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Distributions to shareholders:
Dividends and Share RepurchasesTheories of investor preferences
Signaling effects
Residual model
Dividend reinvestment plans
Stock dividends and stock splits
Stock repurchases
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What is dividend policy?
Its the decision to pay out earnings versusretaining and reinvesting them. Includes
these elements: High or low payout?
Stable or irregular dividends?
How frequent? Do we announce the policy?
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Do investors prefer high or low payouts?
Three theories:
Dividends are irrelevant: Investors dont care
about payout Bird in the hand: Investors prefer a high payout
Tax preference: Investors prefer a low payout,hence growth
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Dividend Irrelevance Theory
Investors are indifferent between dividendsand retention-generated capital gains. If they
want cash, they can sell stock. If they dontwant cash, they can use dividends to buystock
Modigliani-Miller support irrelevance
Theory is based on unrealistic assumptions(no taxes or brokerage costs), hence may notbe true. Need empirical test
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Dividend Irrelevance (Example)
Firms A, B, and C:Net Income 5,000 (in perpetuity);
1,000 shares outstanding
Cost of equity 20%
No individual taxes
New project: investment 5,000; IRR 20%
A plans to pay no dividends and to invest into project;B will pay all income as dividend and will skip theproject, C wants to pay dividends and sell new sharesafterwards to invest into project
You can buy 10 shares right now (cum-dividend).Which firm?
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Dividend Irrelevance (Example)
N old shares= 1000kE = 20%
Firm A Firm B Firm C
EPS (old) 5 5 5
Capital raised 0 0 5,000Dividend 0 5 5
Pcum 30 30 30
New N shares 1,000 1,000 1,250
Pex 30 25 25
Your wealth 300 250+50 250+50
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Dividend Irrelevance (Example)
Calculating new share price for company C:
Vnew= 30,000-5,000+5,000=30,000
Raised X shares: XPnew=5,000 (X+1000) Pnew=30,000
Pnew=25; X=200
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Bird-in-the-Hand Theory
Investors think dividends are less risky thanpotential future capital gains, hence they like
dividends If so, investors would value high payout firms
more highly, i.e., a high payout would result ina high P
0
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Tax Preference Theory
Retained earnings lead to long-term capitalgains, which are taxed at lower rates than
dividends: 20% vs. up to 39.6%. Capitalgains taxes are also deferred.
This could cause investors to prefer firms withlow payouts, i.e., a high payout results in a lowP0
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Theory Implication
Irrelevance Any payout OKBird in the hand Set high payout
Tax preference Set low payout
But which, if any, is correct???
Implications of 3 Theories for Managers
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Stock Price ($)
DividendPayout50% 100%
40
30
20
10
Bird-in-Hand
Irrelevance
Tax preference
0
Possible Stock Price Effects
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Which theory is most correct?
The jury is still there Empirical testing hasnot been able to determine which theory iscorrect
Thus, managers use judgment when settingpolicy
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Whats the information content, or
signaling, hypothesis?Managers hate to cut dividends, so wont raise
dividends unless they think raise issustainable. So, investors view dividendincreases as signals of managements view ofthe future
Therefore, a stock price increase at time of adividend increase could reflect higherexpectations for future EPS, not a desire fordividends
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Whats the clientele effect?
Different groups of investors, or clienteles,prefer different dividend policies
Firms past dividend policy determines itscurrent clientele of investors
Clientele effects impede changing dividend
policy. Taxes & brokerage costs hurt investorswho have to switch companies
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Whats the residual dividend model?
Find the retained earnings needed for thecapital budget
Pay out any leftover earnings (the residual) asdividends
This policy minimizes flotation and equity
signaling costs, hence minimizes the WACC
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Dividends = Net
income
Target
equityratio
Total
capitalbudget[ ]))((
Using the Residual Model to Calculate
Dividends Paid
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Example
Capital budget: 800,000
Target capital structure: 40% debt, 60%
equity. Want to maintainForecasted net income: 600,000
How much of the 600,000 should we pay out
as dividends?
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Of the 800,000 capital budget, 0.6(800,000) =480,000 must be equity to keep at target capital
structure. [0.4(800,000) = 320,000 will be debt.]
With 600,000 of net income, the residual is600,000 480,000 = 120,000 = dividends paid.
Payout ratio = 120,000/600,000= 0.20 = 20%
Example (2)
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Example (3)
How would a drop in NI to 400,000 affect thedividend?
NI = 400,000: Need 480,000
of equity, soshould retain the whole 400,000 (and issue
80,000more). Dividends = 0.
A rise to 800,000 ?
