Cash Flow Statement: Infosys

Financial Management
Payout Policy
Readings: BM Chapter 17

Source: https://in.finance.yahoo.com/ 4

Dividend History: Infosys Payout Policy: Microsoft Corporation

Distributed cash to investors primarily through share repurchase
• During 1999-2004 period, Microsoft spent an average of $5.4 billion per
year on share repurchases

Started paying dividends in 2003 (dividend of 8 cents per share)

On July 2004, announced that it would pay single cash dividend of
$32 billion ($3 per share)
Since then Microsoft has repurchased over $120 billion in shares and
raised its quarterly dividend 10 times (by late 2015 its dividend was
$0.36 per share)
Source: www.moneycontrol.com
2 5

Share Repurchase: Infosys Payout Policy

“Infosys closes Rs 8,260-crore buyback offer, takes back 11.05 crore When a firm’s investments generate free cash flow, the firm must
shares “ decide how to use that cash

Source: If the firm has new positive-NPV investment opportunities, it can

https://economictimes.indiatimes.com/markets/stocks/news/infosys
-closes-rs-8260-crore-buyback-offer-takes-back-11-05-crore-
shares/articleshow/70852446.cms?utm_source=contentofinterest&
utm_medium=text&utm_campaign=cppst
reinvest the cash and increase the value of the firm
Many young, rapidly growing firms reinvest 100 percent of their cash
flows in this way
Mature, profitable firms often generate more cash than they need to
fund all of their attractive investment opportunities

3 6

1
Distributions to Shareholders
Free cash flow – retain or pay out
• Retain – Invest in new projects or increase cash reserves
• Pay out – Repurchase shares or pay dividends
The way a firm chooses between these alternatives is referred to as
its pay out policy
7 10
Dividends
A public company’s board of directors determines the amount of the
firm’s dividend
The board sets the amount per share that will be paid and decides
when the payment will occur (payable date or distribution date)
The date on which the board authorize the dividend is the
declaration date
After the board declares the dividend, the firm is legally obligated to
make the payments
The firm will pay the dividend to all shareholders of record on a
specific date (record date)
8 11
Dividends
Most companies that pay dividends pay them at regular, quarterly
intervals
Companies typically adjust the amount of their dividends gradually,
with little variation in the amount of the dividend from quarter to
quarter
Occasionally, a firm may pay a one-time, special dividend that is
usually much larger than a regular dividend (Microsoft’s $3 dividend
in 2004)
9 12
Share Repurchases
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
Open market repurchase, tender offer, and targeted repurchase are
common ways through which firms repurchase shares
Open Market Repurchase
It is the most common way that firms repurchase shares, represent
approximately 95 percent of all repurchase transactions
A firm announces its intention to buy its own shares in the open
market, and then proceeds to do so over time like any other investor
Firm may take a year or more to buy the shares
It is not obligated to repurchase the full amount it originally stated
Firm must not buy its shares in order to manipulate the price
Tender Offer
A firm offers to buy shares at a pre-specified price during a specified
time period
The price is usually set at a premium to the current market price
The offer often depends on shareholders tendering a sufficient
number of shares
If shareholders do not tender enough shares, the firm may cancel
the offer and no buyback occurs
2
Dutch Auction Dividends versus Share Repurchase
Firm lists different prices at which it is prepared to buy shares Consider a hypothetical firm, Genron, which has $20 million in
excess cash and no debt
Shareholders in turn indicate how many shares they are willing to
sell at each price It has 10 million outstanding shares
The firm then pays the lowest price at which it can buy back its The firm expects to generate additional free cash flows of $48
desired number of shares million per year in subsequent years
Genron’s unlevered cost of capital is 12 percent
Genron’s board is meeting to decide how to pay out its $20 million
cash to shareholders

13 16

Targeted Repurchase Dividends versus Share Repurchase

A firm may purchase shares directly from a major shareholder and Board is evaluating following options:
negotiate purchase price directly with the seller
(1) Pay $20 million in dividends
A major shareholder may be willing to sell shares back to the firm at
a discount to the current market price, if a large number of shares (2) Repurchase shares
could not be sold in the market without severely affecting the price
because the market for the shares is not sufficiently liquid to sustain (3) Pay $48 million in dividends by raising additional cash of $28
such a large sale million through equity issue

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 shareholder – often at a large premium
over the current market price
14
Analyze the consequences of each of these three alternative policies
and compare them in a setting of perfect capital markets
17

Dividends versus Share Repurchase Alternative 1: Pay Dividend

If a corporation decides to pay cash to shareholders, it can do so
through either dividend payments or share repurchases
In the perfect capital markets setting of Modigliani and Miller, the
method of payment does not matter
With 10 million shares outstanding, Genron will be able to pay $2
dividend per share
Because the firm expects to generate future cash flows of $48
million per year, it anticipates paying a dividend of $4.80 per share
each year thereafter
The board declares the dividend and sets the record date as
December 14, so that the ex-dividend date is December 12

