CHAPTER 17

Distributions to Shareholders: Dividends and Repurchases

17-2

Topics in Chapter

Overview Theories of investor preferences Clientele Effect and Signaling Hypothesis Cash dividends Residual Distribution Model Stock repurchases Stock dividends and stock splits Dividend reinvestment plans (DRIPS)

17-3

Distribution Policy

Defines: Level of cash distributions to

shareholders Form of the distribution

Dividend vs. Stock repurchase Stability of the distribution

17-4

Good Ways to Use FCF

1. Pay interest expense2. Pay down principal on debt3. Pay dividends4. Repurchase stock5. Buy non-operating assets such as

Treasury bills

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Uses for FCF FCF = f (Investment opportunities

and operating plans) Debt/Interest payment = f (Capital

structure) Investment in marketable securities

= f (Working capital policy)Remaining FCF should be

distributed to shareholders

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Distribution Patterns Over Time

The percent of total payouts as a percentage of net income has been stable at around 26%-28% Dividend payout rates Stock repurchases

Now greater than dividends

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Distribution Patterns Over Time

Smaller percentage of companies now pay dividends Young companies first make

distributions as repurchases Dividend payouts =more

concentrated in a smaller number of large, mature firms

17-8

Dividend Yields for Selected Industries

Industry Div. Yield %Recreational Products 3.30Forest Products 3.79Software 1.48Household Products 1.55Food 1.16Electric Utilities 3.48Banks 4.46Tobacco 9.88Source: Yahoo Industry Data, April 2008

17-9

Investor Preference Theories

Dividend Irrelevance Investors don’t care about payout

Dividend Preference (Bird-in-the-Hand) Investors prefer a high payout

Tax Effect Investors prefer a low payout

17-10

Dividend Irrelevance Theory Investors are indifferent between dividends

and capital gains If they want cash, they can sell stock Else use dividends to buy stock

Miller-Modigliani (1961) support irrelevance Payout policy has no effect on stock value or the required return on stock

Theory is based on unrealistic assumptions (no taxes or brokerage costs)

17-11

Dividend Preference Theory(Bird-in-the-Hand)

Investors view dividends as less risky than potential future capital gains

High payouts reduce agency costs Deprive managers of cash to waste Need to go to external capital markets

provides more management monitoring

Investors value high payout firms Require a lower return

17-12

Tax Effect Theory Low payouts mean higher capital

gains Capital gains taxes are deferred until

realized Taxed at a lower effective rate than

dividends

Investors require a higher pre-tax return resulting in a lower stock price

17-13

Research Results Some research high payout =

high required return on stock Supports tax effect hypothesis

Internationally, countries with poor investor protection (severe agency costs) high payout = more highly valued

Empirical tests =mixed results

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The “Clientele Effect” “Clienteles” = different groups of

investors who prefer different dividend policies

Firm’s past dividend policy determines its current clientele of investors

Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who

switch companies due payout policy changes

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The “Signaling Hypothesis”

Dividend changes = signals of management’s view of the future Managers hate to cut dividends Won’t raise dividends unless raise

is sustainable Stock prices fall when dividends

cut

17-16

Cash Distributions = Dividends

Company must have cash to make a cash distribution

Sources of Cash: FCF = Cash flow available for distribution

to investors after expenses, taxes and necessary investments in operating capital.

Recapitalization Sale of an asset

17-17

Dividend Payment Procedures

Usually paid quarterly in cash Increased once a year Voted on quarterly by the

Board of Directors

17-18

Dividend Payment Dates Declaration date

Board officially declares dividend Holder-of-record date

Stock transfer books close Ex-dividend date

Stock trades without the dividend 2 days prior to holder-of-record date

Payment Dividend checks mailed

17-19

Dividend Payment Example Declaration date = 11/6/09

“The Board of Directors has declared a quarterly dividend of $0.50 per share payable to holders of record on 12/05/09 payable on 1/2/10.”

Dividend goes with stock =12/02/09 Ex-dividend date = 12/03/09 Holder of record date = 12/05/09 Payment date = 01/02/2010

17-20

Optimal Distribution Ratio

Four Factors:1. Investors’ preference for

dividends versus capital gains2. Firm’s investment opportunities3. Target capital structure4. Availability and cost of external

capital

17-21

The “Residual Distribution Model”1. Determine optimal capital budget2. Determine amount of equity needed to

fund capital budget given target capital structure

3. Use retained earnings to meet equity needs to extent possible

4. Pay dividends or repurchase stock if funds leftover (residual)

Residual policy minimizes flotation and equity signaling costs, and minimizes the WACC

17-22

Using the Residual Model to Calculate Distributions Paid

Distr. = – X Netincome

Targetequityratio

Totalcapitalbudget

(17-1)

17-23

Texas & Western Transport Company

WACC = 10% (if all equity = r/e) Target capital structure:

40% debt, 60% equity Forecasted net income: $60 million If all distributions are in the form of

dividends, how much of the $600,000 should we pay out as dividends?

