1. Chapter 15 Distributions to Shareholders
Investor Preferences on Dividends
Signaling Effects
Residual Dividend Model
Stock Repurchases
Stock Dividends and Stock Splits

2. What is dividend policy?
The decision to pay out earnings versus retaining & reinvesting them
Dividend policy includes
How much of the cash flows should be distributed to shareholders?
Should the distribution be in the form of dividends, or should the cash be passed on to shareholders by buying back stock?
How stable should the distribution be
Companies usually face three important questions:
How much of our free cash flow should we pass on to our shareholders? (b) should we provide this cash to the shareholders using dividends or repurchases? (c) should we maintain a consistent payout policy or should we change it as conditions change?
Mature companies with stable cash flows vs. rapidly growing companies with good investment opportunities
Microsoft, Apple. What did they do?
What about here in Kuwait? Zain for example?
Growth companies evolve into mature cash cows
When making a dividend decision management is asking the following question: will the firm earn more if we kept the cash or will the shareholders earn more if the invest it in similar risk? If the firm earns more it should keep it. If not it should give it back to the shareholders.
Dividend Policy through the lens of P = D/(r – g). The firm should always look to maximize shareholder wealth

3. When managers decide how and when to distribute cash to shareholders, they face a fundamental question:
Could we earn more on the available cash if we kept it in the firm and used it to invest in new projects, or would shareholders earn more if they received the cash and invested it in alternative investments with the same risk?

4. Dividend Irrelevance Theory
This theory states that dividend policy has no effect on either the price of a firm’s stock or its cost of capital.
Investors are indifferent between dividends and retention- generated capital gains.
Investors can create their own dividend policy
If they want cash, they can sell stock.
If they don’t want cash, they can use dividends to buy stock.
Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or transaction costs), hence may not be true. Need an empirical test.
Dividend does not affect P or Cost of Equity
The assumptions are not completely out of whack. There are institutional investors who don’t face taxes and/or minimum transaction costs.

5. Why Investors Might Prefer Dividends
Investors might prefer a sure dividend today to an uncertain future capital gain
If so, investors would value high-payout firms more highly, i.e., a high payout would result in a high P0.
Don’t buy fish in the sea
Dividends reduce the risk of the future capital gain since they are getting some of their required return in the form of dividends which reduces the firm’s Cost of Equity
MM called this “Bird-in-the-Hand Fallacy”. Most investors plan to reinvest their dividends. A firm’s risk at the long run depends on its business and financial risks which basically means the riskiness of the firm’s cash flows and not the firm’s dividend policy

6. Why Investors Might Prefer Capital Gains
May want to avoid transactions costs for investors who prefer reinvesting.
For many investors, taxes on capital gains are lower than taxes on dividends …
Taxes on dividends are due in the year they are received, while taxes on capital gains are due whenever the stock is sold.
If an investor holds a stock until his/her death, beneficiaries can use the date of the death as the cost basis and escape all previously accrued capital gains.
Taxes on capital gains is around 15% to 20%, taxes on dividends depends on your tax bracket (>20%).
Investors will incur transaction costs if they reinvest the dividends

7. When dividends go up stock prices go up too and vice versa…this challenges MM’s point that investor should be indifferent between dividend or repurchase?
MM response:
Firms don’t like to reduce dividends so they only increase dividends when they are sure they can maintain this increase.
This signals to investors that management forecasts good future earnings.
A stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

8. What’s the information content, or signaling, hypothesis?
Investors view dividend increases as signals of management’s view of the future.
Therefore dividends become signals about the future of the firm.
When dividends go up stock prices go up too and vice versa
This finding was a challenge to MM that dividends don’t matter
Why is it a signal? Manager have more information about the future prospects of the firm.

9. 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 and brokerage costs hurt investors who have to switch companies.
Retired people might want to have high dividends as a source of income. On the other hand, others might want hire reinvestment when they are not in need of income since they r in their peak job
Behavioral finance says there is another explanation. Catering theory. Investor’s preferences of dividends vary over time and therefore managers should cater to those changing needs

10. Clientele effects
retired individuals, pension funds, and university endowment funds generally prefer cash income
Such investors are frequently in low or even zero tax brackets, so taxes are of little concern.
Younger stockholders might prefer reinvestment because they have less need for current investment income & simply reinvest dividends
Investors who want current investment income should own shares in high-dividend-payout firms, while investors with no need for current investment income should own shares in low-dividend-payout firms

11. one size does not fit all..
Generally, firms in stable, cash-producing industries such as utilities, food, and tobacco pay relatively high dividends.
Companies in rapidly growing industries such as computer software and biotechnology tend to pay lower dividends.

