1. Chapter 7 Dividends and Share repurchases: Analysis
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2. 1. Introduction
A payout policy is a set of principles regarding a corporation’s distributions to shareholders.
May be established with regard to a dividend payout, a dividend per share, a growth in dividend per share, or any other metric.
May include stock splits and stock dividends.
May include stock repurchases.
Page 258
Introduction
A payout policy (also known as dividend policy) is a set of principles regarding a corporation’s distributions to shareholders.
Note: Using the term “payout policy” encompasses repurchases, whereas the traditional term “dividend policy” implies cash and stock dividends as well as stock splits.
May be established with regard to a dividend payout, a dividend per share, a growth in dividend per share, or any other metric.
May include stock splits and stock dividends.
May include stock repurchases.
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3. 2. Dividend Policy and Company Value: Theory
Dividends Are Irrelevant
Based on MM theories.
If owners want a leveraged position, they can make it themselves.
Bird in the Hand
Cash dividends are more certain than stock appreciation.
Tax Argument
How dividends are taxed relative to capital gains affects investors preferences for dividends.
Other
Clientele effect.
Signaling.
Agency cost effects.
LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.
Page 258
2. Dividend Policy and Company Value: Theory
Explanations for dividend policies:
Dividend are irrelevant.
A “bird in the hand”: Cash dividends are preferred to uncertain capital gains.
Tax argument: Investors prefer capital gains to dividends if capital gains are taxed at a lower rate than capital gains.
Other explanations/influences: Clientele effect, signaling, and agency cost effects.
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4. Dividends are irrelevant
In Miller and Modigliani’s (MM) world with no taxes, no transaction costs, and homogeneous information, dividend policy does not affect the value of the company.
The decision of how a company finances its business is separate from the decision of what and how much to invest in capital projects.
If an investor wants cash flow, he/she could sell some shares.
If an investor wants more risk, he/she could borrow to invest.
An investor is indifferent about a share repurchase or a dividend.
Bottom line: Dividend policy does not affect a firm’s value.
LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.
Pages 258–260
Dividends Are Irrelevant
In MM’s world with no taxes, no transaction costs, and homogeneous information, dividend policy does not affect the value of the company.
The decision of how a company finances its business is separate from the decision of what and how much to invest in capital projects.
If an investor wants cash flow, he/she could sell some shares.
If an investor wants more risk, he/she could borrow to invest.
An investor is indifferent about a share repurchase or a dividend.
Market imperfections can affect conclusions because MM’s world has perfect capital markets.
Note: In a perfect capital market:
All participants have the same information.
There are no taxes (the key is that the tax rates on dividends and capital gains are the same).
There are no costs to financial distress.
Expectations are homogeneous.
Flotation costs associate with issuing new shares.
Bottom line: Dividend policy does not affect a firm’s value.
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5. The Bird-in-the-Hand Argument
Investors prefer a cash dividend to uncertain capital gains.
Hence, investors prefer the “bird in the hand.”
Issue: Riskiness of the stock appreciation.
If this explanation holds, a company that pays a cash dividend will have a higher value than a similar company that does not pay a cash dividend.
Bottom line: Dividend policy affects the value of the firm.
LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.
Page 260
The Bird-in-the-Hand Argument
Investors prefer a cash dividend to uncertain capital gains.
Hence, investors prefer the “bird in the hand.”
Issue: Riskiness of the stock appreciation.
If this explanation holds, a company that pays a cash dividend will have a higher value than a similar company that does not pay a cash dividend.
Bottom line: Dividend policy affects the value of the firm
Copyright © 2013 CFA Institute

6. The Tax Argument
If dividends are taxed at a rate higher than capital gains, investors prefer that companies reinvest cash flow back into the firm.
In other words, investors prefer the lower-taxed capital gains to the higher- taxed cash dividends.
This advocates a zero dividend payout when dividends are taxed at a rate higher than that of capital gains.
Bottom line: Dividend policy affects the value of the firm.
LOS: Compare theories of dividend policy and explain implications of each for share value, given a description of a corporate dividend action.
Pages 260–261
The Tax Argument
If dividends are taxed at a rate higher than capital gains, investors prefer that companies reinvest cash flow back into the firm.
In other words, investors prefer the lower-taxed capital gains to the higher-taxed cash dividends.
This advocates a zero dividend payout when dividends are taxed at a rate higher than that of capital gains.
Bottom line: Dividend policy affects the value of the firm.
Copyright © 2013 CFA Institute

