Chapter 16 DISTRIBUTION TO SHAREHOLERS: DIVIDENDS AND SHARE
REPURCHASES Dividend Policy It is a decision that a company makes
on what it wants to do with its net income whether it wants to
retain and reinvest them (as retained earnings), or it wants to
distribute them (as dividends) to shareholders. Dividend policy
includes: High or low dividend payout Stable or irregular dividend
payout Frequency of dividend payout Announcement of dividend policy
Terms: Target distribution ratio Percentage of net income to be
distributed as either a cash dividend or stock repurchase, and it
should be based in large part on investors preferences for
dividends versus capital gains. (Target) Payout ratio The (target)
percentage of net income paid out as a cash dividend. Optimal
payout policy A policy that must strike a balance between current
cash dividends and capital gains so as to maximize the stock price.
Theories that explain how factors interact to determine a firms
optimal distribution policy: Dividend irrelevance theory Investors
are indifferent on a high or low dividend payout policy.
Bird-in-the-hand theory Investors prefer high dividend payout
policy Dividends are chosen over capital gains Tax preference
theory Investors prefer low dividend payout policy Capital gains
are chosen over dividends Theories of Dividend Policy Dividend
Irrelevance Theory Developed by Franco Modigliani and Merton
Miller. Indicates that an issuance of dividends should have little
to no impact on stock price. Investors can create their own
dividend policy: If dividends are distributed When investors need
money, then good for them. When investors dont need money, they can
use the dividends to buy stocks If dividends are not distributed
When investors need money, they can sell their stock. When
investors dont need money, then good for them. Any payout is okay,
hence, dividends are irrelevant. Based on unrealistic assumptions
(no taxes, no brokerage costs, ready buyer of stocks), hence this
theory may not be true.It needs more empirical testing.
Implication: Any payout is okay. Theories of Dividend Policy
Bird-in-the-hand Theory Developed by Myron Gordon and John Lintner
This theory indicates that investors think dividends are less risky
than potential future capital gains, and thus dividends are more
attractive to shareholders. Purports that lower payouts results in
higher costs of capital (riskier); hence, investors would value
high-payout firms more highly, i.e., a high payout would result in
a high P0. Implication: Set a high dividend payout ratio to
increase P0. MM called this theory the Bird-in-the hand fallacy, as
this theory states that a firms value will be maximized by setting
a high dividend payout ratio.Yet MM sated that a firms value is
determined by the riskiness of operating cash flows and not by the
dividend payout policy. Theories of Dividend Policy Tax Preference
Theory First developed by Robert H. Litzenberger and Krishna
Ramaswamy. This theory indicates that investors may prefer to have
companies retain their earnings because of various tax advantages.
Why investors prefer low payout companies? Long-term capital gains
allow the investor to defer tax payment until they decide to sell
the stock.Taxes are not paid on the gain until a stock is sold. If
someone holds a stock until he or she dies, no capital gains tax is
due at all Possible stock price effects 40 30 20 10 0 50%100%Payout
Stock Price ($) Bird-in-the-Hand Irrelevance Tax preference
Possible cost of equity effects Tax preference Irrelevance
Bird-in-the-Hand 30 25 20 15 10 5 0 50%100%Payout Cost of Equity
(%) Which theory is most correct? Empirical testing has not been
able to determine which theory, if any, is correct. Thus, managers
use judgment when setting policy. Analysis is used, but it must be
applied with judgment. Investors cannot be seen to uniformly prefer
either higher or lower dividends.However, individual investors do
have strong preferences. Both evidence and logic suggests that
investors prefer firms that follow a stable, predictable dividend
policy. Other issues that have a bearing on optimal dividend policy
Information Content or Signaling Hypothesis Signal is an action
taken by management that provides clues to investors about how
management views the firms prospects. Clientele Effect Information
Content or Signaling Hypothesis A dividend increase announcement is
often accompanied by an increase in stock price.Cutting dividends
sends a negative signal to investors. Managers wont raise dividends
unless they think raise is sustainable. Investors view dividend
increases as signals of managements view of the future. A stock
price increase at time of a dividend increase could reflect higher
expectations for future EPS, not a desire for dividends. Stock
price changes indicates that there is an important information
content in dividend announcements. Clientele Effect Clientele
refers to different groups of investors, or clienteles that prefer
different dividend policies.Clientele effect is the tendency of a
firm to attract a set of investors that like its dividend policy. A
firm establishes a dividend policy and then attracts a specific
clientele that is drawn to this dividend policy.Thus, the firms
past dividend policy determines its current clientele of investors.
