Chapter 4

A firm can either retain or pay out free cash flow:

• Retain:

  • Invest in new projects

  • Increase cash reserves

• Pay Out:

  • Repurchase shares

  • Pay dividends

1. Declaration Date (Jan 15): The board of directors announces a dividend will be paid.

2. Ex-Dividend Date (Jan 29): Buyers on or after this date will not receive the dividend; sellers retain it.

3. Record Date (Jan 30): Only shareholders on record this day will receive the dividend.

4. Payment Date (Feb 16): Dividends are mailed to shareholders of record.

1. Regular Dividend: Paid consistently by companies in cash.

2. Special Dividend: A one-time, large dividend payment.

3. Stock Split (Stock Dividend): Dividend paid in additional shares instead of cash.

4. Dividend in Kind: Non-cash dividend, e.g., products or services (like chewing gum or cremation discounts).

5. Liquidating Dividend: Return of capital to shareholders when a business is closing down.

1. Open Market Repurchase: Firm buys its own shares on the open market using cash.

2. Tender Offer: Public offer to all shareholders to buy a set number of shares at a premium (10–20% above market price), usually open for ~20 days.

3. Targeted Repurchase: Company buys shares directly from a specific shareholder.

4. Dutch Auction: Company proposes a price range; shareholders indicate how many shares they’ll sell at each price. The firm buys at the lowest price to meet its goal.

5. Greenmail: Company buys back shares at a premium from a large shareholder to avoid a takeover.

• Buybacks are preferred because capital gains are taxed less and can be deferred, while dividends are taxed immediately.

• Tax preferences vary based on:

  • Income level

  • Investment horizon

  • Retirement account status

Key Idea: Companies attract different types of investors depending on their dividend policy.

Clientele Effect refers to how a company’s dividend policy attracts certain investors based on their tax situation. Investor preferences:

• High-tax individuals → Prefer low or no dividends to minimize taxes

• Tax-free investors (e.g., retirement accounts, endowments) → Prefer high dividends

• Corporations → Prefer dividends due to special tax advantages

The Dividend-Capture Theory explains how investors trade shares around dividend dates to reduce taxes:

• Taxed investors sell shares before the dividend date.

• Non-taxed investors buy those shares to receive the dividend tax-free.

• After the dividend is paid, shares return to the original (taxed) owners.

In Perfect Capital Markets:

• After funding all positive-NPV projects, it doesn't matter if cash is retained or paid out.

• Buying/selling securities has no impact on firm value (zero-NPV).

With Market Imperfections:

• Retaining cash lowers future financing costs but may lead to higher taxes and agency costs.

• Paying out cash can prevent wasteful investment in negative-NPV projects.

In perfect capital markets, if a firm invests excess cash in financial securities, then the choice between paying out or retaining cash is irrelevant—it does not affect the initial share price.

1. Corporate taxes make it expensive to hold excess cash.

2. Holding cash = negative leverage, which means firms lose out on tax benefits of debt.

3. Therefore, there’s a tax disadvantage to holding cash instead of using it or leveraging it.

Issuance & Distress Costs:

• Firms retain cash to avoid future capital shortages.

• They accept tax disadvantages to avoid costly capital raising during distress.

Agency Costs:

• Too much cash can lead to managerial inefficiency.

• Paying out cash (via dividends or buybacks) can reduce this risk and improve stock value.

• Still, firms might keep cash for flexibility and risk management.

Dividend Signaling:

• Dividend Smoothing: Firms keep dividends stable to maintain a target payout ratio.

• Increase in Dividends: Signals confidence in future earnings (but may also show lack of growth opportunities).

• Decrease in Dividends: May show uncertainty, or that funds are being redirected to high-return investments.

Share Repurchase Signaling:

• Repurchases signal that shares are undervalued.

• If shares are actually overpriced, buybacks hurt long-term shareholders.

• Investors respond positively if they trust management’s judgment about the firm’s future.

A firm can issue:

• Stock Dividends: Gives shareholders extra shares instead of cash.

• Stock Splits: A large stock dividend (typically over 50%), e.g., a 50% dividend becomes a 3:2 stock split.

• Spin-offs: Shareholders receive shares of a subsidiary company instead of cash.

• No cash payout; total equity value stays the same.

• More shares issued → stock price drops proportionally.

• Not taxed for shareholders.

• Firms issue them to:

  • Keep stock prices attractive to small investors.

  • Avoid prices being too high (low liquidity) or too low (high transaction costs).

  • Use reverse splits if prices fall too low.

A firm can either retain or pay out free cash flow:

• Retain:

  • Invest in new projects

  • Increase cash reserves

• Pay Out:

  • Repurchase shares

  • Pay dividends

A spin-off is when a firm sells a subsidiary by distributing its shares separately. Its advantages over cash dividends are that it avoids transaction costs and is not taxed as a cash payout.