Corporate Finance

Mr. Ridha ESGHAIER

http://ridhaesghaier.wix.com/finance-tbs

CHAPTER 7
Distributions to Shareholders:
Dividends and Repurchases

Fall 2013

Payout

Repurchases

Mr. Ridha ESGHAIER

Chapter Plan

Theories of investor preferences

Dividend Irrelevance Theory
Bird-in-the-Hand Theory
Tax Preference Theory
Signaling effects
Residual model
Stock repurchases
Stock dividends and stock splits
Dividend reinvestment plans
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Free Cash Flow is generated from operations and is available for

distribution to all investors (debtholders and shareholders).
This chapter focuses on the distributions of FCF to
shareholders in the form of dividends and stock repurchases.

Mr. Ridha ESGHAIER

Mr. Ridha ESGHAIER

Overview of Cash Distributions

We have seen in the previous chapters that a management

main objective is to maximize the companys value that
depends on its ability to generate free cash flow (FCF).
A companys investment opportunities and operating plans
determine its level of FCF. The companys capital structure
policy determines the amount of debt and interest
payments. Working capital policy determines the investment
in marketable securities. The remaining FCF should be
distributed to shareholders.
In this chapter we will focus on the use of these FCFs for
cash distributions to stockholders and will try to answer
the following questions:
(in the next slide) 4

key questions

Can a company increase its value through its choice

of distribution policy, defined as

(1) the level of distributions,

(2) the form of distributions (cash dividends versus stock
repurchases), and
(3) the stability of distributions

Do different groups of shareholders prefer one form

of distribution over the other?
Do shareholders perceive distributions as signals
regarding a firms risk and expected future free cash
flows?
Mr. Ridha ESGHAIER

What is
distribution policy?

The distribution policy defines:

The level of cash distributions to

shareholders
The form of the distribution (dividend vs.
stock repurchase)
The stability of the distribution

Mr. Ridha ESGHAIER

Mr. Ridha ESGHAIER

Cash distribution & Firm Value

A company can change its value of operations
only if it changes the cost of capital or investors
perceptions regarding expected free cash flow.
This is true for all corporate decisions, including
the distribution policy.
Is there an optimal distribution policy that
maximizes a companys intrinsic value?
The answer depends in part on investors
preferences for returns in the form of dividend
yields versus capital gains.

Distribution ratio Versus

Payout ratio

Mr. Ridha ESGHAIER

The relative mix of dividend yields and capital

gains is determined by :

the target distribution ratio, which is the

percentage of net income distributed to
shareholders through cash dividends or stock
repurchases, and
the target payout ratio, which is the
percentage of net income paid as a cash dividend.
Notice that the payout ratio must be less than the
distribution ratio because the distribution ratio
includes stock repurchases as well as cash dividends.

Dividend Yield Versus

Capital Gains Yield

Mr. Ridha ESGHAIER

A high distribution ratio and a high payout ratio mean that

a company pays large dividends and has small (or zero)
stock repurchases. In this situation, the dividend yield is
relatively high and the expected capital gain is low.
If a company has a large distribution ratio but a small
payout ratio, then it pays low dividends but regularly
repurchases stock, resulting in a low dividend yield but a
relatively high expected capital gain yield.
If a company has a low distribution ratio, then it must also
have a relatively low payout ratio, again resulting in a low
dividend yield and, it is hoped, a relatively high capital
gain.
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Do investors prefer
high or low payouts?

DY
CGY

We examine three theories of investor

preferences for dividend yield versus
capital gains:

Dividends are irrelevant: Investors dont care

about payout (dividend).
Bird-in-the-hand (or Dividend Preference
Theory): Investors prefer a high payout.
Tax preference: Investors prefer a low payout,
hence growth (Capital Gains).
Mr. Ridha ESGHAIER

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a. Dividend Irrelevance
Theory

Mr. Ridha ESGHAIER

Modigliani-Miller support irrelevance. They argued that

the value of the firm depends only on the income
produced by its assets, not on how this income is split
between dividends and retained earnings.

Dividend policy does not affect a stocks value or risk.

According to this Theory, Investors are indifferent

between dividends and retention-generated capital
gains. If they want cash, they can sell stock. If they
dont want cash, they can use dividends to buy stock.
This theory is based on unrealistic assumptions (no
taxes or brokerage costs), hence may not be true.

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b. Bird-in-the-Hand
Theory
Investors think dividends are sure things,
then are less risky than potential future
capital gains, hence they like dividends.
A bird in the hand is worth more than two
in the bush
If so, investors would value high payout firms
more highly,
a high payout would result in a high stock
price, P0.
Mr. Ridha ESGHAIER
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c. Tax Preference
Theory
Low payouts mean higher capital gains.
Capital gains taxes are deferred, so have a
lower effective cost than the dividend
taxes (paid sooner)
This could cause investors to prefer firms
with low payouts, and high Capital Gains.
a high payout results in a low stock
price,P0.

Mr. Ridha ESGHAIER

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Implications of the three

Theories for Managers
Theory

Implication

-Irrelevance

Any payout OK

-Bird-in-the-hand

Set high payout

-Tax preference

Set low payout

Mr. Ridha ESGHAIER

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Mr. Ridha ESGHAIER

Which theory is most correct?

Empirical testing has not been able to determine

which theory, if any, is correct.
The evidence from these studies is mixed as to
whether the average investor uniformly prefers either
higher or lower distribution levels, other research
does show that individual investors have strong
preferences. Also, other research shows that
investors prefer stable, predictable dividend payouts.
Thus, managers use judgment when setting policy.
Analysis is used, but it must be applied with
judgment.
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Dividend policy and firms

clientele of investors

Different groups of investors, or clienteles, prefer

different dividend policies.
For example, retired individuals generally prefer
cash income, so they may want the firm to pay
out a high percentage of its earnings. On the
other hand, stockholders who are saving rather
than spending dividends might favor the lowpayout policy.
Firms past dividend policy determines its current
clientele of investors.
Mr. Ridha ESGHAIER

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Whats the clientele effect?

