Fundamentals of Corporate Finance Fourth Edition Chapter 17

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Fundamentals of Corporate Finance Fourth Edition Chapter 17 Payout Policy Copyright © 2018, 2015,

Fundamentals of Corporate Finance Fourth Edition Chapter 17 Payout Policy Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 1 Cash Distributions to Shareholders (1 of 4) • Payout Policy – The

17. 1 Cash Distributions to Shareholders (1 of 4) • Payout Policy – The way a firm chooses between the alternative ways to pay cash out to shareholders Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Figure 17. 1 Uses of Free Cash Flow Copyright © 2018, 2015, 2012 Pearson

Figure 17. 1 Uses of Free Cash Flow Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 1 Cash Distributions to Shareholders (2 of 4) • Dividends – – Declaration

17. 1 Cash Distributions to Shareholders (2 of 4) • Dividends – – Declaration Date Ex-Dividend Date Record Date Payable (Distribution) Date Figure 17. 2 Important Dates for Microsoft’s Special Dividend Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Figure 17. 3 Dividend History for GM Stock, 1983 -2008 Copyright © 2018, 2015,

Figure 17. 3 Dividend History for GM Stock, 1983 -2008 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (1 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (1 of 22) • 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: Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (2 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (2 of 22) • 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 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (3 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (3 of 22) • Alternative Policy 1: Pay Dividend with Excess Cash – With 10 million shares outstanding, Genron will be able to pay a $2 dividend immediately § Because the firm expects to generate future free cash flows of $48 million per year, it anticipates paying a dividend of $4. 80 per share each year thereafter Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (4 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (4 of 22) • Alternative Policy 1: Pay Dividend with Excess Cash – Genron’s share price just before the stock pays its dividend (cum-dividend): ‒ Genron’s share price just after the stock goes exdividend: Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (5 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (5 of 22) • Alternative Policy 1: Pay Dividend with Excess Cash – In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (6 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (6 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – Suppose that Genron does not pay a dividend this year, but instead uses the $20 million to repurchase its shares on the open market § How will the repurchase affect the share price? Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (7 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (7 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – With an initial share price of $42, Genron will repurchase $20 million ÷ $42 per share = 0. 476 million shares, leaving only 10 − 0. 476 = 9. 524 million shares outstanding Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (8 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (8 of 22) Alternative Policy 2: Share Repurchase (No Dividend) Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (9 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (9 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – The market value of Genron’s assets falls when the company pays out cash, but the number of shares outstanding also falls from 10 million to 9. 524 million § The two changes offset each other, so the share price remains the same at $42 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (10 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (10 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – Genron’s Future Dividends § In future years, Genron expects to have $48 million in free cash flow, which can be used to pay a dividend of $48 million ÷ 9. 524 million shares = $5. 04 per share each year. Thus, Genron’s share price today is: Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (11 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (11 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – 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 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (12 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (12 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – 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: Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (13 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (13 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – Investor Preferences § Would an investor prefer that Genron issue a dividend or repurchase its stock? – In either case, the value of the investor’s portfolio is $84, 000 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (14 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (14 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – Investor Preferences § What if the firm repurchases shares but investor wants cash? – The investor could sell shares to raise cash (aka homemade dividend) Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (15 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (15 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – Investor Preferences § What if the firm pays a dividend and the investor does not want cash? – The investor could use the dividend to purchase additional shares Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (16 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (16 of 22) • Alternative Policy 2: Share Repurchase (No Dividend) – Investor Preferences § In either case, the value of the investor’s portfolio is $84, 000 – In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases – By reinvesting dividends or selling shares, they can replicate either payout method on their own Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (17 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (17 of 22) • 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 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (18 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (18 of 22) • Alternative Policy 3: High Dividend (Equity Issue) – One was way to raise more cash is to borrow money or sell new shares – Given a current share price of $42, Genron could raise $28 million by selling $28 million $42 per share = 0. 67 million shares Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (19 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (19 of 22) • Alternative Policy 3: High Dividend (Equity Issue) – Because this equity issue will increase Genron’s total number of shares outstanding to 10. 67 million, the amount of the dividend per share each year will be: Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (20 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (20 of 22) • Alternative Policy 3: High Dividend (Equity Issue) – Under this new policy, Genron’s cum-dividend share price is: • The initial share value is unchanged by this policy, and increasing the dividend has no benefit to shareholders Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Example 17. 1 Homemade Dividends (1 of 4) Problem: • Suppose Genron does not

