Chapter 17

Sharing Firm Wealth: Dividends, Share Repurchases, and Other Payouts

McGraw-Hill/Irwin

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved

Introduction

• Taxation of capital distributions – Different treatments for capital gains versus dividends and interest payments – Differing tax rates for shareholders 17-2

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Dividends versus Capital Gains

Use the constant growth formula to choose between paying cash dividend or stock repurchase 17-3

Dividends versus Capital Gains

Firms that pay out high percentages of current earnings have less capital to fund future growth 17-4

Dividends versus Capital Gains

• Firms that keep more retained earnings have less to pay current dividends • Recommend firms retain earnings to extent they can make project investments with as high return as investors could earn elsewhere at similar risk 17-5

Dividend Irrelevance Theory

• Modigliani and Miller • In perfect world the decision to pay or not to pay dividends does not matter 17-6

Dividend Irrelevance Theory

• Reminder: The “perfect world” assumes – No taxes – No transaction costs – Perfectly competitive markets – Completely rational investors 17-7

Dividend Irrelevance Theory

• • In M&M’s “perfect world,” paying dividends reduces each share’s value by the dividend amount If the firm chooses not to pay dividends, investors who want dividends can sell their shares to realize income not supplied by dividends 17-8

Dividend Irrelevance Theory

• In 2003, tax rates on capital gains and most dividends lowered • Dividends now more attractive relative to capital gains 17-9

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Why Some Investors Favor Dividends

Bird-in-the-hand theory – Dividends less risky, more attractive to risk-averse investors than future capital gains • Bird-in-the-hand fallacy – Most investors invest dividends in similar firms – Firm’s risk profile determined by asset cash flows not dividend payout policy 17-10

Why Some Investors Favor Capital Gains

At the same tax rates, capital gains have potential tax advantages over dividends – All shareholders pay taxes on dividends – Only selling shareholders incur taxes on realized capital gains when a growing firm retains earnings 17-11

Other Dividend Policy Issues

• Tangible effects – Risks – Taxation – Cash flow timing • Also intangible effects 17-12

The Information Effect

• Firms hesitate to increase dividends unless they can be maintained • Analysts interpret dividend increases as positive signal about firm’s future cash flows 17-13

The Clientele Effect

• Investors (clientele) have different desires about taxability and timing of firm payouts • Payout policies of different firms attract different investor groups 17-14

Corporate Control Issues

• Shareholders with large stakes in the firm may dictate dividend payout policy • Closely-held companies may retain more earnings as owners try to minimize the effect of double taxation 17-15

Real-World Dividend Policy

• Basic dividend policy – Pay out surplus cash flow as dividends after investing in positive net present value projects 17-16

The Residual Dividend Model

• Also known as the free cash flow theory of dividends • Assumes that cash flow, beyond that needed to invest in positive NPV projects, is paid out as dividends 17-17

Extraordinary Dividends

• Firms divide dividends into two classes to manage 1) Ordinary dividends (relatively low) 2) Extraordinary dividends (periodic, extra) • Firms forego extraordinary when needed 17-18

Dividend Payment Logistics

• Declaration date – Board of directors announces intention to pay a dividend – Firm records the liability on its books • Ex-dividend date – The first day that shares trade without dividend attached 17-19

Dividend Payment Logistics

• Record date – Firm identifies the owners of record to begin addressing payments – Record date is set several business days after ex dividend date to allow time for registration process • Payment date – Firm sends out the dividends 17-20

Effect of Dividends on Stock Prices

• Stock prices increase as the next dividend approaches • Stock prices fall by the present value of the dividend once the stock goes ex-dividend 17-21

Stock Dividends and Stock Splits

• Both increase shares outstanding without changing total market value of owner’s equity • Both will decrease the stock price 17-22

Stock Dividends

• Pro-rata distribution of new shares to current stockholders – Example: A 20 percent stock dividend would increase the number of shares held by each shareholder by 20 percent 17-23

Stock Splits

• Company exchanges new shares for old shares • Each old share usually converts into more than one new share 17-24

Stock Splits

• Alter par value of firm’s stock on company’s books • Do not cause shift in owner’s equity accounts 17-25

Effect of Splits and Stock Dividends on Stock Prices

• • Firms want shares to trade in price range – Stock dividend or split brings stock price back in range Investors like to trade in 100 share “round lots” 17-26

Stock Repurchases

• Firm buys shares of own stock on stock exchange like any investor – Open-market stock repurchase – May take months or years 17-27

Advantages of Repurchases

• Can offer an efficient way to return money to shareholders • Reduction or cessation of repurchases not seen as a negative 17-28

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Disadvantages of Repurchases

Can make firm vulnerable to litigation from selling shareholders – Management may have undisclosed information about good future prospects for firm • Overpayments for shares result in share dilution • IRS penalties if proven the repurchase was primarily to avoid dividend taxation 17-29

Effect of Repurchases on Stock Prices

– Advantages outweigh the disadvantages – Repurchasing companies produce significant excess returns for several years after repurchase 17-30