I need help from a Financial expert who is very familiar with exchange rate exposure & payout policy.I will adjust the price as you suggest. For some reason I am not able to do it here. Please be sure you follow these instructions.

Use Excel to show your work and then in a word document explain your calculations process. For essay questions, use the knowledge (including formula, graph, or terms) learned in this class to explain your answer. Be clear and concise in your answers. Question 3 - Exchange Rate Exposures (40 points) A domestic firm, Home Company, is evaluating the effect of an appreciation in the home currency on the firm's economic exposure. In each of the following categories of economic exposure, indicate whether the domestic currency appreciation is likely to have a positive or negative effect on Home Company's cash flow. State your conclusion and offer an one-sentence explanation for you conclusion as in the example shown for the first row. Direct economic exposure Revenue from sales abroad negative - foreign revenue worth less in home currency terms Cost of inputs sourced (purchased) abroad Profits repatriated from abroad Foreign tax liabilities Indirect economic exposure Position vis--vis a competitor who sources abroad Domestic competitor who sells abroad Foreign competitor who sells in Home Co.'s country Supplier who sources abroad Customer who sells abroad Customer who sources abroad 1 2 Question 4 Case Study: Google's Payout Policy 160 points Read: Payout Policy at Google Case on the next page and answer the following questions a.) What are Google's financing needs, explain? Will it need the $20 billion in cash, explain? How do these considerations change if the payout is a share repurchase? b.) 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? 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.) d.) What should Patrick Pichette recommend to Google's board? 3 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 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. 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/ 4 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 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. 5 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 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 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. 8 \"Feeling Flush, Startups Spend Away,\" Evelyn Rusli, The Wall Street Journal , Oct. 6, 2014, pp. B1, B4. 6 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 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. 7 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 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 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. 8 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. 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 9 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 activitistshareholder pressure to increase its payout. But its cash balance had almost doubled since 2010. 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 10 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? 11 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? chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1416438973392&chddm=980237&chls=Interv alBasedLine&cmpto=INDEXNASDAQ%3A.IXIC&cmptdms=0&q=NASDAQ %3AGOOG&ntsp=0&fct=big&ei=tSRtVIDzLYaaiQLrwYG4Dw 12 13 14 15 16 17 18 19 \f Cash Distributions to Shareholders Dividends Versus Share Repurchase in a Perfect Capital Market The Tax Disadvantage of Dividends Payout Versus Retention of Cash Signaling with Payout Policy Stock Dividends, Splits, and Spin-offs Finance 470 Lecture 12&13 Payout Policy 2 Payout Policy The way a firm chooses between the alternative ways to distribute free cash flow to equity holders Finance 470 Lecture 12&13 Payout Policy 3 Dividends Declaration Date Ex-Dividend Date Record Date Payable Date Important Dates for Microsoft's Special Dividend Finance 470 Lecture 12&13 Payout Policy 4 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 Return of Capital Liquidating Dividend Finance 470 Lecture 12&13 Payout Policy 5 Finance 470 Lecture 12&13 Payout Policy 6 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. Share Repurchase Methods Open Market Repurchase Tender Offer Dutch Auction Targeted Repurchase Greenmail Finance 470 Lecture 12&13 Payout Policy 7 Perfect Market Condition: No Tax No Corporate Tax No Personal Income Tax No Transaction Costs No costs for either the dividend payment process or share repurchase process No information asymmetry Investors know as much as the manager about the future cash flows of the firm Finance 470 Lecture 12&13 Payout Policy 8 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: $48 million Enterprise Value PV (Future FCF) $400 million 12% Finance 470 Lecture 12&13 Payout Policy 9 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 Finance 470 Lecture 12&13 Payout Policy 10 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. Finance 470 Lecture 12&13 Payout Policy 11 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 Pcum Current Dividend PV (Future Dividends) 2 4.80 2 40 $42 0.12 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 Finance 470 Lecture 12&13 Payout Policy 12 Suppose that instead of paying a dividend this year, Genron uses the $20 million to repurchase its shares on the open market. How will the repurchase affect the share price? With an initial share price of $42, Genron will repurchase 476,000 shares. $20 million $42 per share = 0.476 million shares This will leave only 9.524 million shares outstanding. 