A firm can change from one dividend payout policy to another and
let stockholders who dont like the new policy sell to other
investors who do.However, clientele effects impede or hinders
changing dividend policy.Taxes and brokerage costs hurt investors
who have to switch companies. Importance of Dividend Stability Many
stockholders rely on dividends to meet expenses, and they would be
seriously inconvenienced if the dividend stream were unstable.
Reducing dividends could send negative and/or incorrect signals to
investors, who may interpret the dividend cut to mean that the
companys future earnings prospects have been diminished. Components
of Dividend Stability How dependable is the growth rate? Can we
count on at least receiving the current dividend in the future?
Investors prefer stocks that pay more predictable dividends to
stocks that pay the same average amount of dividendsbut in a more
erratic manner. If a firm stabilizes its dividends as much as
possible, the cost of equity will be minimized and the stock price
maximized. What is a Stable Dividend Policy? The most stable policy
is a firm whose dividend growth rate is predictable. A companys
total return (DY + CGY) would be relatively stable over the long
run, and its stock would be a good hedge against inflation The
second most stable policy is where stockholders can be reasonably
sure that the current dividend will not be reduced. May not grow at
a steady rate, but management will probably be able to avoid
cutting the dividend. Establishing dividend policy in practice: How
much cash must be distributed to shareholders? Must follow the
objective: Maximize shareholder value Firms cash flows really
belong to shareholders, so management should refrain from retaining
income unless it can be reinvested to produce returns higher than
shareholders could themselves earn by investing the cash in
investments of equal risk Optimal Payout ratio is a function of
four factors: Investors preferences for dividends vs. capital gains
Firms investment opportunities Firms target capital structure
Availability and cost of external capital Factors influencing
dividend policy decisions Constraints: Bond indentures (may
restrict dividend distribution) Preferred stock restrictions (may
restrict dividend distribution) Impairment of capital rule
(dividends must be paid out of profits and not from a corporations
capital.Liquidating dividends can be paid out of capital but must
be indicated as such and must not reduce capital below the limits
stated in debt contracts.) Availability of cash (Shortage amount of
cash may restrict dividend distribution.However, the ability to
borrow can offset this factor) Penalty tax on improperly
accumulated earnings (may boost dividend distribution.Relevant only
to privately owned firms) Investment opportunities: Number of
profitable investment opportunities (More opportunities = lower
payout) Possibility of accelerating or delaying projects
(Availability of real options permits adherence to a more stable
dividend policy) Alternative sources of capital: Cost of selling
new stock (high cost of new equity, lower payout so that there will
be more RE) Ability to substitute debt for equity (high ability to
swap debt for equity = higher payout) Control (want control =
reluctant to sell stock = retain more earnings) Residual dividend
model A model based on the premise that investors prefer to have a
firm retain and reinvest earnings rather than pay them out in
dividends if the rate of return the firm can earn on reinvested
earnings exceeds the rate of return investors can obtain for
themselves on other investments of comparable risk. It is less
expensive for the firm to use retained earnings than it is to issue
new common stock. This policy minimizes flotation costs and equity
signaling costs, hence minimizes the WACC Steps for a firm using
the residual policy: Determine the optimal capital budget Determine
the amount of equity needed to finance the optimal capital budget,
given the firms target capital structure Use retained earnings to
meet equity requirements to the extent possible. Make distributions
(dividends or stock repurchases) only if more earnings are
available than are needed to support the optimal capital budget.