15 18

3
Alternative 1: Pay Dividend Alternative 2: Repurchase Share
The fair price for the shares is the present value of the expected Genron uses the $20 million to repurchase its shares at the market
dividends given Genron’s equity cost of capital price of $42/share
Because Genron has no debt, its equity cost of capital equals its $
unlevered cost of capital of 12 percent Number of shares purchased = = 0.476 Million
$ /

Just before the ex-dividend date, the stock is said to trade Remaining Shares = 10 − 0.476 = 9.524 Million
cumdividend (with the dividend) because anyone who buys the
stock will be entitled to the dividend The market value of Genron’s assets falls when the company pays
out cash but the number of shares outstanding also falls
Stock price, 𝑃 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝑃𝑉 𝐹𝑢𝑡𝑢𝑟𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
4.80 These changes offset each other so the share price remains the same
𝑃 =2+ = $42
0.12
19 22

Alternative 1: Pay Dividend Alternative 2: Repurchase Share

After the stock goes ex-dividend, new buyers will not receive the In future years, free cash flow of $48 million can be used to pay a
current dividend dividend of
$
= $5.04/𝑠ℎ𝑎𝑟𝑒 each year
.
At this point the share price will reflect only the dividends in .
subsequent years: Genron’s share price today, 𝑃 = = $42
.
4.8 The increase in future dividends compensates shareholders for the
𝑃 = 𝑃𝑉 𝐹𝑢𝑡𝑢𝑟𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 = = $40
0.12 dividend they give up today
The share price will drop on the ex-dividend date, December 12 In perfect capital markets, share repurchase has no effect on the
The amount of the price drop is equal to the amount of the current stock price
dividend, $2
20 23

Alternative 1: Pay Dividend Alternative 3: High Dividend (Equity Issue)

Although the stock price falls, holders of Genron stock do not incur a Genron raises $28 million by equity issue to pay $48 million dividend
loss overall (using $20 million cash plus raised equity)
Before the dividend, their stock was worth $42 Genron could raise $28 million by selling 0.67 million shares ($28
million ÷ $42 per share)
After the dividend, their stock is worth $40 and they hold $2 in cash
from the dividend, for a total value of $42 The amount of dividend per share each year will be $4.50 ($48
million ÷ $10.67 million shares)
In perfect capital markets, when a dividend is paid, the share price
drops by the amount of the dividend when the stock begins to trade Genron’s share price, 𝑃 = 4.50 +
.
= $42
.

Increasing the dividend has no benefit to shareholders, initial share

value is unchanged by this policy
21 24

4
Alternative 3: High Dividend (Equity Issue)
Note that Genron raises $28 million by equity issue
It could have also raised cash:
(1) By scaling back its investments: If the investments have positive
NPV, reducing them would lower firm value
(2) Borrow money
Advantages and disadvantages of these two options?
Investor Preferences
But if Genron repurchases shares and the investor wants cash, she
can raise cash by selling shares
For example, she can sell 95 shares ($4000 ÷ $42 per share) to raise
about $4,000 in cash
She will then hold 1905 shares or 1905 × $42 = $80,000 in stock
Thus, in the case of a share repurchase, by selling shares an investor
can create a homemade dividend

25 28

Investor Preferences Investor Preferences

Would an investor prefer that Genron issue a dividend or repurchase
its stock?
Both policies lead to the same initial share price of $42
Is there a difference in shareholder value after the transaction?
If Genron pays a dividend and the investor does not want the cash,
she can use the $4000 proceeds of the dividend to purchase 100
additional shares at the ex-dividend share price of $40 per share
As a result, she will hold 2100 shares, worth 2100 × $40 = $84,000

26 29

Investor Preferences Investor Preferences

Consider an investor who holds 2000 shares of Genron stock The two cases discussed can be summarized as:
Assuming the investor does not trade the stock, the investor’s (1) Dividend + Buy 100 shares
holdings after a dividend or share repurchase are as follows:
$40 × 2100 = $84,000 stock
Dividends: $40 × 2000 = $80,000 stock and $2 × 2000 = $4,000 cash
Repurchase: $42 × 2000 = $84,000 stock (2) Repurchase + Sell 95 shares
In either case, the value of the investor’s portfolio is $84,000 $42 × 1905 = $80,000 stock and $42 × 95 = $4,000 cash
immediately after the transaction except for the distribution
between cash and stock holdings
The investor may prefer one approach or the other based on
whether he needs the cash
27 30