10 million 0.476 million = 9.524 million Finance 470 Lecture 12&13 Payout Policy 13 The net effect is that the share price remains unchanged. Finance 470 Lecture 12&13 Payout Policy 14 Genron's Future Dividends It should not be surprising that the repurchase had no effect on the stock price. After the repurchase, the future dividend would rise to $5.04 per share. $48 million 9.524 million shares = $5.04 per share Genron's share price is Prep 5.04 $42 0.12 Finance 470 Lecture 12&13 Payout Policy 15 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. Finance 470 Lecture 12&13 Payout Policy 16 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: What if the firm repurchases shares but investor wants cash? What if the firm pays a dividend and the investor does not want cash? Finance 470 Lecture 12&13 Payout Policy 17 Investor Preferences In the case of Genron, if the firm repurchases shares and the investor wants cash, the investor can raise cash by selling shares. This is called a homemade dividend. If the firm pays a dividend and the investor would prefer stock, they can use the dividend to purchase additional shares. Finance 470 Lecture 12&13 Payout Policy 18 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 Finance 470 Lecture 12&13 Payout Policy 19 Under this new policy, Genron's cum-dividend share price is: 4.50 Pcum 4.50 4.50 37.50 $42 0.12 The initial share value is unchanged by this policy, and increasing the dividend has no benefit to shareholders Genron's Dividends per Share Each Year Under the Three Alternative Policies: Finance 470 Lecture 12&13 Payout Policy 20 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. Finance 470 Lecture 12&13 Payout Policy 21 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. Finance 470 Lecture 12&13 Payout Policy 22 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. Finance 470 Lecture 12&13 Payout Policy 23 Evaluate: Again, the policy that the firm chooses is irrelevantthe investor can transact in the market to create a homemade dividend policy that suits her preferences. Finance 470 Lecture 12&13 Payout Policy 24 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. Dividend Policy and Perfect Capital Markets Although dividends do determine share prices, a firm's choice of dividend policy does not. Finance 470 Lecture 12&13 Payout Policy 25 Taxes on Dividends and Capital Gains 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. Finance 470 Lecture 12&13 Payout Policy 26 Finance 470 Lecture 12&13 Payout Policy 27 Source: Fidelity Finance 470 Lecture 12&13 Payout Policy 28 Taxes on Dividends and Capital Gains The higher tax rate on dividends makes it undesirable for a firm to raise funds to pay a dividend. 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. Finance 470 Lecture 12&13 Payout Policy 29 The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all. The payment of dividends has declined on average over the last 30 years while the use of repurchases has increased. Finance 470 Lecture 12&13 Payout Policy 30 Source: Compustat. Finance 470 Lecture 12&13 Payout Policy 31 Source: Compustat data for U.S. firms, excluding financial firms and utilities. Finance 470 Lecture 12&13 Payout Policy 32 Dividend Puzzle Why firms continue to issue dividends despite their tax disadvantage? Finance 470 Lecture 12&13 Payout Policy 33 The effective dividend tax rate differs across investors for a variety of reasons. Income Level Investment Horizon Tax Jurisdiction Type of Investor or Investment Account As a result of their different tax rates investors will have varying preferences regarding dividends. Finance 470 Lecture 12&13 Payout Policy 34 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 o Tax-free investors and corporations have a preference for stocks with high dividends o The dividend policy of a firm is optimized for the tax preference of its investor clientele Finance 470 Lecture 12&13 Payout Policy 35 Finance 470 Lecture 12&13 Payout Policy 36 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. Finance 470 Lecture 12&13 Payout Policy 37 If a firm has already taken all positive-NPV projects, any additional projects it takes on are zero or negativeNPV 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. Finance 470 Lecture 12&13 Payout Policy 38 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? Finance 470 Lecture 12&13 Payout Policy 39 Solution: 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. 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. 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. Finance 470 Lecture 12&13 Payout Policy 40 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. Finance 470 Lecture 12&13 Payout Policy 41 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. Finance 470 Lecture 12&13 Payout Policy 42 Problem: Recall Hershey Co. from previous example. Suppose Hershey must pay corporate taxes at a 35% rate on the interest it will earn from the oneyear 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? Finance 470 Lecture 12&13 Payout Policy 43 Solution: 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? 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. 