week 8

Slide 1

Introduction

Welcome to Financial Management. In this lesson we will discuss distribution to shareholders: dividends and repurchases.

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Slide 2

Topics

The following topics will be covered in this lesson:

An overview of cash distributions;

Procedures for cash distributions;

Cash distributions and firm value;

Clientele effect;

Information content or signaling hypothesis;

Implications for dividend stability;

Setting the target distribution level: the residual distribution model;

The residual distribution model in practice;

A tale of two cash distributions: dividends versus stock repurchases;

The pros and cons of dividends and repurchases;

Other factors influencing distributions;

Summarizing the distribution policy decision;

Stock splits and stock dividends; and

Dividend reinvestment plans.

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Slide 3

An Overview of Cash Distributions

More often than not the firm’s cash comes from internally generated free cash flow, FCF. Remember, FCF is that amount of cash available for distribution to all investors and funds are available after expenses, taxes, and required investments in operating capital. The level of FCF is determined by the firm’s investment opportunities and its operating plans. During a high growth period, the firm’s FCF may be negative, but as growth slows and assuming it is profitable the FCF will be positive. When this happens there are five ways in which the firm can use FCF:

Pay interest expense;

Pay down its principle on debt;

Pay dividends;

Repurchase stock; or

Buy non-operating assets.

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Slide 4

Procedures for Cash Distributions

Usually dividends are paid quarterly and are distributed in the form of cash dividends or stock repurchases. When the firm distributes cash to its stockholders it follows a certain procedure. First, the declaration date is a date on which the firm announces the amount of the dividend and the date on which the dividend will be paid. The holder of record date is the date on which the firm prepares the stockholder list.

The security industry has set up a convention under which the right to the dividend remains with the stock until two business days prior to the holder of record date. The date when the right to the dividend leaves a stock is called the ex-dividend date. The payment date is a date on which the dividend is paid to the holders of record. A stock repurchase is one in which the firm buys back some of its outstanding shares. When the firm repurchases its stock it does so for one of three reasons.

First, the firm may issue more debt and use the proceeds to repurchase the stock.

Second, it may sell shares to its employees in the form of stock options.

Last, the firm may have excess cash.

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Slide 5

Cash Distributions and Firm Value

Does an optimal distribution policy that maximizes the firm’s intrinsic value exist?

The answer is that it depends, in part on investors’ preferences for dividend yield versus capital gains. The combination of dividend yield and capital gains is determined by the target distribution ratio which is the percentage of net income distributed to shareholders and the target payout ratio which is the percentage of net income paid as cash dividends. There are three theories that address investor preferences for dividend yield versus capital gains.

The dividend irrelevance theory was developed by Merton Miller and Franco Modigliani, known as MM. Using a number of simplifying assumptions they argued that the value of the firm depends solely on the income produced by its assets and not how its income is divided between dividends and retained earnings. Therefore dividend policy is irrelevant and cannot affect the stock’s value, risk, or the required rate of return on equity, R sub S.

In contrast, Myron Gordon and John Lintner proposed that as dividends increase a stock’s risk declines. Hence, a return in the form of dividends is certain but a return in the form of capital gains is risky. Therefore, investors prefer dividends and are willing to accept a lower required rate of return on equity. This theory is called the-bird-in-the-hand theory.

The tax effect theory says that capital gains are preferred to dividends for two reasons.

First, because of the time value of money a dollar of taxes paid in the future results in a lower effective cost than a dollar paid today.

Second, no taxes are paid on capital gains if the stock is held until the shareholder dies. While empirical evidence is mixed with respect to whether the average investor prefers either higher or lower dividend distribution levels there individual investors who prefer different dividend payout policies.

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Slide 6

Clientele Effect

Different groups of investors, or clienteles, of stockholders prefer different dividend payout policies. Stockholders in a low or zero tax bracket such as retired individuals and pension funds, usually prefer cash income and may want the firm to pay out a high percentage of its earnings.

In contrast, stockholders in their peak earning years may prefer reinvestment, since this group has less need for current income. Therefore, investors who need income prefer to own shares in high dividend payout firms and investors with no need for current income preferred to own shares in low dividend paid firms. Empirical evidence suggests there is a clientele effect. MM and others claim that the existence of a clientele effect does not imply that one dividend policy is better than another. However no one has been able to prove that overall firms disregard clientele effects.

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Slide 7

Information Content or Signaling Hypothesis

When MM developed their irrelevancy of dividends theory, they assumed that everyone has the same information about the firm’s future earnings and dividends. Realistically, this is not always true. MM argued that since firms are reluctant to cut an established dividend this implies that firms don’t increase dividends unless they anticipate higher earnings in the future. In this way MM argued that a higher than expected dividend increase is a signal to investors that the firm’s management forecasts good earnings.

On the other hand, a reduction in dividends or a smaller increase than expected signals that future earnings are expected to be poor. MM claimed that investors’ reactions to changes in dividend policy do not necessarily show that investors prefer dividends to retained earnings. Hence, any price change following dividend actions indicates that there is important information or signaling, contained in dividend announcements. On balance there is some information content in dividend announcements because stock prices tend to decrease when dividends are cut and don’t always increase when dividends are increased.