5
Investor Preferences
By selling shares or reinvesting dividends, the investor can create any
combination of cash and stock desired
In perfect capital markets, investors are indifferent between the firm
distributing funds through dividends or share repurchases
By reinvesting dividends or selling shares, they can replicate either
payout method on their own
31
Homemade Dividends
Suppose Genron decides to pay a $2 dividend per share today
Show how an investor holding 2000 shares could create a
homemade dividend of $4.50 per share × 2000 shares = $9000 per
year on her own
32
Homemade Dividends
Investor receives $4000 in cash dividends and holds the rest in stock
To receive $9000 in total today, she can raise an additional $5000 by
selling 125 shares at $40 per share just after the dividend is paid
She will now own 2000 – 125 = 1875 shares
In future years, Genron will pay a dividend of $4.80 per share
Investor will receive dividends of 1875 × $4.80 = $9000 per year
33
Modigliani-Miller and Dividend Policy Irrelevance
Trade Off
(1) Pay out all cash as a dividend or finance a larger dividend by
issuing equity or debt
(2) Pay no dividend and use the cash instead to repurchase shares
Higher current dividend per share: Lower future dividends per share
Share repurchase: Higher future dividend per share (fewer shares in
the future)
The net effect of this trade-off is to leave the total present value of
all future dividends, and hence the current share price, unchanged
34
Modigliani-Miller Propositions: Capital Structure
In perfect capital markets, buying and selling equity and debt are
zero-NPV transactions that do not affect firm value
Any choice of leverage by a firm could be replicated by investors
using homemade leverage
As a result , the firm’s choice of capital structure is irrelevant
35
Modigliani-Miller: Dividend Policy Irrelevance
Regardless of the amount of cash the firm has on hand, it can pay a
smaller dividend (and use the remaining cash to repurchase shares)
or a larger dividend (by selling equity to raise cash)
Because buying or selling shares is a zero-NPV transaction, such
transactions have no effect on the initial share price
Shareholders can create a homemade dividend of any size by buying
or selling shares themselves
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
36
6
Modigliani-Miller: Dividend Policy Irrelevance
A firm’s choice of dividend today affects the dividends it can afford
to pay in the future in an offsetting fashion
Thus, while dividends do determine share prices, a firm’s choice of
dividend policy does not
Value of a firm ultimately derives from its underlying free cash flow
A firm’s free cash flow determines the level of payouts that it can
make to its investors
37
Modigliani-Miller and Dividend Policy Irrelevance
In a perfect capital market, whether these payouts are made through
dividends or share repurchases does not matter
However, in reality capital markets are not perfect
As with capital structure, it is the imperfections in capital markets
that determine the firm’s dividend and payout policy
• Market imperfections such as taxes, agency costs, transaction costs, and
asymmetric information between managers and investors
38
Dividend Policy with Taxes
As with capital structure, taxes are an important market
imperfection that influences a firm’s decision to pay dividends or
repurchase shares
Shareholders pay taxes on dividends as well as capital gains
Tax rate on dividends and on capital gains are usually different
The tax rates applied to dividends and long-term capital gains further
depend on individual’s income level
39
Dividend Policy with Taxes
When a firm pays a dividend, shareholders are taxed according to
the dividend tax rate
If the firm repurchases shares instead, and shareholders sell shares
and taxed according to the capital gains tax rate
If dividends are taxed at a higher rate than capital gains,
shareholders will prefer share repurchases to dividends
Further capital gains taxes are deferred until the asset is sold
40
Dividend Policy with Taxes
A 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 off – they get back the
money they put in
However, when dividends are taxed at a higher rate than capital
gains, this transaction hurts shareholders because they will receive
less than their initial investment
41
Dividend Policy with Taxes
Suppose a firm raises $10 million by issuing equity
It uses this cash to pay dividends
Dividend is taxed at a 40 percent rate
Capital gains are taxed at a 15 percent rate
How much will shareholders receive after taxes?
42
7
Dividend Policy with Taxes Effective Dividend Tax Rate
Shareholders will owe 40 percent of $10 million, or $4 million in Therefore, the investor earns a profit by trading to capture the
dividend taxes dividend if after-tax dividend exceeds the after-tax capital loss
The value of the firm will fall when the dividend is paid Conversely, if the after-tax capital loss exceeds the after-tax
dividend, the investor benefits by selling the stock just before it goes
Shareholders’ capital gain on the stock will be $10 million less when ex-dividend and buying it afterward, thereby avoiding the dividend
they sell, lowering their capital gains taxes by 15 percent of $10
million or $1.5 million
Thus, in total, shareholders will pay $2.5 (4 – 1.5) million in taxes and
they will receive back only $7.5 million of their $10 million
investments

