CHAPTER 7 DIVIDENDS AND SHARE REPURCHASES: ANALYSIS Presenter’s name Presenter’s title dd Month yyyy

CHAPTER 7DIVIDENDS AND SHARE REPURCHASES: ANALYSISPresenter’s namePresenter’s titledd Month yyyy

Copyright © 2013 CFA Institute 2

1. INTRODUCTION

A payout policy is a set of principles regarding a corporation’s distributions to shareholders.

- May be established with regard to a dividend payout, a dividend per share, a growth in dividend per share, or any other metric.

- May include stock splits and stock dividends.

- May include stock repurchases.


2. DIVIDEND POLICY AND COMPANY VALUE: THEORY

Dividends Are Irrelevant

• Based on MM theories.

• If owners want a leveraged position, they can make it themselves.

Bird in the Hand

• Cash dividends are more certain than stock appreciation.

Tax Argument

• How dividends are taxed relative to capital gains affects investors preferences for dividends.

Other

• Clientele effect.

• Signaling.• Agency cost

effects.


DIVIDENDS ARE IRRELEVANT

In Miller and Modigliani’s (MM) world with no taxes, no transaction costs, and homogeneous information, dividend policy does not affect the value of the company.

- The decision of how a company finances its business is separate from the decision of what and how much to invest in capital projects.

- If an investor wants cash flow, he/she could sell some shares.

- If an investor wants more risk, he/she could borrow to invest.

- An investor is indifferent about a share repurchase or a dividend.

Bottom line: Dividend policy does not affect a firm’s value.


THE BIRD-IN-THE-HAND ARGUMENT

• Investors prefer a cash dividend to uncertain capital gains.

- Hence, investors prefer the “bird in the hand.”

- Issue: Riskiness of the stock appreciation.

• If this explanation holds, a company that pays a cash dividend will have a higher value than a similar company that does not pay a cash dividend.

Bottom line: Dividend policy affects the value of the firm.


THE TAX ARGUMENT

If dividends are taxed at a rate higher than capital gains, investors prefer that companies reinvest cash flow back into the firm.

- In other words, investors prefer the lower-taxed capital gains to the higher-taxed cash dividends.

- This advocates a zero dividend payout when dividends are taxed at a rate higher than that of capital gains.

Bottom line: Dividend policy affects the value of the firm.


THE CLIENTELE EFFECT

• The clientele effect is the influence of groups of investors attracted to companies with specific dividend policies.

- Clientele are simply a group of investors who have the same preference.

• Types of clientele:

- If an investor has a marginal tax on capital gains lower than the marginal tax on dividends, the investor prefers a return in the form of capital gains.

- Investors who are tax exempt (e.g., pension funds) are indifferent about dividends and capital gains.

- Some investors, by policy or restrictions, only invest in stocks that pay dividends.

• The importance of the existence of clientele is that investors will have a preference for stocks with a specific dividend policy.

Bottom line: The clientele effect does not necessarily imply that dividends affect value.


DIVIDENDS AND SIGNALING

• Under MM’s theory, everyone has the same information.

• When there is asymmetric information, dividend changes may convey information.

Positive Information• Dividend initiations• Dividend increases

Negative Information• Dividend omissions• Dividend reductions


AGENCY COSTS AND DIVIDEND POLICY

• The separation of ownership and management in a corporation may lead to suboptimal investment.

- Management may invest in negative NPV projects to enhance the company’s size or management’s control.

• Jensen’s free cash flow hypothesis is that having free cash flow tempts management to make investments that are not positive NPV.

- Paying dividends or interest on debt uses this free cash flow and averts an agency issue.

• If a company’s debt has a restriction on paying dividends, it may avoid the issue of paying dividends (thus benefiting owners) and may increase the risk to bondholders.

Bottom line: Dividends may reduce agency costs and, therefore, increase the value of the firm.


3. FACTORS AFFECTING DIVIDEND POLICY

Investment Opportunities

Expected Volatility of

Future Earnings

Financial Flexibility

Tax Considerations

Flotation CostsContractual and

Legal Restrictions


FACTORS AFFECTING DIVIDEND POLICY

• Investment opportunities:

- A company with more investment opportunities will pay out less in dividends.

- A company with fewer investment opportunities will pay out more in dividends.

• Expected volatility of future earnings:

- Companies with greater earnings volatility are less likely to increase dividends—a greater chance of not maintaining the increased dividend.

• Financial flexibility:

- Companies seeking more flexibility are less likely to pay dividends or to increase dividends because they want to preserve cash.


FACTORS AFFECTING DIVIDEND POLICY

• Tax considerations

- The tax rate on dividends and how dividends are taxed relative to capital gains affect investors’ preferences and, hence, companies’ dividend policy.

• Flotation costs

- These costs make it more expensive to use newly issued stock instead of internally generated funds.

- Smaller companies face higher flotation costs.

• Contractual and legal restrictions

- Forms of restrictions:

- Impairment of capital rule

- Bond indentures

- Requirement of preferred shares


TAX SYSTEMS AND DIVIDEND POLICY

Consider a company that has earnings before tax of $100 million and pays all its earnings as dividends. The company’s tax rate is 35%, and individual shareholders have a marginal tax rate of 25%. In countries with a split-rate system, dividends are taxed at 28% at the corporate level.

