Lectures Notes Financial markets first semester, Study notes of Economics

Download Lectures Notes Financial markets first semester 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