43 46

Dividend Policy with Taxes Effective Dividend Tax Rate

When the tax rate on dividends exceeds the tax rate on capital gains, Arbitrage opportunity exists unless the price drop and dividend are
shareholders will pay lower taxes if a firm uses share repurchases for equal after taxes
all payouts rather than dividends
𝑃 −𝑃 1−𝜏 =𝐷 1−𝜏
Firms that use dividends will have to pay a higher pretax return to
their investors so that the investors get the same after-tax return as Rewriting above equation:
firms that use share repurchases 1−𝜏 𝜏 −𝜏
𝑃 −𝑃 =𝐷 =𝐷 1− = 𝐷 1 − 𝜏∗
The fact that firms continue to issue dividends despite their tax 1−𝜏 1−𝜏
advantage is often referred to as the dividend puzzle
Where, 𝜏 ∗ is defined as the effective dividend tax rate
(additional tax paid by the investor per dollar of after-tax capital
gains income that is instead received as a dividend)
44 47

Effective Dividend Tax Rate Effective Dividend Tax Rate

Consider an investor who buys a stock today just before it goes ex- Consider an individual investor in the highest tax bracket who plans
dividend and sells the stock just after to hold a stock for more than one year
• By doing so, the investor will qualify for, and capture, the dividend
For this investor, tax rate on dividends and capital gains are 39 and
After-tax cash flow from the dividend is 𝐷 1 − 𝜏 , where 𝐷 is the 20 percent, respectively
amount of dividend paid and 𝜏 is the investor’s dividend tax rate
. .
Effective dividend tax rate, 𝜏 ∗ = = 23.75 percent
The price just before the stock goes ex-dividend, (𝑃 ) exceeds the .
price just after (𝑃 ), the investor will incur a capital loss on his trade This indicates a significant tax disadvantage of dividends, each $1 of
dividends is worth only $0.7625 (1 - 0.2375) in capital gains
His after-tax loss is 𝑃 −𝑃 1 − 𝜏 , where 𝜏 is the tax rate on
capital gain

45 48

8
Effective Dividend Tax Rate Clientele Effects: Tax Differences Across Investors
Suppose that tax rate on both dividends and capital gains were Type of Investor or Investment Account:
reduced to 15 percent • Stocks held by individual investors in a retirement account are generally
not subject to taxes on dividends or capital gains
∗ . .
Effective dividend tax rate, 𝜏 = = 0 percent • Stocks held through pension funds or non-profit endowment funds may
. not be subjected to dividend or capital gains taxes
Therefore, the tax cut eliminated the tax advantage of dividends for • Corporations may pay different tax rates on income earned through
a one-year investor dividends and capital gains

49 52

Clientele Effects: Tax Differences Across Investors
The effective dividend tax rate 𝜏 ∗ for an investor depends on the tax
rates the investor faces on dividends and capital gains
These rates differ across investors for a variety of reasons
• Income Level
• Investment Horizon
• Tax Jurisdiction
• Type of Investor or Investment Account
Clientele Effects: Tax Differences Across Investors
Consider four different investors:
(1) A “buy and hold” investor who holds the stock in a taxable
account and plans to transfer the stock to her heirs
(2) An investor who holds the stock in a taxable account but plans to
sell it after one year
(3) A pension fund
(4) A corporation

50 53

Clientele Effects: Tax Differences Across Investors
Income Level: Investors with different levels of income fall into
different tax brackets and face different tax rates
Investment Horizon: Tax rates on capital gains and dividends vary
with the period for which investors hold the stock
• Long-term investors can defer the payment of capital gains taxes
(lowering their effective capital gains tax rate even further)
• Investors who plan to bequeath stocks to their heirs may avoid the capital
gains tax altogether
Tax Jurisdiction: State taxes differ by state, tax rates for foreign and
domestic investors might be different
51
Clientele Effects: Tax Differences Across Investors
The effective dividend tax rate for each are as follows:
Buy and hold individual investor: 𝜏 = 20, 𝜏 = 0, and 𝜏 ∗ = 20 percent
One-year individual investor: 𝜏 = 20, 𝜏 = 20, and 𝜏 ∗ = 0
Pension Fund: 𝜏 = 0, 𝜏 = 0, and 𝜏 ∗ = 0
Corporation: Given a corporate tax rate of 35 percent, 𝜏 = 1 − 70 ×
35 = 10.5, 𝜏 = 35, and 𝜏 ∗ = 38
(Corporations can exclude 70 percent of the dividends they receive from corporate taxes)
As a result of the different tax rates, these investors will have varying
preferences regarding dividends
54

