Chapter 16

*IntroductionWhen a firm generates cash from operations, what can the firm do with the cash?Use the cash to fund new investments,Use the cash to pay off some of its debt, and/orDistribute the cash back to the firms shareholders either as a cash dividend, or as stock repurchases.

*How Do Firms Distribute Cash to their Shareholders? (cont.)With cash dividend, cash is paid directly to the shareholders.

With a share repurchase, a company uses cash to buy back its own shares from the market place, thereby reducing the number of outstanding shares.

*Cash DividendsA firms dividend policy determines how much cash it will distribute to its shareholders and when these distributions will be made.

Dividends are generally described in terms of dividend payout ratio, which indicates the amount of dividends paid relative to the companys earnings.

*Cash Dividend PoliciesConstant Dividend Payout RatioIf directors declare a constant payout ratio of, for example, 30%, then for every peso of earnings available to stockholders, 30 cents would be paid out as dividends.The ratio remains constant over time, but the peso value of dividends changes as earnings change.

*Cash Dividend PoliciesWith a constant-payout-ratio dividend policy, the firm establishes that a specific percentage of earnings is paid to shareholders each period.A major shortcoming of this approach is that if the firms earnings drop or are volatile, so too will be the dividend payments.Investors view volatile dividends as negative and riskywhich can lead to lower share prices.

*Peachtree Industries, a miner of potassium, has a policy of paying out 40% of earnings in cash dividends. In the periods when a loss occurs, the firms policy is to pay no cash dividends.

Cash Dividend Policies

*Cash Dividend PoliciesStable peso/Regular Dividend Policy:The firm tries to pay a fixed peso dividend each period.Firms and stockholders prefer stable dividends. Decreasing the dividend sends a negative signal.

*

Cash Dividend PoliciesIt provides stockholders with positive information indicating that the firm is doing well and it minimizes uncertainty.Generally, firms using this policy will increase the regular dividend once earnings are proven to be reliable.

*The dividend policy of Woodward Laboratories, a producer of a popular artificial sweetener, is to pay annual dividends of P1.00 per share until per-share earnings exceeded P4.00 for three consecutive years. At that point, the annual dividend is raised to P1.50 per share, and a new earnings plateau is established. The firm does not anticipate decreasing its dividend unless its liquidity is in jeopardy. Data for Woodwards earnings, dividends, and average stock prices for the past 12 years follow.Cash Dividend Policies

*Cash Dividend Policies

*Cash Dividend Policies3. Small Regular Dividend plus Year-End Extras The firm pays a stable dividend regularly and includes an extra dividend in prosperous years.By identifying the additional dividend as extra, directors hope to avoid signaling that this is a permanent dividend.

*Cash Dividend Policies4. Residual Dividend Policy The firm first finances its investments using its own earnings. Dividends are paid out of the residual earnings that are not needed to finance new investment opportunities.While this policy minimizes the cost of financing, it can lead to unstable dividends for shareholders.

*Other Factors Playing a Role in How Much to DistributeLiquidity Position

Because dividend payments and stock repurchases are made with cash, and not with retained earnings, the firm must have cash available for payouts to be made.

*Other Factors Playing a Role in How Much to Distribute (cont.)Lack of Other Sources of Financing

Many small or new companies may not have access to the capital markets, and must depend upon internally generated funds to fund their investment opportunities. As a result, the dividend pay out ratio for such firms is generally lower.

*Other Factors Playing a Role in How Much to Distribute (cont.)Earnings Predictability

A companys payout ratio depends to some extent on the predictability of a firms profits over time. Firms with stable earnings will typically pay out a larger portion of its earnings.

*Dividend Payment ProceduresImportant dates with regard to dividend payment:Announcement date: It is the date on which dividend is formally declared by the board of directors.Date of record: Investors who own stock on this date receive the dividend.Ex-dividend date: This is three days before the date of record and any investor who buys shares after the ex-dividend date is not entitled to dividend.Payment date: This is the date on which dividend checks are mailed to the investors.

*

*Stock Repurchases (Stock Buyback)Stock repurchase is when a firm uses its cash to repurchase some of its own stock. This results in reduction in the firms cash balance as well as the number of shares of stock outstanding (reverse dilution)Increase EPS and ROE resulting in a higher market priceIncreases leverage; alters the firms capital structure

*Stock Repurchases (Stock Buyback)

If the firm pays the dividend, all stockholders would have to pay tax on the dividend incomeIf the firm repurchases some of its stock in the stock market, current stockholders benefit from an increased market price and would not be taxed until they sell their shares at a later time.

