1. Distributions to Shareholders: Dividends and Repurchases
Lecture 6
Distributions to Shareholders: Dividends and Repurchases

2. Topics in Chapter Theories of investor preferences Signaling effects
Residual model
Stock repurchases
Stock dividends and stock splits
Dividend reinvestment plans

3. = Free Cash Flow: Distributions to Shareholders Free cash flow (FCF)
Sales revenues −
Operating costs and taxes
Required investments in operating capital −
Free cash flow
(FCF) =
Sources
Uses
Figure 1-6 in FM13.
Interest
payments
(after tax)
Purchase of
short-term
investments
Stock
repurchases
Principal
repayments
Dividends

5. Steps to dividend decision…

6. What is “distribution policy”?
The distribution policy defines:
The level of cash distributions to shareholders
The form of the distribution (dividend vs. stock repurchase)
The stability of the distribution

7. Distributions Patterns Over Time
The percent of total payouts a a percentage of net income has been stable at around 26%-28%.
Dividend payout rates have fallen, stock repurchases have increased.
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.

8. Dividend Yields for Selected Industries
Industry
Div. Yield %
Recreational Products
0.02
Forest Products
0.91
Software
0.32
Household Products
0.62
Food
0.04
Electric Utilities
1.10
Banks
0.21
Tobacco
0.45
Source: Yahoo Industry Data, March 2009

12. Do investors prefer high or low payouts?
There are three dividend theories:
Dividends are irrelevant: Investors don’t care about payout.
Dividend preference, or bird-in-the-hand: Investors prefer a high payout.
Tax effect: Investors prefer a low payout.

13. 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.
Implies payout policy has no effect on stock value or the required return on stock.
Theory is based on unrealistic assumptions (no taxes or brokerage costs).

14. 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 causing managers to have more scrutiny by going to the 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.

15. 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.

23. Which theory is most correct?
Some research suggests that high payout companies have higher required returns on stock, supporting the tax effect hypothesis.
But other research using an international sample shows that in countries with poor investor protection (where agency costs are most severe), high payout companies are valued more highly than low payout companies.
Empirical testing has produced mixed results.

24. 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 due to a change in payout policy.

30. An alternative story… Increasing Div are bad news

33. What’s the “information content,” or “signaling,” 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.
Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

34. Form of Distribution

35. 1. Introduction of distribution form
A dividend is a pro rata distribution to shareholders that is declared by the company’s board of directors and may or may not require approval by shareholders.
A repurchase of stock is a distribution in the form of the company buying back its stock from shareholders.
The board of directors determines the company’s payout policy.
Cash dividends and share repurchases are both methods of distributing cash to shareholders.
The effects on financial ratios and on shareholders’ investment returns are different between these two methods.
These distributions may provide information about the company’s future prospects.
Issuing companies cannot deduct distributions to shareholders for tax purposes.

36. Noncash Distributions
2. Dividends: Forms
Cash Distributions
Regular Cash Dividend
Extra Dividend
Liquidating Dividend
Noncash Distributions
Stock Dividend
Stock Split
Reverse Stock Split

37. Regular cash dividends
A regular cash dividend is a cash dividend paid at regular intervals of time
The regular intervals may be any frequency, but the most common are quarterly, semiannually, or annually.
Tendency of companies is to maintain or increase dividends
Often viewed as signals of management’s assessment of the company’s future (that is, whether the company can maintain the dividend in the future).
Companies prefer not to cut or reduce the dividend.

38. Dividend reinvestment plans
A dividend reinvestment plan (DRP) is a program that permits investors to reinvest cash dividends automatically into the stock of the issuing company.
The shares provided in exchange for the cash dividends may be acquired in the open market by the issuer or may be newly issued shares.
Advantages to the issuer:
Encourage owners with smaller holdings to accumulate shares.
“Raise” new equity capital without flotation costs.
Advantages to the investor:
Cost averaging of share purchases.
Opportunity (in some cases) to buy shares at a discount from market value.
Disadvantages to the investor:
Recordkeeping
Dividends are taxed when “received,” whether reinvested or not.

