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CHAPTER 7 Distributions to Shareholders: Dividends and Repurchases

Corporate Finance Mr. Ridha ESGHAIER

http://ridhaesghaier.wix.com/finance-tbs

Fall 2013

Repurchases

Payou

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Chapter Plan

Theories of investor preferences

Dividend Irrelevance Theory

Bird-in-the-Hand Theory

Tax Preference Theory

Signaling effects

Residual model

Stock repurchases

Stock dividends and stock splits

Dividend reinvestment plans

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Free Cash Flow is generated from operations and is available for distribution to all investors (debtholders and shareholders). This chapter focuses on the distributions of FCF to shareholders in the form of dividends and stock repurchases.

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Overview of Cash Distributions

We have seen in the previous chapters that a management main objective is to maximize the company’s value that depends on its ability to generate free cash flow (FCF).

A company’s investment opportunities and operating plans determine its level of FCF. The company’s capital structure policy determines the amount of debt and interest payments. Working capital policy determines the investment in marketable securities. The remaining FCF should be distributed to shareholders.

In this chapter we will focus on the use of these FCFs for cash distributions to stockholders and will try to answer

the following questions: (in the next slide)

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key questions

Can a company increase its value through its choice of distribution policy, defined as

(1) the level of distributions,

(2) the form of distributions (cash dividends versus stock repurchases), and

(3) the stability of distributions

Do different groups of shareholders prefer one form of distribution over the other?

Do shareholders perceive distributions as signals regarding a firm’s risk and expected future free cash flows?

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What is “distribution policy”?

The distribution policy defines:

The level of cash distributions to shareholders

The form of the distribution (dividend vs. stock repurchase)

The stability of the distribution

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Cash distribution & Firm Value

A company can change its value of operations only if it changes the cost of capital or investors’ perceptions regarding expected free cash flow. This is true for all corporate decisions, including the distribution policy.

Is there an optimal distribution policy that

maximizes a company’s intrinsic value?

The answer depends in part on investors’ preferences for returns in the form of dividend yields versus capital gains.

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Distribution ratio Versus Payout ratio

The relative mix of dividend yields and capital gains is determined by :

the target distribution ratio, which is the percentage of net income distributed to shareholders through cash dividends or stock repurchases, and

the target payout ratio, which is the percentage of net income paid as a cash dividend.

Notice that the payout ratio must be less than the

distribution ratio because the distribution ratio includes stock repurchases as well as cash dividends.

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Dividend Yield Versus Capital Gains Yield

A high distribution ratio and a high payout ratio mean that a company pays large dividends and has small (or zero) stock repurchases. In this situation, the dividend yield is relatively high and the expected capital gain is low.

If a company has a large distribution ratio but a small payout ratio, then it pays low dividends but regularly repurchases stock, resulting in a low dividend yield but a relatively high expected capital gain yield.

If a company has a low distribution ratio, then it must also have a relatively low payout ratio, again resulting in a low dividend yield and, it is hoped, a relatively high capital gain. 9

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Do investors prefer high or low payouts?

We examine three theories of investor preferences for dividend yield versus capital gains:

Dividends are irrelevant: Investors don’t care about payout (dividend).

Bird-in-the-hand (or Dividend Preference Theory): Investors prefer a high payout.

Tax preference: Investors prefer a low payout, hence growth (Capital Gains).

DY

CGY

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a. Dividend Irrelevance Theory

Modigliani-Miller support irrelevance. They argued that the value of the firm depends only on the income produced by its assets, not on how this income is split between dividends and retained earnings.

Dividend policy does not affect a stock’s value or risk.

According to this Theory, Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock.

This theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true.

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b. Bird-in-the-Hand Theory

Investors think dividends are sure things, then are less risky than potential future capital gains, hence they like dividends.

A “bird in the hand” is worth more than two

in the bush

If so, investors would value high payout firms more highly,

a high payout would result in a high stock

price, P0. Mr. Ridha ESGHAIER

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c. Tax Preference Theory

Low payouts mean higher capital gains. Capital gains taxes are deferred, so have a lower effective cost than the dividend taxes (paid sooner)

This could cause investors to prefer firms with low payouts, and high Capital Gains.

a high payout results in a low stock

price,P0.

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Implications of the three Theories for Managers

Theory Implication

-Irrelevance Any payout OK

-Bird-in-the-hand Set high payout

-Tax preference Set low payout

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Which theory is most correct?

Empirical testing has not been able to determine which theory, if any, is correct.

The evidence from these studies is mixed as to whether the average investor uniformly prefers either higher or lower distribution levels, other research does show that individual investors have strong preferences. Also, other research shows that investors prefer stable, predictable dividend payouts.

Thus, managers use judgment when setting policy.

Analysis is used, but it must be applied with judgment.