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. Finance 470 Lecture 12&13 Payout Policy 44 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 o Under most tax regimes there remains a substantial tax disadvantage for the firm to retaining excess cash even after adjusting for investor taxes o Finance 470 Lecture 12&13 Payout Policy 45 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 o A firm must balance the tax costs of holding cash with the potential benefits of not having to raise external funds in the future Finance 470 Lecture 12&13 Payout Policy 46 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 o Paying out excess cash through dividends or share repurchases can boost the stock price by reducing managers' ability and temptation to waste resources Finance 470 Lecture 12&13 Payout Policy 47 Finance 470 Lecture 12&13 Payout Policy 48 Dividend Smoothing The practice of maintaining relatively constant dividends Firms raise their dividends only when they perceive a longterm sustainable increase in the expected level of future earnings, and cut them only as a last resort Dividend Signaling The idea that dividend changes reflect managers' views about a firm's future earnings prospects Finance 470 Lecture 12&13 Payout Policy 49 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 o The dividend decrease might lead to a positive, rather than negative, stock price reaction. Finance 470 Lecture 12&13 Payout Policy 50 Signaling and Share Repurchases Share repurchases are a credible signal that the shares are underpriced, because if they are over-priced a share repurchase is costly for current shareholders 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 Finance 470 Lecture 12&13 Payout Policy 51 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 o Also called a 3:2 (\"3-for-2\") stock split A 100% stock dividend is equivalent to a 2:1 stock split Finance 470 Lecture 12&13 Payout Policy 52 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 Finance 470 Lecture 12&13 Payout Policy 53 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 o On average, announcements of stock splits are associated with a 2% increase in the stock price o Most firms use splits to keep their share prices from exceeding $100 o Finance 470 Lecture 12&13 Payout Policy 54 Finance 470 Lecture 12&13 Payout Policy 55 Spin-off 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 It avoids the transaction costs associated with a subsidiary sale. The special dividend is not taxed as a cash distribution. Finance 470 Lecture 12&13 Payout Policy 56 Different ways in which corporations can make distributions to shareholders Modigliani-Miller & Dividend Policy Tax advantage for share repurchases versus dividends Payout Policy and agency problems Payout Policy and financial flexibility Payout policy in signaling information to the market Non-cash methods for payouts Finance 470 Lecture 12&13 Payout Policy 57 Finance 470 Lecture 12&13 Payout Policy 58 Source: \"What Apple's Stock Split Means for You\ \f Cash Distributions to Shareholders Dividends Versus Share Repurchase in a Perfect Capital Market The Tax Disadvantage of Dividends Payout Versus Retention of Cash Signaling with Payout Policy Stock Dividends, Splits, and Spin-offs Finance 470 Lecture 12&13 Payout Policy 2 Payout Policy The way a firm chooses between the alternative ways to distribute free cash flow to equity holders Finance 470 Lecture 12&13 Payout Policy 3 Dividends Declaration Date Ex-Dividend Date Record Date Payable Date Important Dates for Microsoft's Special Dividend Finance 470 Lecture 12&13 Payout Policy 4 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 Return of Capital Liquidating Dividend Finance 470 Lecture 12&13 Payout Policy 5 Finance 470 Lecture 12&13 Payout Policy 6 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. Share Repurchase Methods Open Market Repurchase Tender Offer Dutch Auction Targeted Repurchase Greenmail Finance 470 Lecture 12&13 Payout Policy 7 Perfect Market Condition: No Tax No Corporate Tax No Personal Income Tax No Transaction Costs No costs for either the dividend payment process or share repurchase process No information asymmetry Investors know as much as the manager about the future cash flows of the firm Finance 470 Lecture 12&13 Payout Policy 8 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: $48 million Enterprise Value PV (Future FCF) $400 million 12% Finance 470 Lecture 12&13 Payout Policy 9 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 Finance 470 Lecture 12&13 Payout Policy 10 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. Finance 470 Lecture 12&13 Payout Policy 11 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 Pcum Current Dividend PV (Future Dividends) 2 4.80 2 40 $42 0.12 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 Finance 470 Lecture 12&13 Payout Policy 12 Suppose that instead of paying a dividend this year, Genron uses the $20 million to repurchase its shares on the open market. How will the repurchase affect the share price? With an initial share price of $42, Genron will repurchase 476,000 shares. $20 million $42 per share = 0.476 million shares This will leave only 9.524 million shares outstanding. 