7. The Clientele Effect
The clientele effect is the influence of groups of investors attracted to companies with specific dividend policies.
Clientele are simply a group of investors who have the same preference.
Types of clientele:
If an investor has a marginal tax on capital gains lower than the marginal tax on dividends, the investor prefers a return in the form of capital gains.
Investors who are tax exempt (e.g., pension funds) are indifferent about dividends and capital gains.
Some investors, by policy or restrictions, only invest in stocks that pay dividends.
The importance of the existence of clientele is that investors will have a preference for stocks with a specific dividend policy.
Bottom line: The clientele effect does not necessarily imply that dividends affect value.
LOS: Explain how clientele effects and agency issues may affect a company’s payout policy.
Pages 261–265
The Clientele Effect
The clientele effect is the influence of groups of investors attracted to companies with specific dividend policies.
Clientele are simply a group of investors who have the same preference.
Types of clientele:
If an investor has a marginal tax on capital gains lower than the marginal tax on dividends, the investor prefers a return in the form of capital gains.
Investors who are tax exempt (e.g., pension funds) are indifferent about dividends and capital gains.
Some investors, by policy or restrictions, only invest in stocks that pay dividends.
The importance of the existence of clienteles is that investors will have a preference for stocks with a specific dividend policy.
Bottom line: The clientele effects does not necessarily imply that dividends affect value.
If the tax rates on dividends and capital gains are the same, we should expect the price of a stock to drop by the amount of the dividend on the ex-dividend date.
The marginal investor is the investor most likely to make the next trade, and therefore is important in setting the price of the stock.
If the marginal tax rates on dividends and capital gains are not the same, then the price change (that is, drop), determined by the marginal investor, is
Price drop= Dividend × 1 − Marginal tax rate on dividends 1 − Marginal tax rate on capital gains
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8. Dividends and Signaling
Under MM’s theory, everyone has the same information.
When there is asymmetric information, dividend changes may convey information.
Positive Information
Dividend initiations
Dividend increases
Negative Information
Dividend omissions
Dividend reductions
LOS: Describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey.
Pages 265–268
Dividends and Signaling
Under MM’s theory, everyone has the same information.
Therefore, dividends do not signal anything.
When there is asymmetric information, dividend changes may convey information:
Positive information: Initiations and increases
Negative information: Omissions and decreases
Some evidence suggests that increasing a dividend attracts attention to the stock.
Companies do brag about their record of dividend payments (consistency, growth, etc.).
Companies that tend to grow their dividends consistently tend to be dominant in their industry, have global operations, have a high return on assets, and have low financial leverage.
Examples: Proctor & Gamble (PG), Diebold (DBD), Johnson & Johnson (JNJ), Coca-Cola (KO)
Cutting dividends are generally negative signals.
J.C. Penney (JCP) stopped its dividend in 2013.
Deutsche Telekom announced a reduction in 2012 (effective 2013 and 2014).
CenturyLink (CTL) announced a cut its dividend in Feb 2013.
Telecom Italia (TT) announced a cut in its dividend in Feb 2013.
Vale SA announced a dividend cut in 2013.
Copyright © 2013 CFA Institute

9. Agency costs and Dividend policy
The separation of ownership and management in a corporation may lead to suboptimal investment.
Management may invest in negative NPV projects to enhance the company’s size or management’s control.
Jensen’s free cash flow hypothesis is that having free cash flow tempts management to make investments that are not positive NPV.
Paying dividends or interest on debt uses this free cash flow and averts an agency issue.
If a company’s debt has a restriction on paying dividends, it may avoid the issue of paying dividends (thus benefiting owners) and may increase the risk to bondholders.
Bottom line: Dividends may reduce agency costs and, therefore, increase the value of the firm.
LOS: Explain how clientele effects and agency issues may affect a company’s payout policy.
Pages 268–271
Clientele and Agency Influence on Dividend Policy
The separation of ownership and management in a corporation may lead to suboptimal investment.
Management may invest in negative NPV projects to enhance the company’s size or management’s control.
Jensen’s free cash flow hypothesis is that having free cash flow tempts management to make investments that are not positive NPV.
Paying dividends or interest on debt uses this free cash flow and averts an agency issue.
If a company’s debt has a restriction on paying dividends, it may avoid the issue of paying dividends (thus benefiting owners) and may increase the risk to bondholders.
Bottom line: Dividends may reduce agency costs and, therefore, increase the value of the firm
Copyright © 2013 CFA Institute

10. 3. Factors Affecting Dividend policy
Investment Opportunities
Expected Volatility of Future Earnings
Financial Flexibility
Tax Considerations
Flotation Costs
Contractual and Legal Restrictions
LOS: Explain factors that affect dividend policy.
Pages 271–272
3. Factors Affecting Dividend Policy
Investment opportunities
Expected volatility of future earnings
Financial flexibility
Tax considerations
Flotation costs
Contractual and legal restrictions
Copyright © 2013 CFA Institute