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Texas and Western Investment Opportunities

Table 17-2

(millions) Poor Average Good

Capital budget $40 $70 $150

Net income $60 $60 $60

Equity required (60%) $24.0 $42.0 $90.0

Distributions paid (NI-Required equity) $36.0 $18.0 ($30.0)

Distribution ratio 60% 30% -50%

A capital budget of $150 million would require the use of all retained earnings plus the issuance of $30 m in new debt.

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Investment Opportunities and Residual Dividends

Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout.

More good investments would lead to a lower dividend payout.

17-26

Advantages and Disadvantages of the Residual Dividend Policy Advantages:

Minimizes new stock issues and flotation costs

Disadvantages: Results in variable dividends Sends conflicting signals Increases risk Appeals to no specific clientele

17-27

Residual Model Conclusions

Consider residual model when setting target payout, but don’t follow it rigidly

Consider “low-regular-dividend-plus-extras” policy Low regular dividend that can be

maintained Specially designated dividends when

cash available

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Stock Repurchases Repurchases = Buying own stock

back from stockholders Reasons for repurchases:

Alternative to distributing cash as dividends

Dispose of one-time cash from asset sale

Execute large capital structure change

17-29

Stock Repurchase Procedures Company buys back its own stock

Repurchased stock = “treasury stock” Negative value on balance sheet

Reasons to Repurchase stock:1. Increase leverage (issue debt/buy

stock)2. Use shares for options exercise3. Firm has excess cash

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Stock Repurchase Procedures

1. Open market purchase through broker

2. Tender offer3. Targeted stock repurchase

Purchase block of shares through negotiation with large shareholder

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Advantages of Repurchases Stockholders can tender or not Helps avoid setting a high dividend that

cannot be maintained Repurchased stock can be used in

takeovers or resold to raise cash as needed Income received is capital gains rather

than higher-taxed dividends Stockholders may take as a positive

signal--management thinks stock is undervalued

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Disadvantages of Repurchases May be viewed as a negative signal

Firm has poor investment opportunities IRS could impose penalties if repurchases

were primarily to avoid taxes on dividends

Selling stockholders may not be well informed, hence be treated unfairly

Firm may have to bid up price to complete purchase, thus paying too much for its own stock

17-33

Stock Repurchase Formulas

5)-(17

4)-(17 P

3)-(17 cash ExtraP(

2)-(17 n

Cash Extra

0

o

P

Vn

n

V

)nn

VP

OP

OP

OP0

17-34

Stock Repurchase Example

Earnings = $400 million Shares outstanding = 40 million = n0

Payout ratio = 50% Earnings growth = 5% = g Return on equity = 10% = rE

Assume no tax effects

17-35

Stock Repurchase ExampleIf 50% paid as cash dividends (p.609)

D0 = .50 x (400/40) = $5.00 D1 = $5.00 * (1.05) = $5.25 P0 = $5.25 / (.10 - .05) = $105.00 P1 = $105 x (1.10) - $5.25 =

$110.25 rE = 5% (CGY) + 5% (DY) 10% S1 = $110.25 x 40 = $4,410 million

17-36

50% Dividends

Year 0 1Earnings $400.00 $420.00Shares 40 40Payout % 50% 50%g 5% 5%R(e) 10% 10%T 0 0

Dividend $5.00 $5.25P(0) $105.00P(1) pre div $115.50P(1) post div $110.25S (Equity) $4,200.00 $4,410.00

50% Dividend Payout

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Stock Repurchase ExampleIf 50% used to repurchase shares

Earnings (yr 1) = 400 * (1.05) = 420 Repurchase cash = 50% x $420 =

$210 P1 = $105 x (1.10) = $115.50 P1(n0 – n) = Cash repurchase

n = number of share remaining $115.50 x (40 – n) = $210 m n = 38.182 shares

S1 = $115.50 x 38.182 = $4,410 m

(17-3)

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50% Stock Repurchase

Year 0 1Earnings $400.00 $420.00Shares 40 38.1818 Repo % 50%g 5% 5%R(e) 10% 10%T 0 0

Repo Cash $210.00P(0) $105.00P(1) pre div $115.50P(1) post repo $115.50S (Equity) $4,200.00 $4,410.00

