CHAPTER 17Distributions to Shareholders: Dividends and Repurchases

Topics in ChapterOverviewTheories of investor preferencesClientele Effect and Signaling HypothesisCash dividendsResidual Distribution ModelStock repurchasesStock dividends and stock splitsDividend reinvestment plans (DRIPS)

Distribution PolicyDefines:Level of cash distributions to shareholdersForm of the distribution Dividend vs. Stock repurchaseStability of the distribution

Good Ways to Use FCFPay interest expensePay down principal on debtPay dividendsRepurchase stockBuy non-operating assets such as Treasury bills

Uses for FCFFCF = 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

Distribution Patterns Over TimeThe 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

Distribution Patterns Over TimeSmaller percentage of companies now pay dividendsYoung companies first make distributions as repurchasesDividend payouts =more concentrated in a smaller number of large, mature firms

Dividend Yields for Selected Industries

Investor Preference TheoriesDividend Irrelevance Investors dont care about payoutDividend Preference (Bird-in-the-Hand)Investors prefer a high payoutTax Effect Investors prefer a low payout

Dividend Irrelevance TheoryInvestors are indifferent between dividends and capital gains If they want cash, they can sell stockElse use dividends to buy stockMiller-Modigliani (1961) support irrelevance Payout policy has no effect on stock value or the required return on stockTheory is based on unrealistic assumptions (no taxes or brokerage costs)

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

Tax Effect TheoryLow payouts mean higher capital gainsCapital gains taxes are deferred until realizedTaxed at a lower effective rate than dividendsInvestors require a higher pre-tax return resulting in a lower stock price

Research ResultsSome research high payout = high required return on stockSupports tax effect hypothesisInternationally, countries with poor investor protection (severe agency costs) high payout = more highly valuedEmpirical tests =mixed results

The Clientele EffectClienteles = different groups of investors who prefer different dividend policiesFirms past dividend policy determines its current clientele of investorsClientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who switch companies due payout policy changes

The Signaling HypothesisDividend changes = signals of managements view of the future Managers hate to cut dividendsWont raise dividends unless raise is sustainableStock prices fall when dividends cut

Cash Distributions = DividendsCompany must have cash to make a cash distributionSources of Cash:FCF = Cash flow available for distribution to investors after expenses, taxes and necessary investments in operating capital.RecapitalizationSale of an asset

Dividend Payment ProceduresUsually paid quarterly in cashIncreased once a yearVoted on quarterly by the Board of Directors

Dividend Payment DatesDeclaration dateBoard officially declares dividendHolder-of-record dateStock transfer books closeEx-dividend dateStock trades without the dividend2 days prior to holder-of-record datePaymentDividend checks mailed

Dividend Payment ExampleDeclaration date = 11/6/09The 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 =12/02/09Ex-dividend date = 12/03/09Holder of record date = 12/05/09Payment date = 01/02/2010

Optimal Distribution RatioFour Factors:Investors preference for dividends versus capital gainsFirms investment opportunitiesTarget capital structureAvailability and cost of external capital

The Residual Distribution ModelDetermine optimal capital budgetDetermine amount of equity needed to fund capital budget given target capital structureUse retained earnings to meet equity needs to extent possiblePay dividends or repurchase stock if funds leftover (residual)Residual policy minimizes flotation and equity signaling costs, and minimizes the WACC

Using the Residual Model to Calculate Distributions Paid(17-1)

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

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

Sheet1

Table 17-2

(millions)PoorAverageGood

Capital budget$40$70$150

Net income$60$60$60

Equity required (60%)$24.0$42.0$90.0

Distributions paid (NI-Required equity)$36.0$18.0($30.0)

Distribution ratio60%30%-50%

Sheet2

Sheet3

Investment Opportunities and Residual DividendsFewer good investments would lead to smaller capital budget, hence to a higher dividend payout.More good investments would lead to a lower dividend payout.

