1. Distributions to Shareholders: Dividends and Repurchases
CHAPTER 17
Distributions to Shareholders: Dividends and Repurchases

2. Topics in Chapter Overview Theories of investor preferences
Clientele Effect and Signaling Hypothesis
Cash dividends
Residual Distribution Model
Stock repurchases
Stock dividends and stock splits
Dividend reinvestment plans (DRIPS)

3. Distribution Policy Defines:
Level of cash distributions to shareholders
Form of the distribution
Dividend vs. Stock repurchase
Stability of the distribution

4. Good Ways to Use FCF Pay interest expense Pay down principal on debt
Pay dividends
Repurchase stock
Buy non-operating assets such as Treasury bills

5. Uses for FCF FCF = f (Investment opportunities and operating plans)
Debt/Interest payment = f (Capital structure)
Investment in marketable securities = f (Working capital policy)
Remaining FCF should be distributed to shareholders

6. Distribution Patterns Over Time
The percent of total payouts as a percentage of net income has been stable at around 26%-28%
Dividend payout rates 
Stock repurchases 
Now greater than dividends

7. Distribution Patterns Over Time
Smaller percentage of companies now pay dividends
Young companies first make distributions as repurchases
Dividend payouts =more concentrated in a smaller number of large, mature firms

8. Dividend Yields for Selected Industries
Industry
Div. Yield %
Recreational Products
3.30
Forest Products
3.79
Software
1.48
Household Products
1.55
Food
1.16
Electric Utilities
3.48
Banks
4.46
Tobacco
9.88
Source: Yahoo Industry Data, April 2008

9. Investor Preference Theories
Dividend Irrelevance
Investors don’t care about payout
Dividend Preference (Bird-in-the-Hand)
Investors prefer a high payout
Tax Effect
Investors prefer a low payout

10. Dividend Irrelevance Theory
Investors are indifferent between dividends and capital gains
If they want cash, they can sell stock
Else use dividends to buy stock
Miller-Modigliani (1961) support irrelevance
 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)

11. Dividend Preference Theory (Bird-in-the-Hand)
Investors view dividends as less risky than potential future capital gains
High payouts reduce agency costs
Deprive managers of cash to waste
Need to go to external capital markets provides more management monitoring
Investors value high payout firms
Require a lower return

12. Tax Effect Theory Low payouts mean higher capital gains
Capital gains taxes are deferred until realized
Taxed at a lower effective rate than dividends
Investors require a higher pre-tax return resulting in a lower stock price

13. Research Results
Some research  high payout = high required return on stock
Supports tax effect hypothesis
Internationally, countries with poor investor protection (severe agency costs)  high payout = more highly valued
Empirical tests =mixed results

14. The “Clientele Effect”
“Clienteles” = different groups of investors who 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 switch companies due payout policy changes

15. The “Signaling Hypothesis”
Dividend changes = signals of management’s view of the future
Managers hate to cut dividends
Won’t raise dividends unless raise is sustainable
Stock prices fall when dividends cut

16. Cash Distributions = Dividends
Company must have cash to make a cash distribution
Sources of Cash:
FCF = Cash flow available for distribution to investors after expenses, taxes and necessary investments in operating capital.
Recapitalization
Sale of an asset

17. Dividend Payment Procedures
Usually paid quarterly in cash
Increased once a year
Voted on quarterly by the Board of Directors

18. Dividend Payment Dates
Declaration date
Board officially declares dividend
Holder-of-record date
Stock transfer books close
Ex-dividend date
Stock trades without the dividend
2 days prior to holder-of-record date
Payment
Dividend checks mailed

19. Dividend Payment Example
Declaration date = 11/6/09
“The Board of Directors has declared a quarterly dividend of $0.50 per share payable to holders of record on 12/05/09 payable on 1/2/10.”
Dividend goes with stock =12/02/09
Ex-dividend date = 12/03/09
Holder of record date = 12/05/09
Payment date = 01/02/2010

20. Optimal Distribution Ratio
Four Factors:
Investors’ preference for dividends versus capital gains
Firm’s investment opportunities
Target capital structure
Availability and cost of external capital

21. The “Residual Distribution Model”
Determine optimal capital budget
Determine amount of equity needed to fund capital budget given target capital structure
Use retained earnings to meet equity needs to extent possible
Pay dividends or repurchase stock if funds leftover (residual)
Residual policy minimizes flotation and equity signaling costs, and minimizes the WACC

22. Using the Residual Model to Calculate Distributions Paid
(17-1)
Distr. = – X
Net
income
Target
equity
ratio
Total
capital
budget

23. Texas & Western Transport Company
WACC = 10% (if all equity = r/e)
Target capital structure:
40% debt, 60% equity
Forecasted net income: $60 million
If all distributions are in the form of dividends, how much of the $600,000 should we pay out as dividends?

24. Texas and Western Investment Opportunities
A capital budget of $150 million would require the use of all retained earnings plus the issuance of $30 m in new debt.

25. 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.

