Distributions to Shareholders: Dividends and Share Repurchases

Dividend

Dividend decision

• Theories of investor preferences

• Signaling effects

• Residual model

• Dividend reinvestment plans

• Stock dividends and stock splits

• Stock repurchases

Cash Dividends

• Regular cash dividend – cash payments made directly to stockholders, usually each quarter

• Extra cash dividend – indication that the “extra” amount may not be repeated in the future

• Special cash dividend – similar to extra dividend, but definitely won’t be repeated

• Liquidating dividend – some or all of the business has been sold

Stock Dividends and Stock Splits

• Stock Dividend -- A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend

What is “dividend policy”?

• It’s the decision to pay out earnings versus retaining and reinvesting them. Includes these elements: 1. High or low payout?

2. Stable or irregular dividends?

3. How frequent?

4. Do we announce the policy

Do investors prefer high or low payouts? There are three theories

• Dividends are irrelevant: Investors don’t care about payout.

• Bird in the hand: Investors prefer a high payout.

• Tax preference: Investors prefer a low payout, hence growth.

Low Payout

• Why might a low payout be desirable? – Individuals in upper income tax brackets might

prefer lower dividend payouts, given the immediate tax liability, in favor of higher capital gains with the deferred tax liability

– Flotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs

– Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends

High Payout

• Why might a high payout be desirable? – Desire for current income

• Individuals that need current income, i.e. retirees

• Groups that are prohibited from spending principal (trusts and endowments)

– Uncertainty resolution – no guarantee that the higher future dividends will materialize

– Taxes • Dividend exclusion for corporations

• Tax-exempt investors don’t have to worry about differential treatment between dividends and capital gains

Dividend Policy in Practice

• Residual dividend policy

• Constant growth dividend policy – dividends increased at a constant rate each year

• Constant payout ratio – pay a constant percent of earnings each year

• Compromise dividend policy

Factors Influencing Dividend Policy

• Legal Rules

• Capital Impairment Rule -- many states prohibit the payment of dividends if these dividends impair “capital” (usually either par value of common stock or par plus additional paid-in capital).

Other Issues to Consider

• Funding Needs of the Firm

• Liquidity

• Ability to Borrow

• Restrictions in Debt Contracts (protective covenants)

• Control

Dividend theories

• They are as follows:

• 1. Walter’s model

• 2. Gordon’s model

• 3. Modigliani and Miller’s hypothesis

Dividend Irrelevance 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.

• Modigliani-Miller support irrelevance.

• Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test.

Modigliani and Miller’s hypothesis:

• They argue that the value of the firm depends on the firm’s earnings which result from its investment policy.

ASSUMPTION

• 1. The firm operates in perfect capital market

• 2. Taxes do not exist

• 3. The firm has a fixed investment policy

• 4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and dividends with certainty and one discount rate is appropriate for all securities and all time periods. Thus, r = K = Kt for all t.

From the above M-M fundamental principle we can derive their valuation

model as follows:

• P1 = P0 * (1 + k) – D

• Where,

• P1 = market price of the share at the end of a period

• P0 = market price of the share at the beginning of a period

• k = cost of capital

• D = dividends received at the end of a perio

example

• The original price of the stock is Rs. 150. The discount rate applicable to the company is 10%. The company had declared Rs. 10 as dividends in an year. Calculate the market price of the share at the end of one year using the Modigliani – Miller’s model.

• Here, P0 = 150 • k = 10% • D = 10 • Market price of the stock = P1 = 150 * (1 + .10) –

10 = 150 *1.1 – 10 = 155.

• P0=P1+D1/1+Ke • The number of shares to be issued to implement the project

• N= I-(E-nD1)/P1

• N = number of new shares

• I= total investment

• E= earning

• n= number of shares outstanding at the begning

• D1= dividend to be received at the end

• P1 =mp at the end

Criticism:

• 1. The assumption that taxes do not exist is far from reality. • 2. M-M argue that the internal and external financing are

equivalent. This cannot be true if the costs of floating new issues exist.

• 3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm pays dividends or not. But, because of the transactions costs and inconvenience associated with the sale of shares to realise capital gains, shareholders prefer dividends to capital gains.

•

CONT---

• 4. Even under the condition of certainty it is not correct to assume that the discount rate (k) should be same whether firm uses the external or internal financing.

• If investors have desire to diversify their port folios, the discount rate for external and internal financing will be different.

• 5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is considered, dividend policy continues to be irrelevant. But according to number of writers, dividends are relevant under conditions of uncertainty.

Walter’s model:

• Professor James E. Walterargues that the choice of dividend policies almost always affects the value of the enterprise. His model shows clearly the importance of the relationship between the firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that will maximise the wealth of shareholders

ASSUMPTIONS

• .1 The firm finances all investment through retained earnings; that is debt or new equity is not issued;

• 2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;

• 3. All earnings are either distributed as dividend or reinvested internally immediately.

• 4. Beginning earnings and dividends never change. The values of the earnings pershare (E), and the divided per share (D) may be changed in the model to determine results, but any given values of E and D are assumed to remain constant forever in determining a given value.

• 5. The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is as follows:

• P = D/K +r(E-D)/K/K

The criticisms on the model are as follows:

• 1 the model assumes that the investment opportunities of the firm are

financed by retained earnings only and no external financing debt or

equity is used for the purpose

• 2 Walter’s model is based on the assumption that r is constant

• 3 A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly with the firm’s risk

Gordon’s Model:

• Assumptions: • Gordon’s model is based on the following assumptions. • 1. The firm is an all Equity firm • 2. No external financing is available • 3. The internal rate of return (r) of the firm is constant. • 4. The appropriate discount rate (K) of the firm remains constant. • 5. The firm and its stream of earnings are perpetual • 6. The corporate taxes do not exist. • 7. The retention ratio (b), once decided upon, is constant. Thus, the

growth rate (g) = br is constant forever. • 8. K > br = g if this condition is not fulfilled, we cannot get a

meaningful value for the share.

Dividend Irrelevance 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.

• Modigliani-Miller support irrelevance. • Implies payout policy has no effect on stock

value or the required return on stock. • Theory is based on unrealistic assumptions

(no taxes or brokerage costs).

Dividend Preference (Bird-in-the-Hand) Theory

• Investors might think dividends (i.e., the-bird-in-the-hand) are less risky than potential future capital gains.

• Also, high payouts help reduce agency costs by depriving managers of cash to waste and causing managers to have more scrutiny by going to the external capital markets more often.

• Therefore, investors would value high payout firms more highly and would require a lower return to induce them to buy its stock

• According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is equal to the present value of an infinite stream of dividends to be received by the share. Thus:

•

• Po=E1(1-b)/K-br

• The above equation explicitly shows the relationship of current earnings (E,), dividend policy, (b), internal profitability (r) and the all-equity firm’s cost of capital (k), in the determination of the value of the share (P0).

Bird-in-the-Hand Theory

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

• If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P0.

Tax Effect Theory

• Low payouts mean higher capital gains. Capital gains taxes are deferred until they are realized, so they are taxed at a lower effective rate than dividends.

• This could cause investors to require a higher pre-tax return to induce them to buy a high payout stock, which would result in a lower stock price

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

What’s the “clientele effect”?

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

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

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