REFER TO THE TEXTBOOK ATTACHED 1. In a world without taxes dividends are irrelevant in determining the value of a firm. Why?

2. In a world with corporate and personal taxes dividends are important in determining the value of a firm. Why?

3. Signaling The signaling theory for dividends can be summarized as follows: one of the things rms can do with excess cash ow is to pay it out to its stockholders. Firms that need cash can't. (We discussed this in the chapters on Marriott, AT&T, and MCI.) Dividends and stock repurchases are the two major ways a rm can return cash to its stockholders. So if a rm pays a dividend or repurchases shares, it sends a signal to the market that the rm has enough cash ow to pay shareholders. If a rm wants to send a positive signal and pays dividends or does a repurchase without actually having excess cash ows, then the rm will incur a cost, and it will need to nd the cash elsewhere, usually through additional nancing. Why all the emphasis on cash ows when we discuss signaling? Because cash is a wonderful signal. It is credible, it is simple, it is visible, and there is a cost to false signals regarding cash ows. Imagine that in their annual report management says, \"We had a great year last year, we are having a very good year this year, and we expect an exceptional year next year.\" Is that credible? What does it mean? who knows? We don't know if management is telling the truth. If this year and next year turn out not to be good years, management can just say, \"Whoops, we made a mistake in our original predictions.\" Management statements are just thatstatementsand their accuracy and veracity are impossible to determine in advance. Imagine instead that management announces an increase in its dividends. Is an increase in dividends credible? Yes. Dividend increases are real and represent a cost to the rm. The rm will have to use cash to pay the higher dividends, and if it doesn't have the cash, the rm will have to take out additional nancing in the future just to pay the higher dividends. Are dividends simple? Yes. Although management may say they had a great year last year, investors don't know what \"great\" means. \"Great\" is not easy to calibrate. In contrast, if management paid a dividend of $1.00 last year and increased it to $1.20 this year, this is both simple and clear. The increase of 20% is easy to calibrate and implies the rm is having a good year. Are dividends visible? Yes. Dividends are a lot more visible than management pronouncements or security lings. An investor may not keep track of every news release a rm makes. However, a dividend check is difcult to ignore; investors can see and touch it.2 Finally, there is a cost to false signaling with dividends. Because of information asymmetry, we don't know if management is accurate or not in their forecasts, and there is usually little or no consequence to management for being wrong. However, with dividends, if management's dividend policy for the future is not sustainable, there are nancial consequences. In C_hapter 10, we discussed whether MCI should pay a dividend. Had MCI paid a dividend of $1.00 a share, this would have required $585 million over ve years (since MCI had approximately 117 million shares outstanding). If MCI paid that dividend because it incorrectly forecasted higher cash ows (or had been trying to send a false signal), MCI would have had to nance an additional $585 million. What about share repurchases as a signal? Share repurchases, as the reader may remember from the discussion in Chapter 8 (on Marriott), are another method for a rm to return cash to its shareholders. Are share repurchases also credible, simple, and visible? Share repurchases are credible, similarly to dividends, since they also represent a use of cash and a cost to the rm. They are simple in a different way. A change in dividends can be compared to the old dividend. A share repurchase involves a purchase price and an amount. It is also visible shareholders will rarely be unaware of a tender offer or share repurchase program. So, if share repurchases and dividends are alternative methods of returning cash to stockholders, and share repurchases are taxed as capital gains, which often have lower tax rates for shareholders than dividend income does, why not have more frequent repurchases? One reason is that there are IRS rules against a rm substituting dividends with repurchases. If a rm does a regular stock repurchase (e.g., every quarter), the IRS may treat the repurchases as dividends and thereby void any tax benets from using repurchases instead of dividends. So, are share repurchases as reliable a signal as dividends? Not really, since share repurchases are not as regular as dividends. They are usually infrequent events. Also, as we'll discuss, dividends are sticky (once paid, rarely reduced) while stock repurchases are not (e.g., management can announce a repurchase program and then delay it). Thus, regular quarterly dividends3 are consistent with, and t well into, signaling theory. They are simple, visible, and credible. Paying dividends without sufcient cash ow to support them is costly. This is why signaling is the primary theoretical explanation for dividend policy. 