Chapter 6 Dividends and Share repurchases: Basics Presenter’s name Presenter’s title dd Month yyyy

1. Introduction A dividend is a pro rata distribution to shareholders that is declared by the company’s board of directors and may or may not require approval by shareholders. A repurchase of stock is a distribution in the form of the company buying back its stock from shareholders. The board of directors determines the company’s 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 are different between these two methods. These distributions may provide information about the company’s future prospects. Issuing companies cannot deduct distributions to shareholders for tax purposes. LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. Pages 229–230 Introduction A cash dividend is based on the number of shares an investor owns. A share repurchase is an opportunity for investors to sell shares back to the issuing company. Both a cash dividend and a share repurchase are methods of distributing cash to shareholders. International differences: whether a dividend is approved by shareholders and whether dividends received are taxed and at what rate(s). Copyright © 2013 CFA Institute

Noncash Distributions 2. Dividends: Forms Cash Distributions Regular Cash Dividend Extra Dividend Liquidating Dividend Noncash Distributions Stock Dividend Stock Split Reverse Stock Split LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. 2. Dividend: Forms Copyright © 2013 CFA Institute

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 are quarterly, semiannually, or annually. Tendency of companies is to maintain or increase dividends Often viewed as signals of management’s assessment of the company’s future (that is, whether the company can maintain the dividend in the future). Companies prefer not to cut or reduce the dividend. LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. Page 231 Regular Cash Dividends Regular cash dividends are periodic, and companies tend to keep these dividends level or increase the dividend. Eliminating or reducing dividends is generally viewed as a negative signal and the company’s stock price tends to fall when this is announced, so companies hesitate to reduce or cut the dividend. Copyright © 2013 CFA Institute

Dividend reinvestment plans A dividend reinvestment plan (DRP) is a program that permits investors to reinvest cash dividends automatically into the stock of the issuing company. The shares provided in exchange for the cash dividends may be acquired in the 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. LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. Pages 231–232 Dividend Reinvestment Plans A dividend reinvestment plan (DRP) is a program that permits investors to reinvest cash dividends automatically into the stock of the issuing company. This results most often in fractional shares. The shares provided in exchange for the cash dividends may be acquired in the open market by the issuer or may be newly issued shares. Newly issued shares dilute the ownership interests of other shareholders. 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: Shares are purchased at each dividend payment date. Opportunity (in some cases) to buy shares at a discount from market value. Disadvantage to the investor: Recordkeeping (though most of these are electronic entry). Dividends are taxed when “received,” whether reinvested or not. This means that there are taxes that must be paid, but not cash flow. Copyright © 2013 CFA Institute

Extra or Special Dividends An extra dividend (or special dividend) is a dividend that is either paid by a company that does not pay dividends regularly or paid by a company in addition to a regular dividend. Example: Whole Foods Market announced a $2 special dividend in December 2012. This was in addition to its $0.20 per quarter cash dividend. Motivation: Pay out in strong years without investors expecting an increased dividend. LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. Pages 232–233 Extra or Special Dividends An extra dividend (or special dividend) is a dividend that is either paid by a company that does not pay dividends regularly or paid by a company in addition to a regular dividend. Example: Whole Foods Market announced a $2 special dividend in December 2012. This was in addition to its $0.20 per quarter cash dividend. Motivation: Pay out in strong years without investors expecting an increased dividend. Copyright © 2013 CFA Institute

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. LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. Page 232–233 Liquidating Dividend A liquidating dividend is a distribution of cash to shareholders when Going out of business (in exchange for the surrender of shares). Example: Myrexis (MYRX) liquidating/dissolution in January 2013 Selling a portion of the business. Paying a dividend when retained earnings are not positive. Copyright © 2013 CFA Institute

Stock Dividends A stock dividend is the distribution of additional shares of stock to shareholders 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 shareholder’s proportionate ownership, the shareholder does not receive cash, and there are no tax consequences. Advantages for the issuer: More shares outstanding and, therefore, potential for more shareholders. Lowers the stock’s price, which may make it more attractive as an investment. No economic effect. Does not affect financial ratios. LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. Pages 234–236 Stock Dividends A stock dividend is the distribution of additional shares of stock to shareholders on a pro rata basis. Also known as a bonus issue of shares. Generally stated as a percentage of current shares outstanding. If there are 1 million shares outstanding and a 10% stock dividend, there will be 1.1 million shares outstanding after the stock dividend. A stock dividend does not change a shareholder’s proportionate ownership, the shareholder does not receive cash, and there are no tax consequences. If the shareholder owned 1/10,000 before the stock dividend, the shareholder owns 1/10,000 after. Advantages for the issuer: More shares outstanding and, therefore, potential for more shareholders. Lowers the stock’s price, which may make it more attractive as an investment. No economic effect (no cash flow, no change in ownership interest). Does not affect financial ratios. Note about accounting: shift from retained earnings to contributed capital. Copyright © 2013 CFA Institute