50% Stock Repurchase

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Comparison

Year 0 1 Year 0 1Earnings $400.00 $420.00 Earnings $400.00 $420.00Shares 40 40 Shares 40 38.1818 Payout % 50% 50% Repo % 50%g 5% 5% g 5% 5%R(e) 10% 10% R(e) 10% 10%T 0 0 T 0 0

Dividend $5.00 $5.25 Repo Cash $210.00P(0) $105.00 P(0) $105.00P(1) pre div $115.50 P(1) pre div $115.50P(1) post div $110.25 P(1) post repo $115.50S (Equity) $4,200.00 $4,410.00 S (Equity) $4,200.00 $4,410.00

50% Dividend Payout 50% Stock Repurchase

17-40

Stock Repurchase: Key Results

1. Ignoring tax effects and signaling, the total market value of equity remains the same whether a firm pays cash dividends or repurchases stock

2. The repurchase does not change the stock price; it does reduce the number of shares outstanding

3. With fewer shares outstanding, the stock price will rise faster

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Dividends versus Repurchases Advantages of Repurchases:

Viewed as a positive signal Stockholders have choice Dividends are “sticky” in the short-run Companies can divid target cash

distribution into dividend and repurchase Can produce large scale changes in capital

structure Repurchase shares for use with incentive

stock options

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Dividends versus Repurchases

Disadvantages of Repurchases: Cash dividends are dependable but

repurchases are not Selling shareholders may not be fully

informed Firm may pay too much for shares

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Conclusions Repurchases have a tax advantage Dividends are more dependable Volatile dividends lower investor

confidence “Signaling”

Repurchases useful to: Make capital structure shifts Distribute cash from one-time events Obtain shares for employee stock options

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Constraints Bond indentures Preferred stock restriction Impairment of capital rule

Dividend payments > Balance sheet retained earnings

Availability of cash Penalty tax on improperly

accumulated earnings

17-45

Alternative Sources of Capital

Cost of selling new stock New equity if flotation costs are low

Ability to substitute debt for equity Control

Management reluctant to sell new stock

17-46

The Distribution Policy Decision

Decision made jointly with capital structure and capital budgeting decisions Managers do not want to issue new

stock Dividend changes = signals

Use residual model to set long-term dividend payout target

Set cash dividend low enough to be maintained

17-47

The Distribution Policy Decision

Steady or increasing dividend stream signals firm’s financial condition is under control

Stable dividends decrease investor uncertainty

Firms with superior investment opportunities should set lower cash dividends and retain earnings

17-48

Dividend Policy Conclusions Younger firms with many investment

opportunities but low cash flow should retain earnings

Executive survey results: NOT reducing dividends is more important

than initiating a dividend or increasing it Capital budgeting decisions are more

important than distribution decisions Repurchase shares when shares

undervalued

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Stock Splits and Stock Dividends Stock split:

Firm increases the number of shares outstanding, say 2:1

Shareholders sent more shares Stock dividend:

Firm issues new shares in lieu of paying a cash dividend

If 10%, get 10 shares for each 100 shares owned

17-50

Both increase the number of shares outstanding Divides pie into smaller pieces

Stock price falls so as to keep each investor’s wealth unchanged Unless the stock dividend or split conveys

information, or is accompanied by another event like higher dividends

“Optimal price range”

Stock Splits and Stock Dividends

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Stock Split Explanations Signaling

Stock splits generally occur when management is confident

Interpreted as positive signals “Catering”

Optimal price range = $20 to $80 Stock splits can keep price in optimal range Attractive to small investors Google ($577.07) ? Berkshire-Hathaway A ($122,815) ?

17-52

Reverse Stock Splits

Reduces number of shares outstanding

Drives stock price up Meet listing requirements

Frequently seen as a negative signal

Can be used to force out small shareholders

17-53

Stock Splits & Dividends

Stock splits usually follow a price run up to produce a price reduction Split = positive, value-related

signal Stock dividends used on a

regular basis will keep the stock price constrained

17-54

Effect on Stock Prices

Announcement of stock split or dividend usually results in a price increase Signaling If not followed by earnings or

dividend increase, price will revert Split may reduce liquidity

17-55

Dividend Reinvestment Plan (DRIP)

Shareholders can automatically reinvest dividends in shares of firm’s common stock

Two types of plans: Open market (“Old Stock”) New stock

Firms can switch between the plans

17-56

Open Market Purchase Plan DRIP funds turned over to trustee,

who buys shares on the open market.

Brokerage costs reduced by volume purchases

Used by firms with no need for additional capital

Convenient, easy way to invest

17-57

New Stock Plan Firm issues new stock to DRIP

enrollees Used by firms needing new

capital No fees charged Stock sold at discount from

market price