Residual Dividend Model Should be used by firms to help set their
long-run target payout ratios, but not as a guide to the payout in
any one year, because investment opportunities and earnings vary
year to year. Advantage: Minimizes new stock issues and flotation
costs Disadvantage: Results in variable dividends, sends
conflicting signals, increases risk, and doesnt appeal to any
specific clientele. Conclusion: Consider residual policy when
setting target payout, but dont follow it rigidly. Residual
Dividend Model ((((
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\|=budgetcapitalTotal ratioequity Target - Income NetDividends
Capital budget $800,000 Target capital structure 40% debt, 60%
equity Forecasted net income $600,000 How much of the forecasted
net income should be paid out as dividends? What is the dividend
payout ratio? How much of the forecasted net income should be paid
out as dividends and what is the dividend payout ratio if net
income drops to $400,000?How about if NI rises to $800,000? Problem
16-1: Residual Dividend Model Axel Telecommunications has a target
capital structure that consists of 70% debt and 30% equity.The
company anticipates that its capital budget for the upcoming year
will be $3,000,000.If Axel reports net income of $2,000,00 and it
follows a residual dividend payout policy, what will be its
dividend payout ratio? Problem 16-6: Residual Dividend Model Welch
Company is considering three independent projects, each of which
requires a $5 million investment.The estimated internal rate of
return and cost of capital for these projects are presented here:
Cost of Capital IRR Project H (high risk)16%20% Project M (medium
risk)12%10% Project L (low risk)8%9% Note that the projects costs
of capital vary because the projects have different levels of
risk.The companys optimal capital structure calls for 50% debt and
50% common equity.Welch expects to have net income of $7,287,500.If
Welch establishes its dividends from the residual model, what will
be its payout ratio? How would a change in investment opportunities
affect dividend under the residual policy? Few good investments
higher dividend payout More good investments lower dividend payout
Setting the dividend policy Forecast capital needs over a planning
horizon, often 5 years. (Todays dividend decisions are constrained
by policies set in the past, hence setting a policy for the next
five years necessitates a review of the current situation). Set a
target capital structure. Estimate annual equity needs. Set target
payout based on the residual model. Generally, some dividend growth
rate emerges.Maintain target growth rate if possible, varying
capital structure somewhat if necessary. Dividend Payment
Procedures: Declaration date BODs declares the dividend.It is the
date on which a firms directors issue a statement declaring a
dividend. Amount of dividend to be paid is set, holder-of record
date is set, and payment date is set. Holder-of-record date Stock
transfer books of the corporation are closed.Those listed on the
books on this date are the holders of record who will receive the
announced dividends. Ex-dividend date Usually two business days
before holder-of-record date.Shares purchased after the ex-dividend
date are not entitled to the dividend. Payment date The day when
dividend checks are actually mailed to the holders of record.
Dividend Reinvestment Plan A plan where stockholders can
automatically reinvest dividends received back into the shares of
the companys stock.Therefore, stockholders get more stock than
cash. Income tax on the amount of the dividends must still be paid
even through stock, rather than cash, is received. Two types of
DRIPs: Open market (plans involving already old stock that is
already outstanding). Dollars to be reinvested are turned over to
trustee, who buys shares on the open market. Brokerage costs are
reduced by volume purchases. Convenient, easy way to invest, thus
useful for investors. New stock (plans involving newly issued
stock) Firm issues new stock to DRIP enrollees (usually at a
discount from the market price), keeps money and uses it to buy
assets. Firms that need new equity capital use new stock plans.
Firms with no need for new equity capital use open market purchase
plans. Most NYSE listed companies have a DRIP.Useful for investors.
Low-Regular-Dividend-plus Extras The policy of announcing a
low-regular dividend that can be maintained nomatter what, and then
when times are good, paying a designated extra dividend. Offered by
companies, especially in cyclical industries, that have difficulty
maintaining in bad times a dividend that is really too low in good
times. This is a good way for companies to deal with information
asymmetry and manage shareholder expectations. Recap on dividend
policy: Dividend policy decisions are truly exercises in informed
judgment, not decisions quantified based on rules. Firms should try
to establish a rational dividend policy & stick with it.
Dividend policy can be changed but this can cause problems and
negative implications for stock prices: Inconvenience the firms
existing shareholders. Send unintended signals. Convey the
impression of dividend instability. However, economic circumstances
do change and occasionally, such changes dictate that a firm should
alter its dividend policy. Dividend policy still remains one of the
most judgmental decisions that firms must make, so it must always
be set by the BODs.Financial staff analyzes the situation and makes
a recommendation, but the the board makes the final decision.
Factors influencing dividend policy: Constraints Bond indentures
Preferred stock restrictions Impairment of capital rule
Availability of cash Improperly accumulated earnings tax (IAET)
Investment Opportunities Number of profitable investment
opportunities Possibility of accelerating or delaying projects.
Factors influencing dividend policy: Alternative Sources of Capital
Cost of selling new stock (Flotation cost) Ability to substitute
debt for equity Control Effects on Dividend Policy on rs
Stockholders desire for current versus future income Perceived
riskiness of dividends versus capital gains Tax advantage of
capital gains Information content of dividends (signaling) Stock
Repurchases (Treasury Stock) Buying own stock back from
stockholders. It has the effect of decreasing shares outstanding,
increasing EPS and often increasing the stock price due to positive
signaling. An alternative to dividends for transmitting cash to
shareholders. Principal types of repurchases: Firms has cash
available or it has one-time cash from asset sales and distributes
cash by repurchasing shares rather than by paying cash dividends.
Large capital structure change.Firm concludes that its capital
structure is too heavily weighted with equity so it sells debt and
uses the proceeds to buy back its stock. Effects of Repurchase: ADC
expects to earn P4.4 million in 2011 and 50% of this amount has
been allocated for distribution to shareholders.There are 1.1
million shares outstanding and the market price is P20 a share.ADC
believes that it can either use the $2.2 million to repurchase
100,000 of its shares through a tender offer at P22 a share or else
pay a cash dividend of P2 a share. 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.