Example 17. 1 Homemade Dividends (1 of 4) Problem: • Suppose Genron does not adopt the third alternative policy and instead pays a $2 dividend per share today. • Show an investor holding 2000 shares could create a homemade dividend of $4. 50 per share × 2000 shares = $9000 per year on her own. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Example 17. 1 Homemade Dividends (2 of 4) Solution: Plan: • If Genron pays

Example 17. 1 Homemade Dividends (2 of 4) Solution: Plan: • If Genron pays a $2 dividend, the investor receives $4000 in cash and holds the rest in stock. • She can raise $5000 in additional cash by selling 125 shares at $40 per share just after the dividend is paid. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Example 17. 1 Homemade Dividends (3 of 4) Execute: • The investor creates her

Example 17. 1 Homemade Dividends (3 of 4) Execute: • The investor creates her $9000 this year by collecting the $4000 dividend and then selling 125 shares at $40 per share. • In future years, Genron will pay a dividend of $4. 80 per share. Because she will own 2000 − 125 = 1875 shares, the investor will receive dividends of 1875 × $4. 80 = $9000 per year from then on. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Example 17. 1 Homemade Dividends (4 of 4) Evaluate: • Again, the policy that

Example 17. 1 Homemade Dividends (4 of 4) Evaluate: • Again, the policy that the firm chooses is irrelevant—the investor can transact in the market to create a homemade dividend policy that suits her preferences. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (21 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (21 of 22) • Modigliani-Miller and Dividend Policy 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 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Table 17. 1 Genron’s Dividends per Share Each Year Under the Three Alternative Policies

Table 17. 1 Genron’s Dividends per Share Each Year Under the Three Alternative Policies Blank Initial Share Price Dividend Paid ($ per share) for Year 0 Dividend Paid ($ per share) for Year 1 Dividend Paid ($ per share) for Year 2 … Policy 1: $42. 00 4. 80 … Policy 2: $42. 00 0 5. 04 … Policy 3: $42. 00 4. 50 … Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (22 of 22)

17. 2 Dividends Versus Share Repurchases in a Perfect Capital Market (22 of 22) • Dividend Policy and Perfect Capital Markets – Although dividends do determine share prices, a firm’s choice of dividend policy does not § A firm’s free cash flows determine the level of payouts that it can make to its investors § In a perfect capital market, whether these payouts are made through dividends or share repurchases does not matter Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 3 The Tax Disadvantage of Dividends (1 of 9) • Taxes on Dividends

17. 3 The Tax Disadvantage of Dividends (1 of 9) • Taxes on Dividends and Capital Gains – Shareholders typically must pay: § Taxes on the dividends they receive § Capital gains taxes when they sell their shares Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 3 The Tax Disadvantage of Dividends (2 of 9) • Taxes on Dividends

17. 3 The Tax Disadvantage of Dividends (2 of 9) • Taxes on Dividends and Capital Gains – When a firm pays a dividend, shareholders are taxed according to the dividend tax rate § If dividends are taxed at a higher rate than capital gains (which they were until 2003) shareholders will prefer share repurchases to dividends – Because long-term investors can defer the capital gains tax until they sell, there is still a tax advantage for share repurchases over dividends Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Table 17. 2 Long-Term Capital Gains Versus Dividend Tax Rates in the United States,

