14.2 The Mechanics of Payout Policy

LG 1 14.2 The Mechanics of Payout Policy

CASH DIVIDEND PAYMENT PROCEDURES At quarterly or semiannual meetings, a firm’s board of directors decides whether

and in what amount to pay cash dividends. If the firm has already established a precedent of paying dividends, the decision facing the board is usually whether to maintain or increase the dividend, and that decision is based primarily on the firm’s recent performance and its ability to generate cash flow in the future. Boards rarely cut dividends unless they believe that the firm’s ability to generate cash is in serious jeopardy. Figure 14.3 plots the number of U.S. firms that increased or decreased their dividend payment in each year from 1999 through 2009. Clearly, the number of firms increasing their dividends is far greater than

date of record (dividends) the number of companies cutting dividends in most years. When the economy is

Set by the firm’s directors, the

strong, as it was from 2003 to 2006, the ratio of firms increasing dividends to

date on which all persons

those cutting dividends may be 30 to 1 or higher. However, a sign of the severity

whose names are recorded as

of the most recent recession was that in 2009 this ratio was just 1.5 to 1. That stockholders receive a declared year, 1,191 firms increased their dividend, while 804 firms cut dividends.

dividend at a specified future

When a firm’s directors declare a dividend, they issue a statement indicating

time.

the dividend amount and setting three important dates—the date of record, the ex-dividend date, and the payment date. All persons whose names are recorded as

ex dividend stockholders on the date of record receive the dividend. These stockholders are

A period beginning 2 business days prior to the date of

often referred to as holders of record.

record, during which a stock is

Because of the time needed to make bookkeeping entries when a stock is traded, sold without the right to receive the stock begins selling ex dividend 2 business days prior to the date of record.

PART 6

Long-Term Financial Decisions

FIGURE 14.3

U.S. Firms Increasing Number of firms increasing dividends or Decreasing Dividends

Number of U.S. firms that increased or decreased their dividend payment

in each year from 1999 through 2009

Number of firms decreasing dividends

Number of Firms

way to determine the first day on which the stock sells ex dividend is to subtract 2 payment date

Set by the firm’s directors, the

business days from the date of record.

actual date on which the firm

The payment date is the actual date on which the firm mails the dividend

mails the dividend payment to

payment to the holders of record. It is generally a few weeks after the record date.

the holders of record.

An example will clarify the various dates and the accounting effects.

Example 14.1 3 On June 24, 2010, the board of directors of Best Buy announced that the firm’s next quarterly cash dividend would be $0.15 per share, payable on October 26,

2010 to shareholders of record on Tuesday, October 5, 2010. Best Buy shares would begin trading ex dividend on the previous Friday, October 1. At the time of the announcement, Best Buy had 420,061,666 shares of common stock out- standing, so the total dividend payment would be $63,009,250. Figure 14.4 shows a time line depicting the key dates relative to the Best Buy dividend. Before the dividend was declared, the key accounts of the firm were as follows (dollar values quoted in thousands): 1

Cash

Dividends payable

5,797,000 When the dividend was announced by the directors, $63 million of the retained

Retained earnings

earnings ($0.15 per share * 420 million shares) was transferred to the dividends payable account. The key accounts thus became

Cash

Dividends payable

Retained earnings

1. The accounting transactions described here reflect only the effects of the dividend. Best Buy’s actual financial

CHAPTER 14

Payout Policy

FIGURE 14.4

Declaration

Ex Dividend Date of

Payment

Dividend Payment Time

Line Time line for the

announcement and

payment of a cash dividend for Best Buy

Board of directors declares

Stock begins to sell ex

Checks of $0.15 per

$0.15 per share dividend,

dividend on Friday,

share are mailed on

payable to holders of

October 1, which is 2

Tuesday, October 26,

record on Tuesday,

business days before the

to all holders of

October 5, payable on

Tuesday, October 5, date

record on Tuesday,

Tuesday, October 26.

of record.

October 5.

Time

When Best Buy actually paid the dividend on October 26, this produced the fol- lowing balances in the key accounts of the firm:

Cash

Dividends payable

5,734,000 The net effect of declaring and paying the dividend was to reduce the firm’s total

Retained earnings

assets (and stockholders’ equity) by $63 million.

