1. Distributions to Shareholders: Dividends and Repurchases
CHAPTER 14
Distributions to Shareholders: Dividends and Repurchases

2. Topics in Chapter Theories of investor preferences Clientele effect
Read the following sections: 14-1, 14-2, 14-3, 14-4, 14-5, 14-6, 14-7, 14-8, 14-10, 14-12,
Theories of investor preferences
Clientele effect
Signaling effect
Residual distribution model
Stock repurchases
Stock dividends and stock splits

3. Uses of Free Cash Flow: Distributions to Shareholders
Sales revenues −
Operating costs and taxes
Required investments in operating capital −
Free cash flow
(FCF) =
Sources
Uses
Interest
payments
(after tax)
Purchase of
short-term
investments
Stock
repurchases
Principal
repayments
Dividends

4. Overview: Distribution Policy
The distribution policy defines:
The level of cash distributions to shareholders
The form of the distribution (cash dividend vs. stock repurchase)
The stability of the distribution
The Question:
Can a company increase its value through its choice of distribution policy?

5. 14-1 An Overview of Cash Distributions 14-1a Sources of Cash
A firm’s free cash flow (FCF) is the cash flow available for distribution to all the company’s investors (creditors and equity holders) after the company has made all investments necessary to sustain ongoing operations. Therefore, the fundamental value of a firm depends primarily on its expected future FCFs (discounted at the WACC).
FCF = (i) Operating Cash Flow – (ii) Gross Investment in Fixed Assets – (iii) Investment in Net Operating Working Capital
OCF = (Sales Revenue – COGS – SG&A – Depreciation)*(1-T) + Depreciation
= EBIT *(1-T) + Depreciation = Net Operating Profit after Taxes + Depreciation
NOWC = Operating Current Assets – Operating Current Liabilities

6. Distribute to shareholders:
14-2b Uses of Cash
Service debt:
A. Pay interest Expenses;
B. Pay down the principal.
Distribute to shareholders:
A. Pay dividends;
B. Repurchase stock.
Buy short-term investments or other non-operating assets.

7. 14-2 Procedures for Cash Distributions 14-2a Dividend Payment Procedures: example
Wednesday, November 16: Board declares a quarterly dividend of $0.50 per share to holders of record as of Thursday, December 15.
Monday, December 12: Dividend goes with stock.
Tuesday, December 13: Ex-dividend date: any purchase on or after this date will not get dividend.
Thursday, December 15: Holder of record date: used to determine ex-dividend date.
Thursday, January 5: Payment date: dividend is paid to whoever owned the stock at closing the day prior to the ex-dividend date.

8. 14-2b Stock Repurchase Procedures
Stock repurchases are usually made in one of the three ways:
A public firm can buy back its own stock through a broker on the open market;
The firm can make a tender offer for a specified price per share to its shareholders;
The firm can purchase a block of shares from one large holder on a negotiated basis.

9. 14-2c Patterns of Cash Distributions
Total cash distributions as a percentage of net income have been stable at around 26%-28%.
The average dividend payout ratio fell, while the average repurchase payout as a percentage of net income rose.
Repurchases now total more dollars in distributions than dividends.
A smaller percentage of companies now pay dividends. When young companies first begin making distributions, it is usually in the form of repurchases.
Dividend payouts have become more concentrated in a smaller number of large, mature firms.
There is considerable variation in distribution policies at the firm level.

10. 14-3 Cash Distributions and Firm Value: Do Investors Prefer High or Low Payouts?
There are three dividend theories in terms of the level of payout:
Dividend Irrelevance Theory: firm value is not affected by the level of payout.
Dividend Preference, or Bird-in-the-Hand Theory: shareholders prefer dividends and are willing to accept a lower required return on equity.
Tax Effect Theory: since dividends are historically taxed more highly than capital gains, investors require a higher pre-tax return on dividend-paying stocks relative to non-dividend stocks.

11. 14-3a Dividend Irrelevance Theory
Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell some shares. If they don’t want cash, they can use dividends to buy additional shares.
Implies payout policy has no effect on stock value or the required return on stock.
Theory is based on unrealistic assumptions (Perfect Capital Market: no taxes, no brokerage costs or any other frictions).

12. 14-3b Dividend Preference (Bird-in-the-Hand) Theory
Investors might think dividends (i.e., the-bird-in-the-hand) are less risky than potential future capital gains.
Also, high payouts help reduce agency costs by depriving managers of cash to waste and subjecting managers to more scrutiny by going to external capital markets more often.
Therefore, investors would value high payout firms more highly and would require a lower return to induce them to buy its stock.

