Fundamentals of Corporate Finance

Case Study: Payout Policy

You are an influential institutional investor that holds 1 million shares of Cisco System, Inc., purchased on November 17, 2017. In researching Cisco, you found out that they are holding a large amount of cash. Furthermore, you are upset that the Cisco stock price has been somewhat stagnant as of late. You are considering approaching Ciscos Board of Directors with a plan to payout half of the cash the firm has accumulated, but cant decide whether a share repurchase or a special dividend would be best. Because both dividends and capital gains are taxed at the same rate (20%), at the first glance there seems to be no difference between the two options. To confirm, however, you need to run the numbers for each scenario. Assume that the current stock price is $55 and the number of shares outstanding for Ciscos stock is 4,110,000,000 shares.

1. Go to Yahoo Finance, enter the symbol for Cisco (CSCO) into the Quote Lookup box.
   1. Click Financials, Balance Sheet, Annual
      1. Record half of the most recent Cash and Cash Equivalents reported on the balance sheet (*Note that this number is in thousands. Multiply this number by 1000 to convert it into dollars). This is the dollar amount of cash available for payout.
         1. ANSWER IS 5,061,500,000
      2. Using the payout amount found in 1.a.i, compute the dividend per share that could be paid in the dividend scenario
         1. ANSWER IS 1.23
      3. Using the payout amount found in 1.a.i, compute the number of shares that would be repurchased (at the current market price) in the repurchase scenario.
         1. ANSWER IS 92,027,273
2. To get the initial purchase price at which you bought the stock on November 17, 2017, click Historical Prices, enter the date you purchased the stock as the start date and end date, choose Daily frequency, and hit Get Prices. Record the Adj Close price. This is your initial purchase price.
   1. ANSWER IS 29.94
3. Now compute the after-tax payout proceeds that you would receive in each scenario.
   1. Find the after-tax payout proceeds you will receive under the dividend scenario. Taxes you will pay on the dividend income can be computed as:
      1. Divided income taxes = Dividend per share x Number of shares that you are holding x Dividend tax rate
   2. If the cash is (indirectly) paid through stock repurchase instead, payout proceeds are a little bit indirectly realized. Lets assume that you will make a home-made dividend by selling some number of shares from your initial holdings. The number of shares that you can sell and still maintain the same proportion of ownership before and after repurchase program is 22,391 shares (the number to be given in class). Assuming that you can sell these shares at the current market price, compute the after-tax payout proceeds from this home-made dividend under the repurchase scenario. Note that home-made dividends, unlike actual dividends, are realized by selling stock and therefore are subject to capital gain taxes:
      1. Capital gain taxes = (Selling price - Initial purchase price) x Number of shares sold x Capital gain tax rate
4. The calculation in Question 2 reflects your immediate proceeds arising from the payout event itself, but it does not consider the consequences on any remaining shares in your portfolio. To incorporate this feature, you first decide to see what happens if you sells all remaining shares of stock immediately after the payout (either after dividend or after the repurchase). Lets call this liquidation proceeds. Again, note that these liquidation proceeds are subject to capital gain taxes. Also note that the stock price will fall by the amount of the dividend per share immediately after the dividend payment.
   1. Calculate the after-tax liquidation proceeds from immediately selling any remaining shares after the dividend scenario.
   2. Calculate the after-tax liquidation proceeds from immediately selling any remaining shares after the repurchase scenario.
   3. Compute the total after-tax proceeds by adding up after-tax payout proceeds and after-tax liquidation proceed in each scenario, and compute the difference between the two scenarios.
   4. Under which scenario would you be better off after taxes?
5. Rather than selling all remaining shares today, now you decide to consider a longer holding period. That is, you will sell all remaining shares 5 years later rather than immediately. Assume that the stock price will grow at 10% rate per year going forward, regardless of what the starting price is today. Also assume that Cisco will pay no other dividend over the next 5 years.
   1. What would be the stock price after 5 years under each scenario?
   2. Calculate the after-tax liquidation proceeds from selling remaining shares 5 years after the dividend scenario.
   3. Calculate the after-tax liquidation proceeds from selling remaining shares 5 years after the repurchase scenario.
   4. Note that these liquidation proceeds are occurring at time 5 instead of time 0. Calculate the present value (PV) of the after-tax liquidation proceeds in each scenario using discount rate of 10%.
   5. Compute the total after-tax proceeds ( = after-tax payout proceeds + PV of after-tax liquidation proceeds) in each scenario, and compute the difference between the two scenarios, evaluated at time 0.
   6. Which scenario would you prefer now?
6. Do you think your preference changes depending on your investment horizon? If so, how?

Please answer parts 2 through 5 of the case study, and show your work on how each answer was reached.