10 million 0.476 million = 9.524 million Finance 470 Lecture 12&13 Payout Policy 13 The net effect is that the share price remains unchanged. Finance 470 Lecture 12&13 Payout Policy 14 Genron's Future Dividends It should not be surprising that the repurchase had no effect on the stock price. After the repurchase, the future dividend would rise to $5.04 per share. $48 million 9.524 million shares = $5.04 per share Genron's share price is Prep 5.04 $42 0.12 Finance 470 Lecture 12&13 Payout Policy 15 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. Finance 470 Lecture 12&13 Payout Policy 16 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: What if the firm repurchases shares but investor wants cash? What if the firm pays a dividend and the investor does not want cash? Finance 470 Lecture 12&13 Payout Policy 17 Investor Preferences In the case of Genron, if the firm repurchases shares and the investor wants cash, the investor can raise cash by selling shares. This is called a homemade dividend. If the firm pays a dividend and the investor would prefer stock, they can use the dividend to purchase additional shares. Finance 470 Lecture 12&13 Payout Policy 18 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 Finance 470 Lecture 12&13 Payout Policy 19 Under this new policy, Genron's cum-dividend share price is: 4.50 Pcum 4.50 4.50 37.50 $42 0.12 The initial share value is unchanged by this policy, and increasing the dividend has no benefit to shareholders Genron's Dividends per Share Each Year Under the Three Alternative Policies: Finance 470 Lecture 12&13 Payout Policy 20 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. Finance 470 Lecture 12&13 Payout Policy 21 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. Finance 470 Lecture 12&13 Payout Policy 22 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. Finance 470 Lecture 12&13 Payout Policy 23 Evaluate: Again, the policy that the firm chooses is irrelevantthe investor can transact in the market to create a homemade dividend policy that suits her preferences. Finance 470 Lecture 12&13 Payout Policy 24 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. Dividend Policy and Perfect Capital Markets Although dividends do determine share prices, a firm's choice of dividend policy does not. Finance 470 Lecture 12&13 Payout Policy 25 Taxes on Dividends and Capital Gains 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. Finance 470 Lecture 12&13 Payout Policy 26 Finance 470 Lecture 12&13 Payout Policy 27 Source: Fidelity Finance 470 Lecture 12&13 Payout Policy 28 Taxes on Dividends and Capital Gains The higher tax rate on dividends makes it undesirable for a firm to raise funds to pay a dividend. 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. Finance 470 Lecture 12&13 Payout Policy 29 The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all. The payment of dividends has declined on average over the last 30 years while the use of repurchases has increased. Finance 470 Lecture 12&13 Payout Policy 30 Source: Compustat. Finance 470 Lecture 12&13 Payout Policy 31 Source: Compustat data for U.S. firms, excluding financial firms and utilities. Finance 470 Lecture 12&13 Payout Policy 32 Dividend Puzzle Why firms continue to issue dividends despite their tax disadvantage? Finance 470 Lecture 12&13 Payout Policy 33 The effective dividend tax rate differs across investors for a variety of reasons. Income Level Investment Horizon Tax Jurisdiction Type of Investor or Investment Account As a result of their different tax rates investors will have varying preferences regarding dividends. Finance 470 Lecture 12&13 Payout Policy 34 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 o Tax-free investors and corporations have a preference for stocks with high dividends o The dividend policy of a firm is optimized for the tax preference of its investor clientele Finance 470 Lecture 12&13 Payout Policy 35 Finance 470 Lecture 12&13 Payout Policy 36 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. Finance 470 Lecture 12&13 Payout Policy 37 If a firm has already taken all positive-NPV projects, any additional projects it takes on are zero or negativeNPV 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. Finance 470 Lecture 12&13 Payout Policy 38 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? Finance 470 Lecture 12&13 Payout Policy 39 Solution: 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. 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. 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. Finance 470 Lecture 12&13 Payout Policy 40 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. Finance 470 Lecture 12&13 Payout Policy 41 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. Finance 470 Lecture 12&13 Payout Policy 42 Problem: Recall Hershey Co. from previous example. Suppose Hershey must pay corporate taxes at a 35% rate on the interest it will earn from the oneyear 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? Finance 470 Lecture 12&13 Payout Policy 43 Solution: 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? 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. 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. Finance 470 Lecture 12&13 Payout Policy 44 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 o Under most tax regimes there remains a substantial tax disadvantage for the firm to retaining excess cash even after adjusting for investor taxes o Finance 470 Lecture 12&13 Payout Policy 45 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 o A firm must balance the tax costs of holding cash with the potential benefits of not having to raise external funds in the future Finance 470 Lecture 12&13 Payout Policy 46 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 o Paying out excess cash through dividends or share repurchases can boost the stock price by reducing managers' ability and temptation to waste resources Finance 470 Lecture 12&13 Payout Policy 47 Finance 470 Lecture 12&13 Payout Policy 48 Dividend Smoothing The practice of maintaining relatively constant dividends Firms raise their dividends only when they perceive a longterm sustainable increase in the expected level of future earnings, and cut them only as a last resort Dividend Signaling The idea that dividend changes reflect managers' views about a firm's future earnings prospects Finance 