Distributions to

Shareholders: Dividends and

Share Repurchases

ENGRESO | MONTANTE | MORGADO | TUYOR

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 Dividends versus Capital Gains
Target payout ratio— defined as the percentage of net
income to be paid out as cash dividends— should be
based in large part on investors’ preferences for
dividends versus capital gains.

D1
𝑝ෝ =
0
𝑟𝑠 − 𝑔
 “
The optimal dividend policy
must strike the balance
between current dividends
and future growth that
maximizes the stock price.

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 THREE
THEORIES OF
DIVIDEND
POLICY
 Dividend Irrelevance Theory
The theory that a firm’s dividend policy has no effect on either
its value or its cost of capital. Professors Merton Miller and
Franco Modigliani (MM) developed their theory under a stringent set
of assumptions from which they proved that:

“a firm’s value is determined only by its basic

earning power and its business risk.”
Bird-in-the-Hand Theory
Investors prefer a high payout.

Tax Preference Theory

Investors prefer a low payout.
 “
Empirical testing has not
been able to determine
which theory, if any, is
correct. Thus, managers
use judgment when setting
policy.

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Information Content,
or Signaling,
Hypothesis

OTHER
DIVIDEND
POLICY
Clientele Effect
ISSUES

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 Managers hate to cut dividends,
so they won’t raise dividends
unless they think raise is
Information sustainable.
Content, or
Signaling,
Hypothesis Investors view dividend increases
as signals of management’s view
of the future.

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 Different groups of
investors, or clienteles,
prefer different dividend
policies.
Clientele
Firm’s past dividend Effect
policy determines its
current clientele of
investors

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Establishing The Dividend
Policy in Practice

Setting the
Earnings,
Target Payout
Cash Payment
Ratio: The
Flows, and Procedures
Residual
Dividends
Dividend Model

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 Find the ◦ Pay out any
retained leftover
earnings needed earnings (the
The for the capital residual) as
Residual budget. dividends.

Dividend
Model  Target   Total 
   
Dividends  Net Income -  equity    capital 
 ratio   budget
 



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GIVEN:

Capital budget – $800,000 EXAMPLE

Target capital structure –
40% debt, 60% equity
Forecasted net income –
$600,000
ANSWER:
How much of the forecasted net
income should be paid out as Dividend = $600,000 – [0.6($800,000)]
dividends? = $600,000 - $480,000
= $120,000

Calculate dividend payout ratio

$120,000 / $600,000 = 0.20 = 20%

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GIVEN:

Capital budget – $400,000 EXAMPLE

Target capital structure –
40% debt, 60% equity
ANSWER:
Forecasted net income – Dividend = $400,000 – [0.6($800,000)]
$600,000 = $400,000 - $480,000
= $80,000 negative
How much of the forecasted net
Since the dividend results in a negative
income should be paid out as number, the firm must use all of its net
dividends? income to fund its budget, and probably
should issue equity to maintain its target
capital structure.
Calculate dividend payout ratio
$120,000 / $600,000 = 0.20 = 20%

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 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.
Earnings, Cash
Flows, and
Dividends
 Payment
Procedures
 The date on which a firm’s directors
Declaration date issue a statement declaring a dividend.
November 1

If the company lists the stockholder as December 5

Holder-of-record an owner on this date, then the
date stockholder receives the dividend.

Ex-dividend date The date on which the right to the December 3

current dividend no longer accompanies a
stock; it is usually 2 business days
prior to the holder-of-record date.

Payment date The date on which a firm actually mails January 3

dividend checks.
 What’s a “dividend
reinvestment plan (DRIP)”?

