Distribution to Shareholders: Dividends and Share Repurchases

Chapter 16

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 firm’s optimal distribution policy:

• Dividend irrelevance theory

– Investors are indifferent on a high or low dividend payout policy.

• Bird-in-the-hand fallacy/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 don’t 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 don’t 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 firm’s value will be maximized by setting a high dividend payout ratio. Yet MM sated that a firm’s 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 firm’s prospects.

• Clientele Effect

– Clienteles are different groups of stockholders prefer different dividend payout policies.

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 won’t raise dividends unless they think raise is sustainable.

• Investors view dividend increases as signals of management’s 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 firm’s past dividend policy determines its current clientele of investors.

• A firm can change from one dividend payout policy to another and let stockholders who don’t 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 company’s 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 dividends but 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 company’s 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

• Firm’s investment opportunities

• Firm’s 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 corporation’s 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 firm’s 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 doesn’t appeal to any specific clientele.

• Conclusion: – Consider residual policy when setting target payout, but don’t

follow it rigidly.

Residual Dividend Model

budget

capital

Total

ratio

equity

Target

- IncomeNet Dividends

• Capital budget – P800,000

• Target capital structure – 40% debt, 60% equity

• Forecasted net income – P600,000

• 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 P400,000? How about if NI rises to P800,000?

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 P3,000,000. If Axel reports net income of P2,000,000 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 P5 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 company’s optimal capital structure calls for 50% debt and 50% common equity. Welch expects to have net income of P7,287,500. 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. (Today’s 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 firm’s 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 company’s 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 no matter 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 firm’s 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 P2,000,000, and it has 1,000,000 shares of common stock outstanding. The company’s stock currently trades at P32 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 company’s P/E ratio. What will be Beta’s 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 investor’s 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 company’s 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 stock’s liquidity and which lead to an increase in the firm’s 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?

• 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 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 Medical’s stock trades at P90 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 company’s stock price following the stock split?

Problem 16-4: Stock Split

• After a 5-for-1 stock split, Strasburg Company paid a dividend of P0.75 per new share, which represents a 9% increase over last year’s pre-split dividend. What was last year’s dividend per share?

Problem 16-8: Alternative Dividend Policies

• Rubenstein Bros. Clothing is expecting to pay an annual dividend per share of P0.75 out of annual earnings per share of P2.25. Currently, Rubenstein Bros.’ stock is selling for P12.50 per share. Adhering to the company’s target capital structure, the firm has P10 million in assets, of which 40% is funded by debt. Assume that the firm’s 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 stock’s required return?

c. If the firm changed its dividend policy and paid an annual dividend of P1.50 per share, financial analysts would predict that the change in policy will have no effect on the firm’s stock price or ROE. Therefore, what must be the firm’s 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 P0.75 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 P12.50. In other words, for every P12.50 in dividends due to shareholders, a share of stock will be issued. How large will the stock dividend be relative to the firm’s 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 company’s EPS be diluted?