13. 14-3c Tax Effect Theory
Low payouts mean higher capital gains. Capital gains taxes are deferred until they are realized, so they are taxed at a lower effective rate than dividends.
This could cause investors to require a higher pre-tax return to induce them to buy a high payout stock, which would result in a lower stock price.
So capital gains and consequently low payout policies are preferred due to tax reasons.

14. 14-3d Empirical Evidence on Distribution Policies
Although the evidence from empirical studies is mixed as to whether the average investor uniformly prefers either higher or lower distribution levels, other research does show that individual investors have strong preferences (section 14-4).
Also other research shows that investors prefer stable, predictable dividend payouts regardless of the payout level (section 14-6).
And investors interpret dividend changes as signals about firms’ future prospects (section 14-5).

15. 14-4 Clientele Effect
Different groups of investors, or clienteles, 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 have to switch companies due to a change in payout policy.

16. 14-5 Signaling Hypothesis / Information Content Hypothesis
Investors view dividend changes as signals of management’s view of the future. Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. In other words, dividend changes convey information.
Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future earnings, not a desire for higher payout.

17. 14-6 Implications for Dividend Stability
The clientele effect and the information content in dividend announcements have implications regarding the desirability of stable vs. volatile dividends: maximizing stock price probably requires a firm to maintain a stable dividend policy because frequent switching of dividend policy would seriously inconvenience the established clientele and could send confusing signals to investors.

18. Implications for Dividend Stability (Continued)
Because sales and earnings are expected to grow (even volatile) for most firms, a stable dividend policy means a company’s regular cash dividends should also grow at a steady, predictable rate. To avoid dividend cut and exploit investment opportunities in the future, most companies will move toward small, sustainable, regular cash dividends that are supplemented by stock repurchases.

19. 14-7 Setting the Target Distribution Level: the Residual Distribution Model
Find the reinvested earnings needed for the capital budget.
Pay out any leftover earnings (the residual) as either dividends or stock repurchases.
This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

20. Using the Residual Model to Calculate Distributions Paid
Net
income
Target
equity
ratio
Total
capital
budget
Distr. = – Required equity

21. Application of the Residual Distribution Approach: Data for T&W
Capital budget with different investment opportunities: good $150 million; average $70 million; poor $40 million.
Target capital structure: 40% debt, 60% equity. Want to maintain.
Net income: $60 million.

22. Application of the Residual Distribution Approach: Table 14-2
Investment Opportunities
Poor
Average
Good
Equity ratio (ws)
60%
Capital budget
$40
$70
$150
Net income
$60
Req. equ.: (ws X Cap. Bgt.)
$24
$42
$90
Dist. paid: (NI – Req. equity)
$36
$18
($30)
Payout ratio (Dividend/NI)
30% 0%

23. Investment Opportunities and Residual Dividends
Taking positive NPV projects is first priority: it determines capital budget.
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.

24. Advantages and Disadvantages of the Residual Model
Advantages of the residual distribution model:
Considers the firm’s investment opportunities (which is most important to increase firm value: investment and operating decisions determine the firm’s free cash flow and business risk);
Considers the firm’s target capital structure (financing decisions determine the firm’s financial risk and affect the cost of capital);
Considers the availability and cost of external capital (minimizes the new stock issues to avoid possible negative equity signaling effect and high flotation costs).
Disadvantages of the residual distribution model:
Results in volatile dividends;
Sends out conflicting signals;
Doesn’t appeal to any specific clientele.

25. 14-8 The Residual Distribution Model in Practice
In practice, firms should proceed as follows:
Estimate earnings and investment opportunities for the next 5 or so years;
Use this forecasted information and the target capital structure to find the average residual model distributions and dollars of dividends during the planning period;
Set a target payout ratio based on the average projected data.
Thus, firms should use the residual policy to help set their long-run target distribution ratios, but not as a guide to the distribution in any one year because investors dislike volatile regular dividends.
So companies may set a very low “regular” dividend and then supplement it with “extra” dividends or stock repurchases to distribute excess cash.

26. 14-10 The Pros and Cons of Dividends and Repurchases
Repurchases: buying own stock back from stockholders.
Reasons for repurchases:
As an alternative to distributing cash as dividends.
To dispose of one-time cash from an asset sale.
To make a large capital structure change.
To reuse the repurchased shares when employees exercise stock options.

27. The Procedure of a Repurchase
Firm announces intent to repurchase stock.
Three ways to purchase:
Have broker purchase on the open market over a period of time.
Make a tender offer to shareholders.
Make a block (targeted) repurchase.
Firm doesn’t have to complete its announced intent to repurchase.

