Dividend policy (or distribution policy) distributes some amount of cash (possibly zero) to its investors.
Retained earnings is a very tax efficient (zero dividend) policy.
If cash is to be distributed, with most tax systems and taxed investors, share repurchase is the preferred method.
The choice of method is important on several different dimensions.
The amount of dividends can affect stock prices. Barsky and De Long (1993) stated:
“… changes in current and expected future dividends can account for the bulk of long-run stock price fluctuations, although much less so for short-term price movements.”1
The title of this paper could be “Distribution Policy,” since dividends are not the only way of implementing a policy aimed at financially rewarding a firm’s stockholders. The various methods of distributing cash (or not distributing cash), listed in order of preference order from an economic–finance perspective of maximizing shareholder wealth, are:
sale of firm (or part of a firm);
Retention: Tax Deferral
It has been proven that, with enough assumptions, dividend policy is not relevant to the valuation of the common stock equity of a firm. However, the proof assumes zero investor taxes; thus it does not apply to a real-world situation in which such taxes exist. With income taxes, an investor benefits from being able to defer the payment of taxes as well as from the fact that some types of income (capital gains) for individuals may be taxed at lower rates than other types of income (dividends).
If a company retains $100, earns 0.10 in one period, and then pays a dividend of $110, the investor taxed at a rate of 0.40 will net: $110 × (1 – 0.4) = $66.
If the same company had paid a dividend of $100 and if the investor also could earn 0.10 before tax and 0.06 after tax on the $60 after tax proceeds, the investor receiving the $100 dividend ($60 after tax) would have after one period: 60 × 1.06 = $63.60.
The investor is better off by $2.40 with the one-period delay in cash distribution. The investor “defers” $40 of taxes that earn 0.10, or $4. The $4 is taxed ($1.60) and the investor is better off by $2.40.
If desired, one could compute the return necessary for the firm to justify retention. It would be equal to the after-tax return (0.06) available in the market to the investor. Thus, if the corporation could earn 0.06 and then pay a dividend, the investor would net: $100 × 1.06 × (1 – 0.4) = $63.60. This is the same as the investor would net with an immediate cash dividend.
If the planning horizon is n periods instead of one period, then 0.06 still measures the return that the firm must earn to justify retention. If the earning opportunities available to the corporation are greater than 0.06, retention is more desirable than an immediate dividend.
If the planning horizon is n periods, the dollar advantage of tax deferral increases. For example, if the firm can earn 0.10 and the time horizon is 20 years with retention and then a tax rate of 0.40, the investor has:
$100 × 1.1020 × (1 – 0.4) = $100 × 6.73 × 0.6 = $404
With an immediate $100 cash dividend and the investment of $60 by the stockholder to earn 0.06 after tax for 20 years, the investor would have:
$60 × 1.0620 = $60 × 3.207 = $192
With a planning horizon of 20 years, the advantage of tax deferral is $212 for the retention of the $100 earnings. There will be 19 other years between now and the end of the 20 years that will generate comparable tax deferral savings (although of decreasing amounts).
To this point, we have assumed that all income is taxed at one rate. Now we assume that a capital gains tax rate of 0.20 applies to capital gains income. This assumes that retention of earnings leads to stock price increases and that these increases can be realized by investors as capital gains.
Returning to the 20-year horizon, with retention and then capital gains taxation of 0.20, the investor would have:
$100 × 1.1020 × (1 – 0.20) = $100 × 6.73 × 0.80 = $538
The cash dividend and an after-tax earning rate of 0.06 again leads to a value of $192 after 20 years.
The net advantage of retention is $538 – $192 = $346. Capital gains taxation increases the value of retention from the $212 obtained above to $346.
Again, if we considered the tax consequences of the dividend decision for all subsequent years, the value of the difference would be even larger. Tax deferral and capital gains are two powerful factors that must be considered in deciding a distribution policy.
A number of explanations of the motivation behind share repurchase (where a company buys its own stock) have been suggested. It has been argued, for example, that firms buy back their own shares to have them available to acquire other companies or to fulfill the obligations of stock option plans. Unquestionably, some repurchasing has been done for these reasons. Income tax considerations may make it possible for firms to acquire other companies more cheaply for stock than for cash, and the use of stock options and restricted stock as forms of executive compensation have been widespread. However, the growth of share repurchasing cannot be explained by merger and stock option plans. There is no essential reason why firms should use repurchased shares for these purposes, rather than newly issued shares.