Table 17. 2 Long-Term Capital Gains Versus Dividend Tax Rates in the United States, 1971– 2016 Table 17. 2 Long-Term Capital Year Capital Gains Dividends 1971– 1978 35% 70% 1979– 1981 28% 70% 1982– 1986 20% 50% 1987 28% 39% 1988– 1990 28% 1991– 1992 28% 31% 1993– 1996 28% 40% 1997– 2000 20% 40% 2001– 2002 20% 39% 2003– 2012 15% 2013– 2016* 20% * Rates were still current when this book went to press in late 2016. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 3 The Tax Disadvantage of Dividends (3 of 9) • Optimal Dividend Policy

17. 3 The Tax Disadvantage of Dividends (3 of 9) • Optimal Dividend Policy with Taxes – The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Figure 17. 4 Dividend and Capital Gains Tax Rates Around the World Source: OECD

Figure 17. 4 Dividend and Capital Gains Tax Rates Around the World Source: OECD 2015, www. oecd. org; capital gains rates based on marginal rate for an investor with $100, 000 in income exceeding any initial exemption. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 3 The Tax Disadvantage of Dividends (4 of 9) • Optimal Dividend Policy

17. 3 The Tax Disadvantage of Dividends (4 of 9) • Optimal Dividend Policy with Taxes – Dividends in Practice § Prior to 1980, most firms used dividends exclusively to distribute cash to shareholders § By 2015 about 40% of firms relied exclusively on dividends – At the same time, 30% of all firms (and more than half of firms making payouts to shareholders) used share repurchases exclusively or in combination with dividends Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 3 The Tax Disadvantage of Dividends (5 of 9) • Optimal Dividend Policy

17. 3 The Tax Disadvantage of Dividends (5 of 9) • Optimal Dividend Policy with Taxes – Dividends in Practice § Dividend Puzzle – When firms continue to issue dividends despite their tax disadvantage Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Figure 17. 5 The Rise of Repurchases Source: Compustat. Copyright © 2018, 2015, 2012

Figure 17. 5 The Rise of Repurchases Source: Compustat. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Figure 17. 6 The Changing Composition of Shareholder Payouts Source: Compustat/CRSP data for U.

Figure 17. 6 The Changing Composition of Shareholder Payouts Source: Compustat/CRSP data for U. S. firms, excluding financial firms and utilities. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Table 17. 3 Summary of Dividends Versus Repurchases Blank Dividends Share Repurchases How cash

Table 17. 3 Summary of Dividends Versus Repurchases Blank Dividends Share Repurchases How cash is distributed to shareholders Cash payment made on a per-share basis to all shareholders Shares are bought back from some Shareholders Participation Involuntary (everyone with a share receives a dividend) Voluntary (shareholders choose whether to sell their shares) Taxation for ordinary investors Generally taxed as ordinary income, but taxed at 20% as of 2016 Taxed as capital gains, 20% as of 2016 Effect on share price Share price drops by the amount of the Dividend Share price is unaffected as long as shares are repurchased at a fair (market) price Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 3 The Tax Disadvantage of Dividends (6 of 9) • Tax Differences Across

17. 3 The Tax Disadvantage of Dividends (6 of 9) • Tax Differences Across Investors – Dividend Tax Rate Factors § § Income Level Investment Horizon Tax Jurisdiction Type of Investor or Investment Account Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 3 The Tax Disadvantage of Dividends (7 of 9) • Tax Differences Across

17. 3 The Tax Disadvantage of Dividends (7 of 9) • Tax Differences Across Investors – Dividend Tax Rate Factors § Long-term investors are more heavily taxed on dividends, so they would prefer share repurchases to dividend payments § One-year investors, pension funds, and other non-taxed investors have no tax preference for share repurchases over dividends; they would prefer a payout policy that most closely matches their cash needs Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 3 The Tax Disadvantage of Dividends (8 of 9) • Tax Differences Across