SHARE REPURCHASE PROCEDURES The mechanics of cash dividend payments are virtually the same for every divi-

dend paid by every public company. With share repurchases, firms can use at least two different methods to get cash into the hands of shareholders. The most common method of executing a share repurchase program is called an open-

open-market share market share repurchase. In an open-market share repurchase, as the name sug- repurchase

gests, firms simply buy back some of their outstanding shares on the open

A share repurchase program

market. Firms have a great deal of latitude regarding when and how they execute

in which firms simply buy back

these open-market purchases. Some firms make purchases in fixed amounts at

some of their outstanding shares on the open market.

regular intervals, while other firms try to behave more opportunistically, buying back more shares when they think the share price is relatively low and fewer shares when the price is high.

In contrast, firms sometimes repurchase shares through a self-tender offer or tender offer repurchase

simply a tender offer. In a tender offer, a firm announces the price it is willing to

A repurchase program in

pay to buy back shares and the quantity of shares it wishes to repurchase. The

which a firm offers to

tender offer price is usually set at a significant premium above the current market

repurchase a fixed number of

price. Shareholders who want to participate let the firm know how many shares

shares, usually at a premium relative to the market value,

they would like to sell back to the firm at the stated price. If shareholders do not

and shareholders decide

offer to sell back as many shares as the firm wants to repurchase, the firm may whether or not they want to sell either cancel or extend the offer. If the offer is oversubscribed, meaning that

PART 6

Long-Term Financial Decisions

Dutch auction repurchase the firm typically repurchases shares on a pro rata basis. For example, if the firm

A repurchase method in which

wants to buy back 10 million shares, but 20 million shares are tendered by

the firm specifies how many

investors, then the firm would repurchase exactly half of the shares tendered by

shares it wants to buy back

each shareholder.

and a range of prices at which it is willing to repurchase

A third method of buying back shares is called a Dutch auction. In a Dutch

shares. Investors specify how

auction, the firm specifies a range of prices at which it is willing to repurchase

many shares they will sell at

shares and the quantity of shares that it desires. Investors can tender their shares

each price in the range, and

to the firm at any price in the specified range, and this allows the firm to trace out

the firm determines the

a demand curve for their stock. That is, the demand curve specifies how many

minimum price required to

shares investors will sell back to the firm at each price in the offer range. This repurchase its target number of allows the firm to determine the minimum price required to repurchase the

shares. All investors who tender receive the same price.

desired quantity of shares, and every shareholder receives that price.

Example 14.2 3 In July 2010, Fidelity National Information Services announced a Dutch auction repurchase for 86 million common shares at prices ranging from $29 to $31.50 per

share. Fidelity shareholders were instructed to contact the company to indicate how many shares they would be willing to sell at different prices in this range. Suppose that after accumulating this information from investors, Fidelity con- structed the following demand schedule:

Offer price

Shares tendered

Cumulative total

At a price of $31.25, shareholders are willing to tender a total of 86 million shares, exactly the amount that Fidelity wants to repurchase. Each shareholder who expressed a willingness to tender their shares at a price of $31.25 or less receives $31.25, and Fidelity repurchases all 86 million shares at a cost of roughly $2.7 billion.

TAX TREATMENT OF DIVIDENDS AND REPURCHASES For many years, dividends and share repurchases had very different tax conse-

quences. The dividends that investors received were generally taxed at ordinary income tax rates. Therefore, if a firm paid $10 million in dividends, that payout would trigger significant tax liabilities for the firm’s shareholders (at least those subject to personal income taxes). On the other hand, when firms repurchased shares, the taxes triggered by that type of payout were generally much lower. There were several reasons for this. Only those shareholders who sold their shares as part of the repurchase program had any potential tax liability. Shareholders who did not participate did not owe any taxes. Furthermore, some shareholders who did partic-