11. Factors affecting dividend policy
Investment opportunities:
A company with more investment opportunities will pay out less in dividends.
A company with fewer investment opportunities will pay out more in dividends.
Expected volatility of future earnings:
Companies with greater earnings volatility are less likely to increase dividends—a greater chance of not maintaining the increased dividend.
Financial flexibility:
Companies seeking more flexibility are less likely to pay dividends or to increase dividends because they want to preserve cash.
LOS: Explain factors that affect dividend policy.
Pages 272–273
Factors Affecting Dividend Policy
Investment opportunities:
A company with more investment opportunities will pay out less in dividends.
A company with fewer investment opportunities will pay out more in dividends.
A company in the mature phase of the company’s life cycle is more likely to pay dividend than a company in the growth stage.
Expected volatility of future earnings:
Companies with greater earnings volatility are less likely to increase dividends—a greater chance of not maintaining the increased dividend.
Financial flexibility:
Companies seeking more flexibility are less likely to pay dividends or to increase dividends because they want to preserve cash.
Copyright © 2013 CFA Institute

12. Factors affecting dividend policy
Tax considerations
The tax rate on dividends and how dividends are taxed relative to capital gains affect investors’ preferences and, hence, companies’ dividend policy.
Flotation costs
These costs make it more expensive to use newly issued stock instead of internally generated funds.
Smaller companies face higher flotation costs.
Contractual and legal restrictions
Forms of restrictions:
Impairment of capital rule
Bond indentures
Requirement of preferred shares
LOS: Explain factors that affect dividend policy.
Pages 273–278
Factors Affecting Dividend Policy
Tax considerations
The tax rate on dividends and how dividends are taxed relative to capital gains affect investors’ preferences and, hence, companies’ dividend policy.
Note: Tax systems are discussed later in presentation.
Flotation costs
These costs make it more expensive to use newly issued stock instead of internally generated funds.
Smaller companies face higher flotation costs.
Contractual and legal restrictions
Forms of restrictions:
Impairment of capital rule
The impairment of capital rule is a legal restriction on paying dividends if there is not a minimum amount of equity capital.
Bond indentures
Requirement of preferred shares (that is, preference in preferred stock dividends before common stock dividends)
Copyright © 2013 CFA Institute

