Corporate Finance Chapter6

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CHAPTER 6DIVIDENDS AND SHARE

REPURCHASES: BASICSPresenters namePresenters titledd Month yyyy


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1. INTRODUCTION

A dividendis a pro rata distribution to shareholders that is declared by thecompanys board of directors and may or may not require approval by

shareholders.

A repurchaseof stock is a distribution in the form of the company buying backits stock from shareholders.

The board of directors determines the companys payout policy. Cash dividends and share repurchases are both methods of distributing cash

to shareholders.

- The effects on financial ratios and on shareholders investment returns aredifferent between these two methods.

- These distributions may provide information about the companys futureprospects.

- Issuing companies cannot deduct distributions to shareholders for taxpurposes.

Copyright 2013 CFA Institute 2


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2. DIVIDENDS: FORMS

Cash Distributions

Regular Cash

Dividend

Extra Dividend

Liquidating Dividend

NoncashDistributions

Stock Dividend

Stock Split

Reverse Stock Split



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REGULAR CASH DIVIDENDS

A regular cash dividend is a cash dividend paid at regular intervals of time

- The regular intervals may be any frequency, but the most common arequarterly, semiannually, or annually.

- Tendency of companies is to maintain or increase dividends

- Often viewed as signals of managements assessment of the companysfuture (that is, whether the company can maintain the dividend in the future).

- Companies prefer not to cut or reduce the dividend.



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DIVIDEND REINVESTMENT PLANS

A dividend reinvestment plan (DRP) is a program that permits investors toreinvest cash dividends automatically into the stock of the issuing company.

The shares provided in exchange for the cash dividends may be acquired inthe open market by the issuer or may be newly issued shares.

Advantages to the issuer:

- Encourage owners with smaller holdings to accumulate shares.

- Raise new equity capital without flotation costs.

Advantages to the investor:

- Cost averaging of share purchases.

- Opportunity (in some cases) to buy shares at a discount from market value. Disadvantages to the investor:

- Recordkeeping

- Dividends are taxed when received, whether reinvested or not.



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EXTRA OR SPECIAL DIVIDENDS

An extra dividend (or special dividend) is a dividend that is either paid by acompany that does not pay dividends regularly or paid by a company inaddition to a regular dividend.

- Example: Whole Foods Market announced a $2 special dividend inDecember 2012. This was in addition to its $0.20 per quarter cash dividend.

Motivation: Pay out in strong years without investors expecting an increaseddividend.



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LIQUIDATING DIVIDENDS

A liquidating dividend is a distribution of cash to shareholders when

- Going out of business, or

- Selling a portion of the business, or

- Paying a dividend when retained earnings are not positive.



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STOCK DIVIDENDS

A stock dividend is the distribution of additional shares of stock toshareholders on a pro rata basis.

- Also known as a bonus issue of shares.

Generally stated as a percentage of current shares outstanding.

A stock dividend does not change a shareholders proportionate ownership, the

shareholder does not receive cash, and there are no tax consequences.

Advantages for the issuer:

1. More shares outstanding and, therefore, potential for more shareholders.

2. Lowers the stocks price, which may make it more attractive as an

investment.3. No economic effect.

4. Does not affect financial ratios.



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STOCK DIVIDENDS IN PRACTICE

More prevalent in some countries.

Some companies pay stock dividends on a regular basis; some pay theseoccasionally.



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STOCK SPLITS

A stock split is a proportionate increase in the number of shares outstanding.

Stated in the following form:

Number of new shares : Number of old shares

So, 2:1 means that for each share held before the split, the shareholder holdstwo shares after the split.

Stock splits do not affect the dividend yield or the dividend payout ratio.

Accounting: Memorandum entry, no change in accounts.

The announcement is generally viewed as a positive signal.



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REVERSE STOCK SPLITS

A reverse stock split is the proportionate reduction in the number of shares.

A reverse stock split has the opposite effect of the traditional, or forward, stocksplit:

- It reduces the number of shares, with the expectation of increasing the stockprice.

A 1:2 reverse stock split results in half the number of shares outstanding afterthe split.

The goal may be to increase the share price to make it more attractive forinstitutional investors.

Reverse stock splits are most common for companies in financial distress.

It is not permitted in some countries.



