Transcript Dividends, PowerPoint Show - University of Mississippi

CHAPTER 17
Distributions to Shareholders:
Dividends and Repurchases
Topics in Chapter
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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)
17-2
Distribution Policy

Defines:
Level of cash distributions to
shareholders
 Form of the distribution
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Dividend vs. Stock repurchase
Stability of the distribution
17-3
Good Ways to Use FCF
1. Pay interest expense
2. Pay down principal on debt
3. Pay dividends
4. Repurchase stock
5. Buy non-operating assets such as
Treasury bills
17-4
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

17-5
Distribution Patterns Over Time

The percent of total payouts as a
percentage of net income has been
stable at around 26%-28%
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Dividend payout rates 
Stock repurchases 

Now greater than dividends
17-6
Distribution Patterns Over Time
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Smaller percentage of companies now
pay dividends
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Young companies first make distributions
as repurchases
Dividend payouts =more concentrated
in a smaller number of large, mature
firms
17-7
Dividend Yields for Selected
Industries
Industry
Div. Yield %
Recreational Products
3.30
Forest Products
3.79
Software
1.48
Household Products
1.55
Food
1.16
Electric Utilities
3.48
Banks
4.46
Tobacco
9.88
Source: Yahoo Industry Data, April 2008
17-8
Investor Preference Theories
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Dividend Irrelevance
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Dividend Preference (Bird-in-the-Hand)
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Investors don’t care about payout
Investors prefer a high payout
Tax Effect
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Investors prefer a low payout
17-9
Dividend Irrelevance Theory
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Investors are indifferent between dividends
and capital gains
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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)
17-10
Dividend Preference Theory
(Bird-in-the-Hand)
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Investors view dividends as less risky
than potential future capital gains
High payouts reduce agency costs
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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
17-11
Tax Effect Theory
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Low payouts mean higher capital gains
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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
17-12
Research Results
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Some research  high payout = high
required return on stock
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Supports tax effect hypothesis
Internationally, countries with poor
investor protection (severe agency
costs)  high payout = more highly
valued
Empirical tests =mixed results
17-13
The “Clientele Effect”
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“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.
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Taxes & brokerage costs hurt investors who switch
companies due payout policy changes
17-14
The “Signaling Hypothesis”
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Dividend changes = signals of
management’s view of the future
Managers hate to cut dividends
 Won’t raise dividends unless raise is
sustainable
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Stock prices fall when dividends cut
17-15
Cash Distributions = Dividends
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Company must have cash to make a
cash distribution
Sources of Cash:
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FCF = Cash flow available for distribution
to investors after expenses, taxes and
necessary investments in operating capital.
Recapitalization
Sale of an asset
17-16
Dividend Payment Procedures
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Usually paid quarterly in cash
Increased once a year
Voted on quarterly by the Board of
Directors
17-17
Dividend Payment Dates
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Declaration date
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Holder-of-record date
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Stock transfer books close
Ex-dividend date
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Board officially declares dividend
Stock trades without the dividend
2 days prior to holder-of-record date
Payment
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Dividend checks mailed
17-18
Dividend Payment Example
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Declaration date = 11/6/09
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“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
17-19
Optimal Distribution Ratio
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Four Factors:
1. Investors’ preference for dividends
versus capital gains
2. Firm’s investment opportunities
3. Target capital structure
4. Availability and cost of external
capital
17-20
The “Residual Distribution Model”
Determine optimal capital budget
2. 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
1.
17-21
Using the Residual Model to
Calculate Distributions Paid
(17-1)
Net
Distr. =
–
income
Total
Target
equity X capital
budget
ratio
17-22
Texas & Western Transport
Company
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WACC = 10% (if all equity = r/e)
Target capital structure:
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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?
17-23
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)
60%
30%
-50%
Distribution ratio
A capital budget of $150 million would require the use of
all retained earnings plus the issuance of $30 m in new
debt.
17-24
Investment Opportunities and
Residual Dividends
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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.
17-25
Advantages and Disadvantages of
the Residual Dividend Policy
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Advantages:
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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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17-26
Residual Model Conclusions
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Consider residual model when setting
target payout, but don’t follow it rigidly
Consider “low-regular-dividend-plusextras” policy
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Low regular dividend that can be
maintained
Specially designated dividends when cash
available
17-27
Stock Repurchases
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Repurchases = Buying own stock back
from stockholders
Reasons for repurchases:
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Alternative to distributing cash as dividends
Dispose of one-time cash from asset sale
Execute large capital structure change
17-28
Stock Repurchase Procedures
Company buys back its own stock
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Repurchased stock = “treasury stock”
Negative value on balance sheet
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Reasons to Repurchase stock:
Increase leverage (issue debt/buy stock)
2. Use shares for options exercise
3. Firm has excess cash
1.
17-29
Stock Repurchase Procedures
1. Open market purchase through broker
2. Tender offer
3. Targeted stock repurchase
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Purchase block of shares through
negotiation with large shareholder
17-30
Advantages of Repurchases
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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
17-31
Disadvantages of Repurchases
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May be viewed as a negative signal
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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
17-32
Stock Repurchase Formulas
P0 
V OP  Extra Cash
no
P( n 0  n )  Extra cash
P 
n 
V OP
n
V OP
P
(17 - 2)
(17 - 3)
(17 - 4)
(17 - 5)
17-33
Stock Repurchase Example
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Earnings = $400 million
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Shares outstanding = 40 million = n0
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Payout ratio = 50%
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Earnings growth = 5% = g
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Return on equity = 10% = rE
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Assume no tax effects
17-34
Stock Repurchase Example
If 50% paid as cash dividends
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(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
17-35
50% Dividends
50% Dividend Payout
Year
0
Earnings
$400.00
Shares
40
Payout %
50%
g
5%
R(e)
10%
T
0
Dividend
P(0)
P(1) pre div
P(1) post div
S (Equity)
$5.00
$105.00
$4,200.00
1
$420.00
40
50%
5%
10%
0
$5.25
$115.50
$110.25
$4,410.00
17-36
Stock Repurchase Example
If 50% used to repurchase shares
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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
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n = number of share remaining
$115.50 x (40 – n) = $210 m
n = 38.182 shares
(17-3)
S1 = $115.50 x 38.182 = $4,410 m
17-37
50% Stock Repurchase
50% Stock Repurchase
Year
0
1
Earnings
$400.00
$420.00
Shares
40 38.1818
Repo %
50%
g
5%
5%
R(e)
10%
10%
T
0
0
Repo Cash
P(0)
P(1) pre div
P(1) post repo
S (Equity)
$210.00
$105.00
$115.50
$115.50
$4,200.00 $4,410.00
17-38
Comparison
50% Dividend Payout
Year
0
Earnings
$400.00
Shares
40
Payout %
50%
g
5%
R(e)
10%
T
0
Dividend
P(0)
P(1) pre div
P(1) post div
S (Equity)
$5.00
$105.00
$4,200.00
1
$420.00
40
50%
5%
10%
0
$5.25
$115.50
$110.25
$4,410.00
50% Stock Repurchase
Year
0
1
Earnings
$400.00
$420.00
Shares
40 38.1818
Repo %
50%
g
5%
5%
R(e)
10%
10%
T
0
0
Repo Cash
P(0)
P(1) pre div
P(1) post repo
S (Equity)
$210.00
$105.00
$115.50
$115.50
$4,200.00 $4,410.00
17-39
Stock Repurchase: Key Results
1.
2.
3.
Ignoring tax effects and signaling, the total
market value of equity remains the same
whether a firm pays cash dividends or
repurchases stock
The repurchase does not change the stock
price; it does reduce the number of shares
outstanding
With fewer shares outstanding, the stock
price will rise faster
17-40
Dividends versus Repurchases
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Advantages of Repurchases:
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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
17-41
Dividends versus Repurchases
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Disadvantages of Repurchases:
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Cash dividends are dependable but
repurchases are not
Selling shareholders may not be fully
informed
Firm may pay too much for shares
17-42
Conclusions
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Repurchases have a tax advantage
Dividends are more dependable
Volatile dividends lower investor
confidence
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“Signaling”
Repurchases useful to:
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Make capital structure shifts
Distribute cash from one-time events
Obtain shares for employee stock options
17-43
Constraints
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Bond indentures
Preferred stock restriction
Impairment of capital rule
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Dividend payments > Balance sheet
retained earnings
Availability of cash
Penalty tax on improperly accumulated
earnings
17-44
Alternative Sources of Capital
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Cost of selling new stock
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New equity if flotation costs are low
Ability to substitute debt for equity
Control