Corporations also repurchase shares with the intention of retiring them, or at least holding them indefinitely in the treasury. It has been suggested that firms with excessive liquid assets have one or more of the following motives to repurchase shares:
repurchasing shares is the best investment that can be made with these assets;
repurchasing shares has beneficial leverage effects;
repurchasing shares, rather than paying dividends, has a significant tax advantage for stockholders.
Is a firm’s purchase of its own common stock an investment? There are authors who think so: “The repurchase of its own stock by a company is an investment decision—plain and simple.”2
Share Repurchasing as an Investment
Share repurchasing does not possess the same general characteristics as other acts of investment by a firm—for instance, purchasing plant and equipment. Normal investments increase the size of the firm and do not decrease the stockholders’ equity balance. A firm’s repurchase of its own common stock, on the other hand, reduces the size of the enterprise. Specifically, the cash balance is decreased and the stockholders’ equity balance is reduced. In short, repurchasing shares has few characteristics which identify it as a normal investment.
While share repurchasing is clearly not an investment by the firm, there is a change in the relative proportions of ownership if some stockholders sell their shares and some do not sell. The investors who do not sell are implicitly making an investment compared with the investors who do sell. Also, investors not selling make an investment in the firm compared with what would have happened if they had received a cash dividend.
Even though share repurchasing is not an investment, it may be the best use of corporate cash from the point of view of the present investors. This may be the case if the present stock price is below the intrinsic value of the shares.
Taxes and Share Repurchasing
The tax laws can provide powerful incentives for firms with excess liquid assets to repurchase shares rather than pay dividends. The tax code may lead individuals to prefer capital gains to ordinary income, assuming that the top marginal rate of taxation on ordinary income is higher than the rate on capital gains.
Consider now a corporation with excess cash that it desires to pay out to stockholders in the form that will be most attractive from its shareholders’ point of view. If it distributes the assets as dividends, they will represent ordinary income to shareholders, and will be taxed accordingly. If, on the other hand, the corporation buys back shares, the tax basis of the stock will be regarded as a return to the shareholders’ capital and will not be taxed at all, while that portion of the return which is taxed—i.e., the capital gain—will be subject to a lower rate than ordinary income. In addition, the investor who merely wants to reinvest and does not sell is not taxed at all.
Abby Cohen (1994) captures the essence of this thought:3 “First, shareholders are not thrilled by the prospect of double taxation on cash dividends. Many prefer that corporations ‘pay out’ the cash indirectly to shareholders in the form of share repurchases, rather than in the form of cash dividends.”
Given these incentives for returning cash to stockholders by repurchasing shares, a relevant question would seem to be: Why, if the tax law is as described, do firms pay dividends? One important answer is that many stockholders do not pay tax on the dividends they receive (for example, Cornell University and low-income retirees). A second reason (related to the first) is that the receipt of cash dividends to low-tax investors reduces the transaction costs for those investors who need cash. But even if one were to accept the above explanations, the basic question still remains. Why do firms pay dividends to investors who are taxed at high ordinary income tax rates?
A firm has 100,000 shares outstanding and $100,000 available for distribution. Should it pay a dividend or repurchase shares? Assume that the personal tax rate is 0.36 and the capital gains tax rate is 0.20. The initial stock price is $20. Assume that the tax basis is also $20. There is an investor who owns 1,000 shares. With a $1,000 cash dividend for this investor we have:
If the company acquires 100,000/20 = 5,000 shares and the investor tenders 0.05 of the 1,000 shares held, we have:
|Cash received (50 × $20)||$1,000|
With a zero tax basis and a 0.20 tax rate, we have for the share repurchase:
Not selling, the investor’s percentage ownership goes up from 0.01 to 0.0105 (that is, 1,000/95,000). The investor has a choice of receiving cash (selling some stock) or increasing the relative investment in the firm.
When capital gains and ordinary income have different tax treatment, the value of the firm’s stock is influenced by the form of its cash distribution. In addition, with share repurchase and a positive-tax basis, part of the cash distribution is not taxed. There are three factors at work that cause the buying back of shares to be more profitable than dividend payments (from the stockholders’ point of view) under any reasonable set of assumptions that includes taxation of income. For one thing, part of the distribution under the share-repurchasing arrangement is considered a return of capital and is not taxed. Secondly, that part of the distribution subject to tax (i.e., the capital gain) is generally taxed at a lower rate than ordinary income. Finally, the investor can avoid all taxes by not selling.