Repurchase can remove a large block of stock overhanging the
market. Companies that grant a large number of options to purchase
stock can avoid ownership dilution. More flexibility in adjusting
the total distribution that it would if the entire distribution
were in the form of cash dividends. Disadvantages of Repurchases
Are not as dependable as cash dividends; therefore, the stock price
may benefit more from cash dividends. 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. Selling stockholders may not be aware of all the
implications of the repurchase, therefore repurchases are usually
announced in advance. Firm may have to bid up price to complete
purchase, thus paying too much for its own stock.This will be the
disadvantage to the remaining stockholders. Problem 16-3: Stock
Repurchases Beta Industries has net income of $2,000,000, and it
has 1,000,000 shares of common stock outstanding.The companys stock
currently trades at $32 a share.Beta is considering a plan in which
it will use available cash to repurchase 20% of it shares in the
open market.The repurchase is expected to have no effect on net
income or the companys P/E ratio.What will be Betas stock price
following the stock repurchase? Stock dividends versus Stock splits
Stock dividend A dividend paid in the form of additional shares of
stock rather than in cash. Stock split An action taken by a firm to
increase the number of shares outstanding, such as doubling the
number of shares outstanding by giving each stockholder two new
shares for each one formerly held. Stock dividends versus Stock
splits DIFFERENCE Stock dividend Firm issues new shares in lieu of
paying a cash dividend.If 10%, get 10 shares for each 100 shares
owned. Stock split Firm increases the number of shares outstanding,
say 2:1.Sends shareholders more shares. Stock dividends versus
Stock splits SIMILARITIES Both increase the number of shares
outstanding, so the pie is divided into smaller pieces. Unless the
stock dividend or split conveys information, or is accompanied by
another event like higher dividends, the stock price falls so as to
keep each investors wealth unchanged. But splits/stock dividends
may get us to an optimal price range. this is because stock splits
and dividends more often than not send a positive signal to
shareholders. Effects of stock dividends and stock splits on stock
price: On average, the price of a companys stock rises shortly
after an announcement of stock dividend or stock split, and this is
due to a signal of expected higher future earnings.(Conversely it
falls shortly after an announcement of a reverse stock split). If
higher future earnings or dividend increase is not announced later,
stock price will drop back to the earlier level. Stock splits tend
to increase the stocks liquidity and which lead to an increase in
the firms value. Stock splits tend to change the mix of
shareholders.After a split, there is more proportion of individual
investors and less proportion of institutional investors. When and
why should a firm consider splitting its stock? Theres a widespread
belief that the optimal price range for stocks is $20 to $80.Stock
splits can be used to keep the price in this optimal range. Stock
splits generally occur when management is confident, so are
interpreted as positive signals. On average, stocks tend to
outperform the market in the year following a split. Problem 16-2:
Stock Split Gamma Medicals stock trades at $90 a share.The company
is contemplating a 3-for-2 stock split.Assuming that the stock
split will have no effect on the market value of its equity what
will be the companys stock price following the stock split? Problem
16-4: Stock Split After a 5-for-1 stock split, Strasburg Company
paid a dividend of $0.75 per new share, which represents a 9%
increase over last years pre-split dividend.What was last years
dividend per share? Problem 16-8: Alternative Dividend Policies
Rubenstein Bros. Clothing is expecting to pay an annual dividend
per share of $0.75 out of annual earnings per share of
$2.25.Currently, Rubenstein Bros. stock is selling for $12.50 per
share.Adhering to the companys target capital structure, the firm
has $10 million in assets, of which 40% is funded by debt.Assume
that the firms book value of equity equals its market value.In past
years, the firm has earned an ROE of 18%, which is expected to
continue this year and into the foreseeable future. Problem 16-8:
Alternative Dividend Policies a. Based on that information, what
long-run growth can the firm be expected to maintain? b. What is
the stocks required return? c. If the firm changed its dividend
policy and paid an annual dividend of $1.50 per share, financial
analysts would predict that the change in policy will have no
effect on the firms stock price or ROE.Therefore, what must be the
firms new expected long-run growth rate and required return? d.
Suppose instead that the firm has decided to proceed with its
original plan of disbursing $0.75 per share to shareholders, but
the firm intends to do so in the form of a stock dividend rather
than a cash dividend.The firm will allot new shares based on the
current stock price of $12.50.In other words, for every $12.50 in
dividends due to shareholders, a share of stock will be issued.How
large will the stock dividend be relative to the firms current
market capitalization? e. If the plan in Part d is implemented, how
many new shares of stock will be issued and by how much will the
companys EPS be diluted?
