Dividend Policy and Share Repurchase

7/31/2019 Dividend Policy and Share Repurchase

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Lecture 23-24

Chapter 11

Dividend & Share Repurchase:Theory & Practice


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What is dividend policy?

The decision to pay out earnings versusretaining and reinvesting them.

Dividend policy includes

High or low dividend payout?

Stable or irregular dividends?

How frequent to pay dividends?

Announce the policy?


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Do investors prefer high or

low dividend payouts? Three theories of dividend policy:

Dividend irrelevance: Investors dont

care about payout.

Bird-in-the-hand: Investors prefer ahigh payout.

Tax preference: Investors prefer alow payout.


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Dividend irrelevance

theory Investors are indifferent between dividends

and retention-generated capital gains.Investors can create their own dividendpolicy:

If they want cash, they can sell stock.

If they dont want cash, they can usedividends to buy stock.

Proposed by Modigliani and Miller and based

on unrealistic assumptions (no taxes orbrokerage costs), hence may not be true.Need an empirical test.

Implication: any payout is OK.


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Bird-in-the-hand theory

Investors think dividends are less riskythan potential future capital gains,hence they like dividends.

If so, investors would value high-payout firms more highly, i.e., a highpayout would result in a high P0.

Implication: set a high payout.


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Tax Preference Theory

Retained earnings lead to long-termcapital gains, which are taxed at lowerrates than dividends: 20% vs. up to38.6%. Capital gains taxes are alsodeferred.

This could cause investors to prefer firms

with low payouts, i.e., a high payoutresults in a low P0.

Implication: Set a low payout.


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Which theory is most

correct?Empirical testing has not been

able to determine which theory,

if any, is correct.

Thus, managers use judgmentwhen setting policy.

Analysis is used, but it must beapplied with judgment.


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Dividends as aPassive Residual

Pay out only excess cash, Strictly a financing decision

The firm uses earnings plus the additional financing that

the increased equity can support to finance anyexpected positive-NPV projects.

Any unused earnings are paid out in the form ofdividends. This describes a passive dividend policy.

Can the payment of cash dividends affectshareholder wealth?

If so, what dividend-payout ratio willmaximize shareholder wealth? (0 or 1)


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Comments on Residual

Dividend Policy Advantage Minimizes new stock issues and

flotation costs.

Disadvantages Results in variable dividends,sends conflicting signals, increases risk, anddoesnt appeal to any specific clientele.

This policy minimizes flotation and equity costs,hence minimizes the WACC.

Conclusion Consider residual policy whensetting target payout, but dont follow it rigidly.


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Whats the clientele

effect? Different groups of investors, or

clienteles, prefer different dividendpolicies.

Firms past dividend policy determinesits current clientele of investors.

Clientele effects obstruct changingdividend policy. Taxes & brokeragecosts hurt investors who have to switchcompanies.


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Problem 11.1


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Irrelevance of Dividends

M&M argue that the effect of dividendpayments on shareholder wealth isexactly offset by other means offinancing.

The dividend plus the new stock priceafter dilution exactly equals the stockprice prior to the dividend distribution.

A. Current dividends versus retentionof earnings


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Irrelevance of Dividends

M&M and the total-value principle ensures

that the sum of market value plus currentdividends of two firms identical in allrespects other than dividend-payout ratioswill be the same.

Investors can create any dividend policythey desire by selling shares when thedividend payout is too low or buying shareswhen the dividend payout is excessive.

B. Conservation of value


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Relevance of Dividends

Uncertainty surrounding future company

profitability leads certain investors toprefer the certainty of current dividends.

Investors prefer large dividends.

Investors do not like to manufacturehomemade dividends, but prefer thecompany to distribute them directly.

A. Preference for dividends


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Relevance of Dividends

Capital gains are preferred to dividends,everything else equal. Thus, high dividend-yielding stocks should sell at a discount togenerate a higher before-tax rate of return.

Corporations can typically exclude 70% of

dividend income from taxation. Thus,corporations generally prefer to receivedividends rather than capital gains.