26. Advantages and Disadvantages of the Residual Dividend Policy
Minimizes new stock issues and flotation costs
Disadvantages:
Results in variable dividends
Sends conflicting signals
Increases risk
Appeals to no specific clientele

27. Residual Model Conclusions
Consider residual model when setting target payout, but don’t follow it rigidly
Consider “low-regular-dividend-plus-extras” policy
Low regular dividend that can be maintained
Specially designated dividends when cash available

28. Stock Repurchases
Repurchases = Buying own stock back from stockholders
Reasons for repurchases:
Alternative to distributing cash as dividends
Dispose of one-time cash from asset sale
Execute large capital structure change

29. Stock Repurchase Procedures
Company buys back its own stock
Repurchased stock = “treasury stock”
Negative value on balance sheet
Reasons to Repurchase stock:
Increase leverage (issue debt/buy stock)
Use shares for options exercise
Firm has excess cash

30. Stock Repurchase Procedures
Open market purchase through broker
Tender offer
Targeted stock repurchase
Purchase block of shares through negotiation with large shareholder

31. Advantages of Repurchases
Stockholders can tender or not
Helps avoid setting a high dividend that cannot be maintained
Repurchased stock can be used in takeovers or resold to raise cash as needed
Income received is capital gains rather than higher-taxed dividends
Stockholders may take as a positive signal--management thinks stock is undervalued

32. 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
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

33. Stock Repurchase Formulas

34. Stock Repurchase Example
Earnings = $400 million
Shares outstanding = 40 million = n0
Payout ratio = 50%
Earnings growth = 5% = g
Return on equity = 10% = rE
Assume no tax effects

35. Stock Repurchase Example If 50% paid as cash dividends (p.609)
D0 = .50 x (400/40) = $5.00
D1 = $5.00 * (1.05) = $5.25
P0 = $5.25 / ( ) = $105.00
P1 = $105 x (1.10) - $5.25 = $110.25
rE = 5% (CGY) + 5% (DY) 10%
S1 = $ x 40 = $4,410 million

36. 50% Dividends

37. Stock Repurchase Example If 50% used to repurchase shares
Earnings (yr 1) = 400 * (1.05) = 420
Repurchase cash = 50% x $420 = $210
P1 = $105 x (1.10) = $115.50
P1(n0 – n) = Cash repurchase
n = number of share remaining
$ x (40 – n) = $210 m
n = shares
S1 = $ x = $4,410 m
(17-3)

38. 50% Stock Repurchase

39. Comparison

40. Stock Repurchase: Key Results
Ignoring tax effects and signaling, the total market value of equity remains the same whether a firm pays cash dividends or repurchases stock
The repurchase does not change the stock price; it does reduce the number of shares outstanding
With fewer shares outstanding, the stock price will rise faster

41. Dividends versus Repurchases
Advantages of Repurchases:
Viewed as a positive signal
Stockholders have choice
Dividends are “sticky” in the short-run
Companies can divid target cash distribution into dividend and repurchase
Can produce large scale changes in capital structure
Repurchase shares for use with incentive stock options

42. Dividends versus Repurchases
Disadvantages of Repurchases:
Cash dividends are dependable but repurchases are not
Selling shareholders may not be fully informed
Firm may pay too much for shares

43. Conclusions Repurchases have a tax advantage
Dividends are more dependable
Volatile dividends lower investor confidence
“Signaling”
Repurchases useful to:
Make capital structure shifts
Distribute cash from one-time events
Obtain shares for employee stock options

44. Constraints Bond indentures Preferred stock restriction
Impairment of capital rule
Dividend payments > Balance sheet retained earnings
Availability of cash
Penalty tax on improperly accumulated earnings

45. Alternative Sources of Capital
Cost of selling new stock
New equity if flotation costs are low
Ability to substitute debt for equity
Control
Management reluctant to sell new stock

46. The Distribution Policy Decision
Decision made jointly with capital structure and capital budgeting decisions
Managers do not want to issue new stock
Dividend changes = signals
Use residual model to set long-term dividend payout target
Set cash dividend low enough to be maintained

47. The Distribution Policy Decision
Steady or increasing dividend stream signals firm’s financial condition is under control
Stable dividends decrease investor uncertainty
Firms with superior investment opportunities should set lower cash dividends and retain earnings

48. Dividend Policy Conclusions
Younger firms with many investment opportunities but low cash flow should retain earnings
Executive survey results:
NOT reducing dividends is more important than initiating a dividend or increasing it
Capital budgeting decisions are more important than distribution decisions
Repurchase shares when shares undervalued

49. Stock Splits and Stock Dividends
Firm increases the number of shares outstanding, say 2:1
Shareholders sent more shares
Stock dividend:
Firm issues new shares in lieu of paying a cash dividend
If 10%, get 10 shares for each 100 shares owned

50. Stock Splits and Stock Dividends
Both increase the number of shares outstanding
Divides pie into smaller pieces
Stock price falls so as to keep each investor’s wealth unchanged
Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends
“Optimal price range”

51. Stock Split Explanations
Signaling
Stock splits generally occur when management is confident
Interpreted as positive signals
“Catering”
Optimal price range = $20 to $80
Stock splits can keep price in optimal range
Attractive to small investors
Google ($577.07) ?
Berkshire-Hathaway A ($122,815) ?

52. Reverse Stock Splits Reduces number of shares outstanding
Drives stock price up
Meet listing requirements
Frequently seen as a negative signal
Can be used to force out small shareholders

53. Stock Splits & Dividends
Stock splits usually follow a price run up to produce a price reduction
Split = positive, value-related signal
Stock dividends used on a regular basis will keep the stock price constrained

54. Effect on Stock Prices
Announcement of stock split or dividend usually results in a price increase
Signaling
If not followed by earnings or dividend increase, price will revert
Split may reduce liquidity

55. Dividend Reinvestment Plan (DRIP)
Shareholders can automatically reinvest dividends in shares of firm’s common stock
Two types of plans:
Open market (“Old Stock”)
New stock
Firms can switch between the plans

56. Open Market Purchase Plan
DRIP funds turned over to trustee, who buys shares on the open market.
Brokerage costs reduced by volume purchases
Used by firms with no need for additional capital
Convenient, easy way to invest

57. New Stock Plan Firm issues new stock to DRIP enrollees
Used by firms needing new capital
No fees charged
Stock sold at discount from market price