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25765 Corporate Finance:
Payout policy
University of Technology Sydney
Spring 2023
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Overview
A firm can retain free cash flows to invest in new projects or
to build up cash reserves. It can also distribute the cash to
shareholders.
There are 2 major ways of distributions: dividends and
repurchases.
Suppose ABC Co. has $20 million in FCF, 10 million shares
outstanding, no debt, and Re = 12%.
It expects to generate future FCFs of $48 million per year
thereafter.
How should a firm design its payout policy
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Payout policy irrelevance
Method 1: Dividend payout with excess cash
The cum-dividend share price is:
Scum-div = Current dividend + PV of future dividends
=
$20 million
10 million +
1
0.12
×
$48 million
10 million = $42
After paying out the current dividend, the ex-dividend share price
falls to:
Sex-div = PV of future dividends
=
1
0.12
×
$48 million
10 million = $40
In a perfect market, the share price drops by the amount of dividend
paid out when the stock begins to trade ex-dividend.
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Method 2: Share repurchase (1)
Suppose that ABC instead uses the $20 million to repurchase its
shares on the open market. It can repurchase:
$20 million
$42 per share = 0.476 million shares
After the repurchase, ABC’s market value of assets also decreases
to:
$42 × 10 million $20 million
|
{z
}
cash for repurchase
= $400 million
Post-repurchase share price is now:
$400 million
10 million 0.476 million = $42
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Method 2: Share repurchase (2)
After the repurchase, the future dividends would rise to:
$48 million
10 million 0.476 million = $5.04 per share
The stream of dividends is valued at:
S =
$5.04
0.12
= $42
So, shareholders are indifferent between participating and not par_x005f ticipating in ABC’s repurchase exercise.
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Homemade payouts (1)
In perfect markets, an open market repurchase has no effect
on the share price.
Investors are indifferent between the $20 million distributed
via dividends or repurchases.
By re-investing dividends or selling shares, investors can
replicate either payout method on their own.
If ABC repurchases shares, investors who like dividends can
sell shares.
If ABC pays out dividends, investors who do not like dividends
can buy stock.
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Homemade payouts (2)
How would an investor who owns 2000 shares create a homemade
dividend of $9000 per year First, we show that the investor will
now receive a dividend of:
2000 shares × $2 = $4000
She is short of $9000 $4000 = $5000 today. So, she can make up
for it by selling:
$5000 = 125 shares $40
In future years, she is left with 2000 shares 125 shares = 1875 shares.
At $4.80 dividend per share, she gets:
1875 shares × $4.80 = $9000 per year
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Homemade payouts (3)
Suppose ABC chooses to pay out the $2 dividend per share. How ever, what can an investor who owns 2000 shares and dislikes div idends do Because she dislikes dividends, she can re-invest the
dividends into more stock at the ex-dividend price. She will then
have:
2000 shares + $4000
$40 = 2100 shares
Her portfolio value is now 2100 shares × $40 = $84000. If she had
accepted the dividends and done nothing, her portfolio value would
also be:
2000 shares × $40 + $4000 = $84000
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Method 3: High dividend (1)
Suppose that ABC still has 10 million shares outstanding. It only
has $20 million in cash today, but it wants to pay $42 million more
in dividends. ABC wants to raise the entire $42 million by issuing
new equity. It can sell:
$42 million
$42 per share = 1 million shares
The new current dividend is now:
$20 million + $42 million
10 million + 1 million = $5.64 per share
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Method 3: High dividend (2)
Future dividends are
$48 M
11M = $4.36 per share
So, the cum-dividend share price is:
Scum-div = $5.64 + $4.36
0.12
= $42
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Dividend policy irrelevance (1)
Modigliani-Miller: In perfect markets, holding fixed a firm’s
investment policy, the firm’s dividend policy is irrelevant.
Tradeoff between current dividends ↑↓ and future dividends ↓↑
such that the initial stock price remains constant.
