10.

Payout Policy II: The

Real World
Mike D.
Modigliani & Miller Payout Irrelevance
• In a perfect world…

MM Payout Irrelevance

In perfect capital markets, the firm’s choice of dividend (payout) policy is

irrelevant and does not affect the value of the firm, holding fixed the
investment policy of a firm.

Point 1: 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 ex-dividend

Point 2: 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

Point 3: 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

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The real world is rather different

• 1. Taxes

• 2. Issuance and distress costs

• 3. agency costs

• 4. Information asymmetry and signaling theory

• Transaction costs, etc.

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1. Taxes: “Nothing is certain except for death and taxes.” – Benjamin Franklin

• 2 types of taxes
• Tax on dividends and tax on capital gains

• When you receive a cash dividend, you pay dividend tax on that amount
• When you sell a share, you pay capital gains tax on the profit (sale price – purchase price)

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Tax implication on payout policy: dividends vs. repurchase
• Tax code change under Bush’s administration in 2003 set two tax rates equal

• If dividend tax > capital gains tax (until 2002)

• Investors should prefer repurchase to dividends
• Shareholders will pay lower taxes if firm uses repurchases than dividends
• This tax savings also increases firm value
• Optimal dividend policy: Pay no dividends at all, always repurchase

• If dividend tax = capital gains tax (starting 2003)

• Investors should still prefer repurchase to dividends
• Because long-term investors would have the option to defer capital gains tax until they sell
• Remember time value of money?
• Optimal dividend policy: Pay no dividends at all, always repurchase

• There is always a tax advantage for share repurchases over dividends

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Taxes
• Dividends in practice

• Given the tax disadvantage, still a large % of firms insist on paying dividends
• Dividend puzzle?

• Share repurchases grow to become the major payout method

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Taxes
• It’s actually more complicated: Tax rates on dividends and capital gains differ across investors
• Income level
• Taxes differ when income differs in different state

• Investment horizon
• Sooner you sell your stock, higher the capital gains tax
• Can defer capital gains tax payment by being a long-term investor

• Tax jurisdiction
• Tax rates differ across states (e.g. NH: dividend 5%, cap 0%)
• Foreign investors are taxed differently (30% withholding for dividends, but not capital gains)

• Type of investor or investment account

• Stocks held through retirement accounts, pension funds, nonprofit endowment funds are not subject to
dividend or capital gains taxes
• Corporations that hold stocks can exclude 70% of dividend receipts from corporate taxes, but not capital
gains

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Taxes
• Reconciling the dividend puzzle
• Tax rates on dividends and capital gains differ across investors thus
• Long-term investors would prefer repurchases to dividends
• Short-term investors, pension funds, other non-taxed investors have no tax preference
• Would prefer payout policy depending on cash needs
• Corporations would prefer high dividend stocks

• Clientele effects: Firm dividend policy is optimized for tax preference of its investor clientele

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Taxes
• What about payout vs. cash retention?
• With retained cash, firm pays tax on interest earned on that cash
• Flipside of leverage, where firm gets tax deduction on interest paid
• Cash can be thought of as negative leverage
• With retained cash, investor must sell shares to create homemade dividends
• Investor must pay capital gains tax when selling shares
• Effectively, interest earned on retained cash is taxed twice from investor’s perspective
• Corporate tax paid on interest
• Capital gains tax paid again when selling shares

• If firm had paid dividend, investor would have earned interest on that, and paid tax on that interest,
just once
• Hence, tax disadvantage to firm retaining excess cash

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2. Issuance and Distress Costs
• If there is a tax disadvantage to retaining cash, why do some firms accumulate large cash balances?