*Stock Repurchases (Stock Buyback)Firms use one of three methods to purchase the shares:open market repurchasetender offerdirect purchase

*How do Firms Repurchase Their Shares?Open Market Repurchase The firm acquires the stock on the market, often buying a relatively small number of shares everyday. This will put upward pressure on share prices. This is the most widely used method for stock repurchase.

*How do Firms Repurchase Their Shares? (cont.)Tender Offer A company uses this method when it wants to buy a relatively large number of shares very quickly.The company makes a formal offer to buy a specified number of shares at a stated price.The price is set above the market price to attract sellers.

*How do Firms Repurchase Their Shares? (cont.)Direct Purchase from a large investorHere the firm purchases the stock from one or more major stockholders on a negotiated basis. This method is not used frequently.

*Non-Cash Distributions: Stock Dividends and Stock SplitsA stock dividend is a pro-rata distribution of additional shares of stock to the firms current stockholders. These distributions are generally defined in terms of a fraction paid per share.Example: Citizens Corporation announces a 5% stock dividend to all shareholders of record. For each 100 shares held, shareholders receive another five shares.Does the shareholders wealth increase?

*Stock DividendsFrom a market value standpoint, stock dividends function much like stock splits. The investor ends up owning more shares, but the value of their shares is less.From a book value standpoint, funds are transferred from retained earnings to common stock and additional paid-in-capital.

*The current stockholders equity on the balance sheet of Garrison Corporation, a distributor of prefabricated cabinets, is as shown in the following accounts.Stock DividendsAccounting Aspects

*Stock DividendsAccounting AspectsIf Garrison declares a 10% stock dividend and the current market price of the stock is P15/share, P150,000 of retained earnings (10% x 100,000 shares x P15/share) will be capitalized.The P150,000 will be distributed between the common stock (par) account and paid-in-capital in excess of par account based on the par value of the common stock. The resulting balances are as follows:

*Stock DividendsAccounting AspectsBecause 10,000 new shares (10% x 100,000) have been issued at the current price of P15/share, P150,000 (P15/share x 10,000 shares) is shifted from retained earnings to the common stock and paid-in-capital accounts.

*Stock DividendsThe Companys ViewpointDisadvantages of stock dividends include:The cost of issuing the new sharesTaxes and listing fees on the new sharesOther recording and clerical costsAdvantages of stock dividends include:The company conserves needed cashSignaling effect to the shareholders that the firm is retaining cash because of lucrative investment opportunities

*Stock SplitsStock Split: The firm increases the number of shares outstanding and reduces the par value of each share.Example: Jolly, Inc. announces a 3-for-2 stock split. For each 100 shares held, shareholders receive another 50 sharesDoes this increase shareholder wealth?Are a stock dividend and a stock split the same?

*Delphi Company, a forest products concern, had 200,000 shares of P2-par value common stock outstanding and declares a 2-for-1 split. The total before and after split impact on stockholders equity is:Stock SplitsA stock split is a recapitalization that affects the number of shares outstanding, par value, earnings per share, and market price.The rationale for a stock split is that it lowers the price of the stock and makes it more attractive to individual investors

*

Stock Splits

*Stock SplitsA reverse stock split reduces the number of shares outstanding and raises the par valuethe opposite of a stock split.The rationale for a reverse stock split is to add respectability to the stock and convey the message that it is not a junk stock.

*Stock Dividends and Stock SplitsStock Splits and Stock Dividends are economically the same: The number of shares outstanding increases and the price of each share drops. The value of the firm does not change.

Example: To the stockholder, a 3-for-2 stock split is the same as a 50% stock dividend. For each 100 shares held, shareholders receive another 50 shares.

*Stock Dividend Example An investor has 120 shares of PNB. Assume the following:Shares outstanding: 1,000,000Net income = P5,000,000 EPS = P5 P/E ratio = 20Value of 120 shares: (20 x P5) x 120 shares = P12,000After a 25% stock dividend does the value of the investors shares change?

*Stock Dividend ExampleAfter the 25% stock dividend:Shares outstanding = 1,000,000 x 1.25 = 1,250,000EPS = 5,000,000/1,250,000 = P4If P/E ratio = 20, Price = P80 per share Investor now has 120 x 1.25 = 150 sharesValue = P80 x 150 shares = P12,000

*GAAP vs. IFRS