womack, April 12, 2012, http://www.bloomberg.comews/2012-04-12/google-investors-seek-apple-like-dividend-as-cash-piles-up-tech.html

[7] Ibid.

[8] ?Feeling Flush, Startups Spend Away,? Evelyn Rusli, The Wall Street Journal , Oct. 6, 2014, pp. B1, B4.

[9] ?The Downside to Stock Buybacks; There Could Be Better Uses for the Money,? Jonathan Clements, The Wall Street Journal, Oct. 25, 2014.

[10] ?Microsoft Sweetens Payout,? Don Clark and Ben Fox Rubin, The Wall Street Journal, Sept. 18, 2013, pp. B1, B2.

[11] Also, shareholders must pay taxes on dividends as ordinary income when the dividends are received, but they don?t pay capital gains taxes until the gains are realized, which is when the stock is sold.

[12] ?The Downside to Stock Buybacks; There Could Be Better Uses for the Money,? Jonathan Clements, The Wall Street Journal, Oct. 25, 2014.

[13] Ibid.

[14] ?With All of Apple?s Cash, Why Is It Issuing Bonds?,? Tim Worstall, Forbes.com, April 30, 2013.

[15] ?Google Ripe for a Stock Buyback or Dividend,? Douglas MacMillan, Bloomberg Businessweek, July 27, 2010.

[16] ?Precautionary Savings with Risky Assets: When Cash is Not Cash,? Ran Duchin, Thomas Gilbert, Jarrad Harford and Christopher Hrdlicka, Working Paper, 2014.

[17]?Google Ripe for a Stock buyback or Dividend,? Douglas MacMillan, July 27, 2010, Bloomberg Businessweek, http://www.businessweek.com/technology/content/jul2010/te20100727_799534.htm

[18] ?Apple Raises $17 billion in Record Corporate Bond Sale,? Charles Mead and Sarika Gangar, Bloomberg.com, April 30, 2013.

[19] http://www.shareholderssquaretable.com/sale-apple-shares-at-half-price/

[20] At that point, there were 118 companies in the index that had never declared a dividend. Source: ?Google Ripe for a Stock buyback or Dividend,? Douglas MacMillan, July 27, 2010, Bloomberg Businessweek, http://www.businessweek.com/technology/content/jul2010/te20100727_799534.htm