Stock Option Plans
Share repurchase programs by corporations enhance the value of stock options compared to cash dividends by forcing the stock price up relative to a cash dividend of equal dollar amount (the number of shares outstanding is reduced). The stock price effect is not a real advantage to the investor, but it is an advantage to the holders of stock options.
For example, suppose a firm has one million shares outstanding selling at $40 per share. The value of the stock equity is $40 million. If it pays a $4 million cash dividend, the value of the stock equity will be $36 million. Then, as a result of the cash dividend:
|Stock price per share||$36|
|Total value to investor per share||$40|
The investor is indifferent to the share repurchase and dividends (with zero taxes), but the holder of the stock options prefers the share repurchase.
The firm could buy 100,000 shares with the $4 million. The value of the firm after purchase will be $36 million, and the stock price per share will be $40 (that is, $36,000,000/900,000 = $40). The investor is indifferent to share repurchase and cash dividend (with no taxes), but the holder of a stock option prefers the $40 market price with share repurchase to the $36 price with cash dividends.
The stock price after one year is interesting. Assume that the stock equity is again $40 million (the firm made earnings of $4 million during the year).
Having paid a $4 million dividend last year, the stock value per share would be $40. If the firm had repurchased 100,000 shares instead of a dividend, the stock value per share would be $40,000,000/900,000 = $44.44.
A share repurchase program, all things equal, will result in an increasing stock price through time compared to the price with dividends being paid. With a stock option contract (not adjusted for share repurchases) the increase in stock price resulting from a share repurchase strategy rather than a cash dividend is valuable for the holder of the stock option.
Of course, the owner of an exercisable option can convert it to stock and receive any dividend that is paid. This will require a cash outlay equal to the option’s exercise price. Also, the cash dividend is taxed. With the stock repurchase by the firm and the owner not exercising the option, the tax on the cash dividend is avoided and the cash outlay of the option’s exercise price is delayed.
A Flexible Dividend
One tax advantage of stock repurchase in lieu of cash dividends is that investors who do not want to convert their investments into cash do not sell their stock back to the corporation. By not selling, they avoid realization of the capital gain and do not have any taxation on the increment to the value of their wealth (they also avoid transaction costs).
The investors who want to receive cash sell a portion of their holdings, and even though they pay tax on the gain, it is apt to be less than if the cash distribution were taxed as ordinary income. By using stock repurchase as the means of the cash distribution, the company tends to direct the cash to those investors who want the cash and bypass the investors who do not need cash at the present time. Also, the tax consequences are favorable for investors.
The Signaling Effect of Repurchase
Would management be more likely to launch a share repurchase program if the firm’s stock is overvalued or undervalued? While many companies implement share repurchase programs irrespective of whether the stock price is too low or too high, there is evidence that firms are more likely to buy stock that is undervalued by the market. Thus, some investors will consider the start of a stock buyback program as a signal that management thinks the stock is undervalued. Two studies that find evidence supporting this signaling effect are Dann (1981) and Vermaelen (1981).
Investors Like Dividends
The attitude of investors is an important factor to be considered. Consistently increasing dividends are generally welcomed by investors as indicators of profitability and safety. Uncertainty is increased by lack of dividends or dividends that fluctuate widely. Grigoli (1986) agrees with this conclusion: “Because investors value stable dividends, it may not be in a corporation’s best interests to raise dividends to unsustainable levels.”4
Dividends are thought to have an information content; that is, an increase in dividends means that the board of directors expects the firm to do well in the future. This “signaling effect” might favorably affect the firm’s common stock price. On the other hand, if income expectations do not justify the optimism, the indication of a more positive future than is justified by the facts is not likely to lead to a favorable outcome.
Since trust officers can only invest in securities with a consistent dividend history, firms like to establish a history of dividends so that they can make the “trust legal list.” This consideration sometimes leads to the payment of cash dividends before the firm would otherwise start paying a dividend.
Another important reason for the payment of dividends is that a wide range of investors need the dividends for consumption purposes. Although such investors could sell a portion of their holdings, this latter transaction has relatively high processing costs compared with cashing a dividend check. The presence of investors desiring cash for consumption makes it difficult to change the current dividend policy. One group of investors may benefit from a change in dividend policy, but another group may be harmed. Although we see that income taxes paid by investors tend to make a retention policy more desirable than cash dividends, the presence in the real world of zero tax and low tax investors needing cash dictates that we consider each situation individually and be flexible in arriving at a dividend policy.