• To cover potential future cash shortfalls

• Firm with volatile earnings may experience operating losses and become unable to repay
debt
• Firm with lots of positive NPV investment opportunities may not have enough earnings to
fund large-scale R&D projects or large acquisitions
• In the face of such shortfalls, raising new capital is costly
• Direct costs (underwriting fee) for debt (1~3%) and equity (3.5~7%)
• Indirect costs associated with agency and adverse selection problems can be substantial

• Cash retention vs. payout is a tradeoff between tax disadvantage of cash and potential costs
of raising it when in need

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Summary
• Company should choose
• Cash dividends
• When major investors are corporations

• Repurchases
• When major investors are long-term investors
• When capital gain tax rate < dividend tax rate

• Cash retention
• When cost of financing new capital > tax disadvantages of cash retention
3. Agency Costs

• Managerial entrenchment
• “Excess cash” beyond investment and liquidity needs has no benefit to shareholders

• Managers may use this money to pursue negative NPV pet projects, give themselves excessive
perks, or overpay for firm-enlarging acquisitions

• Dividends and share repurchases can discipline managers by reducing excess cash
available to them
• Similar to leverage

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Payout vs. Retention Revisited

In the real world…

The firm’s choice of payout versus cash

retention depends on the balance between the
benefits (e.g. preserving financial slack for
future growth, avoiding issuance and financial
distress costs) and costs of holding cash (e.g.
tax disadvantage, agency cost of wasteful
investment)

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4. Information Asymmetry
• “Dividend smoothing”
• Firms maintain dividend payments regardless of earnings performance
• GM’s earnings and dividends ($ per share)

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Information Asymmetry
• Dividend signaling hypothesis

• Managers know more than investors

• Use dividends to signal information about firm prospects

• Increase dividend: Could mean…

• Management expects to be able to afford higher dividends for the foreseeable future
• But could also mean management believes there won’t be many positive NPV investment
opportunities

• Cut dividends: Could mean…

• Management has given up hope that earnings will rebound in the near future
• But could also mean management has found better places to spend that money: Positive
NPV projects abound

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Information Asymmetry
• Dividend signaling hypothesis

• Feb 23, 2009:

• J.P. Morgan cut its dividend from 38 cents to 5 cents per share
• J.P. Morgan’s share price increased by 5%

• Why?
• Unlike other U.S. banks at the time, J.P. Morgan was profitable
• CEO James Dimon said dividend cut would prepare JPM for worst-case recession and allow it
to pay back funds from the Troubled Asset Relief Program (TARP) more quickly

• Investors should interpret the dividends in the context on new information the manager acquires

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Information Asymmetry
• Signaling with repurchases
• Repurchase indicates that manager believes stock to be underpriced

• But repurchases may be less of a signal than dividends

• Managers are much less committed to share repurchases
• They can and often repurchase less than the maximum amount announced
• Can take long, often over a year
• Repurchase is more of a one-off event, and isn’t smoothed year after year like dividends
• Isn’t a long-term commitment, thus less indicative of long-term future earning prospects

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Understanding Payout in The Real World

• “Charlie [Warren Buffett's partner] and I favor repurchases when two conditions are met:

first, a company has ample funds to take care of the operational and liquidity needs of its business;

second, its stock is selling at a material discount to the company’s intrinsic business value,
conservatively calculated.”

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Misunderstanding Payout in The Real World
• Not every case passes Warren Buffett’s test
• Bad example: Netflix

• From 2007 to 2011, Netflix spent over $1 billion on share buybacks

• Management, including CEO, had been selling shares
• It left the company with just $366 million in cash when it had $200 million in debt
• Failed to build up ample cushion to guard against slowdown
• Netflix bled customers once it started raising subscription prices
• Eventually had to raise more capital
• Read more in 2011 WSJ article
• http://www.wsj.com/articles/SB10001424052970203710704577054431537105996

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Summary

Payout Cash retention

Dividends Repurchase
Tax (after 2002) Good for corporate Good for long-term Bad for all investors
investors investors

Cost of financing / Bad when cash is in need Good when cash is in need
distress costs
Agency issue Good for investors to discipline managers Bad when manager waste
money

Asymmetric information Increase (decrease) Signal underpricing of Signal bad performance or

signal good (bad) firm shares or lack of more investment opp;
performance or fewer investment opp; interpretation based on
(more) investment opp; interpretation based released info
interpretation based on on released info
released info