B. Taxes on the investor


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Other Dividend Issues

Flotation costs

Favors the retention of earnings

Transaction costs and divisibility of securitiesRestricts the arbitrage process

Divisibility problems

Institutional restrictions

Seek stocks paying reasonable dividends

Financial signaling


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Empirical Testingof Dividend Policy

Tax Effect

Dividends are taxed more heavily (in PV terms) thancapital gains, so before-tax returns should be higher

for high-dividend-paying firms. Empirical results are mixed -- recently the evidence

is largely consistent with dividend neutrality.

Financial Signaling

Cash dividends speak louder than words

Expect that increases (decreases) in dividends leadto positive (negative) excess stock returns.

Empirical results are consistent with theseexpectations.


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18

Empirical Testing andImplications for Payout

Ex-dividend day tests

Behavior of common stock prices

Dividend-yield approachRelationship between dividend yields

and stock returns

Financial signaling studies

At the time of the dividend change findthat there is a significant earningschange


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Implications forCorporate Policy

Establish a policy that will maximizeshareholder wealth.

Distribute excess funds to shareholdersand stabilize the absolute amount ofdividends if necessary (passive).

Payouts greater than excess fundsshould occur only in an environmentthat has a net preference for dividends.


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Implications forCorporate Policy

There is a positive value associatedwith a modest dividend. Could be due

to institutional restrictions orsignaling effects.

Dividends in excess of the passive

policy does not appear to lead toshare price improvement because oftaxes and flotation costs.


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Factors InfluencingDividend Policy

Capital Impairment Rule -- many states prohibit thepayment of dividends if these dividends impair

(weaken) capital (usually either par value of commonstock or par plus additional paid-in capital).

Insolvency Rule -- some states prohibit the payment ofcash dividends if the company is insolvent under either

a fair market valuation or equitable sense. Undue Retention of Earnings Rule -- prohibits the

undue retention of earnings in excess of the presentand future investment needs of the firm.

Legal Rules


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Factors InfluencingDividend Policy

Funding Needs of the Firm

Liquidity

Ability to Borrow

Restrictions in Debt Contracts(protective covenants)

Managerial Consideration


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Dividend Stability

Stability -- maintaining the position of the firmsdividend payments in relation to a trend line.

DollarsP

erShare

3

4

2

1

Earnings per share

Dividendsper share

Time

50% of earningspaid out as dividends


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Dividend Stability

Dividends begin at 50% of earnings, but are stable andincrease only when supported by growth in earnings.

DollarsPerShare

3

4

2

1

Earnings per share

Dividends per share

Time

50% dividend-payoutrate with stability


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Valuation ofDividend Stability

Information content -- management may be able toaffect the expectations of investors through theinformational content of dividends. A stable dividend

suggests that the company expects stable orgrowing dividends in the future.

Current income desires -- some investors who desirea specific periodic income will prefer a company withstable dividends to one with unstable dividends.

Institutional considerations -- a stable dividend maypermit certain institutional investors to buy thecommon stock as they meet the requirements to beplaced on the organizations approved list.


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Types of Dividends

Extra dividend

A non recurring (non frequent) dividendpaid to shareholders in addition to theregular dividend. It is brought about byspecial circumstances.

Regular Dividend

The dividend that is normally expected to

be paid by the firm.


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Problem 11.10


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Stock Dividendsand Stock Splits

Small-percentage stock dividends

Typically less than 25% of previouslyoutstanding common stock.

Assume a company with 400,000 shares of $5 parcommon stock outstanding pays a 5% stockdividend. The pre-dividend market value is $40.How does this impact the shareholders equity

accounts?

Stock Dividend -- A payment of additionalshares of stock to shareholders. Often usedin place of or in addition to a cash dividend.


