Chapter 7 Dividends and Share Repurchases Analysis

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<p>Chapter 7 Dividends and Share Repurchases Analysis</p> <p>Chapter 7Dividends and Share repurchases: AnalysisPresenters namePresenters titledd Month yyyy</p> <p>1</p> <p>1. IntroductionA payout policy is a set of principles regarding a corporations 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. Copyright 2013 CFA Institute2</p> <p>Page 258</p> <p>Introduction</p> <p>A payout policy (also known as dividend policy) is a set of principles regarding a corporations distributions to shareholders. Note: Using the term payout policy encompasses repurchases, whereas the traditional term dividend policy implies cash and stock dividends as well as stock splits.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. </p> <p>2</p> <p>2.Dividend Policy and Company Value: TheoryCopyright 2013 CFA Institute3</p> <p>LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.Page 258</p> <p>2. Dividend Policy and Company Value: Theory</p> <p>Explanations for dividend policies:Dividend are irrelevant.A bird in the hand: Cash dividends are preferred to uncertain capital gains.Tax argument: Investors prefer capital gains to dividends if capital gains are taxed at a lower rate than capital gains.Other explanations/influences: Clientele effect, signaling, and agency cost effects. 3</p> <p>Dividends Are Irrelevant</p> <p>Based on MM theories.</p> <p>If owners want a leveraged position, they can make it themselves.</p> <p>Bird in the Hand</p> <p>Cash dividends are more certain than stock appreciation.</p> <p>Tax Argument</p> <p>Other</p> <p>Clientele effect.</p> <p>Signaling.</p> <p>Agency cost effects.</p> <p>How dividends are taxed relative to capital gains affects investors preferences for dividends.</p> <p>Dividends are irrelevantIn Miller and Modiglianis (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 firms value.Copyright 2013 CFA Institute4</p> <p>LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.Pages 258260</p> <p>Dividends Are Irrelevant</p> <p>In MMs 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.</p> <p>Market imperfections can affect conclusions because MMs world has perfect capital markets.Note: In a perfect capital market: All participants have the same information.There are no taxes (the key is that the tax rates on dividends and capital gains are the same).There are no costs to financial distress.Expectations are homogeneous.Flotation costs associate with issuing new shares.</p> <p>Bottom line: Dividend policy does not affect a firms value.</p> <p>4</p> <p>The Bird-in-the-Hand ArgumentInvestors 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. </p> <p>Bottom line: Dividend policy affects the value of the firm.</p> <p>Copyright 2013 CFA Institute5</p> <p>LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action. Page 260</p> <p>The Bird-in-the-Hand Argument</p> <p>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. </p> <p>Bottom line: Dividend policy affects the value of the firm</p> <p>5</p> <p>The Tax ArgumentIf 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.</p> <p>Bottom line: Dividend policy affects the value of the firm.Copyright 2013 CFA Institute6</p> <p>LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.Pages 260261</p> <p>The Tax Argument</p> <p>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.</p> <p>Bottom line: Dividend policy affects the value of the firm.</p> <p>6</p> <p>The Clientele EffectThe 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.Copyright 2013 CFA Institute7</p> <p>LOS: Explain how clientele effects and agency issues may affect a companys payout policy.Pages 261265</p> <p>The Clientele Effect</p> <p>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.</p> <p>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.</p> <p>The importance of the existence of clienteles is that investors will have a preference for stocks with a specific dividend policy.</p> <p>Bottom line: The clientele effects does not necessarily imply that dividends affect value. </p> <p>If the tax rates on dividends and capital gains are the same, we should expect the price of a stock to drop by the amount of the dividend on the ex-dividend date. The marginal investor is the investor most likely to make the next trade, and therefore is important in setting the price of the stock.If the marginal tax rates on dividends and capital gains are not the same, then the price change (that is, drop), determined by the marginal investor, is</p> <p>7</p> <p>Dividends and SignalingUnder MMs theory, everyone has the same information.When there is asymmetric information, dividend changes may convey information.