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Transcript of CHAPTER 17
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CHAPTER 17
Distributions to Shareholders: Dividends and Repurchases
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Topics in Chapter
Overview Theories of investor preferences Clientele Effect and Signaling Hypothesis Cash dividends Residual Distribution Model Stock repurchases Stock dividends and stock splits Dividend reinvestment plans (DRIPS)
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Distribution Policy
Defines: Level of cash distributions to
shareholders Form of the distribution
Dividend vs. Stock repurchase Stability of the distribution
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Good Ways to Use FCF
1. Pay interest expense2. Pay down principal on debt3. Pay dividends4. Repurchase stock5. Buy non-operating assets such as
Treasury bills
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17-5
Uses for FCF FCF = f (Investment opportunities
and operating plans) Debt/Interest payment = f (Capital
structure) Investment in marketable securities
= f (Working capital policy)Remaining FCF should be
distributed to shareholders
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Distribution Patterns Over Time
The percent of total payouts as a percentage of net income has been stable at around 26%-28% Dividend payout rates Stock repurchases
Now greater than dividends
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Distribution Patterns Over Time
Smaller percentage of companies now pay dividends Young companies first make
distributions as repurchases Dividend payouts =more
concentrated in a smaller number of large, mature firms
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Dividend Yields for Selected Industries
Industry Div. Yield %Recreational Products 3.30Forest Products 3.79Software 1.48Household Products 1.55Food 1.16Electric Utilities 3.48Banks 4.46Tobacco 9.88Source: Yahoo Industry Data, April 2008
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Investor Preference Theories
Dividend Irrelevance Investors don’t care about payout
Dividend Preference (Bird-in-the-Hand) Investors prefer a high payout
Tax Effect Investors prefer a low payout
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Dividend Irrelevance Theory Investors are indifferent between dividends
and capital gains If they want cash, they can sell stock Else use dividends to buy stock
Miller-Modigliani (1961) support irrelevance 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)
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Dividend Preference Theory(Bird-in-the-Hand)
Investors view dividends as less risky than potential future capital gains
High payouts reduce agency costs Deprive managers of cash to waste Need to go to external capital markets
provides more management monitoring
Investors value high payout firms Require a lower return
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Tax Effect Theory Low payouts mean higher capital
gains Capital gains taxes are deferred until
realized Taxed at a lower effective rate than
dividends
Investors require a higher pre-tax return resulting in a lower stock price
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Research Results Some research high payout =
high required return on stock Supports tax effect hypothesis
Internationally, countries with poor investor protection (severe agency costs) high payout = more highly valued
Empirical tests =mixed results
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The “Clientele Effect” “Clienteles” = different groups of
investors who 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
switch companies due payout policy changes
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The “Signaling Hypothesis”
Dividend changes = signals of management’s view of the future Managers hate to cut dividends Won’t raise dividends unless raise
is sustainable Stock prices fall when dividends
cut
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Cash Distributions = Dividends
Company must have cash to make a cash distribution
Sources of Cash: FCF = Cash flow available for distribution
to investors after expenses, taxes and necessary investments in operating capital.
Recapitalization Sale of an asset
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Dividend Payment Procedures
Usually paid quarterly in cash Increased once a year Voted on quarterly by the
Board of Directors
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Dividend Payment Dates Declaration date
Board officially declares dividend Holder-of-record date
Stock transfer books close Ex-dividend date
Stock trades without the dividend 2 days prior to holder-of-record date
Payment Dividend checks mailed
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Dividend Payment Example Declaration date = 11/6/09
“The Board of Directors has declared a quarterly dividend of $0.50 per share payable to holders of record on 12/05/09 payable on 1/2/10.”