A firm’s free cash flows determine the level of payouts it can
make to investors.
The type of payout is irrelevant because investors can
manufacture their desired payout patterns.
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Dividend policy irrelevance (2)
Dividend per share ($)
S ($) Year 0 Year 1 Year 2 . . .
Policy 1 42 2.00 4.80 4.80 . . .
Policy 2 42 0.00 5.04 5.04 . . .
Policy 3 42 4.50 4.50 4.50 . . .
Payout policy is irrelevant in perfect markets.
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Dividends and taxes
Dividends and taxes (1)
In reality, there are taxes on dividends and capital gains.
Dividends are suboptimal from a tax perspective because τd is
often higher than τg .
In fact, long-term investors can defer capital gains taxes
indefinitely by not selling.
When τd > τg , raising cash via equity issuances to pay
dividends hurts shareholders.
Consider the setup on Slide 9 with τd = 40% and τg = 15%.
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Dividends and taxes (2)
If ABC had not raised the extra cash, it would have paid out only
$20 million in dividends. Investors pay taxes on these dividends.
40% × $20 million = $8 million
But, equity value falls exactly by $20 million ex-dividend so investor
save some money on capital gains taxes.
15% × $20 million = $3 million
On net, investors pay $5 million in taxes due to the dividend payout.
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Dividends and taxes (3)
Because ABC raised extra cash to pay a total of $62 million of
dividends, investors pay net taxes of:
(40% 15%) × $62 million = $15.5 million
Compared to the base case, investors paid extra taxes.
$15.5 million $5 million = $10.5 million
So, ABC destroyed $10.5 million out of the $42 million investment.
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Dividend and taxes (4)
The tax impact of dividends is partly offset by savings on capital
gains tax. So, when τd 6 = τg , the effective dividend tax rate is not
exactly τd .
(Scum-div Sex-div) × (1 τg )
|
{z
}
after-tax loss
= DIV × (1 τd )
|
{z
}
after-tax gain
If after-tax loss > after-tax gain, then investors avoid the dividend
by selling the stock cum-dividend and buying it back ex-dividend.
If after-tax loss < after-tax gain, then investors rush to buy the stock cum-dividend to capture the dividend, and sell it ex-dividend. When after-tax loss = after-tax gain, there is no profitable arbitrage at this equilibrium. 16 / 31 Dividend and taxes (5) Rearranging the terms, Scum-div Sex-div = DIV × 1 τ 1 τ d g = DIV × 1 τd τg 1 τg | {z } τ d The effective dividend tax rate τd measures the tax disadvantage of dividends relative to capital gains. 17 / 31 Dividend and taxes (6) Suppose τd = 39% and τg = 20%, then: τd = 0.39 0.20 1 0.20 = 23.75% This means that, after taxes, every $1 of dividends is worth only: (1 23.75%) × $1 = $0.7625 in capital gains 18 / 31 Clientele effects 19 / 31 Retention and payout Retention and payout (1) In perfect markets, once a firm has taken all positive-NPV projects, it is indifferent between saving excess cash and paying it out. Rather than waste excess cash on negative-NPV projects, the firm can purchase financial assets. Because there are no transaction costs, buying or selling financial assets does not affect firm value. Modigliani-Miller: In perfect markets, the firm’s choice of payout versus retention is irrelevant if it has access to financial assets. 20 / 31 Retention and payout (2) Suppose ABC Co. has $100000 in excess cash. ABC can invest the cash in one-year Treasury bills at 6% interest, and use the cash to pay a dividend next year. Alternatively, ABC can pay a dividend immediately. If ABC retains the cash, at year-end, it can pay a dividend of: $100000 × 1.06 = $106000 If ABC pays a dividend immediately, shareholders can invest the payout in Treasury bills themselves and receive at year-end: $100000 × 1.06 = $106000 So, the retention-payout decision is irrelevant. 