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Dividend policy and firm’s “clientele” of investors

Different groups of investors, or clienteles, prefer different dividend policies.

For example, retired individuals generally prefer cash income, so they may want the firm to pay out a high percentage of its earnings. On the other hand, stockholders who are saving rather than spending dividends might favor the low-payout policy.

Firm’s past dividend policy determines its current clientele of investors.

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What’s the “clientele effect”?

Management should be hesitant to change its dividend policy, because a change might cause current shareholders to sell their stock, forcing the stock price down. Such a price decline might be temporary but might also be permanent

“Clientele effects” impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies due to a change in payout policy.

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What’s the “information content”, or “signaling,” hypothesis?

Investors view dividend changes as signals of management’s view of the future.

Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable.

Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

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What’s the “residual distribution model”?

Under this model a firm follows theses two steps when establishing its target distribution ratio:

Find the reinvested earnings needed for the capital budget.

Pay out any leftover earnings (the residual) as either dividends or stock repurchases.

This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

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Distr. = – Net

income

Target equity ratio

Total capital budget [ ] ) ) ( (

Using the Residual Model to Calculate Distributions Paid

Retained Earnings needed to

finance new investments

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Application1:

Capital budget: $800,000. Given.

Target capital structure: 40% debt, 60% equity. Want to maintain.

Forecasted net income: $600,000.

Q1. If all distributions are in the form of dividends, how much of the $600,000 should we pay out as dividends?

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Solution:

to keep at target capital structure, of the $800,000 capital budget:

60%($800,000) = $480,000 must be equity.

So 40%($800,000) = $320,000 will be debt.

With $600,000 of net income, the residual is: $600,000 - $480,000 = $120,000 = dividends paid.

Distribution =$600,000 – (60%x $800,000) =$120,000

Payout ratio = Dividends / Net Income

= $120,000/$600,000 = 20%.

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Q2. How would a drop in NI to $400,000 affect the dividend? A rise to $800,000?

NI = $400,000: Need $480,000 of equity, so should retain the whole $400,000.

Dividends = 0.

payout =0%

NI = $800,000: Need $480,000 of equity

Dividends = $800,000 - $480,000

= $320,000

Payout = $320,000/$800,000 = 40%.

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Investment Opportunities and Residual Dividends

Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout.

More good investments would lead to a lower dividend payout.

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Advantages and Disadvantages of the Residual Dividend Policy

Advantages: Minimizes new stock issues and

flotation costs.

Disadvantages:

Results in variable dividends,

sends conflicting signals,

increases risk, and doesn’t appeal to any specific clientele.

Conclusion: Consider residual policy when

setting target payout, but don’t follow it rigidly. Mr. Ridha ESGHAIER

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Stock Repurchases

Repurchases: Buying own stock back from stockholders.

Reasons for repurchases:

As an alternative to distributing cash as dividends.

Want to obtain shares for use in an employee stock option plan and avoid issuing new shares.

To make a large capital structure change.

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Advantages of Repurchases

Stockholders have the choice, they can sell or not sell, according to their need of cash.

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).

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Disadvantages of Repurchases

May be viewed as a negative signal (firm has poor investment opportunities).

Government could impose penalties if repurchases were primarily to avoid taxes on dividends.

Selling stockholders may not be well informed, hence be treated unfairly.

Firm may have to bid up price to complete purchase, thus paying too much for its own stock.

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Setting Dividend Policy

Forecast capital needs over a planning horizon, often 5 years.

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.

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Stock Dividends vs. Stock Splits

Stock dividend: Firm issues new shares instead of paying a cash dividend.

For example on a 10% stock dividend, the holder of 100 shares would receive an additional 10 shares (without cost).

Stock split: Firm increases the number of shares outstanding.

For example doubling the number of shares outstanding (2-for-1 stock split). The firm sends shareholders more shares.

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Cont.

Both stock dividends and stock splits 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 investor’s wealth unchanged.

Stock splits and stock dividends may get us to an “optimal price range”.

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When should a firm consider splitting its stock?

Stock splits occur when the company think that its stock price is too high which limit the number of investors who could buy the stock (reduce demand for the stock) and thus keep the firm’s total market value below what it could be if there were more shares outstanding, at a lower price.

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What Effect on Stock Prices?

There’s a widespread belief that the optimal price range for stocks is $20 to $80. if the stock is within this range, the firm’s value will be maximized.

Stock splits can be used to keep the price in the optimal range.

In general, stock splits (as well as stock dividend) generally occur when management is confident, so are interpreted as positive signals.

On average, the price of a company’s stock rises shortly after it announces a stock split or a stock dividend (due to positive signal).

However, if during the next few months it does not announce an increase in earnings and dividends, then its stock price will drop back to the earlier level.

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For any question concerning the course please visit my web site: http://ridhaesghaier.wix.com/finance-tbs

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No Pain … … No Gain