Management reluctant to sell new stock
17-45
The Distribution Policy Decision

Decision made jointly with capital
structure and capital budgeting
decisions
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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
17-46
The Distribution Policy Decision
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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
17-47
Dividend Policy Conclusions
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Younger firms with many investment
opportunities but low cash flow should retain
earnings
Executive survey results:
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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
17-48
Stock Splits and Stock Dividends
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Stock split:
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Firm increases the number of shares
outstanding, say 2:1
Shareholders sent more shares
Stock dividend:

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Firm issues new shares in lieu of paying a
cash dividend
If 10%, get 10 shares for each 100
shares owned
17-49
Stock Splits and Stock Dividends

Both increase the number of shares
outstanding
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Stock price falls so as to keep each investor’s
wealth unchanged

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Divides pie into smaller pieces
Unless the stock dividend or split conveys
information, or is accompanied by another event
like higher dividends
“Optimal price range”
17-50
Stock Split Explanations
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Signaling
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Stock splits generally occur when management is
confident
Interpreted as positive signals
“Catering”
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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) ?
17-51
Reverse Stock Splits
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Reduces number of shares outstanding
Drives stock price up
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Meet listing requirements
Frequently seen as a negative signal
Can be used to force out small
shareholders
17-52
Stock Splits & Dividends

Stock splits usually follow a price run
up to produce a price reduction

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Split = positive, value-related signal
Stock dividends used on a regular
basis will keep the stock price
constrained
17-53
Effect on Stock Prices

Announcement of stock split or
dividend usually results in a price
increase

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Signaling
If not followed by earnings or dividend
increase, price will revert
Split may reduce liquidity
17-54
Dividend Reinvestment Plan
(DRIP)


Shareholders can automatically reinvest
dividends in shares of firm’s common
stock
Two types of plans:
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
Open market (“Old Stock”)
New stock
Firms can switch between the plans
17-55
Open Market Purchase Plan
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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
17-56
New Stock Plan
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Firm issues new stock to DRIP
enrollees
Used by firms needing new capital
No fees charged
Stock sold at discount from market
price
17-57