39. Extra or Special Dividends
An extra dividend (or special dividend) is a dividend that is either paid by a company that does not pay dividends regularly or paid by a company in addition to a regular dividend.
Example: Whole Foods Market announced a $2 special dividend in December This was in addition to its $0.20 per quarter cash dividend.
Motivation: Pay out in strong years without investors expecting an increased dividend.

40. Liquidating dividends
A liquidating dividend is a distribution of cash to shareholders when
Going out of business, or
Selling a portion of the business, or
Paying a dividend when retained earnings are not positive.

41. Stock Dividends
A stock dividend is the distribution of additional shares of stock to shareholders on a pro rata basis.
Also known as a bonus issue of shares.
Generally stated as a percentage of current shares outstanding.
A stock dividend does not change a shareholder’s proportionate ownership, the shareholder does not receive cash, and there are no tax consequences.
Advantages for the issuer:
More shares outstanding and, therefore, potential for more shareholders.
Lowers the stock’s price, which may make it more attractive as an investment.
No economic effect.
Does not affect financial ratios.

42. Stock Dividends in Practice
More prevalent in some countries.
Some companies pay stock dividends on a regular basis; some pay these occasionally.

43. Number of new shares : Number of old shares
Stock Splits
A stock split is a proportionate increase in the number of shares outstanding.
Stated in the following form:
Number of new shares : Number of old shares
So, 2:1 means that for each share held before the split, the shareholder holds two shares after the split.
Stock splits do not affect the dividend yield or the dividend payout ratio.
Accounting: Memorandum entry, no change in accounts.
The announcement is generally viewed as a positive signal.

44. Reverse Stock Splits
A reverse stock split is the proportionate reduction in the number of shares.
A reverse stock split has the opposite effect of the traditional, or forward, stock split:
It reduces the number of shares, with the expectation of increasing the stock price.
A 1:2 reverse stock split results in half the number of shares outstanding after the split.
The goal may be to increase the share price to make it more attractive for institutional investors.
Reverse stock splits are most common for companies in financial distress.
It is not permitted in some countries.

45. 3. Dividends: Payment Chronology|
Declaration Date
Ex-Dividend Date
Holder-of-Record Date
Payment Date
Relationship Based on Trade Cycle ↑
Corporation Issues Dividend Declaration
Established by Markets Based on the Trade Settlement Cycle
Established by Corporation as Date of Ownership of Stock
Established by Corporation as Date the Dividend Is Actually Paid

46. 4. Share Repurchases
A share repurchase is the transaction in which the stock issuer buys back its shares from investors.
Also known as a share buyback.
Once repurchased, the shares become treasury shares (or treasury stock).
Share repurchases are restricted by regulations in some countries.
Motives for repurchasing shares include the following:
Signal that the stock is undervalued.
Flexibility of distributing cash without the expectation of cash dividends.
Tax efficiency when the tax rate on capital gains is less than that of cash dividends.
Offset share increases from executive stock options.

47. Share Repurchase Methods
Buy in the Open Market
Use brokers to buy shares.
Method provides flexibility for the company.
Fixed Price Tender Offer
Specify the number of shares and the share price.
Buy pro rata if oversubscribed.
Dutch Auction Tender Offer
Specify the number of shares and the range of prices.
Shareholders determine the number of shares they will sell back and specify the price within the range.
Direct Negotiation
Negotiate with a specific shareholder.
Method may be used to prevent “activist” shareholder from getting on board.

