Chapter 14 Distribution to shareholders: dividends & repurchases Finance Chapter 14 Distribution to shareholders: dividends & repurchases

Dividend policy Case, pg. 521 Target payout ratio = the percentage of net income paid out as cash dividends as desired by the firm What fraction of earnings should be distributed? Should distribution be in the form of cash or stock repurchase? Should the dividend dividend growth rate be stable? Optimal dividend policy = The dividend policy that strikes a balance between current dividends and future growth and maximizes the firm’s stock price

Dividend irrelevance theory MM’s dividend irrelevance theory = a firm’s dividend policy has no effect on either its value or cost of capital The value of a firm is determined by business risk; only on the income produced by its assets, not on how this income is split between dividends and retained earnings Individual investors can sell shares or buy additional shares to create their own dividend policy Ignores brokerage fees and taxes

Bird-in-the-hand & tax preference theories The bird-in-the-hand theory = the firm’s value will be maximized by a high dividend payout ration, because investors regard cash dividends as being less risky than potential capital gains Tax preference theory = because long term capital gains are subject to less taxes than dividends, investors prefer to have companies retain earnings rather than pay them out as dividends Empirical tests of the 3 theories are inconclusive (pg. 526)

Other dividend policy issues Information content (signaling) hypothesis = the theory that investors regard dividend changes as signals of management’s earnings forecast Investor behavior: Higher dividends signals management’s belief that future earnings will be good Lower dividends signals management’s belief that future earnings will be lower MM argue that investors’ reactions to changes in dividend policy may not reflect a preference for dividends or retained earnings, but as important information (a signal)

Other dividend policy issues Clientele (group of stockholders) effect = the tendency of a firm to attract a set of investors who like its dividend policy, e.g.: Retirees prefer cash income Retirees are in a low or zero tax bracket so taxes are of no concern Evidence suggests this effect may be true Firms should consider both information signaling and clientele effect when considering a change to dividend policy

In practice: dividend stability In practice, most firms try to follow a policy of paying a steadily increasing dividend. This policy provides investors with stable, dependable income. Changes in this policy give investors signals about management’s expectations for future earnings. Pg. 526

Residual dividend model Residual dividend model = dividend policy is set equal to net income minus the amount of retained earnings necessary to finance the firm’s optimal capital budget Dividends = Net income – Retained earnings required to help finance new investments Dividends = Net income – [(Target equity ratio) (Total capital budget)]

Residual dividend model To implement the residual dividend policy only if investors are not bothered by fluctuating dividends. The residual model can help set long-run target payout rations, but not as a guide to payout in any one year. Estimate the firm’s earnings and investment opportunities, on average, over the next five or so years Use this forecasted information to find the residual model payout ratio and dollars of dividends during the planning period The set a target payout ratio on the basis of the projected data

Low-regular-dividend-plus-extras Low-regular-dividend-plus extras = the policy of announcing a low, regular dividend that can be maintained no matter what, and then paying an “extra” dividend in good times. Ford GM

Dividend reinvestment plan (DRIP) DRIP allows stockholders to automatically use dividends to purchase additional stock. This plan avoids brokerage fees May be stopped when no need for further equity capital “open enrollment” – about ½ of all DRIPS allow investors to buy stock directly from the company and avoid brokerage fees

Summary: Factors influencing dividend policy Constraints Bond indentures – debt contracts often limit dividend payments to earnings generated after the load was granted and no dividends can be paid unless safety ratios are exceed minimum (e.g., current ratio, times-interest-earned ration) Preferred stock restrictions – preferred arrearages must be satisfied before common dividends can be resumed

Summary: Factors influencing dividend policy Impairment of capital rule – a legal constraint, dividend payments cannot exceed the balance sheet item “retained earnings”. This protects creditors. Availability of cash Penalty tax on improperly accumulated earnings – if the IRS can demonstrate that a firm is deliberately holding down its dividend payout ratio to help its stockholders avoid paying taxes (usually only affects privately held firms)

Summary: Factors influencing dividend policy Investment opportunities Number of profitable investment opportunities determines low or high payout ratio Possibility of accelerating or delaying projects will help a firm to keep to a stable dividend policy

Summary: Factors influencing dividend policy Alternative sources of capital Cost of selling new stock – if flotation costs are high (includes signaling effect) a firm may set a low payout ratio and finance through retained earnings If flotation costs are low, a firm will maintain a high payout ratio Ability to substitute debt for equity – if the firm can pay the expected dividend, even if earnings fluctuate, they’ll increase their debt ratio

Summary: Factors influencing dividend policy Control – if management is concerned about maintaining control, it may not want to sell new stock, thus retain earnings. However, if stockholders want higher dividends, a proxy fight looks, then the dividend will be increased

Stock split A stock split increases the number of shares outstanding Normally, splits reduce the price per share in proportion to the increase in shares since splits “divide the pie in smaller pieces” Firms split their stock: The price is quite high Management thinks the future is bright Stock splits are often seen as a positive signal resulting in a boost of stock prices

Stock dividend A stock dividend = a dividend paid in shares of stock rather than cash Stock splits and stock dividends are used to keep stock prices within an “optimal” trading range

Stock repurchase plan A stock repurchase plan = a firm buying back some of its outstanding shares of stock, reducing the number of shares, which should Increase the EPS Increase the stock price Repurchases are useful for making major changes in capital structure as well as for distributing excess cash Pg. 547