15 - 1
Distributions to Shareholders:
Dividends and Share Repurchases
[email protected]
15 - 2
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?
Optimal Dividend Policy D1
P0
ks g
Balance between current dividends and future
growth and maximize the stock price
15 - 3
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.
15 - 4
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.
15 - 5
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.
15 - 6
Tax Preference Theory
Retained earnings lead to long-term
capital gains, which are taxed at
lower rates than dividends: 20% vs.
up to 39.6%. Capital gains taxes
are also deferred.
This could cause investors to prefer
firms with low payouts, i.e., a high
payout results in a low P0.
15 - 7
Implications of 3 Theories for
Managers
Theory Implication
Irrelevance Any payout OK
Bird in the hand Set high payout
Tax preference Set low payout
But which, if any, is correct???
15 - 8
Possible Stock Price Effects
Stock Price ($)
Bird-in-Hand
40
30 Irrelevance
20
Tax preference
10
0 50% 100% Payout
15 - 9
Possible Cost of Equity Effects
Cost of equity (%)
Tax Preference
20
15 Irrelevance
10 Bird-in-Hand
0 50% 100% Payout
15 - 10
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.
15 - 11
What’s the “information content,” or
“signaling,” hypothesis?
Managers hate to cut dividends, so
won’t raise dividends unless they think
raise is sustainable. So, investors view
dividend increases as signals of
management’s view of the future.
Therefore, a stock price increase at
time of a dividend increase could
reflect higher expectations for future
EPS, not a desire for dividends.
15 - 12
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.
15 - 13
What’s the “residual dividend model”?
Find the retained earnings needed
for the capital budget.
Pay out any leftover earnings (the
residual) as dividends.
This policy minimizes flotation and
equity signaling costs, hence
minimizes the WACC.
15 - 14
4 Steps in Establishing Payout Ratio
Determine optimal capital budget
Determine the amount of equity needed to
finance that budget
It uses R/E to meet equity requirements
It pays dividend only if more earnings are
available than are needed to support the
optimal capital budget
Dividend = NI – R/E
15 - 15
Using the Residual Model to Calculate
Dividends Paid
Net
[( )( )]
Dividends = income –
Target
equity
ratio
Total
capital
budget
.
15 - 16
Data for SSC
Capital budget: $800,000. Given.
Target capital structure: 40% debt,
60% equity. Want to maintain.
Forecasted net income: $600,000.
How much of the $600,000 should
we pay out as dividends?
15 - 17
Of the $800,000 capital budget,
0.6($800,000) = $480,000 must be equity
to keep at target capital structure.
[0.4($800,000) = $320,000 will be debt.]
With $600,000 of net income, the residual
is $600,000 – $480,000 = $120,000 =
dividends paid.
Payout ratio = $120,000/$600,000
= 0.20 = 20%.
15 - 18
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.
NI = $800,000: Dividends =
$800,000 – $480,000 = $320,000.
Payout = $320,000/$800,000 = 40%.
15 - 19
How would a change in investment
opportunities affect dividend under the
residual policy?
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.
15 - 20
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.
15 - 21
What’s a “dividend reinvestment plan
(DRIP)”?
Shareholders can automatically
reinvest their dividends in shares of
the company’s common stock. Get
more stock than cash.
There are two types of plans:
Open market
New stock
15 - 22
Open Market Purchase Plan
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.
15 - 23
New Stock Plan
Firm issues new stock to DRIP
enrollees, keeps money and uses it
to buy assets.
No fees are charged, plus sells
stock at discount of 5% from market
price, which is about equal to
flotation costs of underwritten stock
offering.
15 - 24
Firms that need new equity capital use
new stock plans.
Firms with no need for new equity
capital use open market purchase plans.
Firm can expand their DRIPs by moving
to “open enrollment” whereby anyone
can purchase the firm’s stock directly
Most NYSE listed companies have a
DRIP. Useful for investors.
15 - 25
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.
15 - 26
Dividend Payout Ratios for
Selected Industries
Industry Payout ratio
Banking 38.29
Computer Software Services 13.70
Drug 38.06
Electric Utilities (Eastern U. S.) 67.09
Internet n/a
Semiconductors 24.91
Steel 51.96
Tobacco 55.00
Water utilities 67.35
*None of the internet companies included in the
Value Line Investment Survey paid a dividend.
15 - 27
Stock Repurchases
Repurchases: Buying own stock back
from stockholders.
Reasons for repurchases:
As an alternative to distributing cash as
dividends.
To dispose of one-time cash from an
asset sale.
To make a large capital structure change.
15 - 28
Advantages of Repurchases
Stockholders can tender or not.
Helps avoid setting a high dividend that
cannot be maintained.
Repurchased stock can be used in take-
overs 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.
15 - 29
Disadvantages of Repurchases
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.
Firm may have to bid up price to complete
purchase, thus paying too much for its
own stock.
15 - 30
Stock Dividends vs. Stock Splits
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.
15 - 31
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.
But splits/stock dividends may get us to
an “optimal price range.”
15 - 32
When should a firm consider splitting
its stock?
There’s a widespread belief that the
optimal price range for stocks is $20
to $80.
Stock splits can be used to keep the
price in the optimal range.
Stock splits generally occur when
management is confident, so are
interpreted as positive signals.