</p> <p>Copyright 2013 CFA Institute8</p> <p>LOS: Describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey.Pages 265268</p> <p>Dividends and Signaling</p> <p>Under MMs theory, everyone has the same information. Therefore, dividends do not signal anything.When there is asymmetric information, dividend changes may convey information: Positive information: Initiations and increasesNegative information: Omissions and decreasesSome evidence suggests that increasing a dividend attracts attention to the stock. Companies do brag about their record of dividend payments (consistency, growth, etc.). Companies that tend to grow their dividends consistently tend to be dominant in their industry, have global operations, have a high return on assets, and have low financial leverage. Examples: Proctor &amp; Gamble (PG), Diebold (DBD), Johnson &amp; Johnson (JNJ), Coca-Cola (KO)Cutting dividends are generally negative signals. J.C. Penney (JCP) stopped its dividend in 2013. Deutsche Telekom announced a reduction in 2012 (effective 2013 and 2014).CenturyLink (CTL) announced a cut its dividend in Feb 2013.Telecom Italia (TT) announced a cut in its dividend in Feb 2013.Vale SA announced a dividend cut in 2013.</p> <p>8</p> <p>Positive Information</p> <p>Dividend initiations</p> <p>Dividend increases</p> <p>Negative Information</p> <p>Dividend omissions</p> <p>Dividend reductions</p> <p>Agency costs and Dividend policyThe separation of ownership and management in a corporation may lead to suboptimal investment.Management may invest in negative NPV projects to enhance the companys size or managements control.Jensens 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 companys 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.</p> <p>Bottom line: Dividends may reduce agency costs and, therefore, increase the value of the firm.Copyright 2013 CFA Institute9</p> <p>LOS: Explain how clientele effects and agency issues may affect a companys payout policy.Pages 268271</p> <p>Clientele and Agency Influence on Dividend Policy</p> <p>The separation of ownership and management in a corporation may lead to suboptimal investment. Management may invest in negative NPV projects to enhance the companys size or managements control.Jensens 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 companys 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.</p> <p>Bottom line: Dividends may reduce agency costs and, therefore, increase the value of the firm</p> <p>9</p> <p>3. Factors Affecting Dividend policyCopyright 2013 CFA Institute10</p> <p>LOS: Explain factors that affect dividend policy.Pages 271272</p> <p>3. Factors Affecting Dividend Policy</p> <p>Investment opportunitiesExpected volatility of future earningsFinancial flexibilityTax considerationsFlotation costsContractual and legal restrictions</p> <p>10</p> <p>Investment Opportunities</p> <p>Expected Volatility of Future Earnings</p> <p>Financial Flexibility</p> <p>Tax Considerations</p> <p>Flotation Costs</p> <p>Contractual and Legal Restrictions</p> <p>Factors affecting dividend policyInvestment 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 dividendsa 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.</p> <p>Copyright 2013 CFA Institute11</p> <p>LOS: Explain factors that affect dividend policy.Pages 272273</p> <p>Factors Affecting Dividend Policy</p> <p>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.A company in the mature phase of the companys life cycle is more likely to pay dividend than a company in the growth stage.Expected volatility of future earnings:Companies with greater earnings volatility are less likely to increase dividendsa 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.11</p> <p>Factors affecting dividend policyTax considerationsThe tax rate on dividends and how dividends are taxed relative to capital gains affect investors preferences and, hence, companies dividend policy.Flotation costsThese costs make it more expensive to use newly issued stock instead of internally generated funds.Smaller companies face higher flotation costs.Contractual and legal restrictionsForms of restrictions:Impairment of capital ruleBond indenturesRequirement of preferred sharesCopyright 2013 CFA Institute12</p> <p>LOS: Explain factors that affect dividend policy.Pages 273278</p> <p>Factors Affecting Dividend Policy</p> <p>Tax considerations The tax rate on dividends and how dividends are taxed relative to capital gains affect investors preferences and, hence, companies dividend policy.Note: Tax systems are discussed later in presentation.</p> <p>Flotation costs These costs make it more expensive to use newly issued stock instead of internally generated funds.Smaller companies face higher flotation costs.</p> <p>Contractual and legal restrictions Forms of restrictions:Impairment of capital ruleThe impairment of capital rule is a legal restriction on paying dividends if there is not a minimum amount of equity capital. Bond indenturesRequirement of preferred shares (that is, preference in preferred stock dividends before common stock dividends) </p> <p>12</p> <p>Tax Systems and Dividend PolicyConsider a company that has earnings before tax of $100 million and pays all its earnings as dividends. The companys 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.Copyright 2013 CFA Institute13</p> <p>LOS: Calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double-taxation, split-rate, and tax imputation dividend tax regimes.Pages 274276</p> <p>Tax Systems and Dividend Policy</p> <p>Double taxation (U.S.) Earnings are taxed at corporate level; dividends are taxed at shareholder level.Effective tax on dividends = ($35 + $16.25) $100 = 51.25%Form...</p>

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