Dividend & share buyback (Chapter 14)

Distribution Policy Level of distribution Form of distribution Stability of distribution

Theories of Investor Preferences Dividend irrelevance theory Dividend preference (bird-in-the-hand) theory Tax preference theory

Dividend Irrelevance Theory Merton Miller & Franco Modigliani (MM) Firm value depends on income generated (not how income is distributed). No effect on stock price Indifferent b/w dividends & capital gains

Dividend preference (bird-in-the-hand) theory Myron Gordon & John Lintner Dividends are less risky than future capital gains. Prefer dividends over R/E High P/O firm is less risky than low P/O firm High P/O firm  High stock price

Tax Preference Theory Investors prefer capital gains over dividends. Capital gains taxes can be deferred. Tax on dividends must be paid when receive. Prefer firm to retain earnings rather than payouts Prefer low P/O firms -- willing to pay more

Implications Dividend irrelevance theory: Bird-in-the-hand theory: Any dividend payout ratio Bird-in-the-hand theory: High payout ratio Tax preference theory: Low payout ratio Theories are in conflict

Which theory is most correct? Unable to determine which theory is correct Cannot tell if investors prefer dividends or capital gains Can still use concepts to help developing dividend policy

Clientele effect Different investor groups prefer different dividend policies. Own shares of high P/O firms if want current income Own shares of low P/O firms if no need for current income Past dividend policy determines its current investor groups.

Clientele effect Taxes & brokerage fees hurt investors to switch companies Impede changing dividend policy – shareholders sell stocks Implication: Change slowly to give time to adjust

Information Content (Signaling) Hypothesis Announcement of dividend increase (cut) often results in an increase (fall) in stock price. Investors prefer dividends to capital gains. MM argue that dividend announcements convey signal Information asymmetries: Management know more about firm’s prospect Increase dividends only if they can sustain higher income Higher stock price could reflect higher expectations for future EPS (not a desire for dividends).

Implications Clientele effect & signaling imply dividend stability. Many shareholders rely on dividend income to meet expenses -- they are not happy if dividend stream are unstable. Further, reducing dividends to make funds available for capital investment could send incorrect signals to investors -- they may interpret the dividend cut that firm’s future earnings prospects have been diminished.

Residual Distribution Model Setting target distribution level:

Residual Distribution Model Fewer good investment opportunities lead to smaller capital budget needed, hence a higher dividend payout. More good investment opportunities lead to more capital budget needed, hence a lower dividend payout.

Residual Distribution Model Advantage: Minimize new stock issues & flotation costs Disadvantages: Variable dividends Conflicting signals to investors Not appeal any specific clientele Conclusion: Consider the model when setting target payout but not follow rigidly

Share Repurchase Buy back some stocks from shareholders Reasons: Alternative way to distribute cash Have excess cash inflow temporally Have more free cash flow than its needed Change capital structure

Share Repurchase Buy back through brokers in the open market Make a tender offer, under which it permits stockholders to send in (that is “tender”) shares in exchange for a specified price per share. Buy a block of shares from a large holder on a negotiated basis – a target stock repurchase [a technique used to prevent a hostile (unfriendly) takeover in which the target firm purchases back its own stock from an unfriendly bidder, usually at a price well above market value]

Advantages Positive signals -- shares are undervalued Stockholders have choices whether they can sell or not sell. Distribute temporarily excess cash Change capital structure Buy back shares for employee when exercise stock options – avoid new shares issuance and earnings dilution

Disadvantages Negative signal -- poor investment opportunities Stockholders may not be well informed -- treated unfairly Pay too much for its own stock