Shareholders can automatically reinvest

their dividends in shares of the
company’s common stock. Get more stock
than cash.
 OPEN MARKET
• Dollars to be reinvested are
turned over to trustee, who buys
shares on the open market.
• Brokerage costs are reduced by
volume purchases.
• Convenient, easy way to invest,
thus useful for investors.
NEW STOCK
• Firm issues new stock to DRIP
enrollees (usually at a discount
from the market price), keeps
money and uses it to buy assets.
• Firms that need new equity
capital use new stock plans.
• Firms with no need for new equity
capital use open market purchase
plans.
Summary of Factors
Influencing
Dividend Policy
 Alternative
Investment Effects of
Constraints Sources of
Opportunities Dividend Policy
Capital
Stockholders’ desire
Number of profitable Cost of selling new
Bond indentures for current versus
investment opportunities stock.
future income

Possibility of Ability to The perceived riskiness

Preferred stock
accelerating or delaying substitute debt for of dividends versus
restrictions
projects. equity. capital gains

Impairment of capital The tax advantage of

Control.
rule capital gains

The information content

Availability of cash of dividends
(signaling)

Penalty tax on
improperly accumulated
earnings
STOCK DIVIDENDS
AND STOCK SPLITS
 Stock Splits
An action taken by a firm to increase the number of shares outstanding,
such as doubling the number of shares outstanding by giving each
stockholder two new shares for each one formerly held.

Stock Dividend
A dividend paid in the form of additional shares of stock rather than incash.
 ◦ On average, the price of a company’s stock
rises shortly after it announces a stock
split or dividend.
◦ One reason that stock splits and stock
dividends may lead to higher prices is
that investors often take stock
Effect splits/dividends as signals of higher
future earnings.
on Stock ◦ If a company announces a stock split or
Prices ◦
dividend, its price will tend to rise.
By creating more shares and lowering the
stock price, stock splits may also
increase the stock’s liquidity.
◦ There also is evidence that stock splits
change the mix of shareholders.

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 A transaction in which a
firm buys back shares of its
own stock, thereby decreasing STOCK
shares outstanding, increasing
EPS, and often increasing the REPURCHASES
stock price.

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 ◦ Situations where the firm has cash
available for distribution to its
Three stockholders and it distributes this
cash by repurchasing shares rather than by
principal paying cash dividends,
Situations where the firm concludes that
types of ◦
its capital structure is too heavily
stock weighted with equity and it sells debt and
uses the proceeds to buy back its stock,
repurchases ◦ Situations where the firm has issued
options to employees and it uses open
market repurchases to obtain stock for use
when the options are exercised.

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 Advantages of Repurchases
• A repurchase announcement may be viewed as a positive signal by investor
• The stockholders have a choice when the firm distributes cash by repurchasing
stock—they can sell or not sell.
• Remove a large block of stock that is “overhanging” the
market
• managements may prefer to make distributions as share repurchases rather
than to declare increased cash dividends that cannot be maintained.
• Companies can use the residual model to set a target cash distribution level,
then divide the distribution into a dividend component and a repurchase
component.
• Repurchases can be used to produce large-scale changes in capital structure.
• Companies that use stock options as an important component of employee
compensation can repurchase shares and then reissue those shares when
employees exercise their options.
 Disadvantages of Repurchases
• Stockholders may not be indifferent between dividends and
capital gains.

• The selling stockholders may not be fully aware of all the

implications of a repurchase, or they may not have all the
pertinent information about the corporation’s present and
future activities.

• The corporation may pay too high a price for the repurchased
stock, to the disadvantage of remaining stockholders.
 Once a company becomes profitable, it must decide what to
do with the cash it generates. It may choose to retain cash and
use it to purchase additional operating assets, to repay
outstanding debt, or to acquire other companies. Alternatively,
it may choose to return cash to shareholders. Keep in mind that
every dollar that management chooses to retain is a dollar that
shareholders could have received and invested elsewhere.

Therefore, managers should retain earnings if and only if

they can invest the money within the firm and ear n more than
stockholders can earn outside the firm. Consequently, high-
growth companies with many good projects tend to retain a high
percentage of earnings, whereas mature companies with a great
deal of cash but limited investment opportunities tend to have
generous cash distribution policies.