13. Tax Systems and Dividend Policy
Consider a company that has earnings before tax of $100 million and pays all its earnings as dividends. The company’s tax rate is 35%, and individual shareholders have a marginal tax rate of 25%. In countries with a split-rate system, dividends are taxed at 28% at the corporate level.
Double Taxation
Earnings taxed at corporate level and dividends taxed at shareholder level
Effective tax on dividends = 51.25%
Dividend Imputation
Earnings taxed at corporate level and tax credit at shareholder level
Effective tax on dividends = 25%
Split-Rate System
Earnings distributed are taxed at a lower rate than retained earnings
Effective tax on dividends = 46%
LOS: Calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double-taxation, split-rate, and tax imputation dividend tax regimes.
Pages 274–276
Tax Systems and Dividend Policy
Double taxation (U.S.)
Earnings are taxed at corporate level; dividends are taxed at shareholder level.
Effective tax on dividends = ($35 + $16.25)  $100 = 51.25%
Formula for 100% of earnings in dividends: Tax rate = tcorporate+ tshareholder – (tcorporate × tshareholder) = 35% + 25% – 8.75% = 51.25%
Dividend imputation (Australia, New Zealand, United Kingdom, France)
Earnings are taxed at corporate level; tax credit at shareholder level.
Effective tax on dividends = ($30 + – $5)  $100 = 25%
Tax calculated by shareholder = ($100 × 0.25) = $25 | Applying what the corporation paid = $25 – $30 = $5 refund
Split-rate system
Earnings distributed are taxed at a lower rate than retained earnings.
Effective tax on dividends = ($28 + $18)  $100 = 46%
Formula, for 100% of earnings in dividends: Tax rate = tcorporate payout + tshareholder – (tcorporate payout × tshareholder) = % – 7% = 46%
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14. 4. Payout Policies
Stable dividend policy: Constant dividend with occasional dividend increases
Increases may represent an adjustment to a target payout ratio.
In theory (John Lintner’s), companies may adjust to the target using an adjustment factor that is less than or equal to 1.0:
Increase in dividends = Increase in earnings × Target payout ratio × Adjustment factor
Common
Constant dividend payout: Constant dividend payout ratio
Uncommon
Residual dividend payout: Pay out earnings remaining after capital expenditures
LOS: Compare stable dividend, target payout, and residual dividend policies and calculate the dividend under each policy.
Pages 279–284
4. Payout Policies
Stable dividend policy: Constant dividend with occasional dividend increases
Increases may represent an adjustment to a target payout ratio.
In theory (John Lintner’s), companies may adjust to the target using an adjustment factor that is less than or equal to 1.0:
Increase in dividends = Increase in earnings × Target payout ratio × Adjustment factor
Common
Note: If the change in earnings is negative, then maintain rather than reduce unless the current earnings are not sustainable.
Constant dividend payout: Constant dividend payout ratio (Dividends  Earnings)
Uncommon because the dividends would have as much variability as earnings
Residual dividend payout: Pay out earnings remaining after capital expenditures
Uncommon because the dividends would be quite volatile
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15. Example: Payout Policies
Consider the financial information for Apple, Inc. (AAPL)
What are dividends for FY2011 and FY2012 if the company followed a stable dividend policy, with a target dividend payout of 10% and an adjustment factor of 0.3?
Fiscal Year Ending
9/29/2012
9/24/2011
9/25/2010
Net income (millions)
$41,773
$25,922
$14,014
Fiscal Year Ending
9/29/2012
9/24/2011
Increase in earnings
$15,851
$11,900
Multiply by target
0.10
Multiply by adjustment factor
0.30
Dividends
$475.53
$357.24
LOS: Compare stable dividend, target payout, and residual dividend policies and calculate the dividend under each policy.
Pages 279–284
Example: Payout Policies
Consider the financial information for Apple, Inc. (AAPL).
What are dividends for FY2011 and FY2012 if the company followed a stable dividend policy, with a target dividend payout of 10% and an adjustment factor of 0.3?
Key: Multiply the increase in earnings (from the prior year) by the target payout ratio and the adjustment factor.
Note: the higher the adjustment factor, the higher in the dividends for this company if earnings are increasing.
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16. Example: Payout Policies
What are dividends for FY2011 and FY2012 if the company followed a constant dividend payout at 6%?
What are dividends for FY2011 and FY2012 if the company followed the residual payout policy?
Fiscal Year Ending
9/29/2012
9/24/2011
Net income (millions)
$41,773
$25,922
Multiply by 6%
0.06
Dividends
$2,506
$1,555.32
LOS: Compare stable dividend, target payout, and residual dividend policies and calculate the dividend under each policy.
Pages 279–284
Example: Payout Policies
What are dividends for FY2011 and FY2012 if the company followed a constant dividend payout at 6%?
Dividends increase as earnings increase (and fall as earnings fall).
What are the dividends for FY2011 and FY2012 if the company followed the residual payout policy?
Dividend are variable because of earnings variability and the “lumpiness” of capital expenditures.
Actual dividends of Apple, Inc. (Source: Google Finance):
FY 2011: Dividends = $0
FY 2012: Dividends = $2,488 | Dividend payout = 5.96% | DPS = $2.65
Fiscal Year Ending
9/29/2012
9/24/2011
Net income (millions)
$41,773
$25,922
Less: capital expenditures
9,402
7,452
Dividends
$32,371
$18,470
Copyright © 2013 CFA Institute

17. Cash Dividends vs. Repurchasing Stock
Reasons for preferring repurchasing stock over paying a cash dividend
Potential tax advantages
Signaling
Managerial flexibility
Offset dilution from executive stock options
Increase financial leverage
A stock repurchase may be a good alternative to an increase in cash dividends.
LOS: Explain the choice between paying cash dividends and repurchasing shares.
Pages 285–291
Cash Dividends vs. Repurchasing Stock
Reasons for preferring repurchasing stock over paying a cash dividend:
Potential tax advantages
Signaling
Managerial flexibility
Offset dilution from executive stock options
Increase financial leverage
Dubious motive: Increase EPS (dubious because of effect on required rate of return and because free cash flow is not affected)
A stock repurchase may be a good alternative to an increase in cash dividends.
Copyright © 2013 CFA Institute

18. Global Trends in Dividend Payout
Current:
Large, profitable companies tend to have a stable payout policy.
Smaller and/or less profitable companies tend to not be dividend paying.
Trends:
In developed companies, fewer companies pay cash dividends, but more companies are using stock repurchases.
The dividend amounts and payouts have increased for dividend-paying companies, but the proportion of dividend-paying companies has declined.
LOS: Describe global trends in corporate dividend policies.
Pages 291–292
Global Trends in Dividend Payout
Current:
Large, profitable companies tended to have a stable payout policy.
Smaller and/or less profitable companies tend to not be dividend paying.
Trends:
In developed companies, fewer companies pay cash dividends, but more companies are using stock repurchases.
The dividend amounts and payouts have increased for dividend-paying companies, but the proportion of dividend-paying companies has declined
Note: These trends are based on evidence prior to 2009, which may not reflect the effects of the financial crisis.
Copyright © 2013 CFA Institute