9
Clientele Effects: Tax Differences Across Investors
Long-term investors would prefer share repurchases to dividend
payments
One-year investor and pension fund would have no tax preference
for share repurchases over dividends, they would prefer a payout
policy that most closely matches their cash needs
Corporations enjoy a tax advantage associated with dividends,
therefore, will prefer to hold stocks with high dividend yields
55
Clientele Effects: Tax Differences Across Investors
Differences in tax preferences across investor groups create clientele
effects, in which the dividend policy of a firm is optimized for the tax
preference of its investor clientele
Individual 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
56
Payout versus Retention of Cash
A firm can invest the cash in new projects or in financial instruments
Making positive-NPV investments will create value for the firm’s
investors, whereas saving the cash or paying it out will not
In the context of perfect capital markets, once a firm has taken all
positive NPV investments, it is indifferent between saving excess
cash and paying it out
However, because of market imperfections, there is a trade-off
• Retaining cash can reduce the costs of raising capital in the future, but it
can also increase taxes and agency costs
57
Payout versus Retention of Cash
Firms can retain excess cash or invest that in financial securities
In perfect capital markets, buying and selling securities is a zero-NPV
transaction, so it should not affect firm value
Shareholders can make any investment a firm makes on their own if
the firm pays out the cash
Thus, with perfect capital markets, the retention versus payout
decision – just like the dividend versus share repurchase decision – is
irrelevant to total firm value
58
Payout versus Retention of Cash
Rather than waste excess cash on negative-NPV projects, a firm can
hold the cash in the bank or use it to purchase financial assets
The firm can then pay the money to shareholders at a future time or
invest it when positive NPV investment opportunities become
available
59
Payout versus Retention of Cash
Barston Mining has $100,000 in excess cash
It is considering investing the cash in one-year Treasury bills paying 6
percent 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?
60
10
Payout versus Retention of Cash
If Barston pays an immediate dividend, the shareholders receive
$100,000 today
If Barston retains the cash, at the end of one year the company will
be able to pay a dividend of $100,000 × 1.06 = $106,000
This payoff is the same as if shareholders had invested the $100,000
in Treasury bills themselves
Thus, shareholders are indifferent about whether the firm pays the
dividend immediately or retains the cash
61
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
Thus, the decision of whether to retain cash depends on market
imperfections such as taxes, agency costs
62
Payout versus Retention of Cash: Taxes
Suppose Barston must pay corporate taxes at a 35 percent rate on
the interest it will earn from the one-year Treasury bill paying 6
percent interest
Would pension fund investors (who do not pay taxes on their
investment income) prefer that Barston use its excess cash to pay the
$100,000 dividend immediately or retain the cash for one year?
63
Payout versus Retention of Cash: Taxes
If Barston pays dividend now, shareholders receive $100,000 today
If Barston retains the cash for one year, it will earn an after-tax
return on the Treasury bills of 0.06 × (1 - 0.35) = 3.9 percent
Thus, at the end of the year, Barston will pay a dividend of
$100,000 1.039 = $103,900
This amount is less than the $106,000 the investors would have
earned if they had invested the $100,0000 in Treasury bills
themselves
64
Payout versus Retention of Cash: Taxes
Because Barston must pay corporate taxes on the interest it earns,
there is a tax disadvantage to retaining cash
Pension fund investors will therefore prefer that Barston pays the
dividend now
Corporate taxes make it costly for a firm to retain excess cash
65
Payout versus Retention of Cash: Taxes
Microsoft paid special dividend of $3 per share ($32 billion in 2004)
If Microsoft had instead retained that cash permanently, what would
the present value of the additional taxes be?
If Microsoft retained the cash, the interest earned on it would be
subject to a 35 percent corporate tax rate
Because the interest payments are risk free, we can discount the tax
payments at the risk-free interest rate (assuming Microsoft’s
marginal corporate tax rate will remain constant or that changes to it
have a beta of zero)
66
11
Payout versus Retention of Cash: Taxes Taxes
The present value of the tax payments on Microsoft’s additional Suppose the firm pays out its cash immediately as a dividend and
interest income would be shuts down
$32 𝑏𝑖𝑙𝑙𝑖𝑜𝑛 × 𝑟 × 0.35 The ex-dividend price of the firm is zero (it has shut down)
= $11.2 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
𝑟
Before the dividend is paid the firm has a share price of
Equivalently, on a per share basis, Microsoft’s tax savings from
1−𝜏 1−𝜏
paying out the cash rather than retaining it is 𝑃 =𝑃 +𝐷 = 0 + 100
1−𝜏 1−𝜏
$3 × 0.35 = $1.05 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
That is the investor will pay tax on the dividend at rate 𝜏 but will
receive a tax credit (at capital gains tax rate 𝜏 ) for the capital loss
when the firm shuts down
67 70

Taxes
The decision to pay out versus retain cash may also affect the taxes
paid by shareholders
While pension and retirement fund investors are tax exempt, most
individual investors pay taxes on interest, dividends, and capital
gains
Taxes
Alternatively, the firm can retain the cash and invest it in Treasury
bills, earning interest at rate 𝑟 each year
After paying corporate taxes on this interest rate 𝜏 , the firm can pay
a perpetual dividend of 𝐷 = 100𝑟 1 − 𝜏 each year and retain the
$100 in cash permanently
Investor could earn after-tax return of 𝑟 1 − 𝜏 by investing in
Treasury bills on her own, where 𝜏 is the investor’s tax rate on
interest income