Read: Payout Policy at Google Case on the next page and answer the following questions c.) If Google were to pay $20 billion as a special dividend, what would be the effect on market value? On the share price? On net income? On earnings per share? What if Google repurchased shares instead? Assume a 1% rate of interest on any cash balance and a 3% interest rate on the debt. Also assume that the deal takes place in early October 2014. Estimate the impact on the Sept. 30, 2014 balance sheet and the income statement for the next 12 months. (HINT: Solve this problem in the Modigliani-Miller setting, and think qualitatively about what would change in the real world.) Payout Policy at Google 'Decades ago, we used to be worried about companies taking on too much debt,' said Ryan Jacob, manager of the $45 million Jacob Internet Fund, which includes Google shares. 'Now, we're worried about companies taking on too much cash.'1 In November 2014, Google Chief Financial Officer Patrick Pichette pondered recent payout decisions by some of his competitors, including Apple. Google was sitting on over $60 billion in cash and marketable securities, an amount exceeding 17% of firm market capitalization. Should he consider following in Apple's footsteps, and start a payout plan for Google? Google Inc. Headquartered in Mountain View, California, Google is a technology company focused on products and services to organize information. According to the company website:2 Larry Page, our co-founder and CEO, once described the \"perfect search engine\" as something that \"understands exactly what you mean and gives you back exactly what you want.\" Since he spoke those words Google has grown to offer products beyond search, but the spirit of what he said remains. With all our technologiesfrom search to Chrome to Gmailour goal is to make it as easy as 1 \"Google Investors Seek Apple-Like Dividend as Cash Piles Up: Tech,\" Brian Womack, April 12, 2012, http://www.bloomberg.comews/2012-04-12/google-investors-seek-apple-like-dividend-as-cash-pilesup-tech.html 2 http://www.google.com/about/company/products/ 1 possible for you to find the information you need and get the things you need to do done. Google was founded in 1995, when founders Larry Page and Sergey Brin met as doctoral computer science students at Stanford University. Incorporated in 1998 in California, the \"Google Guys\" started with $1 million in seed capital from family and friends such as Sun Microsystems co-founder Andy Bechtolsheim. Subsequent private equity investors included the well-known Silicon Valley venture capital firms of Kleiner Perkins and Sequoia Capital, who each invested about $13 million in 1999. Google went public in August 2004 at a price of $85 per share. Stock price performance since then has been exceptional, with total returns approaching 500%, relative to about 125% for the NASDAQ index (see Exhibit 1). Since its IPO, Google's financial performance has also been stellar. From a base total revenue of $3.2 billion in 2004, sales have grown at a compound annual rate of almost 40% a year, approaching $60 billion by the end of 2013. (See Exhibit 2 for summary historical financials.) Net profit margins exceeded 20% for most of the last decade. By Sept. 30, 2014, Google's total net assets had grown to $126 billion, of which $62 billion, or 49%, was cash and marketable securities. Analysts expect Google's growth to continue, with earnings before interest and taxes (EBIT) for the next 12 months reaching $15.2 billion. Google has 678.3 million shares outstanding.3 With a stock price of $535 per share, its total equity market capitalization exceeds $360 billion. To date, Google has never paid a dividend, although it has modestly repurchased shares (generally in connection with either acquisitions or employee compensation). Payout Policy Dividends come in and out of fashion. Total payout (dividends and share repurchases) decreased substantially during the dot.com bubble. Since 2001, however, total payout as a percent of assets more than doubled, from 1.7% in 2001 to over 4.4% in 2007 (see Exhibit 3). Payout declined during the recent financial crisis, but has since recovered close to its 2007 levels. Repurchases are usually much more variable, and depend strongly on market conditions. Stock buybacks totaled $116.2 billion in the second quarter of 2014, down from almost $160 billion in the first quarter (the second highest level on record).4 3 Google completed a 2 for 1 stock split on April 3, 2014. All per share numbers in this case have been adjusted for the split. Google currently has three classes of common stock outstanding, Classes A, B and C. They differ primarily in their voting rights. For additional information, see http://blogs.wsj.com/moneybeat/2014/04/03/what-googles-stock-split-means-for-you/. 