chap 8 dividends and share repurchases buybacks)

8/3/2019 Chap 8 Dividends and Share Repurchases Buybacks)

1/39


2/39

2

Distributions to shareholders:

Dividends and Share RepurchasesTheories of investor preferences

Signaling effects

Residual model

Dividend reinvestment plans

Stock dividends and stock splits

Stock repurchases


3/39

3

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?


4/39

4

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


5/39

5

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


6/39

6

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?


7/39

7


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


8/39

8


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


9/39

9

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


10/39

10

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


11/39

11

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


12/39

12

Stock Price ($)

DividendPayout50% 100%

40

30

20

10

Bird-in-Hand

Irrelevance

Tax preference

0

Possible Stock Price Effects


13/39

13

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


14/39

14

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


15/39

15

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


16/39

16

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


17/39

17

Dividends = Net

income

Target

equityratio

Total

capitalbudget[ ]))((

Using the Residual Model to Calculate

Dividends Paid


18/39

18

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?


19/39

19

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)


20/39

20

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%


21/39

21

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


22/39

22

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


23/39

23

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


24/39

24

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


25/39

25

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 %


26/39

26

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!


27/39

27

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


28/39

28

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.


29/39

29

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)


30/39

30

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.


31/39

31

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


32/39

32

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


33/39

D i b b k i li f di id d


34/39

34

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

=

===

==

)(

;


35/39

35

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


36/39

36

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


37/39


38/39

38

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


39/39

39

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

chap 8 dividends and share repurchases buybacks)

Documents