Dividend goes with stock =12/02/09 Ex-dividend date = 12/03/09 Holder of record date = 12/05/09 Payment date = 01/02/2010
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Optimal Distribution Ratio
Four Factors:1. Investors’ preference for
dividends versus capital gains2. Firm’s investment opportunities3. Target capital structure4. Availability and cost of external
capital
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The “Residual Distribution Model”1. Determine optimal capital budget2. Determine amount of equity needed to
fund capital budget given target capital structure
3. Use retained earnings to meet equity needs to extent possible
4. Pay dividends or repurchase stock if funds leftover (residual)
Residual policy minimizes flotation and equity signaling costs, and minimizes the WACC
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Using the Residual Model to Calculate Distributions Paid
Distr. = – X Netincome
Targetequityratio
Totalcapitalbudget
(17-1)
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Texas & Western Transport Company
WACC = 10% (if all equity = r/e) Target capital structure:
40% debt, 60% equity Forecasted net income: $60 million 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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Texas and Western Investment Opportunities
Table 17-2
(millions) Poor Average Good
Capital budget $40 $70 $150
Net income $60 $60 $60
Equity required (60%) $24.0 $42.0 $90.0
Distributions paid (NI-Required equity) $36.0 $18.0 ($30.0)
Distribution ratio 60% 30% -50%
A capital budget of $150 million would require the use of all retained earnings plus the issuance of $30 m in new debt.
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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 Appeals to no specific clientele
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Residual Model Conclusions
Consider residual model when setting target payout, but don’t follow it rigidly
Consider “low-regular-dividend-plus-extras” policy Low regular dividend that can be
maintained Specially designated dividends when
cash available
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Stock Repurchases Repurchases = Buying own stock
back from stockholders Reasons for repurchases:
Alternative to distributing cash as dividends
Dispose of one-time cash from asset sale
Execute large capital structure change
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Stock Repurchase Procedures Company buys back its own stock
Repurchased stock = “treasury stock” Negative value on balance sheet
Reasons to Repurchase stock:1. Increase leverage (issue debt/buy
stock)2. Use shares for options exercise3. Firm has excess cash
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Stock Repurchase Procedures
1. Open market purchase through broker
2. Tender offer3. Targeted stock repurchase
Purchase block of shares through negotiation with large shareholder
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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
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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
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Stock Repurchase Formulas
5)-(17
4)-(17 P
3)-(17 cash ExtraP(
2)-(17 n
Cash Extra
0
o
P
Vn
n
V
)nn
VP
OP
OP
OP0
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Stock Repurchase Example
Earnings = $400 million Shares outstanding = 40 million = n0
Payout ratio = 50% Earnings growth = 5% = g Return on equity = 10% = rE
Assume no tax effects
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Stock Repurchase ExampleIf 50% paid as cash dividends (p.609)
D0 = .50 x (400/40) = $5.00 D1 = $5.00 * (1.05) = $5.25 P0 = $5.25 / (.10 - .05) = $105.00 P1 = $105 x (1.10) - $5.25 =
$110.25 rE = 5% (CGY) + 5% (DY) 10% S1 = $110.25 x 40 = $4,410 million
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50% Dividends
Year 0 1Earnings $400.00 $420.00Shares 40 40Payout % 50% 50%g 5% 5%R(e) 10% 10%T 0 0
Dividend $5.00 $5.25P(0) $105.00P(1) pre div $115.50P(1) post div $110.25S (Equity) $4,200.00 $4,410.00
50% Dividend Payout
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Stock Repurchase ExampleIf 50% used to repurchase shares
Earnings (yr 1) = 400 * (1.05) = 420 Repurchase cash = 50% x $420 =
$210 P1 = $105 x (1.10) = $115.50 P1(n0 – n) = Cash repurchase
n = number of share remaining $115.50 x (40 – n) = $210 m n = 38.182 shares
S1 = $115.50 x 38.182 = $4,410 m
(17-3)
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50% Stock Repurchase
Year 0 1Earnings $400.00 $420.00Shares 40 38.1818 Repo % 50%g 5% 5%R(e) 10% 10%T 0 0
Repo Cash $210.00P(0) $105.00P(1) pre div $115.50P(1) post repo $115.50S (Equity) $4,200.00 $4,410.00
50% Stock Repurchase
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Comparison
Year 0 1 Year 0 1Earnings $400.00 $420.00 Earnings $400.00 $420.00Shares 40 40 Shares 40 38.1818 Payout % 50% 50% Repo % 50%g 5% 5% g 5% 5%R(e) 10% 10% R(e) 10% 10%T 0 0 T 0 0
Dividend $5.00 $5.25 Repo Cash $210.00P(0) $105.00 P(0) $105.00P(1) pre div $115.50 P(1) pre div $115.50P(1) post div $110.25 P(1) post repo $115.50S (Equity) $4,200.00 $4,410.00 S (Equity) $4,200.00 $4,410.00
50% Dividend Payout 50% Stock Repurchase
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Stock Repurchase: Key Results