Double Taxation

Earnings taxed at corporate level and dividends taxed at shareholder level

Effective tax on dividends =

51.25%

Dividend Imputation

Earnings taxed at corporate level and

tax credit at shareholder level

Effective tax on dividends = 25%

Split-Rate System

Earnings distributed are taxed at a lower rate than retained

earnings

Effective tax on dividends = 46%


4. PAYOUT POLICIES

• Stable dividend policy: Constant dividend with occasional dividend increases

- Increases may represent an adjustment to a target payout ratio.

- In theory (John Lintner’s), companies may adjust to the target using an adjustment factor that is less than or equal to 1.0:

- Common

• Constant dividend payout: Constant dividend payout ratio

- Uncommon

• Residual dividend payout: Pay out earnings remaining after capital expenditures

- Uncommon


EXAMPLE: PAYOUT POLICIES

Consider the financial information for Apple, Inc. (AAPL)

1. What are dividends for FY2011 and FY2012 if the company followed a stable dividend policy, with a target dividend payout of 10% and an adjustment factor of 0.3?

Fiscal Year Ending 9/29/2012 9/24/2011 9/25/2010

Net income (millions) $41,773 $25,922 $14,014

Fiscal Year Ending 9/29/2012 9/24/2011

Increase in earnings $15,851 $11,900

Multiply by target 0.10 0.10

Multiply by adjustment factor 0.30 0.30

Dividends $475.53 $357.24


EXAMPLE: PAYOUT POLICIES

2. What are dividends for FY2011 and FY2012 if the company followed a constant dividend payout at 6%?

3. What are dividends for FY2011 and FY2012 if the company followed the residual payout policy?


Net income (millions) $41,773 $25,922

Less: capital expenditures 9,402 7,452

Dividends $32,371 $18,470


Net income (millions) $41,773 $25,922

Multiply by 6% 0.06 0.06

Dividends $2,506 $1,555.32


CASH DIVIDENDS VS. REPURCHASING STOCK

• Reasons for preferring repurchasing stock over paying a cash dividend

- Potential tax advantages

- Signaling

- Managerial flexibility

- Offset dilution from executive stock options

- Increase financial leverage

• A stock repurchase may be a good alternative to an increase in cash dividends.


GLOBAL TRENDS IN DIVIDEND PAYOUT

• Current:

- Large, profitable companies tend to have a stable payout policy.

- Smaller and/or less profitable companies tend to not be dividend paying.

• Trends:

- In developed companies, fewer companies pay cash dividends, but more companies are using stock repurchases.

- The dividend amounts and payouts have increased for dividend-paying companies, but the proportion of dividend-paying companies has declined.


DIVIDEND COVERAGE RATIOS

Dividend coverage ratios:

A company has $200 million in earnings, pays $40 million in dividends, has cash flow from operations of $180 million, and had capital expenditures of $60 million. The company spent $10 million for share repurchases.

Therefore:


5. ANALYSIS OF DIVIDEND SAFETY

• We can evaluate the “safety” of the dividend by examining the company’s ability to meet its dividends.

- “Safety” pertains to the ability of the company to continue to pay the dividend or maintain a growth pattern.

- Possible ratios: Dividend coverage and free cash flow coverage

- Using dividends plus repurchases may be more appropriate for some firms.

- Values greater than 1.0 indicate ability to meet the dividend and repurchase, although the greater the coverage, the greater the liquidity and ability to pay.

• It is sometimes difficult to predict changes in dividend because of “surprises,” such as the financial crisis.


6. SUMMARY

• There are three general theories on investor preference for dividends: Dividend policy is irrelevant, the bird-in-hand argument, and the tax explanation.

• An argument for dividend irrelevance given perfect markets is that the corporate dividend policy is irrelevant because shareholders can create their preferred cash flow streams by selling any company’s shares.

• The clientele effect suggests that different classes of investors have differing preferences for dividend income.

• Dividend declarations may provide information to investors regarding the prospects of the company.

• The payment of dividends can help reduce the agency conflicts between managers and shareholders, but can worsen conflicts of interest between shareholders and debtholders.


SUMMARY (CONTINUED)

• Investment opportunities, the volatility expected in future earnings, financial flexibility, taxes, flotation costs, and contractual and legal restrictions affect dividend policies.

• Using a stable dividend policy, a company may attempt to align its dividend growth rate to the company’s long-term earnings growth rate.

• The stable dividend policy can be represented by a gradual adjustment process in which the expected dividend is equal to last year’s dividend per share, plus any adjustment.

• With a constant dividend payout ratio policy, a company applies a target dividend payout ratio to current earnings.

• In a residual dividend policy, the amount of the annual dividend is affected by both the earnings and the capital investment spending.


SUMMARY (CONTINUED)

• Share repurchases usually offer more flexibility than cash dividends by not establishing the expectation that a particular level of cash distribution will be maintained.

• Share repurchases can signal that company officials think their shares are undervalued. On the other hand, share repurchases could send a negative signal that the company has few positive NPV opportunities.

• The issue of dividend safety deals with the likelihood of the dividend being continued.

• Early warning signs of whether a company can sustain its dividend include the level of dividend yield, whether the company borrows to pay the dividend, and the company’s past dividend record.

Documents

CHAPTER 7 DIVIDENDS AND SHARE REPURCHASES: ANALYSIS Presenter’s name Presenter’s title dd Month yyyy