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B/S Changes for the Small-% Stock Dividend

PresentNS o/s 400000Par value /share 5MPS 40EquityCS 2,000,000APiC 1,000,000R/E 7,000,000Total 10,000,000

Stock Dividend 0.05New Shares 20,000Market Value 800,000 subtracted from R/EPar Value 100,000 Added to CSShare premium 700,000 Added to APiC


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Small-PercentageStock Dividends

Before 5% Stock DividendCommon stock

($5 par; 400,000 shares) $ 2,000,000

Additional paid-in capital 1,000,000Retained earnings 7,000,000Total shareholders equity $10,000,000

After 5% Stock DividendCommon stock

($5 par; 420,000 shares) $ 2,100,000Additional paid-in capital 1,700,000Retained earnings 6,200,000Total shareholders equity $10,000,000


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Stock Dividends,EPS, and Total Earnings

Assume that investor SP owns 10,000 shares and thefirm earned $2.50 per share.

Total earnings = $2.50 x 10,000 = $25,000.

After the 5% dividend, investor SP owns 10,500 sharesand the same proportionate earnings of $25,000.

EPS is then reduced to $2.38 per share because of thestock dividend ($25,000 / 10,500 shares = $2.38 EPS).

After a small-percentage stock dividend, whathappens to EPS and total earnings of

individual investors?


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Stock Dividends and StockSplits

Typically 25% or greater of previously outstandingcommon stock.

The material effect on the market price per share causesthe transaction to be accounted for differently.Reclassification is limited to the par value of additionalshares rather than pre-stock-dividend value of additional

shares. Assume a company with 400,000 shares of $5 par common

stock outstanding pays a 100% stock dividend. The pre-stock-dividend market value per share is $40. How doesthis impact the shareholders equity accounts?

Large-percentage stock dividends


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B/S Changes for the Large-

Percentage Stock Dividend

$2 million ($5 x 400,000 new shares)transferred (on paper) out of

retained earnings. $2 million transferred into

common stock account.


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Large-PercentageStock Dividends

Before 100% Stock DividendCommon stock

($5 par; 400,000 shares) $ 2,000,000


After 100% Stock DividendCommon stock


St k Di id d E l 2


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Stock Dividend Example 2

100,000 sharesoutstanding; $1 par;$5 market

Before effect of dividend balance after effect of dividend balance afterCommon stock par value $1.00 $1.00 $1.00Shares outstanding 100,000 issue 5,000 sh 105,000 issue 30,000 sh 130,000Total par value $100,000 5,000 $105,000 30,000 $130,000Additional paid-in capital 750,000 20,000 770,000 750,000

Total paid-in capital 850,000 875,000 880,000Retained earnings 1,000,000 (25,000) 975,000 (30,000) 970,000

Total stockholders' equity $1,850,000 $1,850,000 $1,850,000

5% stock dividend 30% stock dividend

5% stock dividend on100,000 shares: issue5,000 additionalshares recorded at $5per share

30% stock dividendon 100,000 shares:issue 30,000additional sharesrecorded at $1 pershare

5% 30%MPS 5 NS 5000 30000Par 1 Par price 5000 30000Extra 4 Extra 20000 0

MPS

25000

30000


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Similar economic consequences as a 100% stockdividend.

Primarily used to move the stock into a more

popular trading range and increase share demand. Assume a company with 400,000 shares of $5 par

common stock splits 2-for-1. How does this impactthe shareholders equity accounts?

Stock Split -- An increase in the number ofshares outstanding by reducing the par value

of the stock.


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Stock Splits

Before 2-for-1 Stock SplitCommon stock

($5 par; 400,000 shares) $ 2,000,000


After 2-for-1 Stock SplitCommon stock

($2.50 par; 800,000 shares) $ 2,000,000Additional paid-in capital 1,000,000Retained earnings 7,000,000Total shareholders equity $10,000,000


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Used to move the stock into a more popular tradingrange and increase share demand.

Usually signals negative information to the marketupon its announcement (consistent with empirical

evidence). Assume a company with 400,000 shares of $5 par

common stock splits 1-for-4. How does this impactthe shareholders equity accounts?

Reverse Stock Split -- A stock split in which thenumber of shares outstanding is decreased.


