Corporate Financial Strategy

4th edition
Dr Ruth Bender
Chapter 13

Dividends and buy-backs

Corporate Financial Strategy

Dividends and buy-backs: contents

 Learning objectives
 Dividend strategy and the life cycle model
 Some factors that might affect dividend policy
 Signalling effect of a change in dividends
 Reasons for companies to buy back their own shares
 Lintner: target dividend pay-out ratio

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Learning objectives

1. Set out the main arguments in favour of and against companies

paying dividends.
2. Identify different types of dividend policy.
3. Explain why companies might prefer to undertake periodic share
purchases rather than pay dividends.
4. Understand why different types of investor might have a preference for
either dividends or buyouts.

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Dividend strategy and the life cycle model

Cash availability Profit Dividend policy

availability
Launch No spare cash available. All None. Probably Nil dividend pay-out.
cash is needed for investment making losses.
in developing the business.
Growth Cash is needed for May be profitable. Nil dividend pay-out is
development and investment preferable. However,
in growing market share. new shareholders
might prefer a
nominal pay-out.
Maturity The company is now cash Profitable. A medium to high
positive and has fewer dividend pay-out is
opportunities to invest in preferred.
profitable growth.
Decline The company is cash positive, May be profitable; has Full pay-out of
with no reinvestment potential. retained profits. available cash as
dividend, even in
excess of current
profits.

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Some factors that might affect dividend policy

 Tax regime
 To avoid agency issues of holding too much spare cash
 Signalling mechanism to the market

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Signalling effect of a change in dividends
Increase the dividend
Interpretation
level
Good news The company is prospering,
and we can afford to pay out
more of our profits without
damaging our prospects.
Bad news The directors have run out of
ideas for profitable growth.
  Increasing the dividend level
could be seen as a signal of
advancing one stage in the life
cycle.
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Decrease the dividend
 
level
The company has changed its
strategy and the directors see
these very profitable investment
opportunities, which will provide
more shareholder value than will
mere payment of dividends.
Profits and cash flow are falling,
and the company is facing
trouble in the foreseeable future.
Decreasing the dividend level
could be seen as a signal of
moving back one stage in the
life cycle.
Reasons for companies to buy back their own shares

 To increase eps
 To increase management’s percentage holding
 More flexible than paying a dividend
 To buy out weaker shareholders
 To give shareholder a choice of how they get their return
 To offset eps dilution from share option exercise
Apply to buy-backs but not dividends

Apply to buy-backs and to dividends

 To improve management’s business focus by gearing up

 To reduce the cost of capital

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Lintner: target dividend pay-out ratio

Research by Lintner indicated that companies have a target dividend pay-

out ratio, but that they never actually pay that full amount. He suggested
that companies determine their annual dividend based on the following
formula:

DIV1 – DIV0 = a × {(r × eps1) – DIV0}

DIV0 is the dividend paid last year

DIV1 is the dividend to be paid this year
eps1 is the earnings per share this year
r is the target dividend pay-out ratio
a is an adjustment factor.

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