Payout Policy

FOR MANY YEARS, MICROSOFT CORPORATION CHOSE TO distribute cash to investors primarily by repurchasing its own stock. During the five fiscal years ending June 2004, for example, Microsoft spent an average of $5.4 billion per year on share repurchases. Microsoft began paying dividends to investors in 2003, with what CFO John Connors called a starter dividend of $0.08 per share. Then, on July 20, 2004, Microsoft stunned financial markets by announcing plans to pay the largest single cash dividend payment in history, a one-time dividend of $32 billion, or $3 per share, to all shareholders of record on November 17, 2004. Since then Microsoft has repurchased over $100 billion in shares, and raised its quarterly dividend 7 times, so that by late 2012 its dividend was $0.23 per share, representing a 3.5% annual dividend yield. When a firms investments generate free cash flow, the firm must decide how to use that cash. If the firm has new positive-NPV investment opportunities, it can reinvest the cash and increase the value of the firm. Many young, rapidly growing firms reinvest 100% of their cash flows in this way. But mature, profitable firms such as Microsoft often find that they generate more cash than they need to fund all of their attractive investment opportunities. When a firm has excess cash, it can hold those funds as part of its cash reserves or pay the cash out to shareholders. If the firm decides to follow the latter approach, it has two choices: It can pay a dividend or it can repurchase shares from current owners. These decisions represent the firms payout policy. In this chapter, we show that, as with capital structure, a firms payout policy is shaped by market imperfections, such as taxes, agency costs, transaction costs, and asymmetric information between managers and investors. We look at why some firms prefer to pay dividends, whereas others rely exclusively on share repurchases. In addition, we explore why some firms build up large cash reserves, while others pay out their excess cash.

Distributions to Shareholders Figure 17.1 illustrates the alternative uses of free cash flow.1 The way a firm chooses between these alternatives is referred to as its payout policy. We begin our discussion of a firms payout policy by considering the choice between paying dividends and repurchasing shares. In this section, we examine the details of these methods of paying cash to shareholders. Dividends A public companys board of directors determines the amount of the firms dividend. The board sets the amount per share that will be paid and decides when the payment will occur. The date on which the board authorizes the dividend is the declaration date. After the board declares the dividend, the firm is legally obligated to make the payment. The firm will pay the dividend to all shareholders of record on a specific date, set by the board, called the record date. Because it takes three business days for shares to be registered, only shareholders who purchase the stock at least three days prior to the record date receive the dividend. As a result, the date two business days prior to the record date is known as the ex-dividend date; anyone who purchases the stock on or after the ex-dividend date will not receive the dividend. Finally, on the payable date (or distribution date), which is generally about a month after the record date, the firm mails dividend checks to the registered shareholders. Occasionally, a firm may pay a one-time, special dividend that is usually much larger than a regular dividend. More generally, in a stock split or stock dividend, the company issues additional shares rather than cash to its shareholders. Share Repurchases An alternative way to pay cash to investors is through a share repurchase or buyback. In this kind of transaction, the firm uses cash to buy shares of its own outstanding stock. These shares are generally held in the corporate treasury, and they can be resold if the company needs to raise money in the future. We now examine three possible transaction types for a share repurchase.

Open Market Repurchase. An open market repurchase is the most common way that firms repurchase shares.

Tender Offer. A firm can repurchase shares through a tender offer in which it offers to buy shares at a prespecified price during a short time periodgenerally within 20 days.

Targeted Repurchase. A firm may also purchase shares directly from a major shareholder in a targeted repurchase.

Alternatively, if a major shareholder is threatening to take over the firm and remove its management, the firm may decide to eliminate the threat by buying out the shareholderoften at a large premium over the current market price. This type of transaction is called greenmail.

Comparison of Dividends and Share Repurchases: If a corporation decides to pay cash to shareholders, it can do so through either dividend payments or share repurchases. How do firms choose between these alternatives? In this section, we show that in the perfect capital markets setting of Modigliani and Miller, the method of payment does not matter.

- Alternative Policy 1: Pay Dividend with Excess Cash.

- Alternative Policy 2: Share Repurchase (No Dividend).

- Alternative Policy 3: High Dividend (Equity Issue).

