CH15Distributions to Shareholders Dividends and Share Repur

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CHAPTER 15Distributions to Shareholders: Dividends and Share Repurchases

Theories of investor preferences Signaling effects Residual model Dividend reinvestment plans Stock dividends and stock splits Stock repurchasesCopyright © 2001 by Harcourt, Inc. All rights reserved.

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What is “dividend policy”? It’s the decision to pay out earnings versus retaining and reinvesting them. Includes these elements: 1. High or low payout? 2. Stable or irregular dividends? 3. How frequent? 4. Do we announce the policy?Copyright © 2001 by Harcourt, Inc. All rights reserved.

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Do investors prefer high or low payouts? There are three theories: Dividends are irrelevant: Investors don’t care about payout. Bird in the hand: Investors prefer a high payout. Tax preference: Investors prefer a low payout, hence growth.Copyright © 2001 by Harcourt, Inc. All rights reserved.

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Dividend Irrelevance Theory

Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. Modigliani-Miller support irrelevance. Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test.Copyright © 2001 by Harcourt, Inc. All rights reserved.

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Bird-in-the-Hand Theory

Investors think dividends are less risky than potential future capital gains, hence they like dividends. If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P0.

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Tax Preference Theory

Retained earnings lead to longterm capital gains, which are taxed at lower rates than dividends: 20% vs. up to 39.6%. Capital gains taxes are also deferred. This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P0.Copyright © 2001 by Harcourt, Inc. All rights reserved.

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Implications of 3 Theories for Managers

Theory Irrelevance Bird in the hand

Implication Any payout OK Set high payout

Tax preference

Set low payout

But which, if any, is correct???Copyright © 2001 by Harcourt, Inc. All rights reserved.

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Possible Stock Price EffectsStock Price ($)40 Bird-in-Hand

3020 10

Irrelevance

Tax preference

0

50%

100%

PayoutAll rights reserved.

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Possible Cost of Equity EffectsCost of equity (%)Tax Preference 20 15 Irrelevance

10

Bird-in-Hand

0

50%

100%

PayoutAll rights reserved.

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Which theory is most correct?

Empirical testing has not been able to determine which theory, if any, is correct. Thus, managers use judgment when setting policy. Analysis is used, but it must be applied with judgment.Copyright © 2001 by Harcourt, Inc. All rights reserved.

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What’s the “information content,” or “signaling,” hypothesis? Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. So, investors view dividend increases as signals of management’s view of the future. Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.Copyright © 2001 by Harcourt, Inc. All rights reserved.

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What’s the “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.Copyright © 2001 by Harcourt, Inc. All rights reserved.

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What’s the “residual dividend model”? Find the retained earnings needed for the capital budget.

Pay out any leftover earnings (the residual) as dividends. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.Copyright © 2001 by Harcourt, Inc. All rights reserved.

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Using the Residual Model to Calculate Dividends Paid

Net Dividends = income –

[( )( )]Target equity ratioTotal capital budgetAll rights reserved.

.

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Data for SSC

Capital budget: $800,000. Given.

Target capital structure: 40% debt, 60% equity. Want to maintain. Forecasted net income: $600,000. How much of the $600,000 should we pay out as dividends?Copyright © 2001 by Harcourt, Inc. All rights reserved.

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Of the $800,000 capital budget, 0.6($800,000) = $480,000 must be equity to keep at target capital structure. [0.4($800,000) = $320,000 will be debt.]With $600,000 of net income, the residual is $600,000 – $480,000 = $120,000 = dividends paid. Payout ratio = $120,000/$600,000 = 0.20 = 20%.Copyright © 2001 by Harcourt, Inc. All rights reserved.