Advantages and Disadvantages of the Residual Dividend PolicyAdvantages: Minimizes new stock issues and flotation costsDisadvantages: Results in variable dividendsSends conflicting signalsIncreases riskAppeals to no specific clientele

Residual Model ConclusionsConsider residual model when setting target payout, but dont follow it rigidlyConsider low-regular-dividend-plus-extras policyLow regular dividend that can be maintainedSpecially designated dividends when cash available

Stock RepurchasesRepurchases = Buying own stock back from stockholdersReasons for repurchases:Alternative to distributing cash as dividendsDispose of one-time cash from asset saleExecute large capital structure change

Stock Repurchase ProceduresCompany buys back its own stockRepurchased stock = treasury stockNegative value on balance sheetReasons to Repurchase stock:Increase leverage (issue debt/buy stock)Use shares for options exerciseFirm has excess cash

Stock Repurchase ProceduresOpen market purchase through brokerTender offerTargeted stock repurchasePurchase block of shares through negotiation with large shareholder

Advantages of RepurchasesStockholders can tender or notHelps avoid setting a high dividend that cannot be maintainedRepurchased stock can be used in takeovers or resold to raise cash as neededIncome received is capital gains rather than higher-taxed dividendsStockholders may take as a positive signal--management thinks stock is undervalued

Disadvantages of RepurchasesMay be viewed as a negative signal Firm has poor investment opportunitiesIRS could impose penalties if repurchases were primarily to avoid taxes on dividendsSelling stockholders may not be well informed, hence be treated unfairlyFirm may have to bid up price to complete purchase, thus paying too much for its own stock

Stock Repurchase Formulas

Stock Repurchase ExampleEarnings = $400 millionShares outstanding = 40 million = n0Payout ratio = 50%Earnings growth = 5% = gReturn on equity = 10% = rEAssume no tax effects

Stock Repurchase ExampleIf 50% paid as cash dividends (p.609)D0 = .50 x (400/40) = $5.00D1 = $5.00 * (1.05) = $5.25P0 = $5.25 / (.10 - .05) = $105.00P1 = $105 x (1.10) - $5.25 = $110.25rE = 5% (CGY) + 5% (DY) 10%S1 = $110.25 x 40 = $4,410 million

50% Dividends

Sheet1

50% Dividend Payout50% Stock Repurchase

Year01Year01

Earnings$400.00$420.00Earnings$400.00$420.00

Shares4040Shares4038.1818

Payout %50%50%Repo %50%

g5%5%g5%5%

R(e)10%10%R(e)10%10%

T00T00

Dividend$5.00$5.25Repo Cash$210.00

P(0)$105.00P(0)$105.00

P(1) pre div$115.50P(1) pre div$115.50

P(1) post div$110.25P(1) post repo$115.50

S (Equity)$4,200.00$4,410.00S (Equity)$4,200.00$4,410.00

Sheet2

Sheet3

Stock Repurchase ExampleIf 50% used to repurchase sharesEarnings (yr 1) = 400 * (1.05) = 420Repurchase cash = 50% x $420 = $210P1 = $105 x (1.10) = $115.50P1(n0 n) = Cash repurchasen = number of share remaining$115.50 x (40 n) = $210 mn = 38.182 sharesS1 = $115.50 x 38.182 = $4,410 m

(17-3)