4 \"Companies Reduced Stock Buybacks in 2nd Quarter; Buybacks Declined 1.6% from a Year Earlier,\" Tess Stynes, The Wall Street Journal, Sept. 23, 2014. 2 Dividend-paying firms have traditionally been larger, more profitable firms with slower growth and fewer internal investment opportunities. As Exhibit 4 shows, dividend yields are lowest for companies in riskier industries such as biotech, internet services and healthcare. Yields for utilities and commodity-based industries are much higher, averaging over 4% in some industries. Investment Opportunities Google has been accumulating cash at the rate of $2 to $3 billion per quarter. Before deciding on any payout, Pichette wanted to make sure Google retained the cash it needs to grow Google's existing businesses. Google historically reinvested a substantial portion of its cash flows in its operations. For example, research and development spending at Apple recently amounted to about 3% of sales, and capital expenditures were about 5%. At Google, both numbers were much higher, closer to 13%. Google has also acquired over 170 firms since 2001 (and more than 30 so far in 2014). 5 Notable acquisitions (those of about $1 billion or more) include home automation firm Nest Labs for $4.3 billion in January 2014, GPS navigation software company Waze in June 2013, $12.5 billion for Motorola Mobility in August 2011, the $3.1 billion acquisition DoubleClick in 2007, and $1.65 billion for YouTube in 2006. Analyst reaction to Google's acquisitions was generally favorable: Google has been 'pretty successful' with acquisitions, says Jason Helfstein, an analyst at Oppenheimer & Co. For example, the company has emerged as a dominant force in mobile software thanks to its purchase of Android in 2005. It's also benefitted in display advertising and user growth from its acquisition of videosharing site YouTube in 2006.6 Excess cash sometimes tempts managers to make bad acquisitions, or overpay for good ones. Google could make an argument for holding on to its cash, by saying it needs the money for deals or investing in new businesses. Still, a dividend or buyback could assuage investor concerns that Google might instead make an unneeded, large acquisition, said Tim Ghrisky, who as co-founder of Solaris Group helps oversee about $2 billion in assets, including Google shares.7 Pichette was also aware of other issues at neighboring Silicon Valley firms. Venture capital had been pouring into startups during 2014. This trend was causing concern among venture 5 Source: Wikipedia, http://en.wikipedia.org/wiki/List_of_mergers_and_acquisitions_by_Google 6 \"Google Investors Seek Apple-Like Dividend as Cash Piles Up: Tech,\" Brian Womack, April 12, 2012, http://www.bloomberg.comews/2012-04-12/google-investors-seek-apple-like-dividend-as-cash-pilesup-tech.html 7 Ibid. 3 capitalists about wasteful expenses such as luxurious office spaces, high salaries and extravagant, catered lunches. \"Andreessen Horowitz co-founder Marc Andreessen has warned entrepreneurs about overspending, punctuating a string of tweets with the word, 'Worry.'\" 8 Similar problems can easily occur at larger, more established companies with high free cash flows. Pichette wondered whether he should be concerned about these issues at Google. Google's perquisites for employees, such as the well-stocked cafeteria at many of its locations, were famous. Pichette was convinced that these benefits helped Google attract and retain the skilled technical employees who are in such high demand in its industry. He also understood that dividends represented a stronger pledge: 'Dividends are reliable,' notes Robert Arnott, chairman of Research Affiliates, a money manager in Newport Beach, Calif. 'You cut them at your peril. But you can cut a buyback and hardly anybody notices.'9 If he really wanted to let analysts know that Google had no intention of wasting cash, committing to a large dividend payout would be a stronger way to send his message. Signaling Although dividends used to be rare for technology companies, they have become increasingly more common. Technology companies for years resisted paying dividends on the theory that their earnings growth would reward shareholders with higher stock prices. But share price appreciation ended for many companies after the stock market bubble burst in 2000.10 How would the market react to announcement by Google of a dividend or stock repurchase? Many investors and analysts worry that returning cash to investors means that the company does not have good growth opportunities within the firm, or that management isn't reinvesting as much as it should to sustain long-term growth. On the other hand, the decision to repurchase company stock would signal that management views the stock as undervalued, and therefore a good investment opportunity. Dividend Taxation 8 \"Feeling Flush, Startups Spend Away,\" Evelyn Rusli, The Wall Street Journal , Oct. 6, 2014, pp. B1, B4. 