19. Dividend Coverage Ratios
Dividend coverage ratio = Net income Dividends
FCFE coverage ratio = Free cash flow to equity Dividends + Share repurchase
A company has $200 million in earnings, pays $40 million in dividends, has cash flow from operations of $180 million, and had capital expenditures of $60 million. The company spent $10 million for share repurchases.
Therefore:
Dividend coverage ratio = $200 $50 = 5 times
FCFE coverage ratio = $180 − $60 $40 + $10 = $220 $50 = 4.4 times
LOS: Calculate and interpret dividend coverage ratios based on (1) net income and (2) free cash flow.
Pages 293–297
Dividend Coverage Ratios
Dividend coverage ratio = Net income Dividends is the inverse of Dividend payout ratio = Dividends Net income
FCFE coverage ratio = Free cash flow to equity Dividends + Share repurchase
A company has $200 million in earnings, pays $40 million in dividends, has cash flow from operations of $180, and had capital expenditures of $60 million. The company spent $10 million for share repurchases.
Therefore:
Dividend coverage ratio = $200 $50 = 5 times
FCFE coverage ratio = $180 − $60 $40 + $10 = $220 $50 = 4.4 times
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20. 5. Analysis of Dividend Safety
We can evaluate the “safety” of the dividend by examining the company’s ability to meet its dividends.
“Safety” pertains to the ability of the company to continue to pay the dividend or maintain a growth pattern.
Possible ratios: Dividend coverage and free cash flow coverage
Using dividends plus repurchases may be more appropriate for some firms.
Values greater than 1.0 indicate ability to meet the dividend and repurchase, although the greater the coverage, the greater the liquidity and ability to pay.
It is sometimes difficult to predict changes in dividend because of “surprises,” such as the financial crisis.
LOS: Identify characteristics of companies that may not be able to sustain their cash dividend.
Pages 293–297
Analysis of Dividend Safety
We can evaluate the “safety” of the dividend by examining the company’s ability to meet its dividends.
“Safety” pertains to the ability of the company to continue to pay the dividend or maintain a growth pattern.
Possible ratios: Dividend coverage and free cash flow coverage
Using dividends plus repurchases may be more appropriate for some firms.
Values greater than 1.0 indicate ability to meet the dividend and repurchase, although the greater the coverage, the greater the liquidity and ability to pay.
It is sometimes difficult to predict changes in dividend because of “surprises,” such as the financial crisis.
Copyright © 2013 CFA Institute

21. 6. Summary
There are three general theories on investor preference for dividends: Dividend policy is irrelevant, the bird-in-hand argument, and the tax explanation.
An argument for dividend irrelevance given perfect markets is that the corporate dividend policy is irrelevant because shareholders can create their preferred cash flow streams by selling any company’s shares.
The clientele effect suggests that different classes of investors have differing preferences for dividend income.
Dividend declarations may provide information to investors regarding the prospects of the company.
The payment of dividends can help reduce the agency conflicts between managers and shareholders, but can worsen conflicts of interest between shareholders and debtholders.
6. Summary
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22. Summary (continued)
Investment opportunities, the volatility expected in future earnings, financial flexibility, taxes, flotation costs, and contractual and legal restrictions affect dividend policies.
Using a stable dividend policy, a company may attempt to align its dividend growth rate to the company’s long-term earnings growth rate.
The stable dividend policy can be represented by a gradual adjustment process in which the expected dividend is equal to last year’s dividend per share, plus any adjustment.
With a constant dividend payout ratio policy, a company applies a target dividend payout ratio to current earnings.
In a residual dividend policy, the amount of the annual dividend is affected by both the earnings and the capital investment spending.
6. Summary
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23. Summary (continued)
Share repurchases usually offer more flexibility than cash dividends by not establishing the expectation that a particular level of cash distribution will be maintained.
Share repurchases can signal that company officials think their shares are undervalued. On the other hand, share repurchases could send a negative signal that the company has few positive NPV opportunities.
The issue of dividend safety deals with the likelihood of the dividend being continued.
Early warning signs of whether a company can sustain its dividend include the level of dividend yield, whether the company borrows to pay the dividend, and the company’s past dividend record.
6. Summary
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