1. Ignoring tax effects and signaling, the total market value of equity remains the same whether a firm pays cash dividends or repurchases stock
2. The repurchase does not change the stock price; it does reduce the number of shares outstanding
3. With fewer shares outstanding, the stock price will rise faster
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Dividends versus Repurchases Advantages of Repurchases:
Viewed as a positive signal Stockholders have choice Dividends are “sticky” in the short-run Companies can divid target cash
distribution into dividend and repurchase Can produce large scale changes in capital
structure Repurchase shares for use with incentive
stock options
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Dividends versus Repurchases
Disadvantages of Repurchases: Cash dividends are dependable but
repurchases are not Selling shareholders may not be fully
informed Firm may pay too much for shares
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Conclusions Repurchases have a tax advantage Dividends are more dependable Volatile dividends lower investor
confidence “Signaling”
Repurchases useful to: Make capital structure shifts Distribute cash from one-time events Obtain shares for employee stock options
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Constraints Bond indentures Preferred stock restriction Impairment of capital rule
Dividend payments > Balance sheet retained earnings
Availability of cash Penalty tax on improperly
accumulated earnings
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Alternative Sources of Capital
Cost of selling new stock New equity if flotation costs are low
Ability to substitute debt for equity Control
Management reluctant to sell new stock
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The Distribution Policy Decision
Decision made jointly with capital structure and capital budgeting decisions Managers do not want to issue new
stock Dividend changes = signals
Use residual model to set long-term dividend payout target
Set cash dividend low enough to be maintained
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The Distribution Policy Decision
Steady or increasing dividend stream signals firm’s financial condition is under control
Stable dividends decrease investor uncertainty
Firms with superior investment opportunities should set lower cash dividends and retain earnings
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Dividend Policy Conclusions Younger firms with many investment
opportunities but low cash flow should retain earnings
Executive survey results: NOT reducing dividends is more important
than initiating a dividend or increasing it Capital budgeting decisions are more
important than distribution decisions Repurchase shares when shares
undervalued
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Stock Splits and Stock Dividends Stock split:
Firm increases the number of shares outstanding, say 2:1
Shareholders sent more shares Stock dividend:
Firm issues new shares in lieu of paying a cash dividend
If 10%, get 10 shares for each 100 shares owned
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Both increase the number of shares outstanding Divides pie into smaller pieces
Stock price falls so as to keep each investor’s wealth unchanged Unless the stock dividend or split conveys
information, or is accompanied by another event like higher dividends
“Optimal price range”
Stock Splits and Stock Dividends
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Stock Split Explanations Signaling
Stock splits generally occur when management is confident
Interpreted as positive signals “Catering”
Optimal price range = $20 to $80 Stock splits can keep price in optimal range Attractive to small investors Google ($577.07) ? Berkshire-Hathaway A ($122,815) ?
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Reverse Stock Splits
Reduces number of shares outstanding
Drives stock price up Meet listing requirements
Frequently seen as a negative signal
Can be used to force out small shareholders
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Stock Splits & Dividends
Stock splits usually follow a price run up to produce a price reduction Split = positive, value-related
signal Stock dividends used on a
regular basis will keep the stock price constrained
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Effect on Stock Prices
Announcement of stock split or dividend usually results in a price increase Signaling If not followed by earnings or
dividend increase, price will revert Split may reduce liquidity
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Dividend Reinvestment Plan (DRIP)
Shareholders can automatically reinvest dividends in shares of firm’s common stock
Two types of plans: Open market (“Old Stock”) New stock
Firms can switch between the plans
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Open Market Purchase Plan DRIP funds turned over to trustee,
who buys shares on the open market.
Brokerage costs reduced by volume purchases
Used by firms with no need for additional capital
Convenient, easy way to invest
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New Stock Plan Firm issues new stock to DRIP
enrollees Used by firms needing new
capital No fees charged Stock sold at discount from
market price