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Slide 8

Implications for Dividend Stability

With respect to stable versus volatile dividends the clientele effect and information content in dividend announcements suggest that maximizing the firm’s stock price requires the firm to maintain a steady dividend policy. In the case where stockholders need income they prefer a stable dividend to one that is unstable. Additionally, if the firm changes its dividend policy to increase funds available for investment this may send the wrong signal to stockholders because stockholders may sell their shares in which case the stock price decreases. Hence, most companies follow a small but steady cash dividend along with stock repurchases.

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Slide 9

Setting the Target Distribution Level: The Residual Distribution Model

The residual distribution model says that the firm’s optimal distribution ratio depends on the firm’s investment opportunities, its target capital structure, and the availability and cost of external funds. Additionally the firm considers the investors preference for dividends versus capital gains. To establish its target distribution ratio the firm follows a process.

First, the firm determines its optimal capital budget. Given the optimal capital budget, it determines the amount of equity needed to finance the budget.

Next, to the extent possible, the firm uses reinvested earnings to satisfy its equity requirements.

Last, provided earnings are greater than that needed to support its optimal capital budget, the firm pays dividends or repurchases its stock.

In this way, distributions are paid out of leftover earnings. If we assume the firm strictly follows the residual dividend policy then distributions equal net income minus the quantity target equity ratio times the total capital budget. But if the firm strictly adheres to the residual distribution policy this results in unstable distributions because investment opportunities and earnings vary from year to year.

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Slide 10

The Residual Distribution Model in Practice

Since a strict adherence to the residual distribution model yields volatile, unstable dividends the firm should use it to help set their long-run target distribution ratio but should not use it to distribute funds in any given year. Instead, the firm should proceed as follows:

First project earnings at investments for about five years;

Use the forecasted information and the target capital structure to determine the average residual model distributions and dollars of dividends during the planning period;

Last, based on the average projected data set a target payout ratio.

Some firms follow a low–regular-dividend–plus extras policy in which they pay a low but regular dividend and supplement it with an extra dividend when profits are high. This ensures that the firm maintains a regular dividend and investors recognize that the extra dividend may not be maintained in the future.

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A Tale of Two Cash Distributions: Dividends versus Stock Repurchases

Regardless of whether the distribution is in the form of cash dividends or stock repurchases the forecasted income statements are the same and so are the liabilities on the forecasted balance sheets. However when the distribution is in the form of dividends the retained earnings account is reduced but when it is in the form of a stock repurchase the treasury stock account in the in the balance sheet is reduced. Let’s look at the impact on the firm’s intrinsic value.

First the firm must determine its expected FCF and its expected return on invested capital or ROIC, its growth in FCF and its growth in sales.

Next the firm calculates its value of operations. Since the distribution choice does not affect the projected FCF it doesn’t matter whether the distribution is in the form of cash or stock repurchase. If the firm distributes the dividend in the form of cash the intrinsic value of equity and the intrinsic stock price drop. In fact the stock price drops by the amount of the dividend per share. If this didn’t happened there would be an opportunity for arbitrage. Despite the drop in the stock price, shareholder wealth remains the same because shareholders own the stock plus the cash dividend.

However, the distribution is in the form of a stock repurchase the intrinsic stock price doesn’t change but the number of shares outstanding does. The number shares repurchased equals n sub prior minus n sub post which equals cash sub rep divided by P sub prior where n sub prior is the number of shares outstanding prior to the repurchase, n sub post is the number shares outstanding after the repurchase, cash sub rep is the amount of cash and used to repurchase shares, and P sub prior is the intrinsic stock price prior to the repurchase. After the repurchase the total value of shares outstanding declines but total shareholder wealth does not because shareholders receive cash in the repurchase.

Therefore, it doesn’t matter whether the firm pays dividends or repurchases stock because the total market value of equity is the same provided we ignore taxes and signals. When stock is repurchased the stock price doesn’t change but the number of shares outstanding is reduced. The share price of the firm that repurchases stock increases faster than an identical firm that pays a cash dividend but the total return to both firms’ shareholders is the same.

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Slide 12

The Pros and Cons of Dividends and Repurchases

The pros and cons of dividends and repurchases can be summarized as follows:

Stock repurchases have an advantage over dividends because of the deferred tax on capital gains;

Signaling effects require that the firm not have volatile dividend payments;

Therefore the firm can set a low regular dividend and use repurchases to distribute excess cash;

Last, repurchases are advantageous when the firm wants to distribute cash from the sale of an asset or shift its capital structure or when it wants to distribute shares in employee stock option plan.

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Slide 13

Other Factors Influencing Distributions

Other factors that impact distributions fall into one of two categories either constraints on dividend payments or the availability of alternative sources of capital.

Constraints on dividend payments occur in the form of bond indentures, preferred stock restrictions, impairment of capital rule, the availability of cash, and the penalty tax on improperly accumulated dividends.

The cost and availability of capital is another factor that affects distributions and the availability of alternate sources of capital. Examples of this influence or the cost of selling new stock, the firm’s ability to substitute debt for equity and the desire on the part of management to maintain control.