470 Lecture 12&13 Payout Policy 49 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 o The dividend decrease might lead to a positive, rather than negative, stock price reaction. Finance 470 Lecture 12&13 Payout Policy 50 Signaling and Share Repurchases Share repurchases are a credible signal that the shares are underpriced, because if they are over-priced a share repurchase is costly for current shareholders 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 Finance 470 Lecture 12&13 Payout Policy 51 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 o Also called a 3:2 (\"3-for-2\") stock split A 100% stock dividend is equivalent to a 2:1 stock split Finance 470 Lecture 12&13 Payout Policy 52 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 Finance 470 Lecture 12&13 Payout Policy 53 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 o On average, announcements of stock splits are associated with a 2% increase in the stock price o Most firms use splits to keep their share prices from exceeding $100 o Finance 470 Lecture 12&13 Payout Policy 54 Finance 470 Lecture 12&13 Payout Policy 55 Spin-off 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 It avoids the transaction costs associated with a subsidiary sale. The special dividend is not taxed as a cash distribution. Finance 470 Lecture 12&13 Payout Policy 56 Different ways in which corporations can make distributions to shareholders Modigliani-Miller & Dividend Policy Tax advantage for share repurchases versus dividends Payout Policy and agency problems Payout Policy and financial flexibility Payout policy in signaling information to the market Non-cash methods for payouts Finance 470 Lecture 12&13 Payout Policy 57 Finance 470 Lecture 12&13 Payout Policy 58 Source: \"What Apple's Stock Split Means for You\ \f Cash Distributions to Shareholders Dividends Versus Share Repurchase in a Perfect Capital Market The Tax Disadvantage of Dividends Payout Versus Retention of Cash Signaling with Payout Policy Stock Dividends, Splits, and Spin-offs Finance 470 Lecture 12&13 Payout Policy 2 Payout Policy The way a firm chooses between the alternative ways to distribute free cash flow to equity holders Finance 470 Lecture 12&13 Payout Policy 3 Dividends Declaration Date Ex-Dividend Date Record Date Payable Date Important Dates for Microsoft's Special Dividend Finance 470 Lecture 12&13 Payout Policy 4 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 Return of Capital Liquidating Dividend Finance 470 Lecture 12&13 Payout Policy 5 Finance 470 Lecture 12&13 Payout Policy 6 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. Share Repurchase Methods Open Market Repurchase Tender Offer Dutch Auction Targeted Repurchase Greenmail Finance 470 Lecture 12&13 Payout Policy 7 Perfect Market Condition: No Tax No Corporate Tax No Personal Income Tax No Transaction Costs No costs for either the dividend payment process or share repurchase process No information asymmetry Investors know as much as the manager about the future cash flows of the firm Finance 470 Lecture 12&13 Payout Policy 8 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: $48 million Enterprise Value PV (Future FCF) $400 million 12% Finance 470 Lecture 12&13 Payout Policy 9 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 Finance 470 Lecture 12&13 Payout Policy 10 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. Finance 470 Lecture 12&13 Payout Policy 11 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 Pcum Current Dividend PV (Future Dividends) 2 4.80 2 40 $42 0.12 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 Finance 470 Lecture 12&13 Payout Policy 12 Suppose that instead of paying a dividend this year, Genron uses the $20 million to repurchase its shares on the open market. How will the repurchase affect the share price? With an initial share price of $42, Genron will repurchase 476,000 shares. $20 million $42 per share = 0.476 million shares This will leave only 9.524 million shares outstanding. 10 million 0.476 million = 9.524 million Finance 470 Lecture 12&13 Payout Policy 13 The net effect is that the share price remains unchanged. Finance 470 Lecture 12&13 Payout Policy 14 Genron's Future Dividends It should not be surprising that the repurchase had no effect on the stock price. After the repurchase, the future dividend would rise to $5.04 per share. $48 million 9.524 million shares = $5.04 per share Genron's share price is Prep 5.04 $42 0.12 Finance 470 Lecture 12&13 Payout Policy 15 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. Finance 470 Lecture 12&13 Payout Policy 16 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: What if the firm repurchases shares but investor wants cash? What if the firm pays a dividend and the investor does not want cash? Finance 470 Lecture 12&13 Payout Policy 17 Investor Preferences In the case of Genron, if the firm repurchases shares and the investor wants cash, the investor can raise cash by selling shares. This is called a homemade dividend. If the firm pays a dividend and the investor would prefer stock, they can use the dividend to purchase additional shares. Finance 470 Lecture 12&13 Payout Policy 18 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 Finance 470 Lecture 12&13 Payout Policy 19 Under this new policy, Genron's cum-dividend share price is: 4.50 Pcum 4.50 4.50 37.50 $42 0.12 The initial share value is unchanged by this policy, and increasing the dividend has no benefit to shareholders Genron's Dividends per Share Each Year Under the Three Alternative Policies: Finance 470 Lecture 12&13 Payout