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Copyright 2002 by Harcourt Inc. All rights reserved.

CHAPTER 18Distributions to Shareholders:Dividends and Repurchases

Theories of investor preferencesSignaling effectsResidual model

Dividend reinvestment plansStock dividends and stock splitsStock repurchases

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What is dividend policy?

Its the decision to pay out earningsversus retaining and reinvesting

them. Includes these elements:

1. High or low payout?

2. Stable or irregular dividends?3. How frequent?

4. Do we announce the policy?

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Do investors prefer high or low

payouts? There are three theories:

Dividends are irrelevant: Investors

dont care about payout.

Bird-in-the-hand: Investors prefer ahigh payout.

Tax preference: Investors prefer alow payout, hence growth.

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Dividend Irrelevance Theory

Investors are indifferent betweendividends and retention-generatedcapital gains. If they want cash, they

can sell stock. If they dont want cash,they can use dividends to buy stock.

Modigliani-Millersupport irrelevance.

Theory is based on unrealisticassumptions (no taxes or brokeragecosts), hence may not be true. Needempirical test.

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Bird-in-the-Hand Theory

Investors think dividends are lessrisky than potential future capitalgains, hence they like dividends.

If so, investors would value highpayout firms more highly, i.e., a highpayout would result in a high P0.

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Tax Preference Theory

Retained earnings lead to capitalgains, which are taxed at lowerrates than dividends: 28%maximum vs. up to 39.6%. Capitalgains taxes are also deferred.

This could cause investors toprefer firms with low payouts, i.e.,a high payout results in a low P0.

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Implications of 3 Theories for

Managers

Theory Implication

Irrelevance Any payout OK

Bird-in-the-hand Set high payout

Tax preference Set low payout

But which, if any, is correct???

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Possible Stock Price Effects

Stock Price ($)

Payout50% 100%

40

30

20

10

Bird-in-Hand

Indifference

Tax preference

0

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Possible Cost of Equity Effects

Cost of equity (%)

Payout50% 100%

15

20

10

Tax Preference

Indifference

Bird-in-Hand

0

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Which theory is most correct?

Empirical testing has not been ableto determine which theory, if any, iscorrect.

Thus, managers use judgmentwhen setting policy.

Analysis is used, but it must beapplied with judgment.

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Whats the information content, or

signaling, hypothesis?

Managers hate to cut dividends, sowont raise dividends unless they thinkraise is sustainable. So, investors viewdividend increases as signals ofmanagements view of the future.

Therefore, a stock price increase at timeof a dividend increase could reflecthigher expectations for future EPS, nota desire for dividends.

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Whats the clientele effect?

Different groups of investors, orclienteles, prefer different dividend

policies.Firms past dividend policy determines

its current clientele of investors.

Clientele effects impede changingdividend policy. Taxes & brokeragecosts hurt investors who have toswitch companies.

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Whats the residual dividend model?

Find the retained earnings neededfor the capital budget.

Pay out any leftover earnings (theresidual) as dividends.

This policy minimizes flotation andequity signaling costs, henceminimizes the WACC.

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Using the Residual Model to Calculate

Dividends Paid

Dividends = .Net

incomeTargetequityratio

Totalcapitalbudget[ ]))((

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Of the $800,000 capital budget,0.6($800,000) = $480,000 must be equityto keep at target capital structure.

[0.4($800,000) = $320,000 will be debt.]With $600,000 of net income, the residualis $600,000 - $480,000 = $120,000 =dividends paid.

Payout ratio = $120,000/$600,000 = 0.20 = 20%.

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How would a drop in NI to $400,000

affect the dividend? A rise to$800,000?

NI = $400,000: Need $480,000 ofequity, so should retain the whole$400,000. Dividends = 0.

NI = $800,000: Dividends =$800,000 - $480,000 = $320,000.Payout = $320,000/$800,000 = 40%.

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How would a change in investment

opportunities affect dividend under theresidual policy?

Fewer good investments wouldlead to smaller capital budget,hence to a higher dividend payout.

More good investments would leadto a lower dividend payout.

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Advantages and Disadvantages of the

Residual Dividend Policy

Advantages: Minimizes new stockissues and flotation costs.Disadvantages: Results in variable

dividends, sends conflicting signals,increases risk, and doesnt appeal to

any specific clientele.Conclusion: Consider residual policywhen setting target payout, but dontfollow it rigidly.

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Whats a dividend reinvestment

plan (DRIP)?

Shareholders can automatically

reinvest their dividends in shares ofthe companys common stock. Getmore stock than cash.

There are two types of plans:Open market

New stock

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Open Market Purchase Plan

Dollars to be reinvested are turned

over to trustee, who buys shares onthe open market.

Brokerage costs are reduced by

volume purchases.Convenient, easy way to invest, thus

useful for investors.

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New Stock Plan

Firm issues new stock to DRIPenrollees, keeps money and uses itto buy assets.

No fees are charged, plus sellsstock at discount of 5% from marketprice, which is about equal toflotation costs of underwrittenstock offering.

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Optional investments sometimespossible, up to $150,000 or so.

Firms that need new equity capital use

new stock plans.Firms with no need for new equitycapital use open market purchase

plans.Most NYSE listed companies have aDRIP. Useful for investors.

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Setting Dividend Policy

Forecast capital needs over a planninghorizon, often 5 years.Set a target capital structure.Estimate annual equity needs.Set target payout based on the

residual model.

Generally, some dividend growth rateemerges. Maintain target growth rateif possible, varying capital structuresomewhat if necessary.

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Stock Repurchases

Reasons for repurchases:As an alternative to distributing cash

as dividends.

To dispose of one-time cash from anasset sale.

To make a large capital structurechange.

Repurchases: Buying own stock backfrom stockholders.

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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 thanhigher-taxed dividends.Stockholders may take as a positive signal--

management thinks stock is undervalued.

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Disadvantages of Repurchases

May be viewed as a negative signal(firm has poor investmentopportunities).IRS could impose penalties if

repurchases were primarily to avoidtaxes on dividends.

Selling stockholders may not be wellinformed, hence be treated unfairly.Firm may have to bid up price to

complete purchase, thus paying too

much for its own stock.

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Stock Dividends vs. Stock Splits

Stock dividend: Firm issues new

shares in lieu of paying a cashdividend. If 10%, get 10 shares foreach 100 shares owned.

Stock split: Firm increases thenumber of shares outstanding, say2:1. Sends shareholders moreshares.

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Both stock dividends and stock splits

increase the number of sharesoutstanding, so the pie is divided intosmaller pieces.

Unless the stock dividend or splitconveys information, or is accompaniedby another event like higher dividends,the stock price falls so as to keep each

investors wealth unchanged.But splits/stock dividends may get us toan optimal price range.

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Copyright 2002 by Harcourt Inc All rights reserved

When should a firm consider splitting

its stock?

Theres a widespread belief that theoptimal price range for stocks is $20to $80.

Stock splits can be used to keep theprice in the optimal range.

Stock splits generally occur whenmanagement is confident, so areinterpreted aspositive signals.

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