21 / 31 Retention and payout (3) Suppose the same setup in Slide 21. But, the corporate tax rate is 35%, and ABC’s shareholders are tax-exempt. If ABC retains the cash, it can only pay the after-tax return on the Treasury bills as dividends at year-end. $100000 + $100000 × 6% × (1 35%) = $103900 This is lower than the $106000 that the tax-exempt shareholders could have earned if they invested in the Treasury bills themselves. 22 / 31 Retention and payout (4) If ABC chooses to retain the $100000 permanently, what is the PV of tax payments on the additional interest income PV of extra tax payments = $100000 × 6% × 35% 6% = $35000 23 / 31 Retention and payout (5) While some investors are tax-exempt, most individual investors must pay taxes on interest, dividends, and capital gains. We now see how investors’ personal taxes affect the tax disadvantage of retaining cash. Consider this simple example. A firm only has one asset, $100 cash. It has two choices: 1. Pay out the cash as a dividend immediately and shut down. 2. Retain the cash permanently and invest it in Treasury bills at rf . Pay out annual dividends from its after-tax interest income. 24 / 31 Retention and payout (6) Choice #1: After paying out the dividend, the firm shuts down so Sex-div becomes 0. Refer to Slide 16 for the below equation. Scum-div = =0 z }| { Sex-div +DIV × _x0012_ 1 τd 1 τg _x0013_ = $100 × 1 τd 1 τg Choice #2: From its investment in the Treasury bills, the firm can pay a perpetual after-tax dividend of: DIV = $100 × rf × (1 τc ) where τc is the corporate tax rate 25 / 31 Retention and payout (7) Choice #2 (cont’d): What price Sretain will an investor pay for this firm Her cost of capital is the after-tax return that she could have earned by investing in Treasury bills herself: rf × (1 τi). Where τi is the investor’s personal tax on interest income, Sretain = DIV × (1 τd ) rf × (1 τi) = $100 × rf × (1 τc ) × (1 τd ) rf × (1 τi) = $100 × (1 τc ) × (1 τd ) (1 τi) 26 / 31 Retention and payout (8) Choice #2 (cont’d): We now compare Sretain with Scum-div. Sretain Scum-div = $100 × (1 τc )×(1 τd ) (1 τi ) $100 × 1 τd 1 τg = (1 τc ) × (1 τg ) (1 τi) Moving Scum-div to the right-hand-side, and simplifying: Sretain = Scum-div × (1 τ retain) where τ retain = 1 (1 τc ) × (1 τg ) (1 τi) 27 / 31 Retention and payout (9) τ retain = 1 (1 τc ) × (1 τg ) (1 τi) This equation tells us 3 things: 1. The interest on retained cash is taxed twice. 2. For investors in a very high income tax bracket, τ retain can be near zero. 3. For tax-exempt investors, τ retain = τc 28 / 31 Homework questions Question 1 ABC Co. pays a regular dividend of $2.50 per share. Typ ically, ABC’s share price falls by $2.00 when the stock goes ex-dividend. Suppose all investors face the same τg = 20%, but they may pay different tax rates on div idends. Absent transaction costs, what is the highest τd of an investor who can gain from capturing the dividend 29 / 31 Question 2 ABC Co. expects to generate $40 million in FCF per year and will pay out these cash flows as regular dividends. ABC has no debt, 10 million shares outstanding, and a unlevered cost of capital of 10%. It now has $50 million in excess cash and wants to use it to repurchase shares. You own 4000 ABC shares, but you are unhappy with the repurchase. You would have preferred ABC to pay out the $50 million as a special dividend. How would you create such a homemade special dividend 30 / 31 Question 3 ABC Co. is an all-equity firm with 50 million shares out standing. It expects FCFs of $75 million per year, and currently has $200 million in excess cash. ABC’s cost of capital is 10%. The CEO wants to use the excess cash to expand ABC’s operations. This expansion will increase free cash flows by 12%. However, the board of directors believes that the cash should be retained. Which option is better 31 / 31