17.1 Distributions to Shareholders A corporation’s payout policy determines if and when it will distribute cash to its shareholders by issuing a dividend or undertaking a stock repurchase. To issue a dividend, the firm’s board of directors must authorize the amount per share that will be paid on the declaration date. The firm pays the dividend to all shareholders of record on the record date. Because it takes three business days for shares to be registered, only shareholders who purchase the stock at least three days prior to the record date receive the dividend. As a result, the date two business days prior to the record date is known as the exdividend date; anyone who purchases the stock on or after the ex-dividend date will not receive the dividend. Finally, on the payable (or distribution) date, which is generally about a month after the record date, the firm pays the dividend. Just before the ex-dividend date, the stock is said to trade cum-dividend. After the stock goes ex-dividend, new buyers will not receive the current dividend, and the share price will reflect only the dividends in subsequent years. In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade exdividend. Most dividend-paying corporations pay them at quarterly intervals. Companies typically increase the amount of their dividends gradually, with little variation. Occasionally, a firm may pay a one-time, special dividend that is usually much larger than a regular dividend. An alternative way to pay cash to investors is through a share repurchase, in which a firm uses cash to buy shares of its own outstanding stock. These shares are generally held in the corporate treasury and can be resold in the future. An open market repurchase, in which a firm buys its own shares in the open market, is the most common way that firms repurchase shares.
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Berk/DeMarzo • Corporate Finance, Second Edition
A firm can also use a tender offer repurchase in which it offers to buy shares at a prespecified price during a short time period at typically a 10% to 20% premium. In a Dutch auction repurchase, a firm lists different prices at which it is prepared to buy shares, and shareholders indicate how many shares they are willing to sell at each price. The firm then pays the lowest price at which it can buy back the desired number of shares. A firm may also negotiate a purchase of shares directly from a major shareholder in a targeted repurchase. 17.2 Comparison of Dividends and Share Repurchases In perfect capital markets, a stock’s price will fall by the amount of the dividend when a dividend is paid, and a share repurchase has no effect on the stock price. In addition, by selling shares or reinvesting dividends, an investor can effectively create any cash dividend desired and can sell stock in the open market without a share repurchase. As a result, investors are indifferent between the various payout methods the firm might employ. The Modigliani and Miller dividend irrelevance proposition states that in perfect capital markets, holding the investment policy of a firm fixed, the firm’s choice of dividend policy is irrelevant and does not affect share value. 17.3 The Tax Disadvantage of Dividends Taxes are an important market imperfection that affects dividend policy. When the tax rate on dividend exceeds the tax rate on capital gains, the optimal dividend policy is for firms to pay no dividends and use share repurchases for all payouts. Recent changes to the tax code have equalized the tax rates on dividends and capital gains. However, long-term investors can defer the capital gains tax until they sell, so there is still a tax advantage for share repurchases over dividends for most investors. The fact that firms continue to issue dividends despite their tax disadvantage is often referred to as the dividend puzzle....