68 71

Taxes Taxes
Consider a firm whose only asset is $100 in cash Because the investor must pay taxes on the dividends as well, the
value of the firm if it retains the $100 is
Suppose all investors face identical tax rates
( ) ( )( )
𝑃 = = =
A firm is considering paying out $100 cash as an immediate dividend
or retaining the $100 permanently and using the interest earned to
pay dividends 𝑃 =𝑃 =𝑃 1 − 𝜏∗

Where, 𝑟 ∗ measures effective tax disadvantage of retaining cash:

𝜏∗ = 1−

69 72

12
Taxes
Dividend tax will be paid whether the firm pays the cash
immediately or retains the cash and pays the interest over time - the
dividend tax rate does not affect the cost of retaining cash
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
Thus, the interest on retained cash is taxed twice
73
Taxes
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 therefore depends on the combined effect
of the corporate and capital gains taxes, compared to the single tax
in interest income
74
Taxes
If tax rates are as follows:
𝜏 = 35, 𝜏 = 39.6, and 𝜏 = 20 percent
Effective tax disadvantage of retained cash, 𝜏 ∗ = 13.9 percent
Thus, after adjusting for investor taxes, there remains a substantial
tax disadvantage for the firm to retaining excess cash
75
Issuance and Distress Costs
Even though there is a tax disadvantage to retaining cash, some
firms accumulate large cash balances
Firm may retain cash to fund future positive-NPV investment
opportunities, if it expects that future earnings will be insufficient
Accumulating cash also allows firms to avoid the transaction costs of
raising new capital (through new debt or equity issues)
Firms with volatile earnings may build cash reserves so that they can
weather periods of operating losses and thus avoid financial distress
Therefore, a firm must balance the tax costs of holding cash with the
potential benefits of not having to raise external funds in the future
76
Agency Costs of Retaining Cash
Payout policies are generally set by managers whose incentives may
differ from those of shareholders
When firms have excessive cash, managers may use the funds
inefficiently by continuing money-losing projects, paying excessive
executive perks, or over-paying for acquisitions
Leverage is one way to reduce a firm’s excess cash and avoid these
costs; dividends and share repurchases perform a similar role by
taking cash out of the firm
According to the managerial entrenchment theory of payout policy,
managers pay out cash only when pressured to do so by the firm’s
investors
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Agency Costs of Retaining Cash
Rexton Oil is an all-equity firm with 100 million shares outstanding
It has $150 million in cash and expects future free cash flows of $65
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 12 percent
The cost of capital of Rexton’s investments is 10 percent
How share price will change if Rexton uses cash for a share
repurchase rather than the expansion?
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Agency Costs of Retaining Cash
Using the cash to expand:
Future free cash flows: $65 M × 1.12 = $72.8 M per year
Market value: $72.8 M ÷ 0.10 = $728 M or $7.28 per share
Using the cash to repurchase share:
Future free cash flows: $65 M ÷ 0.10 = $650 M
Market value: $800 (650 + 150 cash) M or $8 per share
Rexton repurchases $150 M ÷ $8/share = 18.75 M shares
(remaining number of shares 100 – 18.75 = 81.25 M)
Rexton’s share price: $650 M ÷ 81.25 M shares = $8/share
79
Agency Costs of Retaining Cash
Cutting investment to fund a share repurchase increases the share
price by $0.72 per share because the expansion has a negative NPV
It costs $150 million and has negative NPV
-$150 million + $7.8million/0.10 = -$72 million (-$0.72 per share)
80
Agency Costs of Retaining Cash
Ultimately, firms should choose to retain cash for the same reasons
they would use low leverage - to preserve financial slack for future
growth opportunities and to avoid financial distress costs
These needs must be balanced against the tax disadvantage of
holding cash and the agency cost of wasteful investment
Large global high-tech and biotechnology firms, typically use little
debt, and tend to retain and accumulate large amounts of cash
81
Signalling with Payout Policy
Managers have better information than investors regarding the
future prospects of the firm (asymmetric Information), their payout
decisions may signal this information
Firms can change dividends at any time, but in practice they vary the
sizes of their dividends relatively infrequently, therefore, dividends
are much less volatile than earnings (dividend smoothing)
Firms increase dividends much more frequently than they cut them
• Firms raise dividends only when they perceive a long-term increase in the
expected level of future earnings and cut them only as a last resort
Firms generally set dividends at a level they expect to be able to
maintain based on the firm’s earnings prospects
82
Signalling with Payout Policy (Dividend)
If firms smooth dividends, the firm’s dividend choice will contain
information regarding management’s 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
Conversely, when managers cut the dividend, it may signal that
managers believe that earnings will not rebound in the near term
and reduce the dividend
Dividend Signalling Hypothesis: Dividend changes reflect managers’
views about a firm’s future earnings prospects
83
Signaling with Payout Policy (Dividend)
Increasing debt signals that management believes the firm can
afford the future interest payments
Similarly, raising the dividend signals the firm can afford to maintain
the dividends in the future
However, dividend changes are weaker signal than leverage changes
• Though cutting the dividend is costly for managers in terms of their
reputation and the reaction of investors, it is not as costly as failing to
make debt payments
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Signaling with Payout Policy (Dividend)
While an increase of a firm’s dividend may signal management’s
optimism regarding its future cash flows, it might also signal a lack of
investment opportunities
• Microsoft’s move to initiate dividends in 2003 was largely seen as a result
of its declining growth prospects as opposed to a signal about its
increased future profitability
Conversely, a firm might cut its dividend to exploit new positive-NPV
investment opportunities
In general, dividends as a signal should be interpreted in the context
of the type of new information managers are likely to have
Share Repurchases and Market Timing
Clark Industries has 200 million shares outstanding, a current share
price of $30, and no debt
Clark’s management believes that the true value is $35 per share
Clark plans to pay $600 million in cash to its shareholders by
repurchasing shares at the current market price
Soon after the transaction is completed, new information comes out
that causes investors to revise their opinion of the firm and agree
with management’s assessment of Clark’s value

