Equity Financing  659 When a company then decides to pay out cash to shareholders, there are some good reasons to use share repurchases. In contrast to dividend increases, repurchases offer companies more flexibility in adapting their payouts to un- expected investment needs in a volatile economy. Share buyback programs are not seen as long-term commitments and can be adjusted without influencing investor expectations as much as adjustments to regular dividends would. In addition, they offer investors the flexibility to participate or not. For institu- tional investors, this means they can choose to uphold the amount invested in a stock—for example, because of a client mandate or because they are tracking an index—without having to reinvest dividends and incur any transaction costs. Finally, share buybacks can result in lower taxes than dividend pay- ments for investors in countries where capital gains are taxed at lower rates. In some countries, individuals have the option to defer taxes on any capital gains and realize such gains in a more tax-efficient manner, potentially years later. Because of their flexibility, share repurchases are a very effective way to pay out any cash surpluses that exceed the level of regular dividends. Extraordinary Dividends As an alternative to share repurchases, a company could declare an extraordi- nary dividend payout, as Microsoft did in 2004 as part of its $75 billion, four- year cash return program. Microsoft paid out a significant portion in the form of an extraordinary dividend because of its concern that the share repurchase was so massive that it would swamp the liquidity in the market for Microsoft stock. The drawback of extraordinary dividends, compared with share repur- chases, is that they offer no flexibility to shareholders and force the cash payout on all of them, regardless of their preferences for capital gains or dividends. Equity Financing If a company is facing a cash deficit and has already reached its long-term leverage target, it has little choice (other than selling noncore businesses, as discussed later in this chapter) but to raise equity or cut its dividends. As with all payout and financing decisions, this does not create or destroy value in it- self. But raising equity and—especially—cutting dividends will send negative signals to investors. As noted, companies are extremely reluctant to cut dividends to free up funds for new investments, because the stock market typically interprets such reductions as a strong signal of lower future cash flows. Share prices on aver- age decline around 9 percent on the day a company announces dividend cuts or omissions.45 Furthermore, some investor groups count on dividends being 45 Healey and Palepu, “Earnings Information Conveyed by Dividend Initiations and Omissions.” 660  Capital Structure, Dividends, and Share Repurchases paid out every year. Skipping these dividends will force these investors to liq- uidate parts of their portfolios, leading to unnecessary transaction costs. Only very compelling growth opportunities might somewhat mitigate the negative price reactions.46 Finally, the amount of funds freed up by cutting dividends is often limited, so dividend cuts alone are unlikely to resolve more substantial funding shortages. Issuing equity is also likely to lead to a short-term drop in share prices. Typically, share prices decline by around 3 percent on announcements of so- called seasoned equity offerings.47 Because investors assume that managers have superior insights into the company’s true business and financial out- look, they believe managers will issue equity only if a company’s shares are overvalued in the stock market. Therefore, the share price will likely decrease in the short term on the announcement of an equity issuance, even if it is not actually overvalued. A similar price reaction can be expected for various equity-like instruments, such as preferred stock, convertibles, warrants, and more exotic hybrid forms of capital. Debt Financing In principle, the amount of debt that needs to be issued or redeemed follows from a company’s actual and targeted capital structure. In contrast to equity financing, issuing or redeeming debt typically does not send strong signals to investors about the company’s future cash flows. When issuing debt, companies commit to fixed future interest payments that can be withheld only at considerable cost. Investors also know that debt is more likely to be issued when management perceives a company’s share price to be undervalued. As a result, the issuance of debt typically meets with more favorable share price reactions than the issuance of new equity. Empiri- cal evidence shows that the price reaction is typically flat.48 Redeeming debt does not meet with significant stock market reactions, either, unless the company is in financial distress. In that case, buying back bonds can send a positive signal to the equity markets. For distressed compa- nies, bond prices go up and down with the enterprise value, just as share prices do. A bond buyback could therefore be a credible signal that management 46 L. Lang and R. Litzenberger, “Dividend Announcements: Cash Flow Signaling versus Free Cash Flow Hypothesis,” Journal of Financial Economics 24, no. 1 (1989): 181–192. 47 See, for example, B. Eckbo and R. Masulis, “Seasoned Equity Offerings: A Survey,” in Handbooks in Operations Research and Management Science 9, ed. R. Jarrow, V. Maksimovic, and W. Ziemba (Amster- dam: Elsevier, 1995); and C. Smith, “Investment Banking and the Capital Acquisition Process,” Journal of Financial Economics 15, nos. 1/2 (1986): 3–29. 48 See, for example, W. Mikkelson and M. Partch, “Valuation Effects of Security Offerings and the Issu- ance Process,” Journal of Financial Economics 15, nos. 1/2 (1986): 31–60; and Smith, “Investment Banking and the Capital Acquisition Process.”