17. 3 The Tax Disadvantage of Dividends (8 of 9) • Tax Differences Across Investors – Dividend Tax Rate Factors § Corporations enjoy a tax advantage associated with dividends due to the 70% exclusion rule – A corporation that chooses to invest its cash will prefer to hold stocks with high dividend yields Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 3 The Tax Disadvantage of Dividends (9 of 9) • Tax Differences Across

17. 3 The Tax Disadvantage of Dividends (9 of 9) • 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 – Tax-free investors and corporations have a preference for stocks with high dividends § The dividend policy of a firm is optimized for the tax preference of its investor clientele Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Table 17. 4 Differing Dividend Policy Preferences Across Investor Groups Investor Group Dividend Policy

Table 17. 4 Differing Dividend Policy Preferences Across Investor Groups Investor Group Dividend Policy Preference Proportion of Investors Individual investors Tax disadvantage for dividends Prefer share repurchase ~52% Institutions, pension funds, retirement accounts No tax preference ~47% Prefer dividend policy that matches income needs Corporations Tax advantage for dividends ~1% Source: Proportions based on Federal Reserve Flow of Funds Accounts, 2015. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 4 Payout Versus Retention of Cash (2 of 6) • Retaining Cash with

17. 4 Payout Versus Retention of Cash (2 of 6) • Retaining Cash with Perfect Capital Markets – 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 value of the firm Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 4 Payout Versus Retention of Cash (3 of 6) • Retaining Cash with

17. 4 Payout Versus Retention of Cash (3 of 6) • Retaining Cash with Imperfect Capital Markets – Taxes and Cash Retention § Cash can be thought of as equivalent to negative leverage so the tax advantage of leverage implies a tax disadvantage to holding cash Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 4 Payout Versus Retention of Cash (4 of 6) • Retaining Cash with

17. 4 Payout Versus Retention of Cash (4 of 6) • 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 – Under most tax regimes there remains a substantial tax disadvantage for the firm to retaining excess cash even after adjusting for investor taxes Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 4 Payout Versus Retention of Cash (5 of 6) • Retaining Cash with

17. 4 Payout Versus Retention of Cash (5 of 6) • 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 § A firm must balance the tax costs of holding cash with the potential benefits of not having to raise external funds in the future Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 4 Payout Versus Retention of Cash (6 of 6) • Retaining Cash with

17. 4 Payout Versus Retention of Cash (6 of 6) • 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 – Paying out excess cash through dividends or share repurchases can boost the stock price by reducing managers’ ability and temptation to waste resources Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Table 17. 5 Selected Firms with Large Cash Balances Ticker Company Cash & Marketable

Table 17. 5 Selected Firms with Large Cash Balances Ticker Company Cash & Marketable Securities ($ billion) Percentage of Market Capitalization Mkt Cap AAPL Apple Inc. 215. 7 37% 586. 8 GE General Electric 113. 8 39% 294 MSFT Microsoft 102. 3 23% 443. 2 GOOGL Alphabet (Google) 73. 1 14% 528. 4 CSCO Cisco Systems 59. 1 43% 137. 8 ORCL Oracle Corporation 52. 3 34% 153. 5 AMGN Amgen, Inc. 31. 4 26% 122. 5 GM General Motors 20. 3 38% 52. 9 Source: Google Finance, January 2016. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 5 Signaling with Payout Policy (1 of 5) • Dividend Smoothing – The

17. 5 Signaling with Payout Policy (1 of 5) • Dividend Smoothing – The practice of maintaining relatively constant dividends § Firms raise their dividends only when they perceive a long-term sustainable increase in the expected level of future earnings, and cut them only as a last resort Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 5 Signaling with Payout Policy (2 of 5) • Dividend Signaling – Dividend