85 88

Signaling with Payout Policy (Share Repurchase) Share Repurchases and Market Timing
Share repurchases, like dividends, may also signal managers’ Initial market cap: $30/share × 200 million shares = $6 billion
information to the market, however, there are some important
differences between share repurchases and dividends According to management, Clark’s initial market capitalization should
be $35/share × 200 million shares = $7 billion
First, managers are much less committed to share repurchases than
to dividend payments Clark will repurchase $600 million ÷ $30/share = 20 million shares
• Firms generally announce the maximum amount they plan to spend on
repurchases (actual amount spent may be far less) and may take several
years to complete the share repurchase

Second, firms do not smooth their repurchase activity from year to

year, announcing a share repurchase today does not necessarily
represent a long-term commitment to repurchase shares
86 89

Signaling with Payout Policy (Share Repurchase) Share Repurchases and Market Timing
Third, cost of share repurchase depends on the share’s market price Soon after the transaction is completed, new information comes out
• If managers believe the stock is currently overvalued, a share repurchase that causes investors to revise their opinion of the firm and agree
will be costly to the shareholders who choose to hold on to their shares with management’s assessment of Clark’s value
• When managers perceive the stock to be undervalued repurchasing
shares benefits existing shareholders Value of assets = 7 Billion - 600 Million = $6.4 B
Share repurchases would be a credible signal that management Clark’s share price be
$ .
= $35.556
believes its shares are underpriced
Shares are repurchased at a premium to the current market price,
thus, tender offers and Dutch auction repurchases are even stronger
signals than open market repurchases that management views the
current share price as undervalued
87 90