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3. DIVIDENDS: PAYMENT CHRONOLOGY

| | | |

DeclarationDate

Ex-DividendDate

Holder-of-Record Date

Payment Date

Relationship Based on Trade Cycle

Corporation

IssuesDividend

Declaration

Established by

Markets Based onthe Trade

Settlement Cycle

Established by

Corporation asDate of

Ownership of

Stock

Established by

Corporation asDate the

Dividend Is

Actually Paid



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4. SHARE REPURCHASES

A share repurchase is the transaction in which the stock issuer buys back itsshares from investors.

- Also known as a share buyback.

Once repurchased, the shares become treasury shares (or treasury stock).

Share repurchases are restricted by regulations in some countries.

Motives for repurchasing shares include the following:

- Signal that the stock is undervalued.

- Flexibility of distributing cash without the expectation of cash dividends.

- Tax efficiency when the tax rate on capital gains is less than that of cash

dividends.- Offset share increases from executive stock options.



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SHARE REPURCHASE METHODS

Buy in the OpenMarket

Use brokers tobuy shares.

Method providesflexibility for thecompany.

Fixed PriceTender Offer

Specify thenumber ofshares and theshare price.

Buy pro rata ifoversubscribed.

Dutch AuctionTender Offer

Specify thenumber ofshares and therange of prices.

Shareholdersdetermine thenumber ofshares they willsell back andspecify the pricewithin the range.

DirectNegotiation

Negotiate with aspecificshareholder.

Method may beused to preventactivistshareholderfrom getting onboard.



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SHARE REPURCHASE ANDEARNINGS PER SHARE

The Diluting Company is planning a $100 million share repurchase. Its currentstock price is $25 per share, and there are 16 million shares outstanding prior tothe repurchase. Earnings per share without the repurchase would be $3 pershare. What is the earnings per share under each of these two scenarios?

Scenario 1: Use idle cash on hand.

Scenario 2: Borrow funds at after-tax rate of 7%.

Scenario 1:

Net income = $3 $16 million = $48 million

EPSScenario 1 = $48 million

(16 million4 million) = $4 per shareScenario 2:

Net income = $3 16 million(0.07 $100 million) = $41 million

EPSScenario 2 = $41 million (16 million4 million) = $3.41 per share



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SHARE REPURCHASE ANDBOOK VALUE PER SHARE

When the market price per share is greater than the book value per share(BVPS), the book value per share of equity will decrease with a sharerepurchase.

Continuing the Diluting Company example and adding the book value per share

of $20:

Scenario 1:

Book value = ($20 16 million)$100 million = $220 million

BVPSScenario 1

= $220 million (16 million4 million) = $18.33 per share

Scenario 2:

Book value = ($20 16 million)$100 million$7 million = $213 million

BVPSScenario 2 = $213 million (16 million4 million) = $17.75 per share



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SHARE REPURCHASE VS. CASH DIVIDENDS

If- The tax consequences of dividends and capital gains are the same and

- The information content of cash dividends and stock repurchases is thesame,

Then the effects of cash dividends and repurchases on shareholder value will be

the same.

Both cash dividends and stock repurchases:

- Reduce assets by the amount of the dividend or repurchase.

- Reduce equity by the amount of the dividend or repurchase.

- Provide investors with the same cash flow.



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5. CONCLUDING REMARKS

Share repurchases have a positive effect on share prices. Dividend initiations have a positive effect on share prices.

Dividend increases have a positive effect on share prices.



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6. SUMMARY

Dividends can take the form of regular or irregular cash payments, stockdividends, or stock splits.

Regular cash dividends represent a commitment to pay cash to stockholderson a quarterly, semiannual, or annual basis.

The key dates for cash dividends, stock dividends, and stock splits are the

declaration date, the ex-date, the shareholder-of-record date, and the paymentdate.

Share repurchases, or buybacks, most often occur in the open market.Alternatively, tender offers occur at a fixed price or at a price range through aDutch auction.

Share repurchases made with excess cash have the potential to increaseearnings per share, whereas share repurchases made with borrowed fundscan increase, decrease, or not affect earnings per share, depending on theafter-tax borrowing rate.



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SUMMARY (CONTINUED)

A share repurchase is equivalent to the payment of a cash dividend of equalamount in its effect on shareholders wealth, all other things being equal.

Announcement of a share repurchase is sometimes accompanied by positiveexcess returns in the market when the market price is viewed as reflectingmanagements view that the stock is undervalued.

Initiation of regular cash dividends can also have a positive impact on sharevalue.


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Corporate Finance Chapter6

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