28. Drop in Price with Dividend Distribution
Stock price drops by approximately the amount of dividend per share on ex-dividend date if other things being the same.
If it didn’t, there would be arbitrage opportunity.

29. A repurchase has no effect on stock price!
The announcement of an intended repurchase might send a signal that affects stock price, and the previous events that led to cash available for a distribution affect stock price, but the actual repurchase itself has no impact on stock price because:
If investors thought that the repurchase would increase the stock price, they would all purchase stock the day before, which would drive up its price.
If investors thought that the repurchase would decrease the stock price, they would all sell short the stock the day before, which would drive down the stock price.

30. Stock Repurchase vs. Cash Dividend
Stock price doesn’t fall at time of repurchase.
Number of outstanding shares falls.
Cash Dividend:
Stock price falls by amount of dividend on ex-dividend date
Number of shares doesn’t change

31. Intrinsic Stock Value Over Time: Repurchase vs. Dividends

32. Advantages of Repurchases
Stockholders may take as a positive signal--management thinks stock is undervalued.
Stockholders can choose to sell or not.
Proceeds received are capital gains rather than higher-taxed dividends.
Helps avoid setting a high dividend that cannot be maintained.
Company has more flexibility in adjusting the total distribution than it would if the entire distribution were in the form of cash dividends, because repurchase can be varied from year to year without giving adverse signal.
Repurchases can be used to produce large-scale changes in capital structure.
Repurchased shares (treasury stock) can be used later when employees exercise their stock options.

33. Disadvantages of Repurchases
Cash dividends are generally dependable, but repurchases are not.
The selling stockholders may not be fully aware of all the implications of a repurchase.
The corporation may pay too much for the repurchased stock – to the disadvantage of remaining stockholders.
IRS could impose penalties if repurchases were primarily to avoid taxes on dividends.

34. Comparison of Cash Dividends vs. Stock Repurchases
Because of the deferred tax on capital gains, repurchases have a tax advantage over dividends as a way to distribute income to stockholders. In addition, stockholders have a choice whether to sell or not. On the other hand, dividends are more dependable and are thus better suited for those who need a steady source of income.
Because of clientele and signaling effect, companies should not vary their cash dividends too often. But the “proper” dividend in the sense of the residual distribution model varies because investment opportunities and cash flows vary over time. To reconcile, a firm can set its dividend low enough to keep dividend payments from constraining operations and then use repurchases on a more or less regular basis to distribute excess cash.
Repurchases are also useful when a firm wants to make a large shift in its capital structure, wants to distribute cash from a one-time event such as the sale of a division; or wants to obtain shares for use in an employee stock option plan.

35. 14-12 Summarizing the Distribution Policy Decision
The effects of asymmetric information suggests that, to the extent possible, managers should avoid both new common stock sales (SEO) and dividend cuts, because both actions tend to lower the stock price.
To summarize, many firms’ dividend policies are consistent with the life-cycle theory:
Younger firms with many investment opportunities but relatively low cash flows reinvest their earnings so that they can avoid the large flotation costs associated with raising external capital; As firms mature and begin to generate more cash flows, they tend to pay more dividends and issue more debt as a way to “bond” their cash flows and thereby reduce the agency costs of free cash flow.

36. Survey of Financial Executives on Dividend Policy Decision
It is extremely important to maintain dividends but much less important to initiate or increase dividend payments;
The cash distribution decisions are much less important than capital budgeting decisions;
Mangers like the flexibility provided by repurchase instead of regular dividends. They tend to repurchase shares when they believe their stock price is undervalued, and they believe that shareholders view repurchases as positive signals;
In general, the different taxation of dividends and repurchases is not a major factor when a company chooses how to distribute cash to investors.

37. 14-13 Stock Splits and Stock Dividends
Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10% stock dividend, get 10 additional shares for each 100 shares owned, price/share drops proportionately.
Stock split: Firm increases the number of shares outstanding, e.g. for a 2-for-1 split, 1 share becomes 2 shares, price/share cut in half.
Reverse split: e.g. 1-for-10, 10 shares become 1 share, price/share would be 10 times of the before-reverse-split price.

38. Stock Dividends and Stock Splits (continued)
Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.”
Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends, the stock price falls proportionately so as to keep each investor’s wealth unchanged: from a purely economic standpoint, stock dividends and splits are just additional pieces of paper!
But stock splits/stock dividends may get the price to a “normal trading range” in addition to providing a relatively low-cost way of signaling.

39. Stock Price after the Split or Stock Dividend

40. Homework Questions on P600: 14-1 (except f), 14-3, 14-5 (except c);
Problems on P602: 14-5, 14-7, 14-9.