Chapter 16 Payout Policy 419
bre44380_ch16_410-435.indd 419 10/05/15 01:41 PM
But suppose that Rational announces instead that henceforth it will pay out exactly 50%
of free cash flow as dividends and 50% as repurchases. (We assume that stockholders who
sell their stock back to the company do not miss out on the dividend.) This means that next
year’s dividend will be only $.50. On the other hand, Rational will use $500,000 (50%
of free cash flow) to buy back shares. It will repurchase 47,619 shares at the ex-dividend
price of $10.50 per share, and shares outstanding will fall to 1,000,000 – 47,619 = 952,381
shares.^15 Thus expected free cash flow per share for year 2 increases to $1 million divided by
952,381 = $1.05 per share. So the $.50 reduction in the dividend for year 1 has been offset
by 5% growth in future free cash flow per share, from $1 to $1.05 in year 2. And if you carry
this example forward to year 3 and beyond, you will see that using 50% of free cash flow for
repurchases continues to generate a dividend growth rate of 5% per year.
So the DCF model comes back to exactly the same value for Rational’s shares today, just
as MM would predict. The repurchase program decreases next year’s dividend from $1.00 to
$.50 per share, but generates 5% growth in earnings and dividends per share.
PV =DIV 1
_____r − g = ________.50
.10 − .05= $10Thus we can get to Rational’s price per share in two ways. The easy first method is to
calculate equity market capitalization based on total free cash flow, and then divide by the
current number of shares outstanding. The second, more difficult method is to forecast and
discount dividends per share, taking account of the growth in dividends per share caused by
repurchases. We recommend the easy way when repurchases are important. Note also that
the second way, which works out nicely in our example, becomes much more difficult to do
precisely when repurchases are irregular or unpredictable.
Our example illustrates several general points. First, absent tax effects or other market
frictions, today’s market capitalization and share price are not affected by how payout is split
between dividends and repurchases. Second, shifting payout to repurchases reduces current
dividends but produces an offsetting increase in future earnings and dividends per share.
Third, when valuing cash flow per share, it is double-counting to include both the forecasted
dividends per share and cash received from repurchases. If you sell back your share, you don’t
get any subsequent dividends.
Dividends and Share Issues
We have considered dividend policy as the choice between cash dividends or repurchases. If
we hold total payout constant, smaller dividends mean larger repurchases. But, as we noted
earlier, MM derived their dividend-irrelevance theorem when repurchases were rare. So MM
asked whether a corporation could increase value by paying larger cash dividends. But they
still insisted on holding investment and debt-financing policy fixed.
Suppose a company like Rational Demiconductor has paid out any surplus cash. Now it
wants to try to impress investors by paying out an even larger dividend. The extra money must
come from somewhere. If the firm fixes its borrowing, the only way it can finance the extra
dividend is to print some more shares and sell them. The new stockholders are going to part
with their money only if you can offer them shares that are worth as much as they cost. But
how can the firm sell more shares when its assets, earnings, investment opportunities, and,
therefore, market value are all unchanged? The answer is that there must be a transfer of value
from the old to the new stockholders. The new ones get the newly printed shares, each one
(^15) You can check that next year’s ex-dividend price of $10.50 per share is the only price at which repurchase works. Shareholders will
not sell their shares for less than $10.50, because then $500,000 would purchase more than 47,619 shares, leaving less than 952,381
shares outstanding and a price above $10.50 when the repurchase is completed. The firm should not offer more than $10.50 because
that would repurchase fewer than 47,619 shares and hand a free gift to selling stockholders.