Intro
Chapter Outline
17.1 Distributions to Shareholders
17.2 Comparison of Dividends and Share Repurchases
17.3 The Tax Disadvantage of Dividends
17.4 Dividend Capture and Tax Clienteles
17.5 Payout Versus Retention of Cash
17.6 Signaling with Payout Policy
17.7 Stock Dividends, Splits, and Spin-Offs
17.3 The Tax Disadvantage of Dividends
17.3 The Tax Disadvantage of Dividends
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.
. . .
- The higher tax rate on dividends makes it undesirable for a firm to raise funds to pay a dividend.
- When dividends are taxed at a higher rate than capital gains, if a firm raises money by issuing shares and then gives that money back to shareholders as a dividend, shareholders are hurt because they will receive less than their initial investment.
17.3 The Tax Disadvantage of Dividends
Problem. Assume that:
- A firm raises 25 million from shareholders and uses it to pay 25 million in dividends.
- Dividends are taxed at a 39% tax rate. Capital gains are taxed at a 20% tax rate.
- How much will shareholders receive after taxes?
. . .
Solution
- On dividends, shareholders will owe \(39\% \times 25 = 9.75 million\) in taxes.
. . .
- Because the firm value falls after dividend, the capital gain will be 25 million less when investors sell, lowering the capital gains taxes by \(20\% \times 25 = 5 million\).
. . .
- Shareholders will pay a total of \(9.75 − 5.00 = 4.75 million\) in taxes.
. . .
- Shareholders will receive back only \(25 − 4.75 = 20.25 million\).
17.3 The Tax Disadvantage of Dividends
Optimal Dividend Policy with Taxes
- 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.
- This tax savings will increase the value of a firm that uses share repurchases rather than dividends.
. . .
- The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all.
. . .
Dividend Puzzle
- When firms continue to issue dividends despite their tax disadvantage, when it exists.
17.4 Dividend Capture and Tax Clienteles
17.4 Dividend Capture and Tax Clienteles
The preference for share repurchases rather than dividends depends on the difference between the dividend tax rate and the capital gains tax rate.
The Effective Dividend Tax Rate: Consider buying a stock just before it goes ex-dividend and selling the stock just after. The equilibrium condition is:
\[(P_{cum}-P_{ex})\times(1-\tau_g) = Div(1-\tau_d)\]
which changes to:
\[P_{cum}-P_{ex} = Div\times\frac{1-\tau_d}{1-\tau_g} = Div \times [ 1 - \frac{\tau_d - \tau_g}{1-\tau_g} ] = Div \times (1-\tau^*_d)\]
\[\tau^*_d = \frac{\tau_d - \tau_g}{1-\tau_g} \]
This measures the additional tax paid by the investor per dollar of after-tax capital gains income that is received as a dividend.
17.4 Dividend Capture and Tax Clienteles
Consider the stylized Brazilian case and compute the effective dividend tax rate.
- Capital gain tax: \(\tau_g\) = 15%
- Dividend tax rate: \(\tau_d\) = 30%
. . .
\[\tau^*_d = \frac{0.30 - 0.15}{1-0.15} = 0.176\]
This indicates a significant tax disadvantage of dividends; each 1 of dividends is worth only $0.824 in capital gains.
17.4 Dividend Capture and Tax Clienteles
The effective dividend tax rate differs across investors for a variety of reasons.
- Income Level, Investment Horizon, Tax Jurisdiction, Type of Investor or Type of investment Account, etc.
As a result of their different tax rates, investors will have varying preferences regarding dividends.
. . .
Therefore, we have an effect called: Clientele effect.
When the dividend policy of a firm reflects the tax preference of its investor clientele.
- Individuals in the highest tax brackets have a preference for stocks that pay no or low dividends, whereas tax-free investors and corporations have a preference for stocks with high dividends.
17.4 Dividend Capture and Tax Clienteles
Dividend-Capture Theory
The theory that absent transaction costs, investors can trade shares at the time of the dividend so that non-taxed investors receive the dividend.
An implication of this theory is that we should see large trading volume in a stock around the ex-dividend day, as high-tax investors sell and low-tax investors buy the stock in anticipation of the dividend, and then reverse those trades just after the ex-dividend date.
