Chapter 6 Dividends and Share Repurchases Basics

CHAPTER 6DIVIDENDS AND SHARE REPURCHASES: BASICSPresenter’s namePresenter’s titledd Month yyyy

Copyright © 2013 CFA Institute 2

1. INTRODUCTION• A dividend is a pro rata distribution to shareholders that is declared by the

company’s board of directors and may or may not require approval by shareholders.

• A repurchase of stock is a distribution in the form of the company buying back its stock from shareholders.

• The board of directors determines the company’s payout policy.• Cash dividends and share repurchases are both methods of distributing cash

to shareholders. - The effects on financial ratios and on shareholders’ investment returns are

different between these two methods.- These distributions may provide information about the company’s future

prospects.- Issuing companies cannot deduct distributions to shareholders for tax

purposes.


2. DIVIDENDS: FORMS

Cash Distributions

Regular Cash Dividend

Extra Dividend

Liquidating Dividend

Noncash Distributions

Stock Dividend

Stock Split

Reverse Stock Split


REGULAR CASH DIVIDENDS• A regular cash dividend is a cash dividend paid at regular intervals of time

- The regular intervals may be any frequency, but the most common are quarterly, semiannually, or annually.

- Tendency of companies is to maintain or increase dividends- Often viewed as signals of management’s assessment of the company’s

future (that is, whether the company can maintain the dividend in the future).- Companies prefer not to cut or reduce the dividend.


DIVIDEND REINVESTMENT PLANS• A dividend reinvestment plan (DRP) is a program that permits investors to

reinvest cash dividends automatically into the stock of the issuing company.• The shares provided in exchange for the cash dividends may be acquired in

the open market by the issuer or may be newly issued shares.• Advantages to the issuer:

- Encourage owners with smaller holdings to accumulate shares.- “Raise” new equity capital without flotation costs.

• Advantages to the investor:- Cost averaging of share purchases.- Opportunity (in some cases) to buy shares at a discount from market value.

• Disadvantages to the investor:- Recordkeeping- Dividends are taxed when “received,” whether reinvested or not.


EXTRA OR SPECIAL DIVIDENDS• An extra dividend (or special dividend) is a dividend that is either paid by a

company that does not pay dividends regularly or paid by a company in addition to a regular dividend.- Example: Whole Foods Market announced a $2 special dividend in

December 2012. This was in addition to its $0.20 per quarter cash dividend.• Motivation: Pay out in strong years without investors expecting an increased

dividend.


LIQUIDATING DIVIDENDS• A liquidating dividend is a distribution of cash to shareholders when

- Going out of business, or- Selling a portion of the business, or- Paying a dividend when retained earnings are not positive.


STOCK DIVIDENDS• A stock dividend is the distribution of additional shares of stock to

shareholders on a pro rata basis.- Also known as a bonus issue of shares.

• Generally stated as a percentage of current shares outstanding.• A stock dividend does not change a shareholder’s proportionate ownership, the

shareholder does not receive cash, and there are no tax consequences.• Advantages for the issuer:

1. More shares outstanding and, therefore, potential for more shareholders.

2. Lowers the stock’s price, which may make it more attractive as an investment.

3. No economic effect.

4. Does not affect financial ratios.


STOCK DIVIDENDS IN PRACTICE• More prevalent in some countries.• Some companies pay stock dividends on a regular basis; some pay these

occasionally.


STOCK SPLITSA stock split is a proportionate increase in the number of shares outstanding.• Stated in the following form:

Number of new shares : Number of old shares• So, 2:1 means that for each share held before the split, the shareholder holds

two shares after the split.• Stock splits do not affect the dividend yield or the dividend payout ratio.• Accounting: Memorandum entry, no change in accounts.• The announcement is generally viewed as a positive signal.


REVERSE STOCK SPLITSA reverse stock split is the proportionate reduction in the number of shares.• A reverse stock split has the opposite effect of the traditional, or forward, stock

split: - It reduces the number of shares, with the expectation of increasing the stock

price.• A 1:2 reverse stock split results in half the number of shares outstanding after

the split.• The goal may be to increase the share price to make it more attractive for

institutional investors.• Reverse stock splits are most common for companies in financial distress.• It is not permitted in some countries.