Stock Dividends in Practice More prevalent in some countries. Some companies pay stock dividends on a regular basis; some pay these occasionally. LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. Page 234–235 Stock Dividends in Practice More prevalent in some countries. China: 78% of all stocks. Some companies pay stock dividends on a regular basis; some pay these occasionally. Example: Regular stock dividends: Archer Daniels Midland (ADM). Copyright © 2013 CFA Institute

Number of new shares : Number of old shares 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 holds two 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. LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. Pages 236–238 Stock Splits A stock split is the proportionate increase in the number of shares outstanding. Stated in the form: Number of new shares : Number of old shares So, 2:1 means that for each share held before the split, the shareholder holds two shares after the split. Stock splits Do not affect the dividend yield (dividend/price) or the dividend payout ratio (dividend/earnings). Accounting: Memorandum entry, no change in accounts. The announcement is generally viewed as a positive signal. Discussion question: Why do some companies choose not to split their stocks to achieve a price in the “attractive” trading range? Example: Berkshire Hathaway (BERK). Copyright © 2013 CFA Institute

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, stock split: It reduces the number of shares, with the expectation of increasing the stock price. A 1:2 reverse stock split results in half the number of shares outstanding after the split. The goal may be to increase the share price to make it more attractive for institutional investors. Reverse stock splits are most common for companies in financial distress. It is not permitted in some countries. LOS: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios. Page 237 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 stock split: It reduces the number of shares. A 1:2 reverse stock split results in half the number of shares outstanding after the split. The goal may be to increase the share price to make it more attractive for institutional investors. It is also used by companies trying to avoid being delisted. It is most common for companies in financial distress. It is not permitted in some countries. Example: Citigroup’s (C) 1:10 reverse stock split announced 31 March 2011, effective 6 May 2011. Before the split, the stock was trading around $4.50 per share. After the split, the stock traded for $44 per share (and then dropped below $40 and finally rose to around $45). Copyright © 2013 CFA Institute

3. Dividends: Payment Chronology | Declaration Date Ex-Dividend Date Holder-of-Record Date Payment Date Relationship Based on Trade Cycle ↑ Corporation Issues Dividend Declaration Established by Markets Based on the Trade Settlement Cycle Established by Corporation as Date of Ownership of Stock Established by Corporation as Date the Dividend Is Actually Paid LOS: Describe dividend payment chronology, including the significance of declaration, holder-of-record, ex-dividend, and payment dates. Pages 238–241 3. Dividends: Payment Chronology The board of directors declares the dividend on the declaration date. The declaration specifies the amount of the dividend, the holder-of-record date, and the payment date. The holder-of-record date is the date of ownership for determining who is entitled to the dividend. The exchanges determine the ex-dividend date, which is the date on or after which the buyer of the stock is not entitled to the forthcoming dividend. This may be one or two business days, depending on the market. The payment date is the date on which the dividend is sent to shareholders. Copyright © 2013 CFA Institute

4. Share Repurchases A share repurchase is the transaction in which the stock issuer buys back its shares 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. LOS: Compare share repurchase methods. Pages 241–243 4. Share Repurchases A share repurchase is the transaction in which the stock issuer buys back its shares 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. Examples of restrictions: Canada limits repurchases to 5%. Shareholders must approve repurchase in the United Kingdom, France, and Germany. 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. Copyright © 2013 CFA Institute

Share Repurchase Methods Buy in the Open Market Use brokers to buy shares. Method provides flexibility for the company. Fixed Price Tender Offer Specify the number of shares and the share price. Buy pro rata if oversubscribed. Dutch Auction Tender Offer Specify the number of shares and the range of prices. Shareholders determine the number of shares they will sell back and specify the price within the range. Direct Negotiation Negotiate with a specific shareholder. Method may be used to prevent “activist” shareholder from getting on board. LOS: Compare share repurchase methods. Pages 243–244 Share Repurchase Methods Buy in the open market. Use brokers to buy shares. This method provides flexibility in terms of timing and price of repurchases. Fixed price tender offer Specify the number of shares and the share price. Buy pro rata if oversubscribed. Dutch auction tender offer Specify the number of shares and the range of prices. Shareholders submit bids of shares and prices to sell to the company. Starting at the lowest submitted price, the company then determines the price needed to buy the specified number of shares. Direct negotiation Negotiate with a specific shareholder. This method is referred to as “greenmail” when it is an activist of a hostile acquirer. Classic case: Walt Disney Co. buyout of Saul P. Steinberg shares in 1984 for $325 million (profit to Steinberg: $32 million) . Discussion question: Why would a company want to buy shares in the open market instead of through a tender offer or Dutch auction tender offer? Copyright © 2013 CFA Institute