9 \"The Downside to Stock Buybacks; There Could Be Better Uses for the Money,\" Jonathan Clements, The Wall Street Journal, Oct. 25, 2014. 10 \"Microsoft Sweetens Payout,\" Don Clark and Ben Fox Rubin, The Wall Street Journal, Sept. 18, 2013, pp. B1, B2. 4 Pichette also considered the tax consequences of potential payouts for Google's shareholders. (Exhibit 5 has a list of Google's 10 largest shareholders as of year-end 2013). In the U.S., corporate profits are taxed twice. Payout is made from after-corporate-tax dollars, and investors must pay taxes on the income. Historically, tax rates on dividends have been higher than tax rates on capital gains (see Exhibit 6).11 In 2003, tax reform passed under President George Bush reduced tax rates on both capital gains and dividends to 15%. Although the Bush tax cuts were originally set to expire at the end of 2010, they were temporarily extended in 2010 and made permanent by the American Taxpayer Relief Act of 2012. Uncertainty leading up to the 2012 act prompted a flurry of last-minute special dividends by companies trying to take advantage of the lower tax rates before they expired. For example, discount retailer Costco sold $3.5 billion of bonds in November 2012 to finance a $3 billion special dividend. Although the 2012 Act made favorable tax treatment permanent for qualified dividends, it raised tax rates on both dividends and capital gains to 20%. Google has not previously paid a dividend. Pichette imagined that many Google's major investors bought Google stock precisely because it was a non-dividend paying, high growth company. He worried about the impact of a large change in payout policy on the portfolios of his investors. Executive Compensation As was common at technology companies, many Google executives and employees had equitybased compensation. Google founders Larry Page and Sergey Brin each owned over 46 million shares of Google's Class B stock. Companies regularly repurchase stock to offset new shares issued as part of employee compensation. \"Many buyback programs appear to be prompted less by a company's enthusiasm for its own shares and more by a desire to offset the dilution caused by executives exercising stock options.\" 12 Employee options are typically not adjusted for dividends, to the detriment of employees who own options rather than actual shares. Also, \"there's an incentive for companies to buy back stock, rather than pay dividends. Buybacks can push up share prices, making management's stock options more valuable.\"13 Cash Balances and Repatriation Taxes 11 Also, shareholders must pay taxes on dividends as ordinary income when the dividends are received, but they don't pay capital gains taxes until the gains are realized, which is when the stock is sold. 12 \"The Downside to Stock Buybacks; There Could Be Better Uses for the Money,\" Jonathan Clements, The Wall Street Journal, Oct. 25, 2014. 13 Ibid. 5 Many companies, including technology companies, have accumulated large cash balances in part because of successful overseas operations. (Exhibit 7 lists the top 6 in terms of cash and equivalents as of fiscal-year-end 2013.) In early 2013, shortly before it announced a large payout, Apple had $145 billion in cash, only $45 billion of which was in the U.S. 14 About 50% of Google's cash is overseas.15 Given current tax laws, companies pay taxes on foreign earnings at the tax rate of the country in which they earn the profits. However, if they bring the cash back to the U.S. (for example, to use it to pay a dividend), they will owe \"repatriation taxes\" on these profits equal to the difference in taxes owed at the U.S. corporate rate (now 35% for most large companies) and the typically lower rate in the foreign country. Companies with large overseas operations often choose to leave the cash abroad and avoid paying the repatriation tax penalty. They may use their overseas cash to invest overseas (such as Microsoft's $8.5 billion deal to acquire Skype in 2011 or its $7 billion purchase of Nokia's core cellphone business in September 2013). Also, \"overseas\" cash need not be invested abroad; it may be held in U.S. assets. But it must be repatriated before it can be used to fund a payout. Interestingly, cash and \"equivalents\" are often invested in very risky securities. In a recent working paper, Duchin, Gilbert, Harford and Hrdlicka (2014) show that risky securities (including assets such as mortgage-backed securities, which are clearly not \"cash equivalents\") comprise 27% of corporate cash holdings.16 To manage its substantial cash and short-term investment portfolio, in 2010 Google hired professional investment managers, including bond traders and portfolio managers, to set up a new trading floor in the company's Mountain View headquarters.17 Payout Policy at Other Tech Companies Over the past two decades, several other large tech companies initiated dividends (see Exhibit 8). Apple paid dividends in its earlier years, but cancelled them beginning in 1996 as the company went through a difficult financial period. Intel's dividend dates back to 1992, and Microsoft initiated dividends in 2003, right around the time of the Bush tax cuts. After long resisting dividends, Cisco paid its first-ever quarterly dividend in March 2011. So far, other tech giants including Yahoo, eBay and Amazon have yet to join the dividend party. 