48. Share repurchase and Earnings Per Share
The Diluting Company is planning a $100 million share repurchase. Its current stock price is $25 per share, and there are 16 million shares outstanding prior to the repurchase. Earnings per share without the repurchase would be $3 per share. What is the earnings per share under each of these two scenarios?
Scenario 1: Use idle cash on hand.
Scenario 2: Borrow funds at after-tax rate of 7%.
Scenario 1:
Net income = $3 × $16 million = $48 million
EPSScenario 1 = $48 million  (16 million – 4 million) = $4 per share
Scenario 2:
Net income = $3 × 16 million – (0.07 × $100 million) = $41 million
EPSScenario 2 = $41 million  (16 million – 4 million) = $3.41 per share

49. Share repurchase and Book value Per Share
When the market price per share is greater than the book value per share (BVPS), the book value per share of equity will decrease with a share repurchase.
Continuing the Diluting Company example and adding the book value per share of $20:
Scenario 1:
Book value = ($20 × 16 million) – $100 million = $220 million
BVPSScenario 1 = $220 million  (16 million – 4 million) = $18.33 per share
Scenario 2:
Book value = ($20 × 16 million) – $100 million – $7 million = $213 million
BVPSScenario 2 = $213 million  (16 million – 4 million) = $17.75 per share

50. Share repurchase vs. Cash Dividends
If…
The tax consequences of dividends and capital gains are the same and
The information content of cash dividends and stock repurchases is the same,
Then the effects of cash dividends and repurchases on shareholder value will be the same.
Both cash dividends and stock repurchases:
Reduce assets by the amount of the dividend or repurchase.
Reduce equity by the amount of the dividend or repurchase.
Provide investors with the same cash flow.

51. 5. Key Information
Share repurchases have a positive effect on share prices.
Dividend initiations have a positive effect on share prices.
Dividend increases have a positive effect on share prices.

52. Key Information
Dividends can take the form of regular or irregular cash payments, stock dividends, or stock splits.
Regular cash dividends represent a commitment to pay cash to stockholders on a quarterly, semiannual, or annual basis.
The key dates for cash dividends, stock dividends, and stock splits are the declaration date, the ex-date, the shareholder-of-record date, and the payment date.
Share repurchases, or buybacks, most often occur in the open market. Alternatively, tender offers occur at a fixed price or at a price range through a Dutch auction.
Share repurchases made with excess cash have the potential to increase earnings per share, whereas share repurchases made with borrowed funds can increase, decrease, or not affect earnings per share, depending on the after-tax borrowing rate.

53. Key Information
A share repurchase is equivalent to the payment of a cash dividend of equal amount in its effect on shareholders’ wealth, all other things being equal.
Announcement of a share repurchase is sometimes accompanied by positive excess returns in the market when the market price is viewed as reflecting management’s view that the stock is undervalued.
Initiation of regular cash dividends can also have a positive impact on share value.

54. Payout Policy : Analysis

55. 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.

56. 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.

57. 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.

58. 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.

59. 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.

60. 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.
Price drop= Dividend × 1 − Marginal tax rate on dividends 1 − Marginal tax rate on capital gains

61. 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

62. 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.

63. 3. Factors Affecting Dividend policy
Investment Opportunities
Expected Volatility of Future Earnings
Financial Flexibility
Tax Considerations
Flotation Costs
Contractual and Legal Restrictions

64. 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.

65. 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

66. 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

67. What’s 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.

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

69. Application of the Residual Distribution Approach: Data for SSC
Capital budget: $112.5 million.
Target capital structure: 20% debt, 80% equity. Want to maintain.
Forecasted net income: $140 million.
Number of shares: 100 million.

70. Application of the Residual Distribution Approach
Number of shares
100
Equity ratio (ws)
80%
Capital budget
$112.5
Net income
$140.0
$90.0
$160.0
Req. equ.: (ws X Cap. Bgt.)
Dist. paid: (NI – Req. equity)
$50.0
$0.0
$70.0
Payout ratio (Dividend/NI)
35.7%
0.0%
43.8%
Dividend per share
$0.50
$0.00
$0.70

71. Investment Opportunities and Residual Dividends
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.

72. Advantages and Disadvantages of the Residual Dividend Policy
Advantages: Minimizes new stock issues and flotation costs.
Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele.
Conclusion: Consider residual policy when setting target payout, but don’t follow it rigidly.

