CHAPTER 17

Distributions to Shareholders:
Dividends and Repurchases

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)
17-2

Distribution Policy

Defines:
Level of cash distributions to
shareholders
Form of the distribution

Dividend vs. Stock repurchase

Stability of the distribution

17-3

Good Ways to Use FCF

1. Pay interest expense
2. Pay down principal on debt
3. Pay dividends
4. Repurchase stock
5. Buy non-operating assets such as

Treasury bills
17-4

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

17-5

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

17-6

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
17-7

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

17-8

Investor Preference Theories

Dividend Irrelevance

Dividend Preference (Bird-in-theHand)

Investors dont care about payout

Investors prefer a high payout

Tax Effect

Investors prefer a low payout

17-9

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)
17-10

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
17-11

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
17-12

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
17-13

The Clientele Effect

Clienteles = different groups of

investors
who prefer different
dividend policies
Firms 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

17-14

The Signaling
Hypothesis

Dividend changes = signals of

managements view of the
future
Managers hate to cut dividends
Wont raise dividends unless raise
is sustainable

Stock prices fall when dividends

cut
17-15

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
17-16

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

17-17

Dividend Payment Dates

Declaration date

Holder-of-record date

Stock transfer books close

Ex-dividend date

Board officially declares dividend

Stock trades without the dividend

2 days prior to holder-of-record date

Payment

Dividend checks mailed

17-18

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
17-19

Optimal Distribution Ratio

Four Factors:
1. Investors preference for

dividends versus capital gains

2. Firms investment opportunities
3. Target capital structure
4. Availability and cost of external
capital
17-20

The Residual Distribution

Model
Determine optimal capital budget
2. Determine amount of equity needed to
fund capital budget given target capital
structure
3. Use retained earnings to meet equity
needs to extent possible
4. Pay dividends or repurchase stock if funds
leftover (residual)

Residual policy minimizes flotation and

equity signaling costs, and minimizes the
WACC
1.

17-21

Using the Residual Model

to
Calculate Distributions
(17-1)
Paid
Distr. =

Net

income

Target
equity
ratio

Total
X capital
budget

17-22

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?
17-23

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.
17-24

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.

17-25

Advantages and
Disadvantages of the
Residual
Dividend
Policy

Advantages:

Minimizes new stock issues and

flotation costs

Disadvantages:
Results in variable dividends
Sends conflicting signals
Increases risk
Appeals to no specific clientele

17-26

Residual Model
Conclusions

Consider residual model when setting

target payout, but dont follow it rigidly
Consider low-regular-dividend-plusextras policy

Low regular dividend that can be

maintained
Specially designated dividends when cash
available
17-27

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
17-28

Stock Repurchase
Procedures
Company buys back its own stock

Repurchased stock = treasury stock

Negative value on balance sheet

Reasons to Repurchase stock:

1.
2.
3.

Increase leverage (issue debt/buy

stock)
Use shares for options exercise
Firm has excess cash
17-29

Stock Repurchase
Procedures
1. Open market purchase through

broker
2. Tender offer
3. Targeted stock repurchase

Purchase block of shares through

negotiation with large shareholder

17-30

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
17-31

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
17-32

Stock Repurchase
Formulas
VOP Extra Cash
P0
no

(17 - 2)

P(n0 n ) Extra cash

(17 - 3)

VOP
P
n

(17 - 4)

VOP
n
P

(17 - 5)
17-33

Stock Repurchase Example

Earnings = $400 million

Shares outstanding = 40 million = n 0

Payout ratio = 50%

Earnings growth = 5% = g

Return on equity = 10% = rE

Assume no tax effects

17-34

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 / (.10 - .05) = $105.00

P1 = $105 x (1.10) - $5.25 =

$110.25
rE = 5% (CGY) + 5% (DY) 10%

S1 = $110.25 x 40 = $4,410 million

17-35

50% Dividends

17-36

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

$115.50 x (40 n) = $210 m
n = 38.182 shares

(17-3)

S1 = $115.50 x 38.182 = $4,410 m

17-37

50% Stock Repurchase

17-38

Comparison

17-39

Stock Repurchase: Key

Results
1.

2.

3.

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
17-40

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
17-41

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

17-42

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
17-43

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
17-44

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

17-45

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
17-46

The Distribution Policy

Decision

Steady or increasing dividend

stream signals firms financial
condition is under control
Stable dividends decrease investor
uncertainty
Firms with superior investment
opportunities should set lower
cash dividends and retain earnings
17-47

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
17-48

Stock Splits and Stock

Dividends

Stock split:

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
17-49

Stock Splits and Stock

Dividends

Both increase the number of shares

outstanding

Stock price falls so as to keep each

investors wealth unchanged

Divides pie into smaller pieces

Unless the stock dividend or split conveys

information, or is accompanied by another
event like higher dividends

Optimal price range

17-50

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) ?
17-51

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
17-52

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
17-53

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

17-54

Dividend Reinvestment Plan

(DRIP)

Shareholders can automatically

reinvest dividends in shares of firms
common stock
Two types of plans:

Open market (Old Stock)

New stock

Firms can switch between the plans

17-55

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
17-56

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
17-57