1. Dividend & share buyback (Chapter 14)

2. Distribution Policy Level of distribution Form of distribution
Stability of distribution

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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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.

10. 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

11. 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).

12. 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.

13. Residual Distribution Model
Setting target distribution level:

14. 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.

15. 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

16. 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

17. 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]

18. 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

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