73. The Procedures of a Dividend Payment: An Example
November 11: Board declares a quarterly dividend of $0.50 per share to holders of record as of December 10.
December 7: Dividend goes with stock.
December 8: Ex-dividend date.
December 10: Holder of record date.
December 31: Payment date to holders of record.

74. Stock 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 use when employees exercise stock options.

75. The Procedures of a Repurchase
Firm announces intent to repurchase stock.
Three ways to purchase:
Have broker/trustee purchase on open market over 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.

76. SSC Before a Distribution: Inputs (Millions)
Value of operations
$1,937.50
Short-term investments
$50.00
Debt
$387.50
Number of shares
100.00

77. Intrinsic Value Before Distribution
Vop
$1,937.50
+ ST Inv.
50.00
VTotal
$1,987.50
− Debt
387.50 S
$1,600.00 ÷n
100.00 P
$16.00

78. Intrinsic Value After a $50 Million Dividend Distribution
Before
After Dividend
Vop
$1,937.50
+ ST Inv.
50.00
0.00
VTotal
$1,987.50
− Debt
387.50 S
$1,600.00
$1,550.00 ÷n
100.00 P
$16.00
$15.50
DPS
$0.50

79. Drop in Price with Dividend Distribution
Note that stock price drops by dividend per share in model.
If it didn’t there would be arbitrage opportunity (assuming no taxes).
In real world, stock price drops on average by about 90% of dividend.

80. 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 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.

81. Remaining Number of Shares After Repurchase
# shares repurchased = nPrior − nPost
# shares repurchased =CashRep/PPrior
nPrior − nPost = CashRep/PPrior
nPost = nPrior − (CashRep/PPrior)

82. Remaining Number of Shares After Repurchase
nPost = nPrior − (CashRep/PPrior)
nPost = 100 − ($50/$16)
nPost = 100 − =

83. Intrinsic Value After a $50 Million Repurchase
Before
After Repurchase
Vop
$1,937.50
+ ST Inv.
50.00
0.00
VTotal
$1,987.50
− Debt
387.50 S
$1,600.00
$1,550.00 ÷n
100.00
96.875 P
$16.00
Shares rep.
3.125

84. Key Points
ST investments fall because they are used to repurchase stock.
Stock price is unchanged by actual repurchase.
Value of equity falls from $1,600 to $1,550 because firm no longer owns the ST investments.
Wealth of shareholders remains at $1,600 because shareholders now directly own the $50 that was previously held by firm in ST investments.

85. Advantages of Repurchases
Stockholders can choose to sell or not.
Helps avoid setting a high dividend that cannot be maintained.
Income received is capital gains rather than higher-taxed dividends.
Stockholders may take as a positive signal--management thinks stock is undervalued.

86. Disadvantages of Repurchases
May be viewed as a negative signal (firm has poor investment opportunities).
IRS could impose penalties if repurchases were primarily to avoid taxes on dividends.

87. Setting Dividend Policy
Forecast capital needs over a planning horizon, often 5 years.
Set a target capital structure.
Estimate annual equity needs.
Set target payout based on the residual model.
Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.

88. Stock Dividends vs. Stock Splits
Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for each 100 shares owned.
Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more shares.
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 so as to keep each investor’s wealth unchanged.
But splits/stock dividends may get us to an “optimal price range.”

89. When should a firm consider splitting its stock?
There’s a widespread belief that the optimal price range for stocks is $20 to $80.
Stock splits can be used to keep the price in the optimal range.
Stock splits generally occur when management is confident, so are interpreted as positive signals.

90. What’s a “dividend reinvestment plan (DRIP)”?
Shareholders can automatically reinvest their dividends in shares of the company’s common stock. Get more stock than cash.
There are two types of plans:
Open market
New stock

91. 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

92. 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
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

93. Analyzing Dividend policy
A practical framework for
Analyzing Dividend policy

116. 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.

117. 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.

118. 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

119. 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.

120. 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.

121. 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.

122. 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.