12. Would it ever be rational for a firm to borrow money in order to pay cash dividends?

13. 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 costs and equity signaling costs, hence minimizes the WACC.
While the vote is still out for whether investors want dividends or capital gains, investors certainly prefer predictable dividends.
How should firms set their payout ratio? Its form? And its stability over time?
Management should always keep in mind that these cash flows are the shareholder’s money and they should utilize them in the best way possible. Management should keep them if they believe they have good investment opportunities. This is important considering that the cost of retained earnings is less expensive than the cost of new equity.
There is no one perfect dividend policy. Some firms have high cash flows but small investment opportunities and vice versa.
The optimal payout policy should be a function of (1) investor’s preference (2) firm’s investment opportunities (3) target capital structure (4) availability and cost of external capital. This is all taken in this model
The model assumes investors have no preference for dividends vs capital gains.

14. Residual Dividend Model
Capital budget ─ $800,000
Target capital structure ─ 40% debt, 60% equity
Forecasted net income ─ $600,000
How much of the forecasted net income should be paid out as dividends?

15. Residual Dividend Model: Calculating Dividends Paid
Calculate portion of capital budget to be funded by equity.
Of the $800,000 capital budget, 0.6($800,000) = $480,000 will be funded with equity.
Calculate excess or need for equity capital.
There will be $600,000 – $480,000 = $120,000 left over to pay as dividends.
Calculate dividend payout ratio.
$120,000/$600,000 = 0.20 = 20%.

16. Residual Dividend Model: What if net income drops to $400,000
Residual Dividend Model: What if net income drops to $400,000? Rises to $800,000?
If NI = $400,000 …
Dividends = $400,000 – (0.6)($800,000) = -$80,000.
Since the dividend results in a negative number, the firm must use all of its net income to fund its budget, and probably should issue new equity to maintain its target capital structure.
Payout = $0/$400,000 = 0%.
If NI = $800,000 …
Dividends = $800,000 – (0.6)($800,000) = $320,000.
Payout = $320,000/$800,000 = 40%.

17. Dividends and investment opportunities

18. How would a change in investment opportunities affect dividends under the residual policy?
Fewer investment opportunities would lead to …?
a smaller capital budget, hence to a higher dividend payout.
More investment opportunities would lead to …?
A larger capital budget, hence to a lower dividend payout.
This model would generate an unstable dividend policy since a firm’s investment opportunities and earnings change over time. Therefore strict adherence to such a model might not be a good idea. However it could help them in setting long-term payout ratios

19. Comments on Residual Dividend Policy
Advantage
Minimizes new stock issues and flotation costs.
Disadvantages
Results in variable dividends
Sends conflicting signals
Increases risk
Doesn't appeal to any specific clientele.
Conclusion – Consider residual policy when setting long-term target payout, but don’t follow it rigidly from year to year.
For firms in cyclical industries they can do a Low-Regular-Dividends-Plus-Extras. This way they set a low dividend they can always pay and when times are good give an extra dividend

20. 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.

23. Low-Regular-DividendPlus-Extras
The policy of announcing a low regular dividend that can be maintained no matter what and then when times are good, paying a designated “extra” dividend.
Because investors recognized that the extras might not be maintained in the future, they did not interpret them as a signal that the companies’ earnings were permanently higher.

24. Payment Procedure
Declaration Date: The date on which a firm’s directors issue a statement declaring a dividend.
Holder-of-Record Date: If the company lists the stockholder as an owner on this date, then the stockholder receives the dividend.
Ex-dividend Date: The date on which the right to the current dividend no longer accompanies a stock; it is usually 2 business days prior to the holder-of-record date
Payment Date.

25. Stock Dividends vs. Stock Splits
Stock dividend: Firm issues new shares instead 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.
Stock dividends: a way to give dividends when not much cash is in the firm. It is also a mechanism to reduce stock price
Give example

26. Stock Dividends vs. Stock Splits
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.”
However this is empirical evidence that shows there r benefits: Increase liquidity. Signal about better prospects since it is harder to increase EPS

27. When and why 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 this optimal range.
Stock splits generally occur when management is confident, so are interpreted as positive signals.
On average, stocks tend to outperform the market in the year following a split.

29. Stock 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.
What do we call the repurchased share?
Stock that is repurchased is called what? What happens to the stock price when a firm repurchases its stock?

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

31. Disadvantages of Repurchases
May be viewed as a negative signal (firm has poor investment opportunities).
Selling stockholders may not be well informed, hence be treated unfairly.
Firm may have to bid up price to complete purchase, thus paying too much for its own stock.

32. Conclusions on Stock Repurchases
Fluctuating dividends are bad. How to deal with changing cash flows and investment opportunities?
Good to make changes in capital structure quickly
1st point: stock repurchases