CHAPTER 17

1. CHAPTER 17 Distributions to Shareholders: Dividends and Repurchases

2. Topics in Chapter • 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)

3. Distribution Policy • Defines: • Level of cash distributions to shareholders • Form of the distribution • Dividend vs. Stock repurchase • Stability of the distribution

4. Good Ways to Use FCF • Pay interest expense • Pay down principal on debt • Pay dividends • Repurchase stock • Buy non-operating assets such as Treasury bills

5. 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

6. Distribution Patterns Over Time • The percent of total payouts as a percentage of net income has been stable at around 26%-28% • Dividend payout rates  • Stock repurchases  • Now greater than dividends

7. Distribution Patterns Over Time • Smaller percentage of companies now pay dividends • Young companies first make distributions as repurchases • Dividend payouts =more concentrated in a smaller number of large, mature firms

8. Dividend Yields for Selected Industries

9. Investor Preference Theories • Dividend Irrelevance • Investors don’t care about payout • Dividend Preference (Bird-in-the-Hand) • Investors prefer a high payout • Tax Effect • Investors prefer a low payout

10. Dividend Irrelevance Theory • Investors are indifferent between dividends and capital gains • 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)

11. Dividend Preference Theory(Bird-in-the-Hand) • Investors view dividends as less risky than potential future capital gains • High payouts reduce agency costs • 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

12. Tax Effect Theory • Low payouts mean higher capital gains • 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

13. Research Results • Some research  high payout = high required return on stock • Supports tax effect hypothesis • Internationally, countries with poor investor protection (severe agency costs)  high payout = more highly valued • Empirical tests =mixed results

14. The “Clientele Effect” • “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. • Taxes & brokerage costs hurt investors who switch companies due payout policy changes

15. The “Signaling Hypothesis” • Dividend changes = signals of management’s view of the future • Managers hate to cut dividends • Won’t raise dividends unless raise is sustainable • Stock prices fall when dividends cut

16. Cash Distributions = Dividends • Company must have cash to make a cash distribution • Sources of Cash: • FCF = Cash flow available for distribution to investors after expenses, taxes and necessary investments in operating capital. • Recapitalization • Sale of an asset

17. Dividend Payment Procedures • Usually paid quarterly in cash • Increased once a year • Voted on quarterly by the Board of Directors

18. Dividend Payment Dates • Declaration date • Board officially declares dividend • Holder-of-record date • Stock transfer books close • Ex-dividend date • Stock trades without the dividend • 2 days prior to holder-of-record date • Payment • Dividend checks mailed

19. Dividend Payment Example • Declaration date = 11/6/09 • “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

20. Optimal Distribution Ratio • Four Factors: • Investors’ preference for dividends versus capital gains • Firm’s investment opportunities • Target capital structure • Availability and cost of external capital

21. The “Residual Distribution Model” • Determine optimal capital budget • Determine amount of equity needed to fund capital budget given target capital structure • Use retained earnings to meet equity needs to extent possible • Pay dividends or repurchase stock if funds leftover (residual) • Residual policy minimizes flotation and equity signaling costs, and minimizes the WACC

22. Total capital budget Target equity ratio Net income Distr. = – X Using the Residual Model to Calculate Distributions Paid (17-1)

23. Texas & Western Transport Company • WACC = 10% (if all equity = r/e) • Target capital structure: • 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?

24. Texas and Western Investment Opportunities A capital budget of $150 million would require the use of all retained earnings plus the issuance of $30 m in new debt.

25. Investment Opportunities and Residual Dividends • 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.

26. Advantages and Disadvantages of the Residual Dividend Policy • Advantages: • Minimizes new stock issues and flotation costs • Disadvantages: • Results in variable dividends • Sends conflicting signals • Increases risk • Appeals to no specific clientele

27. Residual Model Conclusions • Consider residual model when setting target payout, but don’t follow it rigidly • Consider “low-regular-dividend-plus-extras” policy • Low regular dividend that can be maintained • Specially designated dividends when cash available

28. Stock Repurchases • Repurchases = Buying own stock back from stockholders • Reasons for repurchases: • Alternative to distributing cash as dividends • Dispose of one-time cash from asset sale • Execute large capital structure change

29. Stock Repurchase Procedures • Company buys back its own stock • Repurchased stock = “treasury stock” • Negative value on balance sheet • Reasons to Repurchase stock: • Increase leverage (issue debt/buy stock) • Use shares for options exercise • Firm has excess cash

30. Stock Repurchase Procedures • Open market purchase through broker • Tender offer • Targeted stock repurchase • Purchase block of shares through negotiation with large shareholder

31. Advantages of Repurchases • 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

32. Disadvantages of Repurchases • May be viewed as a negative signal • 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

33. Stock Repurchase Formulas

34. Stock Repurchase Example • Earnings = $400 million • Shares outstanding = 40 million = n0 • Payout ratio = 50% • Earnings growth = 5% = g • Return on equity = 10% = rE • Assume no tax effects

35. Stock Repurchase ExampleIf 50% paid as cash dividends (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

36. 50% Dividends

37. Stock Repurchase ExampleIf 50% used to repurchase shares • 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 • n = number of share remaining • $115.50 x (40 – n) = $210 m • n = 38.182 shares • S1 = $115.50 x 38.182 = $4,410 m (17-3)

38. 50% Stock Repurchase

39. Comparison

40. Stock Repurchase: Key Results • 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

41. Dividends versus Repurchases • Advantages of Repurchases: • 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

42. Dividends versus Repurchases • Disadvantages of Repurchases: • Cash dividends are dependable but repurchases are not • Selling shareholders may not be fully informed • Firm may pay too much for shares

43. Conclusions • Repurchases have a tax advantage • Dividends are more dependable • Volatile dividends lower investor confidence • “Signaling” • Repurchases useful to: • Make capital structure shifts • Distribute cash from one-time events • Obtain shares for employee stock options

44. Constraints • Bond indentures • Preferred stock restriction • Impairment of capital rule • Dividend payments > Balance sheet retained earnings • Availability of cash • Penalty tax on improperly accumulated earnings

45. Alternative Sources of Capital • Cost of selling new stock • New equity if flotation costs are low • Ability to substitute debt for equity • Control • Management reluctant to sell new stock

46. The Distribution Policy Decision • Decision made jointly with capital structure and capital budgeting decisions • 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

47. The Distribution Policy Decision • 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

48. Dividend Policy Conclusions • Younger firms with many investment opportunities but low cash flow should retain earnings • Executive survey results: • 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

49. Stock Splits and Stock Dividends • Stock split: • Firm increases the number of shares outstanding, say 2:1 • Shareholders sent more shares • Stock dividend: • Firm issues new shares in lieu of paying a cash dividend • If 10%, get 10 shares for each 100 shares owned

50. Stock Splits and Stock Dividends • Both increase the number of shares outstanding • Divides pie into smaller pieces • Stock price falls so as to keep each investor’s wealth unchanged • Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends • “Optimal price range”