There are stockholders who desire cash. A dividend supplies cash without the investor incurring brokerage expense. If cash is retained by the corporation, the stockholders wanting liquidity will have to sell a fraction of their holdings to obtain cash, and this process will result in brokerage fees. Retired individuals living off their dividends and tax-free universities are apt to prefer dividend-paying corporations to corporations retaining income. While a 100% earnings payout cash dividend has the advantage of giving cash to those investors who desire cash, the policy also results in cash being given to those investors who do not desire cash, and who must incur brokerage fees to reinvest the dividends, and who pay taxes.
Dividend Changes and Signaling
A study by Liu, Szewczyk, and Zantout (2008) shows that “there is no compelling evidence of a post-dividend-reduction or post-dividend-omission price drift” (p. 987).
Assume that a firm’s stock is fairly priced. Let us assume that this firm’s management thinks that if dividends are increased, the market will conclude that this is a favorable signal and the stock price will increase significantly. If the stock was fairly priced to begin with, the stock price after the dividend increase will be too high. This means that with no other changes, the new stockholders will earn less than the firm’s required return on stock. Thus, if a stock is fairly priced initially, an increase in dividends that leads to an unjustifiable stock price is not desirable since it leads to investor returns that are less than those required by the new stockholders.
In January of 2003, Microsoft issued its first cash dividend of $0.02 per quarter. Some investors thought the dividend too low. Others thought the company should have repurchased more shares rather than pay a cash dividend. In July of 2004, the company announced a special $3 cash dividend. With almost 11 billion shares outstanding, this dividend would require a cash outlay of $33 billion.
If investors in a high tax bracket expect the price of a stock to increase because of improved earnings (and a higher level of future dividends), they will be willing to pay more for a stock knowing that if their expectations are realized the stock can be sold and be taxed at the relatively lower capital gains tax rate. Whereas the lower capital gains tax rate tends to increase the value of a share of stock, we have shown that another powerful factor arises from the ability of the stockholder to defer paying taxes if the corporation retains income rather than paying dividends. Tax deferral is an extremely important advantage associated with the retention of earnings by a corporation.
The present tax law allows deferral of tax payment (or complete avoidance) on capital gains, and recognized gains may be taxed at a lower rate than ordinary income. Dividend policies of firms have relevance for public policy in the areas of taxation of both corporations and individuals. As corporate managers adjust their decision-making to include the tax law considerations, the makers of public policy must decide whether the results are beneficial to society.
It is not being argued that all firms should discontinue dividend payments. There is a place for a variety of payout policies, but there is a high cost to investors for all firms attempting to cater to the dividend and reinvestment preferences of an average investor. However, it is entirely appropriate that not all corporations appeal to all investors and that corporations design their common stock (and other securities) in the same way they design their consumer products. A corporation should have a financial personality resulting from its various financial policies (especially capital structure and dividend policies) that is attractive to a given group of investors, and is inappropriate for other groups. Corporate securities should have clienteles.
Define the price (and value) of a share of common stock as being equal to the present value of the next dividend (assumed to be declared and paid one period from now) and the price of the share at the time the dividend is paid. If we keep repeating the substitution process, we find that the value of the firm is equal to the present value of all future dividends, where the word “dividend” is used to include all cash distributions made from the firm to its investors. We replace the price at each future moment in time by the dividends that causes the stock to have value.
A board of directors acting in the interests of the stockholders of a corporation sets the dividend policy of a firm. The ability of an investor to defer income taxes as a result of the company retaining earnings is an important consideration. In addition, the distinction between ordinary income and capital gains for purposes of income taxation by the federal government accentuates the importance of investors knowing the dividend policy of the firm whose stock they are considering purchasing or have already purchased. In turn, this means that the corporation (and its board) has a responsibility to announce its dividend policy and to attempt to be consistent in its policy, changing only when its economic situation changes significantly. In the particular situation in which a firm is expanding its investments rapidly and is financing this expansion by issuing securities to its stockholders, the payment of cash dividends is especially vulnerable to criticism.
1 Barsky and De Long (1993).
2 Rundell (1965), p. 39.
3 Cohen (1994), p. 1.
4 Grigoli (1986), p. 5.