The empirical evidence partially supports this theory. Many high-tax investors keep the stocks anyway.
- We do not have such evidence in Brazil.
17.5 Payout Versus Retention of Cash
17.5 Payout Versus Retention of Cash
In perfect capital markets, once a firm has taken all positive-NPV projects, it is indifferent between saving excess cash and paying it out.
When such market imperfections do exist, 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.
Let’s discuss now the decision of holding cash instead of paying dividends or repurchasing shares.
17.5 Payout Versus Retention of Cash
Retaining Cash with Perfect Capital Markets
- If a firm has already taken all positive-NPV projects, any additional projects it takes on are zero or negative-NPV projects.
- 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.
Thus, with perfect capital markets, the retention versus payout decision is irrelevant.
. . .
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.
17.5 Payout Versus Retention of Cash
Problem
Payne Enterprises has 20,000 in excess cash. Payne is considering investing the cash in one-year Treasury bill paying 5% 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?
. . .
Solution
- If Payne pays an immediate dividend, the shareholders receive 20,000 today.
- If Payne retains the cash, at the end of one year the company will be able to pay a dividend of 21,000 (20,000 × (1.05) = 21,000)
- If shareholders invest the 20,000 in Treasury bills themselves, they would have $21,000 at the end of one year (20,000 × (1.05) = 21,000)
- The present value in either scenario is 20,000
Taxes and Cash Retention
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.
. . .
Problem
What if Payne has a marginal tax rate of 39%. Would a tax-exempt endowment prefer that Payne use its excess cash to pay the dividend immediately or invest the cash in a Treasury bill paying 5% interest and then pay out a dividend?
. . .
Solution
If Payne pays a dividend today, shareholders receive 20,000. If Payne retains the cash for one year, it will earn an after-tax return on the Treasury bills of \(5\% \times (1-0.39)=3.05\%\)
At the end of the year, Payne will pay a dividend of 20,000 × (1.0305) = 20,610. This amount is less than the 21,000 the endowment would have earned if they had invested the $20,000 in the Treasury bills themselves.
17.5 Payout Versus Retention of Cash
Adjusting for Investor Taxes
- The decision to pay out versus retain cash may also affect the taxes paid by shareholders.
- 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 firm value. The interest on retained cash is taxed twice.
. . .
- If the firm paid the cash to its shareholders instead, they could invest it and be taxed only once on the interest that they earn.
- The cost of retaining cash thus depends on the combined effect of the corporate and capital gains taxes, compared to the tax on interest income.
\[\tau^*_{retain} = 1-\frac{(1-\tau_c)(1-\tau_g)}{(1-\tau_i)}\]
17.5 Payout Versus Retention of Cash
Issuance and Distress Costs
A reason to hold cash:
- Generally, firms retain cash balances to cover potential future cash shortfalls, despite the tax disadvantage to retaining cash.
- A firm might accumulate a large cash balance if there is a reasonable chance that future earnings will be insufficient to fund future positive-NPV investment opportunities.
- The cost of holding cash to cover future potential cash needs should be compared to the reduction in transaction, agency, and adverse selection costs of raising new capital through new debt or equity issues.
17.5 Payout Versus Retention of Cash
Agency Costs of Retaining Cash
However…
- When firms have excessive cash, managers may use the funds inefficiently by paying excessive executive perks, over-paying for acquisitions, etc.
- Paying out excess cash through dividends or share repurchases, rather than retaining cash, can boost the stock price by reducing managers’ ability and temptation to waste resources.
. . .
At the end of the day:
- Firms should choose to retain to help with future growth opportunities and to avoid financial distress costs.
- Firms trade off these benefits against agency costs.
17.5 Payout Versus Retention of Cash
Problem
Altgreen is an all-equity firm with 250 million shares outstanding. Altgreen has 300 million in cash and expects future free cash flows of 150 million per year. Management plans to use the cash to expand the firm’s operations, which will in turn increase future free cash flows by 10%. If the cost of capital of Altgreen’s investments is 7%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price?
. . .