3. DIVIDENDS: PAYMENT CHRONOLOGY

| | | |

Declaration Date

Ex-Dividend Date

Holder-of-Record Date

Payment Date

Relationship Based on Trade Cycle

↑ ↑ ↑ ↑

Corporation Issues

Dividend Declaration

Established by Markets Based on

the Trade Settlement Cycle

Established by Corporation as

Date of Ownership of

Stock

Established by Corporation as

Date the Dividend Is

Actually Paid


4. SHARE REPURCHASES• A share repurchase is the transaction in which the stock issuer buys back its

shares from investors.- Also known as a share buyback.

• Once repurchased, the shares become treasury shares (or treasury stock).• Share repurchases are restricted by regulations in some countries.• Motives for repurchasing shares include the following:

- Signal that the stock is undervalued.- Flexibility of distributing cash without the expectation of cash dividends.- Tax efficiency when the tax rate on capital gains is less than that of cash

dividends.- Offset share increases from executive stock options.


SHARE REPURCHASE METHODS

Buy in the Open Market

• Use brokers to buy shares.

• Method provides flexibility for the company.

Fixed Price Tender Offer

• Specify the number of shares and the share price.

• Buy pro rata if oversubscribed.

Dutch Auction Tender Offer

• Specify the number of shares and the range of prices.

• Shareholders determine the number of shares they will sell back and specify the price within the range.

Direct Negotiation

• Negotiate with a specific shareholder.

• Method may be used to prevent “activist” shareholder from getting on board.


SHARE REPURCHASE AND EARNINGS PER SHARE

The Diluting Company is planning a $100 million share repurchase. Its current stock price is $25 per share, and there are 16 million shares outstanding prior to the repurchase. Earnings per share without the repurchase would be $3 per share. What is the earnings per share under each of these two scenarios?

Scenario 1: Use idle cash on hand.

Scenario 2: Borrow funds at after-tax rate of 7%.

Scenario 1:

Net income = $3 × $16 million = $48 million

EPSScenario 1 = $48 million (16 million – 4 million) = $4 per share

Scenario 2:

Net income = $3 × 16 million – (0.07 × $100 million) = $41 million

EPSScenario 2 = $41 million (16 million – 4 million) = $3.41 per share


SHARE REPURCHASE AND BOOK VALUE PER SHARE

• When the market price per share is greater than the book value per share (BVPS), the book value per share of equity will decrease with a share repurchase.

Continuing the Diluting Company example and adding the book value per share of $20:

Scenario 1:

Book value = ($20 × 16 million) – $100 million = $220 million

BVPSScenario 1 = $220 million (16 million – 4 million) = $18.33 per share

Scenario 2:

Book value = ($20 × 16 million) – $100 million – $7 million = $213 million

BVPSScenario 2 = $213 million (16 million – 4 million) = $17.75 per share


SHARE REPURCHASE VS. CASH DIVIDENDSIf…

- The tax consequences of dividends and capital gains are the same and- The information content of cash dividends and stock repurchases is the

same,

Then the effects of cash dividends and repurchases on shareholder value will be the same.

Both cash dividends and stock repurchases:- Reduce assets by the amount of the dividend or repurchase.- Reduce equity by the amount of the dividend or repurchase.- Provide investors with the same cash flow.


5. CONCLUDING REMARKS• Share repurchases have a positive effect on share prices.• Dividend initiations have a positive effect on share prices.• Dividend increases have a positive effect on share prices.


6. SUMMARY• Dividends can take the form of regular or irregular cash payments, stock

dividends, or stock splits. • Regular cash dividends represent a commitment to pay cash to stockholders

on a quarterly, semiannual, or annual basis.• The key dates for cash dividends, stock dividends, and stock splits are the

declaration date, the ex-date, the shareholder-of-record date, and the payment date.

• Share repurchases, or buybacks, most often occur in the open market. Alternatively, tender offers occur at a fixed price or at a price range through a Dutch auction.

• Share repurchases made with excess cash have the potential to increase earnings per share, whereas share repurchases made with borrowed funds can increase, decrease, or not affect earnings per share, depending on the after-tax borrowing rate.


SUMMARY (CONTINUED)

• A share repurchase is equivalent to the payment of a cash dividend of equal amount in its effect on shareholders’ wealth, all other things being equal.

• Announcement of a share repurchase is sometimes accompanied by positive excess returns in the market when the market price is viewed as reflecting management’s view that the stock is undervalued.

• Initiation of regular cash dividends can also have a positive impact on share value.

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Chapter 6 Dividends and Share Repurchases Basics