LECTURE 9 CHAPTER 18 Distributions to Shareholders

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LECTURE 9 (CHAPTER 18)Distributions to
Shareholders

• Dividend Theories
• Theories based on investors preferences
• Theories based on signaling
• Residual Model
• Stock Repurchase
• DRIPs, stock dividends and stock splits

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Major Types of Distributions to Shareholders

• Regular dividend
• Special dividend
• Stock repurchase

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Major Types of Dividend Changes

• Initiation
• Increase
• Decrease
• Omission

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Important Days for Dividends

• Ex-dividend date
• Record date

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Dividend Theories Based on Investors Preferences

• Irrelevance theory
• Tax preference theory
• Bird-in-the-hand theory

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Dividend Irrelevance Theory

• MM 1961 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.
• Assumptions no market frictions such as taxes,
  brokerage costs and information asymmetry between
  managers and shareholders.

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Tax Preference Theory

• Retained earnings lead to capital gains, which
  have tax advantages than dividends.
• 2003 dividend tax cut
• This could cause investors to prefer firms with
  low payouts, i.e., a high payout results in a low
  P0.

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Bird-in-the-Hand Theory

• Investors think dividends are less risky than
  potential future capital gains, hence they like
  dividends.
• If so, investors would value high payout firms
  more highly, i.e., a high payout would result in
  a high 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
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Possible Stock Price Effects
Stock Price ()
Bird-in-Hand
40
Indifference
30
20
Tax preference
10
Payout
50
100
0
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Possible Cost of Equity Effects
Cost of equity ()
Tax Preference
20
15
Indifference
10
Bird-in-Hand
Payout
50
100
0
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Clientele Effect

• Different groups of investors, or clienteles,
  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 have to switch companies.

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Dividend Theories Based on Signaling

• General fact positive stock market reactions to
  announcements of dividend increase or stock
  repurchases.
• Justifications
• Cash flow signaling theory
• Free cash flow signaling theory
• Welfare reallocation signaling theory

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Cash Flow Signaling Theory

• Dividend increases convey favorable information
  about the current and future cash flows of the
  firms.
• Evidence significant earnings changes and
  analysts forecast revisions following dividend
  changes.
• Strengthened by clientele effect.
• Managers hate to cut dividends, so wont
  raise dividends unless they think raise is
  sustainable.
• Applies to regular dividend increases.

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Free Cash Flow Signaling Theory

• For firms with free cash flow problems,
  distributions to shareholders might reduce
  markets estimate of the amount of cash that will
  wastefully invested.
• Evidence firms with lower Q (investment
  opportunities) have more significant positive
  market reactions after their dividend increase
  announcements.
• Applies to all types of distributions.

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Welfare Reallocation Signaling Theory

• Distributions to shareholders increase leverage,
  raising default risk of debt since cash available
  for obligation payments drops. They hence signal
  welfare transfers from debtholders to
  equityholders.
• Evidence bonds are twice as likely to be
  downgraded following distributions to
  shareholders.
• Applies to special dividends and stock
  repurchases.

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Conflicts and Evidence for Various Signaling
Theories

• cash flow against free cash flow dividend
  increases (decreases) are associated with
  subsequent significant increases (decreases) in
  capital expenditures over the three years
• free cash flow against cash flow positive
  stock market reaction is stronger towards a large
  special dividend or stock repurchase announcement
  than towards a regular dividend increase or a
  small special dividend announcement.

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• welfare reallocation against cash flow and
  free cash flow distributions are associated
  with bond downgrading rather than upgrading.

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Residual Dividend Model

• Weston and Brigham (1979)
• Find the retained earnings needed for the capital
  budget.
• Pay out any leftover earnings (the residual) as
  dividends.
• This policy minimizes flotation and equity
  signaling costs, hence minimizes the WACC.
• Applies when capital is limited.

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Using the Residual Model to Calculate Dividends
Paid
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Data for SSC

• Capital budget 800,000. Given.
• Target capital structure 40 debt, 60 equity.
  Want to maintain.
• Forecasted 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
is 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 of equity, 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 the residual policy?

• 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.

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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.

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Dividend Yields for Selected Industries
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DRIP dividend reinvestment plan

• Shareholders can automatically reinvest their
  dividends in shares of the companys common
  stock. Get more stock than cash.
• There are two types of plans
• Open market
• New stock

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Stock Repurchases

• As compared to dividends, stock repurchases are
  associated with
• non-recurring accumulations of funds such
• as from an asset sale
• tax advantage
• stock undervaluation
• anti-takeover (sometimes, but costly).

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Other Advantages of Repurchases

• Stockholders can tender or not.
• Helps change capital structure to
• (1) avoid setting a high dividend that cannot
  be maintained.
• (2) counter dilution effect of stock options.
• 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
  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.

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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
  shares.

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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. One opinion
stock dividends are just small stock splits.
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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.

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Are Stock Dividends Just Stock Splits?

• Stock Splits executed by firms that have enjoyed
  an unusual growth in earnings and stock prices,
  and the main objective of split appears to be
  returning the stock price to an optimal range.
• Stock dividends executed by firms with markedly
  different characteristics.