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Share Repurchases and Market Timing
If Clark waited for the new information to come out before
repurchasing the shares, it would buy shares at a market price of $35
per share
Thus, it would be able to repurchase only 17.2 million shares
The share price after the repurchase would be
$6.4 billion ÷ 182.8 million shares = $35
91
Share Repurchases and Market Timing
The gain from buying shares when the stock is underpriced leads to
an increase in the firm’s long-run share price
Similarly, buying shares when the stock is overpriced will reduce the
long-run share price
The firm may therefore try to time its repurchases appropriately
Anticipating this strategy, shareholders may interpret a share
repurchase as a signal that the firm is undervalued
92
Stock Dividends, Splits and Spin-Offs
Other than cash dividends, firm can also pay stock dividend in which
each shareholder who owns the stock receives additional shares of
stock of the firm itself (a stock split) or of a subsidiary (a spin-off)
If a company declares a 10 percent stock dividend, each shareholder
will receive one new share of stock for every 10 shares owned
Stock dividends of 50 percent or higher are generally referred to as
stock splits, for example, with a 50 percent stock dividend, each
shareholder will receive one new share for every two shares owned
• Because a holder of two shares will end up holding three new shares, this
transaction is also called 3:2 or 3-for-2 stock split
93
Stock Dividends, Splits and Spin-Offs
With a stock dividend, a firm does not pay out any cash to
shareholders
The total market value of the firm’s assets and liabilities, and
therefore of its equity, is unchanged
Unlike cash dividends, stock dividends are not taxed, thus, from both
the firm’s and shareholders’ perspectives, there is no real
consequence to a stock dividend
The number of shares is proportionally increased and the price per
share is proportionally reduced because the same total equity value
is now divided over a larger number of shares
94
Stock Dividends, Splits and Spin-Offs
Suppose Genron paid a 50 percent stock dividend (a 3:2 stock split)
rather than a cash dividend
A shareholder who owns 100 shares before the dividend has a
portfolio worth $42 × 100 = $4,200
After the dividend, the shareholder owns 150 shares worth $28,
giving a portfolio value of $28 × 150 = $4,200
95
Stock Dividends and Splits
Why do companies pay stock dividends or split their stock?
To keep the share price in a range thought to be attractive to small
investors
Stocks generally trade in lots of 100 shares, and in any case do not
trade in units less than one share
If the share price rises significantly, it might be difficult for small
investors to afford one share let alone 100
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
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Stock Dividends and Splits
Firms also do not want their stock prices to fall too low
A stock price that is very low raises transaction costs for investors
Exchanges require stocks to maintain a minimum price to remain
listed on an exchange
If the price of the stock falls too low, a company can engage in a
reverse split and reduce the number of shares outstanding
• For example, in a 1:10 reverse split, every 10 shares of stock are replaced
with a single share, as a result, the share price increases tenfold
97
Stock Dividends and Splits
From 1990 to 2000, Cisco Systems split its stock nine times, so that
one share purchased at the IPO split into 288 shares
• Had it not split, Cisco’s share price at the time of its last split in March
2000 would have been 288 × $72.19, or $20,791
Citigroup split its stock 7 times between 1990 and 2000, for a
cumulative increase of 12:1, but in May 2011 it implemented a 1:10
reverse split to increase its stock price from $4.5 to $45 per share
Reverse splits became necessary for many dot-com companies after
the Internet bust in 2000, and for some financial firms during the
global financial crisis
98
Stock Dividends and Splits
Through a combination of splits and reverse splits, firms can keep
their share prices in any range they desire
99
Spin-Offs
Sometimes firms may 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
subsidiary as a separate company
100
Spin-Offs
After selling 15 percent of Monsanto Corporation in an IPO in
October 2000, Pharmacia Corporation announced in July 2002 that it
would spin off its remaining 85 percent holding of Monsanto
Corporation
The spin-off was accomplished through a special dividend in which
each Pharmacia shareholder received 0.170593 share of Monsanto
per share of Pharmacia owned
After receiving the Monsanto shares, Pharmacia shareholders could
trade them separately from the shares of the parent firm
101
Spin-Offs
On the distribution date, Monsanto shares traded for an average
price of $16.21
Thus, the value of the special dividend was
0.170593 Monsanto shares × $16.21 per share = $2.77 per share
A shareholder who initially owned 100 shares of Pharmacia stock
would receive 17 shares of Monsanto stock plus cash of 0.0593 ×
$16.21 shares = $0.96 in place of the fractional shares
102
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Spin-Offs
Alternatively, Pharmacia could have sold the shares of Monsanto and
distributed the cash to shareholders as a cash dividend
The transaction Pharmacia chose offers two advantages over a cash
distribution
It avoids the transaction costs associated with such a sale, and
Special dividend is not taxed as a cash distribution, instead,
Pharmacia shareholders who received Monsanto shares are liable for
capital gains tax only at the time they sell the Monsanto shares
103
Spin-Offs
The decision of whether to do the spin-off raises a new question
When is it better for two firms to operate as separate entities, rather
than as a single combined firm?
104
Summary
Free cash flow – retain or pay out
• Retain – Invest in new projects or increase cash reserves
• Pay out – Repurchase shares or pay dividends
Payout Policy: The way a firm chooses between these alternatives
Dividend Payments: Important dates
• Payable date or distribution date (when dividend will be paid)
• declaration date (board authorize the dividend)
• record date (firm will pay the dividend to all shareholders of record)
Repurchase Shares: Firm uses cash to buy shares of its own
outstanding stock
• Open market repurchase, tender offer, and targeted repurchase
105
Dividends versus Share Repurchase
• In perfect capital markets, the method of payment does not matter
• In perfect capital markets, investors are indifferent between the firm
distributing funds through dividends or share repurchases
• By reinvesting dividends or selling shares, they can replicate either payout method
on their own
Modigliani-Miller and Dividend Policy Irrelevance
• Pay out all cash as a dividend or finance a larger dividend by issuing equity
or debt
• Pay no dividend and use the cash instead to repurchase shares
Markets with imperfections such as taxes, agency problems,
information asymmetry
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Payout versus Retention of Cash
• With perfect capital markets, the retention versus payout decision – just
like the dividend versus share repurchase decision – is irrelevant to total
firm value
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
The decision of whether to retain cash depends on market
imperfections such as taxes, agency costs, issuance and distress costs
107
Signalling with Payout Policy
Managers have better information than investors regarding the
future prospects of the firm (asymmetric Information), their payout
decisions may signal this information
Dividend Signalling Hypothesis: Dividend changes reflect managers’
views about a firm’s future earnings prospects
Share repurchases would be a credible signal that management
believes its shares are underpriced
108
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Other than cash dividends, firm can also pay stock dividend in which
each shareholder who owns the stock receives additional shares of
stock of the firm itself (a stock split) or of a subsidiary (a spin-off)

109

Thank You

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