Solution
If Altgreen uses the cash to expand, its future free cash flows will increase by 10% to 165 million per year. Using the perpetuity formula, its market value will be \(\frac{165}{0.07} = 2.357\) billion or \(\frac{2.357 bi}{250million\;shares} = 9.43\) per share.
. . .
If Altgreen does not expand, the value of its future free cash flows will be \(\frac{150}{0.07} = 2.143 bi\). Adding cash, \(2.143 + 0.300 = \frac{2.443}{250mi} = 9.77\) per share.
. . .
If Altgreen repurchases shares, it will repurchase \(\frac{300mil}{9.77}=30.71\) million shares. Price would be \(\frac{2.143bi}{219.29mi}= 9.77\).
17.6 Signaling with Payout Policy
17.6 Signaling with Payout Policy
Dividend Smoothing
- The practice of maintaining relatively constant dividends
- Firm change dividends infrequently, and dividends are much less volatile than earnings.
17.6 Signaling with Payout Policy
Dividend Signaling Hypothesis
The idea that dividend changes reflect managers’ views about a future earnings.
If firms smooth dividends, the firm’s dividend choice will contain information regarding management’s expectations of future earnings.
When a firm increases dividend, it sends a positive signal to investors that they expect to be able to afford the higher dividend for the foreseeable future.
When a firm decreases dividend, it may signal that they have given up hope that earnings will rebound in the near term and so need to save cash.
. . .
But there is a catch
- Although an increase of a firm’s dividend may signal optimism regarding its future FCF, it might also signal a lack of investment opportunities.
- In this case, the dividend decrease might lead to a positive stock price reaction.
17.6 Signaling with Payout Policy
Signaling and Share Repurchases
- Share repurchases are a credible signal that the shares are underpriced, because if they are overpriced a share repurchase is costly for current shareholders.
- If investors believe that managers have better information regarding the firm’s prospects and act on behalf of current shareholders, then investors will react favorably to share repurchase announcements.
- But, announcing a share repurchase today does not necessarily represent a long-term commitment to repurchase shares. Dividends is a stronger signal in this regard.
- Also, a firm may announce a share repurchase program but not repurchase any shares. It is not mandatory to buy back shares. But once the firm announces dividends payment, it has to pay.
17.7 Stock Dividends, Splits, Spin-Offs
17.7 Stock Dividends, Splits, Spin-Offs
Stock Dividends
- With a stock dividend, a firm does not pay out any cash to shareholders. As a result, the total market value of the firm’s equity is unchanged.
- The only thing that is different is the number of shares outstanding. The stock price will therefore fall because the same total equity value is now divided over a larger number of shares.
. . .
- Suppose Genron paid a 50% stock dividend rather than a cash dividend.
- A shareholder who owns 100 shares (price = $42) before the dividend has a portfolio worth 4,200. After the dividend, the shareholder owns 150 shares.
- Because the portfolio is still worth 4,200, the stock price will fall to 28 (\(\frac{4,200}{150}\)).
Sometimes, firms finance new shares. So, it is like shareholders have received cash and immediately bought new shares. In this case, decline in price is not as large as above.
17.7 Stock Dividends, Splits, Spin-Offs
Splits
- The typical motivation for a stock split is to keep the share price in a range thought to be attractive to small investors.
- If the share price rises “too high,” it might be difficult for small investors to invest in the stock.
- Keeping the price “low” may make the stock more attractive to small investors and 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 small positive increase in the stock price.
Reverse Split (inplit)
- When the price of a company’s stock falls too low and the company reduces the number of outstanding shares. 2 shares become 1 of twice the previous price.
17.7 Stock Dividends, Splits, Spin-Offs
Spin-Off
- When a firm sells a subsidiary by selling shares in the subsidiary alone. That is, the parent turns a subsidiary into a separate company.
- For instance, Itau-XP Spin-off:
- Itau could have sold XP and paid cash as dividends.
- Instead, Itau’s current shareholders received x stocks of XP per share they hold of Itau.
- Spin-Offs offer two advantages.
- It avoids the transaction costs associated with the actual sale.
- The special dividend is not taxed as a cash distribution. Investors will only pay capital gains taxes when they sell the received stocks.
Problems
Question 1
Question 2
Recap
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Henrique C. Martins
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