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Reverse Stock Splits

Before 1-for-4 Stock SplitCommon stock

($5 par; 400,000 shares) $ 2,000,000


After 1-for-4 Stock SplitCommon stock



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Problem 11.8


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Stock Repurchase

Reasons for stock repurchase:

Substitute for cash dividendsAvailable for management stock-option plans

Means to compensate employees

Employees with existing stock options prefer sharerepurchase

Available for the acquisition of other companies

Go private by repurchasing all shares from outside

stockholders. To permanently retire the shares

Stock Repurchase -- The repurchase (buyback)

of stock by the issuing firm, either in the open(secondary) market or by self-tender offer.


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Methods of Repurchase

Fixed-price self-tender offer -- Formal offer tostockholders to purchase so many shares at a setprice

Dutch auction self-tender offer -- A buyer (seller)seeks bids within a specified price range, usually fora large block of stock or bonds. After evaluating therange of bid prices received, the buyer (seller)

accepts the lowest price that will allow it to acquire(dispose of) the entire block.

Open-market purchase -- A company repurchasesits stock through a brokerage house on the

secondary market.SEC rules, Disclose intentions

R h i P t f


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Repurchasing as Part of aDividend DecisionFewer shares remaining outstanding

EPS rise

Dividends per share riseMarket price per share should rise

Personal tax effect

Signaling effect

R h i


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Repurchasing asPart of Dividend Policy

Assume:

Earnings after taxes $ 800,000

Number of commonshares outstanding 400,000

Earnings per share $ 2

Current market priceper share $ 31

Expected dividend per share $ 1

Expected total dividendsto be paid out $ 400,000

R h i


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Repurchasing asPart of Dividend Policy

If dividend is paid, shareholders receive:

Expected dividend per share $ 1

Market price per share $ 30

Total value $ 31If shares repurchased, shareholders receive:

Dividend per share $ 0

Market price per share* $ 31

Total value $ 31

* Shares repurchased = $400,000 / $31 = 12,903Original P/E ratio = $30/$2 = 15New EPS = $800,000 / 387,097 = $2.07

New market price = $2.07 x 15 = $31

S f R h i


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Summary of Repurchasingas Part of Dividend Policy

The capital gain arising from the repurchase(stock rising from $30 to $31) exactly equalsthe dividend ($1) that would have otherwise

been paid.

This result holds in the absence of taxes andtransaction costs.

To the taxable investor, capital gains(repurchases) are favored to dividend incomeas the tax on the capital gain is postponeduntil the actual sale of the common shares.


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Administrative Considerations:Procedural Aspects

Record Date -- The date, set by the board ofdirectors when a dividend is declared, on whichan investor must be a shareholder of record to

be entitled to the upcoming dividend.

The board of directors met on May 8th to declarea dividend payable to shareholders on June 15th

to the shareholders of record on May 31st.

May 8 May 29 May 31 June 15


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Ex-dividend Date -- The first date on which astock purchaser is no longer entitled to the

recently declared dividend.

The buyer and seller of the shares have several days to

settle(pay for the shares or deliver the shares). Thebrokerage industry has a rule that new shareholders areentitled to dividends only if they purchase the stock at

least two business days prior to the record date.



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Declaration Date -- The date that the board ofdirectors announces the amount and date of the

next dividend.

Payment Date -- The date when the corporationactually pays the declared dividend.



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Problem 11.9


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Some Final Observations

Dividend in excess of residual implies afavorable effect on shareholder wealth

Lack of clear empirical evidence

Many companies believe dividend payoutaffects share price

Repurchase of stock

When sizable amount of excess fundsexists

Increasingly more important


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Setting Dividend Policy

Forecast capital needs over a planninghorizon, often 5 years.

Set a target capital structure.

Estimate annual equity needs.

Set target payout based on the residualmodel.

Generally, some dividend growth rateemerges. Maintain target growth rate ifpossible, varying capital structuresomewhat if necessary.

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Dividend Policy and Share Repurchase

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