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Slide 14

Summarizing The Distribution Policy Decision

Firms make the distribution policy decision jointly with the capital structure and capital budgeting decisions because of asymmetric information. Asymmetric information theory assumes that managers prefer to finance projects first with retained earnings, second with debt and last with common stock because they have better information than investors. Managers are reluctant to issue new common stock. Issuing common stock includes issuance costs and dilutes ownership and investors view this as a negative signal. Changes in the firm’s dividend policy provide signals about how managers feel about the firm’s future prospects. A reduction in the firm’s dividends has a negative effect on its stock price. Managers understand this and set dividends low enough so there is little chance that the dividend will be reduced in the future.

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Slide 15

Stock Splits and Stock Dividends

While there is no empirical evidence to support it, it is believed there is an optimal price range for stocks where optimal means that if the stock price is within this range, the firm’s value is maximized. If the stock price trades at the maximum of the range the firm may declare a stock split where current stockholders are given either some number or fraction of shares for each share owned. For example, a two for one stock split results in doubling the number of shares outstanding, reducing earnings and dividends by one-half and lowering the stock price.

The firm may issue a reverse split in which each shareholder is issued a smaller number of new shares in exchange for a particular number of old shares. Usually the firm issues a reverse a split if it wants to increase its stock price. A stock dividend increases the number of shares outstanding and current shareholders are issued additional stock on a proportional basis. Like a stock split, the total number shares outstanding increases and earnings, dividends, and the stock price decline.

What impact does a stock split or stock dividend have on stock price? Empirical evidence suggests the following: after the firm announces a stock split or stock dividend on average its stock price increases; the price increase is most likely the result of signaling; the firm’s stock price tends to increase after the announcement of a stock split or stock dividend but in the next few months if the firm does not announce an increase in earnings and dividends, its stock price will most likely declined to the earlier price; last since it is more expensive to trade lower-priced stocks than higher-priced stocks, stock splits may decrease the liquidity of the firm’s shares. This suggests that stock splits and stock dividends may be harmful.

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Slide 16

Dividend Reinvestment Plans

Dividend reinvestment plans, or DRIPs, were issued during the nineteen seventies by many large corporations in which stockholders chose to automatically reinvested dividends in the stock of the paying corporation. DRIPs take one of two forms either plans that involves of all the outstanding or old stock or plans that involve newly issued shares. In both plans the stockholder must pay taxes on the amount of dividends. DRIPs enable stockholders to purchase additional shares without brokerage fees.

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Slide 17

Check Your Understanding

Slide 18

Summary

We have now reached the end of this lesson. Let’s review what we’ve covered.

First, we learned that firm’s distributions to its shareholders can be in the form of cash dividends, stock dividends, and stock repurchases. If the firm pays a cash dividend it follows a set procedure before the distribution.

Next, we discussed how when the firm’s distributions are in the form of cash dividends or stock repurchases, the forecasted income statements and the liabilities section of the forecasted balance sheets is the same. However when the distribution is in the form of dividends the retained earnings account is reduced but when it is in the form of a stock repurchase the treasury stock account in the in the balance sheet is reduced.

Then, we identified that there are three theories that address the issue of an optimal dividend policy for the firm. The irrelevancy of dividends theory says that the value of the firm depends only on the income produced by the firm’s assets. The bird-in-the-hand-theory says that dividends are preferred over capital gains because the difference in risk. Last, the tax effect theory says that capital gains are preferred to dividends.

Also, we learned that because of the clientele effect and information content in dividend announcements it is advantageous for the firm to maintain a steady dividend policy. If an investor needs income they prefer a stable dividend to one that is unstable. Additionally, a change in dividend policy may send the wrong signal to stockholders.

Then, we discussed how reduction in dividends or a smaller increase than expected signals that future earnings are expected to be poor. Any price change following dividend actions indicates that there is important information or signaling, contained in dividend announcements.

Next, we discovered that regardless of whether the distribution is in the form of cash dividends or stock repurchases the forecasted income statements are the same and so are the liabilities on the forecasted balance sheets.

Also, we identified four pros and cons of dividends and repurchases.

Next, identified that other factors that impact distributions fall into one of two categories either constraints on dividend payments or the availability of alternative sources of capital. Constraints on dividend payments occur in the form of bond indentures, preferred stock restrictions, impairment of capital rule, the availability of cash, and the penalty tax on improperly accumulated dividends

We also learned that the firm makes the distribution policy decision jointly with the capital structure and capital budgeting decisions because of asymmetric information. Asymmetric information theory assumes that managers prefer to finance projects first with retained earnings, second with debt and last with common stock because they have better information than investors.

We learned about stock splits and stock dividends. A firm declares a stock split if it wants to lower its share price. A stock dividend increases the number of shares outstanding and current shareholders are issued additional stock on a proportional basis. Both stock splits and stock dividends may be harmful to the firm.

Finally, we learned that DRIPs were issued during the nineteen seventies by many large corporations in which stockholders chose to automatically reinvested dividends in the stock of the paying corporation. DRIPs enable stockholders to purchase additional shares without brokerage fees.

This concludes this lesson.