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Distributions to Shareholders: Dividends and Repurchases


Investor preferences should guide a firm's distribution policy. ... Repurchases: Buying own stock back from stockholders. Reasons for repurchases: ... – PowerPoint PPT presentation

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Title: Distributions to Shareholders: Dividends and Repurchases

  • Distributions to Shareholders Dividends and

Topics in Chapter 17
  • Theories of investor preferences
  • Signaling effects
  • Residual model
  • Stock repurchases
  • Stock dividends and stock splits
  • Dividend reinvestment plans

What is distribution policy?
  • The distribution policy defines
  • The ___________________ of cash distributions to
  • The ___________________ of the distribution
    (dividend vs. stock repurchase)
  • The ___________________ of the distribution

Impact of dividends on stock returns
  • Returns to shareholders are in the form of
    dividends /or capital gains. The level of
    dividends might not affect the total pretax
    return on stock higher dividends result in lower
    capital gains and vice versa. However, dividend
    policy can affect stock price if investors prefer
    a particular policy.

Investor Preferences
  • Investor preferences should guide a firms
    distribution policy. Investors will pay a
    _____________________ price (and accept a
    ________________ return) for the common stock of
    firms whose dividend policies they prefer.

Do investors prefer high or low payouts? There
are three theories
  • Dividends are ___________________ Investors
    dont care about payout.
  • _______________________________ Investors prefer
    a high payout.
  • ____________ preference Investors prefer a low
    payout, hence growth.

Dividend Irrelevance 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.

Bird-in-the-Hand Theory
  • Investors think dividends are less risky than
    potential future capital gains, hence they like
  • If true, investors prefer firms with
    _____________ payouts high payout would result
    in a _____________ stock price.

Tax Preference Theory
  • Low payouts mean higher capital gains. Capital
    gains taxes are deferred.
  • This might cause investors to prefer firms with
    ______________ payouts a high payout would
    result in a ________ stock price.

Implications of 3 Theories for Managers
Which theory is most correct?
  • Empirical testing has not been able to determine
    which theory, if any, is correct.
  • It is likely that some investors prefer high
    dividends, some prefer capital gains, and some
    dont care.

The clientele effect
  • Different investors prefer different dividend
  • Firms past dividend policy determines its
    current clientele of investors.
  • Clientele effects impede changing dividend
    policy. Taxes brokerage costs hurt investors
    who have to switch companies due to a change in
    payout policy.

The signaling hypothesis
  • A dividend increase is viewed as a signal that
    management is optimistic about the firms future.
  • Therefore, a stock price increase at time of a
    dividend increase could reflect higher
    expectations for future EPS, not a desire for

The residual distribution model
  • How much retained earnings are needed for the
  • 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.

Data for residual model
  • Capital budget 800,000.
  • Target capital structure 40 debt, 60 equity.
  • Forecasted net income 600,000.
  • If all distributions are in the form of
    dividends, how much of the 600,000 should we pay
    out as dividends?

  • Of the 800,000 capital budget, 0.6(800,000)
    480,000 will be financed with equity and
    0.4(800,000) 320,000 will be debt.
  • With 600,000 of net income, the residual is
    600,000 - 480,000 120,000 dividends paid.
  • Payout ratio 120,000/600,000
    0.20 20.

Advantages and Disadvantages of the Residual
Dividend Policy
  • Advantages Minimizes new stock issues and
    flotation costs.
  • Disadvantages Dividends __________________ as
    earnings and investment opportunities vary.
  • Conclusion Consider residual policy when
    setting target payout, but dont follow it

Stock Repurchases
  • Repurchases Buying own stock back from
  • Reasons for repurchases
  • Alternative to distributing cash as dividends.
  • To dispose of one-time cash from an
  • To make a large __________________________ change.

Advantages of Repurchases
  • Stockholders can tender or not.
  • Avoids setting a high dividend that cannot be
  • Repurchased stock can be used in takeovers or
    resold to raise cash as needed.
  • Income received is capital gains rather than
    dividends (potential tax advantage).
  • Stockholders may take as a ______________
    signal--management thinks stock is

Setting Dividend Policy
  • Forecast capital needs over a planning horizon,
    often 5 years.
  • Set 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.

Stock Dividends vs. Stock Splits
  • Stock dividend Firm issues new shares in lieu
    of paying a cash dividend. If 10, get 10 shares
    for each 100 shares owned.
  • Stock split Firm increases the number of shares
    outstanding, say 21. Sends shareholders more

  • 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, there will be no change in
    total firm value so stock price falls and each
    investors wealth is unchanged.

When should a firm consider splitting its stock?
  • Theres a widespread belief that the optimal
    price range for stocks is 20 to 80.
  • Stock splits can be used to keep the price in the
    optimal range.
  • Stock splits generally occur when management is
    confident, so are interpreted as positive signals.

Whats a dividend reinvestmentplan (DRIP)?
  • Shareholders can automatically reinvest dividends
    in shares of the companys common stock.
  • There are two types of plans
  • ________________ market
  • ________________ stock

  • Firms that need new equity capital use new stock
  • Firms with no need for new equity capital use
    open market purchase plans.
  • Most NYSE listed companies have a DRIP.
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