17. 5 Signaling with Payout Policy (2 of 5) • Dividend Signaling – Dividend Signaling Hypothesis § The idea that dividend changes reflect managers’ views about a firm’s future earnings prospects – 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. – When managers cut the dividend, it may signal that they have given up hope that earnings will rebound in the near term and so need to reduce the dividend to save cash Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Figure 17. 7 GM’s Earnings and Dividends per Share, 1985– 2008 Copyright © 2018,

Figure 17. 7 GM’s Earnings and Dividends per Share, 1985– 2008 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 5 Signaling with Payout Policy (3 of 5) • Dividend Signaling – Changes

17. 5 Signaling with Payout Policy (3 of 5) • 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 – The dividend decrease might lead to a positive, rather than negative, stock price reaction. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 5 Signaling with Payout Policy (4 of 5) • Signaling and Share Repurchases

17. 5 Signaling with Payout Policy (4 of 5) • Signaling and Share Repurchases – Share repurchases are a credible signal that the shares are under-priced, because if they are over-priced a share repurchase is costly for current shareholders Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 5 Signaling with Payout Policy (5 of 5) • Signaling and Share Repurchases

17. 5 Signaling with Payout Policy (5 of 5) • 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 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 6 Stock Dividends, Splits, and Spin-offs (1 of 4) • Stock Dividends and

17. 6 Stock Dividends, Splits, and Spin-offs (1 of 4) • 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 – Also called a 3: 2 (“ 3 -for-2”) stock split § A 100% stock dividend is equivalent to a 2: 1 stock split Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 6 Stock Dividends, Splits, and Spin-offs (2 of 4) • Stock Dividends and

17. 6 Stock Dividends, Splits, and Spin-offs (2 of 4) • 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 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 6 Stock Dividends, Splits, and Spin-offs (3 of 4) • Stock Dividends and

17. 6 Stock Dividends, Splits, and Spin-offs (3 of 4) • 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 – On average, announcements of stock splits are associated with a 2% increase in the stock price – Most firms use splits to keep their share prices from exceeding $100 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 6 Stock Dividends, Splits, and Spin-offs (4 of 4) • Stock Dividends and

17. 6 Stock Dividends, Splits, and Spin-offs (4 of 4) • Stock Dividends and Splits – Spin-Offs § When a firm sells a subsidiary by selling shares as a non -cash special dividend in the subsidiary alone – Advantages of a Spin-Off • It avoids the transaction costs associated with such a sale • The special dividend is not taxed as a cash distribution Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 7 Advice for the Financial Manager (1 of 3) • Overall, as a

17. 7 Advice for the Financial Manager (1 of 3) • Overall, as a financial manager, you should consider the following when making payout policy decisions: – For a given payout amount, try to maximize the aftertax payout to the shareholders – Repurchases and special dividends are useful for making large, infrequent distributions to shareholders Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 7 Advice for the Financial Manager (2 of 3) • Overall, as a

17. 7 Advice for the Financial Manager (2 of 3) • Overall, as a financial manager, you should consider the following when making payout policy decisions: – Starting and increasing a regular dividend is seen by shareholders as an implicit commitment to maintain this level of regular payout indefinitely – Because regular dividends are seen as an implicit commitment, they send a stronger signal of financial strength to shareholders than do infrequent distributions such as repurchases Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

17. 7 Advice for the Financial Manager (3 of 3) • Overall, as a

17. 7 Advice for the Financial Manager (3 of 3) • Overall, as a financial manager, you should consider the following when making payout policy decisions: – Be mindful of future investment plans Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Table 17. 6 Navigating the Payout Decision Payout or Not Dividend or Repurchase Do

Table 17. 6 Navigating the Payout Decision Payout or Not Dividend or Repurchase Do we have any unfunded positive. NPV projects? What are our future investment plans? Do we have sufficient cash reserves to weather a recession without distress? Would we benefit from signaling financial strength to the market? What are the tax implications for our shareholder base? Do we value the flexibility that repurchases allow? Do we need to send the stronger signal that dividends would convey? Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.