ModiglianiMiller and Dividend Policy Irrelevance: In our analysis we considered three possible dividend policies for the firm this year: (1) pay out all cash as a dividend, (2) pay no dividend and use the cash instead to repurchase shares, or (3) issue equity to finance a larger dividend.

Dividend Policy with Perfect Capital Markets

The Tax Disadvantage of Dividends As with capital structure, taxes are an important market imperfection that influences a firms decision to pay dividends or repurchase shares.

Taxes on Dividends and Capital Gains: Shareholders typically must pay taxes on the dividends they receive. They must also pay capital gains taxes when they sell their shares. The higher tax rate on dividends also makes it undesirable for a firm to raise funds to pay a dividend. Absent taxes and issuance costs, if a firm raises money by issuing shares and then gives that money back to shareholders as a dividend, shareholders are no better or worse offthey get back the money they put in. When dividends are taxed at a higher rate than capital gains, however, this transaction hurts shareholders because they will receive less than their initial investment.

Optimal Dividend Policy with Taxes: When the tax rate on dividends exceeds the tax rate on capital gains, shareholders will pay lower taxes if a firm uses share repurchases for all payouts rather than dividends. This tax savings will increase the value of a firm that uses share repurchases rather than dividends. We can also express the tax savings in terms of a firms equity cost of capital. Firms that use dividends will have to pay a higher pre-tax return to offer their investors the same after-tax return as firms that use share repurchases.9 As a result, the optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all.

Dividend Capture and Tax Clienteles: While many investors have a tax preference for share repurchases rather than dividends, the strength of that preference depends on the difference between the dividend tax rate and the capital gains tax rate that they face. Tax rates vary by income, jurisdiction, investment horizon, and whether the stock is held in a retirement account. Because of these differences, firms may attract different groups of investors depending on their dividend policy. In this section, we look in detail at the tax consequences of dividends as weell as investor strategies that may reduce the impact of dividend taxes on firm value.

The Effective Dividend Tax Rate: To compare investor preferences, we must quantify the combined effects of dividend and capital gains taxes to determine an effective dividend tax rate for an investor.

Tax Differences Across Investors

Payout Versus Retention of Cash:

Retaining Cash with Perfect Capital Markets: If a firm retains cash, it can use those funds to invest in new projects.

Taxes and Cash Retention

Adjusting for Investor Taxes: The decision to pay out versus retain cash may also affect the taxes paid by shareholders.

Issuance and Distress Costs: Generally, they retain cash balances to cover potential future cash shortfalls.

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, however.

Signaling with Payout Policy One market imperfection that we have not yet considered is asymmetric information. When managers have better information than investors regarding the future prospects of the firm, their payout decisions may signal this information. In this section, we look at managers motivations when setting a firms payout policy, and we evaluate what these decisions may communicate to investors. Dividend Smoothing Firms can change dividends at any time, but in practice they vary the sizes of their dividends relatively infrequently.

Dividend Signaling: If firms smooth dividends, the firms dividend choice will contain information regarding managements expectations of future earnings. When a firm increases its dividend, it sends a positive signal to investors that management expects to be able to afford the higher dividend for the foreseeable future.

Signaling and Share Repurchases Share repurchases, like dividends, may also signal managers information to the market. However, several important differences distinguish share repurchases and dividends.

Stock Dividends, Splits, and Spin-Offs: Stock Dividends, Splits, and Spin-Offs In this chapter, we have focused on a firms decision to pay cash to its shareholders. But a firm can pay another type of dividend that does not involve cash: a stock dividend. In this case, each shareholder who owns the stock before it goes ex-dividend receives additional shares of stock of the firm itself (a stock split) or of a subsidiary (a spin-off).

Stock Dividends and Splits: If a company declares a 10% stock dividend, each shareholder will receive one new share of stock for every 10 shares already owned. Stock dividends of 50% or higher are generally referred to as stock splits.

Spin-Offs: Rather than pay a dividend using cash or shares of its own stock, a firm can also distribute shares of a subsidiary in a transaction referred to as a spin-off. Non-cash special dividends are commonly used to spin off assets or a subsidiary as a separate company.

What are the payout policies adopted by firms? (500-600 words)

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