4. Information Asymmetry Information asymmetry is the idea that management knows more about the rm's true value than outside investors, This is, of course, the reason signaling exists. Investors react to management actions, particularly those involving cash ows in or out of the rm, in determining their own View of a rm's future prospects, which in turn affects the current stock price. Thus, dividends serve as a signal because of the perceived existence of information asymmetry. 5. Agency Another explanation for why rms pay dividends is an agency theory explanation called the \"cash ow hypothesis.\"4 The argument is that management and stockholders' interests often do not align, and if the rm has excess cash, management may use the cash for their own purposes rather than the stockholders'. Retaining excess cash allows management to engage in activities like empire building, undertaking negative NPV projects, consuming excessive perks, and so on. Dividends are a way to take some of the excess cash away from management and return it to stockholders. The cash ow hypothesis usually entails increasing a rm's debt, and thus its interest payments, to limit the management's discretionary use of cash ow. Although dividends can also be used for this purpose, debt and its corresponding interest payments are a better choice, since interest payments on debt are mandatory, while dividends are not. EMPIRICAL EVIDENCE Turning now to the empirical academic research,5 we know the following: First, dividends are sticky. That is, once a rm starts to pay a dividend, it tends to keep the dividend payment constantdividends don't uctuate much year to year. For example, if a rm pays a $0.20 dividend in one year, it will probably maintain the dividend the next year, even if earnings go up (or down) substantially. Second, when dividends do change, they tend to follow a step function. They will be at for a number of years, then go up, then stay at for a number of years, then go up, and so on. Third, not only do rms tend to have sticky dividends, they also rarely cut dividends. Remember a rm does not have to pay dividends, and thus dividends can be reduced. However, dividend reductions are rare, and if a rm does reduce its dividends, it sends a very strong negative signal to the marketempirically, we nd that the rm's stock price falls dramatically. Thus, dividends are generally stable, and rms are very reluctant to cut them. Importantly, the empirical results on dividends have held over time. It is an area of study that has been investigated repeatedly, always with the same results: dividends tend to be sticky. Studies have shown that if a firm increases its dividends by 1%, its stock price rises about 3% on average. If a firm cuts its dividends by 1%, its stock price falls about 7% on average. Thus, the market penalizes a cut in dividends more than it rewards an increase. One way to explain this is that the market believes that firms only cut dividends when they are in trouble. Cutting dividends signals the market that the firm has insufficient cash flow to maintain the dividend, and as dividends are typically not that large a part of the cash flow, the market views the reduction as a very negative signal. There are alternative explanations proposed for why firms pay dividends, including the cash flow hypothesis (discussed above) and, more recently, a catering theory (which postulates that firms pay dividends when market investors want them and don't pay dividends when the market does not want them). However, none of these theories work as well as the signaling theory. Additionally, remember that dividends used to be taxed differently from capital gains, and your co-authors feel that tax-based explanations may also play a part in explaining dividend policy. Z A final note on the signaling theory: some researchers claim that the dissemination of information to the market has improved with the Internet. As such, today's investors presumably have much more information about firms. Thus, the importance of dividends as a signal may be reduced. While this is an interesting idea, our own research shows that while there has been a reduction over time in the size of the market reaction to new dividends, there is still a significant reaction.CHAPTER 11 Dividends and Stock Repurchases (Apple Inc.) This chapter will look at why and how rms return cash to their stockholders in the form of dividends and stock repurchases. We will rst discuss the theory and empirical facts regarding dividends. Then we will use Apple Inc. (Apple) as an example to discuss corporate dividend policy. Next, we will discuss stock repurchases and Apple's recent use of repatriated funds to repurchase shares. THE THEORY OF DIVIDEND POLICY To discuss the theory behind corporate dividends, we begin (as we often do) with M&M (Miller and Modigliani). With dividends we start with M&M (1961). Let's assume an M&M world with efcient markets (there is no information asymmetry; i.e., everyone knows everything, and everyone knows it at the same time, zero transaction costs, zero taxes, and costless arbitrage). Remember that we lived in this world when we discussed capital structure in Chapter 6. In an M&M world, dividend policy does not matter. M&M (1961) shows that dividends are a zero net present value (NPV) transaction (i.e., paying or not paying dividends does not change the value of the rm or the stock). The logic for why dividends don't matter in an M&M world is simple: an investor in this world is indifferent between owning a stock worth $50 and owning a stock worth $48 plus $2 in cash because the investor can costlessly arbitrage. The arbitrage argument is that if an individual prefers dividends and the stock she owns does not pay dividends, the individual can simulate her own dividends by selling part of her stock. To obtain a 5% dividend, an individual simply needs to sell off 5% of her stock every year. Remember, in an M&M world, there are no transaction costs, no information costs, and no taxesthe individual merely creates the equivalent of a dividend by selling stock. Similarly, if an individual does not want a dividend but receives one, she can undo the dividend by buying additional stock with the cash dividend. Thus, in an M&M world with no transaction costs, no taxes, and efcient markets, an individual can alter her stock/ dividend mix to achieve the equivalent of whatever dividend policy she desires, regardless of the actual dividend payments made by the rm. In this world dividends and stock buybacks are equivalent. In our chapter on capital structure theory (Chapter 6) we listed ve things to consider as we moved from the M&M world to the real world: 1. The impact of taxes 2. The costs of nancial distress 3. Signaling 4. Information asymmetry 5. Agency problems We will now discuss how each of these ve factors affects optimal dividend policy. The rst two of the ve criteria that determine capital structure policy (taxes and the costs of nancial distress) are not as important in determining dividend policy. The last three factors on our list are the most important ones in deciding dividend policy. Signaling is particularly important, with information asymmetry and agency costs being less so. Making the Theory on Dividend Policy More Realistic 1. Taxes Just as taxes matter to capital structure policy, they also matter to dividend policyalthough not as much. Equity returns to stockholders come in two forms: dividends and capital gains. These two forms of distribution to stockholders are not necessarily taxed at the same rate or at the same time. The tax rates on dividends and capital gains have changed over time (see the box below). Complicating the difference in tax rates is the timing of when the taxes are paid. Dividends are taxed immediately upon receipt, while taxes on capital gains are postponed until realization (which partially mitigates or exacerbates any differences in the effective tax rates). These differences in tax rates and timing impacts a rm's choice of dividend policy. DIVIDEND TAX RATES Prior to 2003, dividends were taxed at a higher rate than capital gains. (Dividends were taxed at the same rate as income, while capital gains were taxed at a lower rate.) The combination of a higher tax rate on dividends and a later payment date on capital gains made capital gains relatively more attractive to shareholders than dividends. From 2003 to 2012, dividends were taxed at the same rate as capital gains (15%), thereby reversing the tax rate advantage of capital gains. Thus, while capital gains used to dominate from a tax perspective (i.e., lower rates and deferred payment), between 2001 and 2012, dividends had the same tax rates, while capital gains still had the deferred payment. (In 2013, the maximum rate on dividends and capital gains went up to 20%.) 2. Financial distress When discussing how to make capital structure decisions more realistic, our second consideration is the costs of nancial distress. This plays a large role in determining capital structure policy. Financial distress does not play as large a role in dividend policy as it does in capital structure decisions. I'Vhat happens if nancial distress causes a rm to fail to make its interest payments to its lenders? The lenders can force a rm to declare bankruptcy (and realize the related costs). What happens if nancial distress causes a rm to fail to make dividend payments to its shareholders? Shareholders have no process through which they can penalize the rm. If a rm fails to pay dividends, shareholders can go to the annual meeting and complain, or they can sell their shares. However, not paying a dividend does not, by itself, allow stockholders to force a rm into bankruptcy.l So the costs of nancial distress are not as important when considering dividend policy as they are when considering debt policy. 3. Signaling The signaling theory for dividends can be summarized as follows: one of the things rms can do with excess cash ow is to pay it out to its stockholders. Firms that need cash can't. (We discussed this in the chapters on Marriott, AT&T, and MCI.) Dividends and stock repurchases are the two major ways a rm can return cash to its stockholders. So if a rm pays a dividend or repurchases shares, it sends a signal to the market that the rm has enough cash ow to pay shareholders. If a rm wants to send a positive signal and pays dividends or does a repurchase without actually having excess cash ows, then the rm will incur a cost, and it will need to nd the cash elsewhere, usually through additional nancing