Management should be hesitant to change its

dividend policy, because a change might cause
current shareholders to sell their stock, forcing
the stock price down. Such a price decline
might be temporary but might also be
permanent
Clientele effects impede changing dividend
policy. Taxes & brokerage costs hurt investors
who have to switch companies due to a change
in payout policy.
Mr. Ridha ESGHAIER

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Whats the information content,

or signaling, hypothesis?

Investors view dividend changes as signals

of managements view of the future.
Managers hate to cut dividends, so wont
raise dividends unless they think raise is
sustainable.
Therefore, a stock price increase at time of
a dividend increase could reflect higher
expectations for future EPS, not a desire
for dividends.
Mr. Ridha ESGHAIER
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Whats the residual

distribution model?

Under this model a firm follows theses two

steps when establishing its target
distribution ratio:

Find the reinvested earnings needed for the

capital budget.
Pay out any leftover earnings (the residual) as
either dividends or stock repurchases.

This policy minimizes flotation and equity

signaling costs, hence minimizes the WACC.
Mr. Ridha ESGHAIER

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Using the Residual Model to

Calculate Distributions Paid

Net
Distr. = income

[( )( )]
Target
equity
ratio

Total
capital
budget

Retained Earnings needed to

finance new investments
Mr. Ridha ESGHAIER

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Application1:
Capital budget: $800,000. Given.
Target capital structure: 40% debt,
60% equity. Want to maintain.
Forecasted net income: $600,000.
Q1. If all distributions are in the form of
dividends, how much of the $600,000
should we pay out as dividends?

Mr. Ridha ESGHAIER

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Mr. Ridha ESGHAIER

Solution:

to keep at target capital structure, of the $800,000

capital budget:

60%($800,000) = $480,000 must be equity.

So 40%($800,000) = $320,000 will be debt.

With $600,000 of net income, the residual is:

$600,000 - $480,000 = $120,000 = dividends paid.

Distribution =$600,000 (60%x $800,000) =$120,000

Payout ratio

= Dividends / Net Income

= $120,000/$600,000 = 20%.

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Mr. Ridha ESGHAIER

Q2. How would a drop in NI to $400,000

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

NI = $400,000: Need $480,000 of equity,

so should retain the whole $400,000.
Dividends = 0.
payout =0%
NI = $800,000: Need $480,000 of equity
Dividends = $800,000 - $480,000
= $320,000
Payout = $320,000/$800,000 = 40%.
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Investment Opportunities and

Residual Dividends

Mr. Ridha ESGHAIER

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.

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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,
increases risk, and doesnt appeal to any specific
clientele.

Conclusion: Consider residual policy when

setting target payout, but dont follow it rigidly.
Mr. Ridha ESGHAIER

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Stock Repurchases

Repurchases: Buying own stock back from

stockholders.
Reasons for repurchases:
As an alternative to distributing cash as
dividends.
Want to obtain shares for use in an
employee stock option plan and avoid
issuing new shares.
To make a large capital structure change.
Mr. Ridha ESGHAIER

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Advantages of Repurchases

Stockholders have the choice, they can sell or

not sell, according to their need of cash.
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).
Mr. Ridha ESGHAIER

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Disadvantages of Repurchases

May be viewed as a negative signal (firm has

poor investment opportunities).
Government 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.
Mr. Ridha ESGHAIER

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Setting
Dividend Policy

Forecast capital needs over a planning

horizon, often 5 years.
Set a target capital structure.
Estimate annual equity needs.
Set target payout based on the residual
model.
Generally, some dividend growth rate
emerges. Maintain target growth rate if
possible, varying capital structure somewhat
if necessary.
Mr. Ridha ESGHAIER

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Stock Dividends vs.

Stock Splits

Mr. Ridha ESGHAIER

Stock dividend: Firm issues new shares

instead of paying a cash dividend.
For example on a 10% stock dividend, the
holder of 100 shares would receive an
additional 10 shares (without cost).
Stock split: Firm increases the number of
shares outstanding.
For example doubling the number of shares
outstanding (2-for-1 stock split). The firm
sends shareholders more shares.

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Cont.

Both stock dividends and stock splits increase the

number of shares outstanding,
so the pie is divided into smaller pieces.
Unless the stock dividend or split conveys
information, or is accompanied by another event
like higher dividends, the stock price falls so as to
keep each investors wealth unchanged.
Stock splits and stock dividends may get us to an
optimal price range.
Mr. Ridha ESGHAIER

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When should a firm consider

splitting its stock?
Stock splits occur when the company think
that its stock price is too high which limit the
number of investors who could buy the stock
(reduce demand for the stock) and thus keep
the firms total market value below what it
could be if there were more shares
outstanding, at a lower price.

Mr. Ridha ESGHAIER

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What Effect on Stock Prices?

Theres a widespread belief that the optimal price range for

stocks is $20 to $80. if the stock is within this range, the firms
value will be maximized.
Stock splits can be used to keep the price in the optimal range.
In general, stock splits (as well as stock dividend) generally occur
when management is confident, so are interpreted as positive
signals.
On average, the price of a companys stock rises shortly after it
announces a stock split or a stock dividend (due to positive
signal).
However, if during the next few months it does not announce an
increase in earnings and dividends, then its stock price will drop
back to the earlier level.
Mr. Ridha ESGHAIER

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For any question concerning the course

please visit my web site:
http://ridhaesghaier.wix.com/finance-tbs

No Pain

No Gain
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