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Payout Policy
• For many years, dividends and share repurchases had very different
tax consequences.
– The dividends that investors received were generally taxed at ordinary
income tax rates.
– On the other hand, when firms repurchased shares, the taxes triggered by that
type of payout were generally much lower.
• Shareholders who did not participate did not owe any taxes.
• Shareholders who did participate in the repurchase program might not owe any
taxes on the funds they received if they were tax-exempt institutions, or if they
sold their shares at a loss.
• Shareholders who participated in the repurchase program and sold their shares for
a profit only paid taxes at the (usually lower) capital gains tax rate, and even that
tax only applied to the gain, not to the entire value of the shares repurchased.
Using the residual theory of dividends, the firm would treat the
dividend decision in three steps, as follows:
– Determine its optimal level of capital expenditures, which would be the level
that exploits all of a firm’s positive NPV projects.
– Using the optimal capital structure proportions, estimate the total amount of
equity financing needed to support the expenditures generated in Step 1.
– Because the cost of retained earnings, rr, is less than the cost of new common
stock, rn, use retained earnings to meet the equity requirement determined in
Step 2. If retained earnings are inadequate to meet this need, sell new
common stock. If the available retained earnings are in excess of this need,
distribute the surplus amount—the residual—as dividends.