Docsity
Log inSign up
Docsity
Prepare for your exams
Prepare for your exams

Study with the several resources on Docsity

Earn points to download
Earn points to download

Earn points by helping other students or get them with a premium plan

Guidelines and tips
Guidelines and tips
Sell on Docsity
Sell on Docsity
Log inSign up

Prepare for your exams

Study with the several resources on Docsity

Find documents

Prepare for your exams with the study notes shared by other students like you on Docsity

Search Store documents

The best documents sold by students who completed their studies

Search through all study resources
Docsity AINEW

Summarize your documents, ask them questions, convert them into quizzes and concept maps

Explore questions

Clear up your doubts by reading the answers to questions asked by your fellow students

Earn points to download

Earn points by helping other students or get them with a premium plan

Share documents
download point icon20 Points

For each uploaded document

Answer questions
download point icon5 Points

For each given answer (max 1 per day)

All the ways to get free points
Get points immediately

Choose a premium plan with all the points you need

Study Opportunities

Choose your next study program

Get in touch with the best universities in the world. Search through thousands of universities and official partners

Community

Ask the community

Ask the community for help and clear up your study doubts

University Rankings

Discover the best universities in your country according to Docsity users

Free resources

Our save-the-student-ebooks!

Download our free guides on studying techniques, anxiety management strategies, and thesis advice from Docsity tutors

From our blog

Exams and Study
Go to the blog

Payout versus Retention of Cash: A Financial Management Perspective, Study notes of Economics

Washington CollegeEconomics

Lectures Notes Financial markets first semester

Typology: Study notes

2018/2019

Uploaded on 08/13/2019

Messi10mahajara
Messi10mahajara 🇫🇷

3.7

(3)

209 documents

1 / 2

Toggle sidebar

This page cannot be seen from the preview

Don't miss anything!

bg1
Payout versus Retention of Cash
How should a firm decide the amount it should pay out to shareholders and the amount it should
retain?
• Retained money can be invested into new projects or financial instruments
• Once a firm has taken all positive-NPV investments, it is indifferent between saving excess
cash and paying it out
• Once we consider market imperfections, we see a trade-off: retaining cash can reduce the
costs of raising capital in the future, but it can also increase taxes and agency costs.
Retaining Cash with Perfect Capital Markets
• Retained cash can be invested in new projects.
• When all positive-NPV projects have been taken, a firm can hold cash in the bank or buy
financial assets. Firm can pay the money to shareholders at a future time or invest in positive-
NPV when available.
• With perfect capital markets, the retention versus payout decision—just like the dividend
versus share repurchase decision—is irrelevant to total firm value.
MM Payout Irrelevance: In perfect capital markets, if a firm invests excess cash flows in financial
securities, the firm’s choice of payout versus retention is irrelevant and does not affect the initial value
of the firm.
Taxes and Cash Retention
When a firm pays interest, it receives a tax deduction for that interest, whereas when a firm receives
interest, it owes taxes on the interest. Cash is equivalent to negative leverage, so the tax advantage of
leverage implies a tax disadvantage to holding cash.
Adjusting for Investor Taxes
The decision to pay out versus retain cash may also affect the taxes paid by shareholders. While
pension and retirement fund investors are tax exempt, most individual investors must pay taxes on
interest, dividends, and capital gains. Normally, before the dividend is paid, the firm has a share price
of
• Reflects that the investor will pay tax on dividend at rate , but receive a tax credit (at capital
gains rate ) for the capital loss.
A firm could also retain cash and invest it in Treasury bills, earning interest at rate each year. After
paying taxes on this interest rate, the firm can pay a perpetual dividend of
Each year and retain the $100 in cash permanently. Because the investor must pay taxes on the
dividends as well, the value of the firm if it retains the $100 is
pf2

Partial preview of the text

Download Payout versus Retention of Cash: A Financial Management Perspective and more Study notes Economics in PDF only on Docsity!

Payout versus Retention of Cash

How should a firm decide the amount it should pay out to shareholders and the amount it should retain?

  • Retained money can be invested into new projects or financial instruments
  • Once a firm has taken all positive-NPV investments, it is indifferent between saving excess cash and paying it out
  • Once we consider market imperfections, we see a trade-off: retaining cash can reduce the costs of raising capital in the future, but it can also increase taxes and agency costs.

Retaining Cash with Perfect Capital Markets

  • Retained cash can be invested in new projects.
  • When all positive-NPV projects have been taken, a firm can hold cash in the bank or buy financial assets. Firm can pay the money to shareholders at a future time or invest in positive- NPV when available.
  • With perfect capital markets, the retention versus payout decision—just like the dividend versus share repurchase decision—is irrelevant to total firm value.

MM Payout Irrelevance: In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s choice of payout versus retention is irrelevant and does not affect the initial value

of the firm.

Taxes and Cash Retention When a firm pays interest, it receives a tax deduction for that interest, whereas when a firm receives interest, it owes taxes on the interest. Cash is equivalent to negative leverage, so the tax advantage of leverage implies a tax disadvantage to holding cash.

Adjusting for Investor Taxes The decision to pay out versus retain cash may also affect the taxes paid by shareholders. While pension and retirement fund investors are tax exempt, most individual investors must pay taxes on interest, dividends, and capital gains. Normally, before the dividend is paid, the firm has a share price of

  • Reflects that the investor will pay tax on dividend at rate , but receive a tax credit (at capital gains rate ) for the capital loss.

A firm could also retain cash and invest it in Treasury bills, earning interest at rate each year. After paying taxes on this interest rate, the firm can pay a perpetual dividend of

Each year and retain the $100 in cash permanently. Because the investor must pay taxes on the dividends as well, the value of the firm if it retains the $100 is

Dividend tax will either be paid when the firm pays the cash immediately or if it retains the cash and pays interest over time. It doesn’t affect the cost of retaining cash in eq. 17.7.

  • The intuition for Eq. 17.7 is that when a firm retains cash, it must pay corporate tax on the interest it earns. In addition, the investor will owe capital gains tax on the increased value of the firm. In essence, the interest on retained cash is taxed twice. If the firm paid the cash to its shareholders instead, they could invest it and be taxed only once on the interest that they earn. The cost of retaining cash therefore depends on the combined effect of the corporate and capital gains taxes, compared to the single tax on interest income.

Issuance and Distress Costs

  • Firms retain cash balances to cover potential future cash shortfalls.
  • This allows a firm to avoid transaction costs of raising new capital (debt or equity).
  • Firm must balance tax costs of holding cash with potential benefits of not having to raise external funds in the future.
  • Firms with very volatile revenue will also have cash reserves to protect them from periods of operating losses.

Agency Costs of Retaining Cash

  • No benefit to shareholders when a firm holds cash above and beyond its future investment or liquidity needs.
  • When managers have excessive cash, they might use it inefficiently.
  • Entities may take advantage of the firm’s “deep pockets”.
  • Leverage, dividends and share repurchases reduce a firm’s excess cash and avoid these costs.
  • Equity holders of highly levered firms want cash paid out, because excessive cash benefits debt holders. Debt holders will charge higher cost of debt or include covenants restricting the payout policy.
  • Thus, paying out excess cash through dividends or share repurchases can boost the stock price by reducing waste or the transfer of the firm’s resources to other stakeholders.
  • Firms should retain cash to preserve financial slack for future growth opportunities and to avoid financial distress costs – same reason to use low leverage.