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Payout Policy

received if they were tax-exempt institutions or if they sold their shares at a loss. Finally, even those shareholders who participated in the repurchase program and sold their shares for a profit paid taxes only 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. Consequently, investors could generally expect to pay far less in taxes on money that a firm distributed through a share repurchase compared to money paid out as dividends. That differential tax treatment in part explains the growing popularity of share repurchase programs in the 1980s and 1990s.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 significantly changed the tax treatment of corporate dividends for most taxpayers. Prior to passage of the 2003 law, dividends received by investors were taxed as ordinary income at rates as high as 35 percent. The 2003 act reduced the tax rate on cor- porate dividends for most taxpayers to the tax rate applicable to capital gains, which is a maximum rate of 5 percent to 15 percent, depending on the taxpayer’s tax bracket. This change significantly diminishes the degree of “double taxation” of dividends, which results when the corporation is first taxed on its income and then shareholders pay taxes on the dividends that they receive. After-tax cash flow to dividend recipients is much greater at the lower applicable tax rate; the result is noticeably higher dividend payouts by corporations today than prior to passage of the 2003 legislation. (For more details on the impact of the 2003 act, see the Focus on Practice box.)

focus on PRACTICE Capital Gains and Dividend Tax Treatment Extended to 2010

in practice In 1980, the percent-

Long-term capital gains tax rates were age of firms paying

Both the number of companies paying

reduced to the same rates as the new monthly, quarterly, semiannual, or

dividends and the amount of dividends

dividend tax rates through 2010. Pre- annual dividends stood at 60 percent.

spiked following the lowering of tax

JGTRRA taxation of dividends reappears By the end of 2002, this had declined

rates on dividends. For example, total

dividends paid rose almost 14 percent

in 2011 unless further legislation makes

to 20 percent. In May 2003, President in the first quarter after the new tax law the law permanent. As this book went to George W. Bush signed into law

press in 2010, it was unclear whether the Jobs and Growth Tax Relief

was enacted, and the percentage of

legislators would extend the dividend tax Reconciliation Act of 2003 ( JGTRRA).

firms initiating dividends rose by nearly

break beyond 2010. Those arguing for Prior to that new law, dividends were

40 percent the same quarter.

an extension pointed toward the weak taxed once as part of corporate earn-

The tax rates under JGTRRA were

economy and suggested that taxes ings and again as the personal income end of 2008. However, in May 2006,

originally programmed to expire at the

needed to remain low to stimulate busi- of the investor, in both cases with a

ness investment and job creation. Others potential top rate of 35 percent. The

Congress passed the Tax Increase

noted that the U.S. budget deficit was at result was an effective tax rate of

Prevention and Reconciliation Act of

an all-time high, so some combination of 57.75 percent on some dividends.

2005 (TIPRA), extending the beneficial

higher taxes and reduced spending was Though the 2003 tax law did not com-

tax rates for 2 more years. Taxpayers in

necessary to avoid economic problems pletely eliminate the double taxation of

tax brackets above 15 percent paid a

associated with too much debt. dividends, it reduced the maximum possi- before December 31, 2008. For taxpay- ble effect of the double taxation of divi-

15 percent rate on dividends paid

ers with a marginal tax rate of 15 percent 3 reappearance of higher tax rates on How might the expected future dends to 44.75 percent. For taxpayers in or lower, the dividend tax rate was

the lower tax brackets, the combined individuals receiving dividends affect 5 percent until December 31, 2007, effect was a maximum of 38.25 percent. corporate dividend payout policies? and 0 percent from 2008 to 2010.

PART 6

Long-Term Financial Decisions

Personal Finance Example 14.3 3 The board of directors of Espinoza Industries, Inc., on October 4 of the current year, declared a quarterly dividend of $0.46 per

share payable to all holders of record on Friday, October 30, with a payment date of November 19. Rob and Kate Heckman, who purchased 500 shares of Espinoza’s common stock on Thursday, October 15, wish to determine whether they will receive the recently declared dividend and, if so, when and how much they would net after taxes from the dividend given that the dividends would be subject to a 15% federal income tax.

Given the Friday, October 30, date of record, the stock would begin selling ex dividend 2 business days earlier on Wednesday, October 28. Purchasers of the stock on or before Tuesday, October 27, would receive the right to the dividend. Because the Heckmans purchased the stock on October 15, they would be eligible to receive the dividend of $0.46 per share. Thus, the Heckmans will receive $230 in dividends ($0.46 per share * 500 shares) , which will be mailed to them on the November 19 payment date. Because they are subject to a 15% federal income tax on the dividends, the Heckmans will net $195.50 3(1 - 0.15) * $2304 after

taxes from the Espinoza Industries dividend.