Chapter 7 Dividends and Share Repurchases Analysis

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Chapter 7 Dividends and Share Repurchases Analysis

Chapter 7Dividends and Share repurchases: AnalysisPresenters namePresenters titledd Month yyyy

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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

Page 258

Introduction

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.

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2.Dividend Policy and Company Value: TheoryCopyright 2013 CFA Institute3

LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.Page 258

2. Dividend Policy and Company Value: Theory

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

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

Other

Clientele effect.

Signaling.

Agency cost effects.

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

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

LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.Pages 258260

Dividends Are Irrelevant

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.

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.

Bottom line: Dividend policy does not affect a firms value.

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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.

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

Copyright 2013 CFA Institute5

LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action. Page 260

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

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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.

Bottom line: Dividend policy affects the value of the firm.Copyright 2013 CFA Institute6

LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.Pages 260261

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.

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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

LOS: Explain how clientele effects and agency issues may affect a companys payout policy.Pages 261265

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 clienteles is that investors will have a preference for stocks with a specific dividend policy.

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

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

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Dividends and SignalingUnder MMs theory, everyone has the same information.When there is asymmetric information, dividend changes may convey information.

Copyright 2013 CFA Institute8

LOS: Describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey.Pages 265268

Dividends and Signaling

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 & Gamble (PG), Diebold (DBD), Johnson & 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.

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Positive Information

Dividend initiations

Dividend increases

Negative Information

Dividend omissions

Dividend reductions

Agency costs and Dividend policyThe separation of ownership and management in a corporation may lead to suboptimal investment.Management may invest in negative NPV proje