50% Stock Repurchase

Sheet1

50% Dividend Payout50% Stock Repurchase

Year01Year01

Earnings$400.00$420.00Earnings$400.00$420.00

Shares4040Shares4038.1818

Payout %50%50%Repo %50%

g5%5%g5%5%

R(e)10%10%R(e)10%10%

T00T00

Dividend$5.00$5.25Repo Cash$210.00

P(0)$105.00P(0)$105.00

P(1) pre div$115.50P(1) pre div$115.50

P(1) post div$110.25P(1) post repo$115.50

S (Equity)$4,200.00$4,410.00S (Equity)$4,200.00$4,410.00

Sheet2

Sheet3

Comparison

Sheet1

50% Dividend Payout50% Stock Repurchase

Year01Year01

Earnings$400.00$420.00Earnings$400.00$420.00

Shares4040Shares4038.1818

Payout %50%50%Repo %50%

g5%5%g5%5%

R(e)10%10%R(e)10%10%

T00T00

Dividend$5.00$5.25Repo Cash$210.00

P(0)$105.00P(0)$105.00

P(1) pre div$115.50P(1) pre div$115.50

P(1) post div$110.25P(1) post repo$115.50

S (Equity)$4,200.00$4,410.00S (Equity)$4,200.00$4,410.00

Sheet2

Sheet3

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

Dividends versus RepurchasesAdvantages of Repurchases:Viewed as a positive signalStockholders have choiceDividends are sticky in the short-runCompanies can divid target cash distribution into dividend and repurchaseCan produce large scale changes in capital structureRepurchase shares for use with incentive stock options

Dividends versus RepurchasesDisadvantages of Repurchases:Cash dividends are dependable but repurchases are notSelling shareholders may not be fully informedFirm may pay too much for shares

ConclusionsRepurchases have a tax advantageDividends are more dependableVolatile dividends lower investor confidenceSignalingRepurchases useful to:Make capital structure shifts Distribute cash from one-time eventsObtain shares for employee stock options

ConstraintsBond indenturesPreferred stock restrictionImpairment of capital ruleDividend payments > Balance sheet retained earningsAvailability of cashPenalty tax on improperly accumulated earnings

Alternative Sources of CapitalCost of selling new stockNew equity if flotation costs are lowAbility to substitute debt for equityControlManagement reluctant to sell new stock

The Distribution Policy DecisionDecision made jointly with capital structure and capital budgeting decisionsManagers do not want to issue new stockDividend changes = signalsUse residual model to set long-term dividend payout targetSet cash dividend low enough to be maintained

The Distribution Policy DecisionSteady or increasing dividend stream signals firms financial condition is under controlStable dividends decrease investor uncertaintyFirms with superior investment opportunities should set lower cash dividends and retain earnings

Dividend Policy ConclusionsYounger firms with many investment opportunities but low cash flow should retain earningsExecutive survey results: NOT reducing dividends is more important than initiating a dividend or increasing itCapital budgeting decisions are more important than distribution decisionsRepurchase shares when shares undervalued

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

Stock Splits and Stock DividendsBoth increase the number of shares outstandingDivides pie into smaller piecesStock price falls so as to keep each investors wealth unchangedUnless the stock dividend or split conveys information, or is accompanied by another event like higher dividendsOptimal price range

Stock Split ExplanationsSignalingStock splits generally occur when management is confidentInterpreted as positive signalsCateringOptimal price range = $20 to $80Stock splits can keep price in optimal rangeAttractive to small investorsGoogle ($577.07) ?Berkshire-Hathaway A ($122,815) ?

Reverse Stock SplitsReduces number of shares outstandingDrives stock price upMeet listing requirementsFrequently seen as a negative signalCan be used to force out small shareholders

Stock Splits & DividendsStock splits usually follow a price run up to produce a price reductionSplit = positive, value-related signalStock dividends used on a regular basis will keep the stock price constrained

Effect on Stock PricesAnnouncement of stock split or dividend usually results in a price increaseSignalingIf not followed by earnings or dividend increase, price will revertSplit may reduce liquidity

Dividend Reinvestment Plan (DRIP)Shareholders can automatically reinvest dividends in shares of firms common stock Two types of plans:Open market (Old Stock)New stockFirms can switch between the plans

Open Market Purchase PlanDRIP funds turned over to trustee, who buys shares on the open market.Brokerage costs reduced by volume purchasesUsed by firms with no need for additional capitalConvenient, easy way to invest

New Stock PlanFirm issues new stock to DRIP enrolleesUsed by firms needing new capitalNo fees chargedStock sold at discount from market price