14 \"With All of Apple's Cash, Why Is It Issuing Bonds?,\" Tim Worstall, Forbes.com, April 30, 2013. 15 \"Google Ripe for a Stock Buyback or Dividend,\" Douglas MacMillan, Bloomberg Businessweek, July 27, 2010. 16 \"Precautionary Savings with Risky Assets: When Cash is Not Cash,\" Ran Duchin, Thomas Gilbert, Jarrad Harford and Christopher Hrdlicka, Working Paper, 2014. 17\"Google Ripe for a Stock buyback or Dividend,\" Douglas MacMillan, July 27, 2010, Bloomberg Businessweek, http://www.businessweek.com/technology/content/jul2010/te20100727_799534.htm 6 Apple's Payout In March, 2012, Apple announced plans to initiate a dividend and share repurchase program. The initial quarterly dividend of $2.65/share would begin in July of that year. The repurchase program would consist of $10 billion, executed over the next three years, for a total payout of $45 billion over that period. In early 2013, Apple increased its quarterly dividend to $3.05 a share, bumping its total payout up to $100 billion. To avoid repatriation taxes on its overseas cash, on April 30, 2013 Apple sold a record-setting $17 billion in corporate bonds. As described by Bloomberg:18 Apple issued $3 billion of floating-rate notes and $14 billion of fixed-rate securities in six parts with maturities from three to 30 years...Proceeds may help the company avoid repatriation taxes on its $102.3 billion of funds held overseas as Chief Executive Officer Tim Cook returns an additional $55 billion to shareholders through 2014 to compensate for a stock that's been hammered by signs of slowing growth. Interest rates on the debt ranged from 0.45% on the three-year debt to 3.85% on the 30-year bonds. The bonds were rated AA+/Aa1, despite Apple's large cash balance of over $145 billion. Rating agencies may be reluctant to give firms full credit for their cash when rating debt, because companies can pay out cash or use it for other purposes such as acquisitions before the maturity of the debt. Apple again announced in April 2014 that it would increase its share repurchase program by $30 billion, boost its dividend, and split its stock 7 for 1. However, this increase was still not enough to satisfy some of its investors. In an open letter to Apple CEO Tim Cook posted on his website in October 2014, activist investor Carl Icahn (owner of about 1% of Apple stock) urged Apple to increase its payout even further.19 We are simply asking you to help us convince the board to repurchase a lot more, and sooner. We feel compelled to do so because we forecast such impressive earnings growth over the next few years, and therefore we believe Apple is dramatically undervalued in today's market, and the more shares repurchased now, the more each remaining shareholder will benefit from that earnings growth. The Decision After watching recent events at Apple, Pichette pondered Google's next steps. In 2010, Bloomberg ranked Google as the most well-positioned company in the Standard and Poor's 500 18 \"Apple Raises $17 billion in Record Corporate Bond Sale,\" Charles Mead and Sarika Gangar, Bloomberg.com, April 30, 2013. 19 http://www.shareholderssquaretable.com/sale-apple-shares-at-half-price/ 7 to initiate a dividend.20 Fortunately, Google was not yet on the receiving end of strong activitistshareholder pressure to increase its payout. But its cash balance had almost doubled since 2010. With current cash and equivalents of over $60 billion and strong operating profits, such pressure could be imminent. As a first step, Pichette contemplated distributing a third of Google's cash, or $20 billion. Given Google's ample cash balances, he should be able to fund that amount without issuing debt or triggering any repatriation taxes. Should Google proceed with a transaction like this? If so, what would be the impact on Google's financials? And what form should the payout take: dividend, share repurchase, or a combination? 20 At that point, there were 118 companies in the index that had never declared a dividend. Source: \"Google Ripe for a Stock buyback or Dividend,\" Douglas MacMillan, July 27, 2010, Bloomberg Businessweek, http://www.businessweek.com/technology/content/jul2010/te20100727_799534.htm 8 Exhibit 1. Google's Historical Stock Price Performance Relative to the NASDAQ Index. 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