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 would lead to smallercapital budget, hence to a higher dividendpayout
More good investments would lead to a lowerdividend payout
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Setting Dividend Policy
Forecast capital needs over a planning
horizon, often 5 yearsSet a target capital structure
Estimate annual equity needs
Set target payout based on the residual modelGenerally, some dividend growth rate
emerges. Maintain target growth rate if
possible, varying capital structure somewhat ifnecessary
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Example
BT Corporation is reviewing its capital budget for theupcoming year. It has paid a $3.00 dividend per share(DPS) for the past several years, and its shareholders
expect the dividend to remain constant for the nextseveral years. The company's target capital structureis 60 % equity and 40 % debt. It has 1,000,000 sharesof common equity outstanding, and its net income is
$8 million. The company forecasts that it will require$10 million to fund all of its profitable (i.e., positiveNPV) projects for the upcoming year
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Example (2)
DPS 3.00
Target proportion of equity 60%
Target proportion of debt 40%Shares outstanding 1,000,000.00
Net Income 8,000,000.00
Total capital budget 10,000,000.00
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Example (3)
If BT follows the residual dividend model, how much ofNet Income will it need to fund its capital budget?
Reinvested Net Income = Target Equity x Capital Budget
60% x 10 M=6 M
If BT follows the residual dividend model, what will thecompany's dividend per share and payout ratio for thecoming year?
DPS = (NI - Reinvested NI) / Shares outstanding
DPS = (8 M - 6 M)/ 1 M = 2
Payout ratio = Dividend paid / NI = 2 M/8 M= 25 %
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Example (4)
If BT maintains its current 3 DPS for next year, howmuch of N.I. would be available to support the capitalbudget?
N.I. for capital budget = N.I. - DPS Number of shares N.I. for capital budget = 8 M - 31 M = 5 M
Can the company maintain its current capitalstructure, maintain the 3 DPS, and maintain a 10 M capital budget without having to raise new stock?
NO!
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Example (5)
If BT does not want to cut dividend and wants to keepits capital structure and capital budget the same, howmuch debt and equity should it use? (Assume no
impact on WACC) Total capital raised = Capital Budget - N.I. For capital budget
Total capital raised = 10 M - 5 M = 5 M
Equity needed = Capital Budget (D/E)/(1+D/E) = 6 M
Debt needed = Capital Budget/(1+D/E) = 4 M
Equity raised = Equity needed - N.I. for capital budget = 1 M
Debt raised = Debt needed = 4 M
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Advantages and Disadvantages of the
Residual Dividend Policy
Advantages: Minimizes new stock issues
and flotation costs.Disadvantages: Results in variable
dividends, sends conflicting signals, increasesrisk, and doesnt appeal to any specificclientele.
Conclusion: Consider residual policy whensetting target payout, but dont follow it rigidly.
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Industry Payout ratio (%)Banking 38.29Computer Software Services 13.70Drug 38.06Electric Utilities (Eastern U. S.) 67.09
Internet n./a*
Semiconductors 24.91Steel 51.96Tobacco 55.00
Water utilities 67.35
*None of the internet companies included in theValue Line Investment Survey paid a dividend.
Dividend Payout Ratios
for Selected Industries (2000)
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Stock Repurchases
Repurchases: Buying own stock back fromstockholders
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.
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Advantages of Repurchases
Stockholders can tender or not
Helps avoid setting a high dividend that
cannot be maintainedRepurchased stock can be used in take-overs
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 haspoor investment opportunities)
IRS could impose penalties if repurchaseswere primarily to avoid taxes on dividends
Selling 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 ownstock
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Doing buybacks in lieu of dividends(E
new=E
old-C)
Use cash C to buyback shares in all equityfirm in lieu of paying dividend. No otherchanges
oldnew
oldnewnewnewoldnew
newoldoldold
PP
NPNPCEE
PCNPE
=
===
==
)(
;
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Example
P=10; Nold=1 million; C= 10,000. What is thenew price? How many shares will it be able tobuy back?
P=10; = 1,000
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old
cold
old
cold
cold
new
old
cold
new
coldnew
newcoldnew
NDTE
DNDTE
DTEN
N
DTEP
DTEE
DEDTVV
+=
+
=
+=
=
+=+=
1)1(
)1(
Recapitalizing firm
Firm issued debt D to buy back shares. Taxrate Tc
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Stock Dividends and Stock Splits
Stock dividend: Firm issues new shares in lieu ofpaying a cash dividend. If 10%, get 1 share for
each 10 shares owned. Stock split: Firm increases the number of shares
outstanding, say 2:1. Both increase the number of shares outstanding, so
the pie is divided into smaller pieces. Unless the stock dividend or split conveysinformation, or is accompanied by another event likehigher dividends, the stock price falls so as to keepeach investors wealth unchanged.
optimal price range. (?)
When should a firm consider splitting its
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When should a firm consider splitting itsstock in imperfect markets?
Theres a widespread belief that the optimalprice range for stocks is 20 to 80
Stock splits can be used to keep the price inthe optimal range
Stock splits generally occur whenmanagement is confident, so are interpretedas positive signals
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