Share repurchase and Earnings Per Share The Diluting Company is planning a $100 million share repurchase. Its current stock price is $25 per share, and there are 16 million shares outstanding prior to the repurchase. Earnings per share without the repurchase would be $3 per share. 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 million – 4 million) = $4 per share Scenario 2: Net income = $3 × 16 million – (0.07 × $100 million) = $41 million EPSScenario 2 = $41 million  (16 million – 4 million) = $3.41 per share LOS: Calculate and compare the effects of a share repurchase on earnings per share when (1) the repurchase is financed with the company’s excess cash and (2) the company uses funded debt to finance the repurchase. Pages 245–247 Share Repurchase and Earnings Per Share Note: This example is similar (but not identical) to what is in Example 6-7. Scenario 1: Net income = $3 × $16 million = $48 million (start with EPS and multiply by number of shares outstanding) EPSScenario 1 = $48 million  (16 million – 4 million) = $4 per share (divide net income by the new number of shares outstanding) Scenario 2: Net income = $3 ×16 million – (0.07 × $100 million) = $41 million (subtract the interest on the borrowed funds to arrive at the new net income) EPSScenario 2 = $41 million  (16 million – 4 million) = $3.41 per share (divide the new net income by the new number of shares outstanding) After-tax borrowing rate = 7% (given in problem) Earnings yield = $3  $25 = 12% After-tax borrowing rate < Earnings yield Whether EPS increases, stays the same, or decreases: If the after-tax borrowing rate = earnings yield, EPS unchanged from buyback financed with debt. If the after-tax borrowing rate < earnings yield, EPS increases. If the after-tax borrowing rate > earnings yield, EPS decreases. See also Examples 6-6 and 6-7 for earnings per share effects. Copyright © 2013 CFA Institute

Share repurchase and Book 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 share repurchase. 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 million – 4 million) = $18.33 per share Scenario 2: Book value = ($20 × 16 million) – $100 million – $7 million = $213 million BVPSScenario 2 = $213 million  (16 million – 4 million) = $17.75 per share LOS: Calculate the effect of a share repurchase on book value per share. Pages 248–249 Share Repurchase and Book 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 share repurchase. Continuing the Diluting Company example and adding the book value per share of $20: Note: Book value per share is less than the market value per share. Scenario 1: Book value = ($20 × 16 million) – $100 million = $220 million BVPSScenario 1 = $220 million  (16 million – 4 million) = $18.33 per share Scenario 2: Book value = ($20 × 16 million) – $100 million – $7 million = $213 million BVPSScenario 2 = $213 million  (16 million – 4 million) = $17.75 per share Discussion question: Why does the relationship between the market value of equity and book value of equity determine the direction of the BVPS? Copyright © 2013 CFA Institute

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 the same, 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. LOS: Explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders’ wealth, all else being equal. Page 249 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 the same, Then the effects of cash dividends and repurchases on shareholder value wll be the same. Both cash dividends and stock repurchases, if financed the same way: Reduce assets by the amount of the dividend or repurchase (the dollar amount of the dividend or repurchase). Reduce equity by the amount of the dividend or repurchase (treasury stock). Provide investors with the same cash flow. Copyright © 2013 CFA Institute

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. Pages 250–251 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. Dividend reductions or omissions have a negative effect on share prices. Copyright © 2013 CFA Institute

6. Summary Dividends can take the form of regular or irregular cash payments, stock dividends, or stock splits. Regular cash dividends represent a commitment to pay cash to stockholders on 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 payment date. 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 a Dutch auction. Share repurchases made with excess cash have the potential to increase earnings per share, whereas share repurchases made with borrowed funds can increase, decrease, or not affect earnings per share, depending on the after-tax borrowing rate. 6. Summary Copyright © 2013 CFA Institute

Summary (continued) A share repurchase is equivalent to the payment of a cash dividend of equal amount in its effect on shareholders’ wealth, all other things being equal. Announcement of a share repurchase is sometimes accompanied by positive excess returns in the market when the market price is viewed as reflecting management’s view that the stock is undervalued. Initiation of regular cash dividends can also have a positive impact on share value. 6. Summary Copyright © 2013 CFA Institute