Distributions to shareholders:

Dividends and share repurchases

14-1
*Profitable companies face 3 important
questions
• 1) How much of its free cash flow should it pass on to
shareholders?

• 2) Should it provide cash dividend or should it repurchase

the stock?
• 1 million

• 3) Should it maintain a stable, consistent payment policy,

or should it let payments vary as conditions change?
14-2
 *Profitable companies face 3
important questions
• Most firms establish a policy that considers their forecasted
cash flows and forecasted expenditures and then they try to
stick to it.

• The policy can be changed but this can cause problems

because such changes inconvenience shareholders, send
unintended signals, and convey the impression of dividend
instability, all of which have negative implications for stock
prices.

14-3
 *Profitable companies face 3
important questions
• Still, economic circumstances do change, and
occasionally such changes require firms to change
their dividend policies.

• Plowing the earnings back into business and

repurchasing the shares will result in capital gain.

14-4
 Dividends versus Capital Gains
• Target Payout Ratio:
• The percentage of net income paid out as cash dividends as
desired by the firm-(keeping in mind the objective is to
maximise shareholder value).

• Hence Target Payout Ratio should be based on investor’s

preferences for dividends versus capital gains.

• NI = Div. + R.E
• Total Return cs = Dividend + Capital Gain/Loss
14-5
 *Dividends versus Capital Gains
Constant Growth Model:
D1
P0 
ks - g
•If the company increases the payout ratio, this raises D1. this
increase in numerator, taken alone, would cause stock price to
rise. However, if D1 is raised, less money will be available for
reinvestment, that will cause growth rate to decline, and that will
tend to lower the stock price.

•Thus any changes in payout will have two opposing effects.

14-6
 Optimal Dividend Policy

• Therefore a firm’s optimal dividend policy must

strike a balance between current dividend and
future growth so as to maximise the stock price.

• Optimal Dividend Policy-The dividend policy that

strikes a balance between current dividends and
future growth and maximises the firm’s stock price.

14-7
Theories of
investor
preferences
14-8
 Do investors prefer high or low
dividend payouts?
• Three theories of dividend policy:
• Dividend irrelevance: Investors do not care about payout.
• Bird-in-the-hand: Investors prefer a high payout.
• Tax preference: Investors prefer a low payout.

• Total Return cs = Dividend + Capital Gain

14-9
Dividend irrelevance theory
(Miller&Modigliani, 1961)

14-10
 Dividend irrelevance theory

• The value of a firms depends only on income

produced by its assets, not how much this income
is split between dividends and retained earnings.

14-11
 Home made dividends

• Sale of some shares of stock to get cash in an

amount similar to that of a cash dividend.

• It means creating personal dividend cash flows

rather than taking what a company has to offer.

14-12
Bird-in-the-hand theory (Gordon
and Lintner, 1964)

• A bird in the hand is better

than two in the bush.

• TRcs = Dividend + Capital Gain

14-13
 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.
• Implication: set a high payout.

14-14
 Bird-in-the-hand theory

• A theory that postulates that investors prefer

dividends from a stock to potential capital gains
because of the inherent uncertainty of the latter.

• investors prefer the certainty of dividend

payments to the possibility of substantially higher
future capital gains.

14-15
 Tax Preference Theory
(Litzenberger and Ramaswamy, 1980)
• This theory claims that investors prefer lower
payout companies for tax reasons.
• three major reasons why investors might prefer
lower payout comapnies.

14-16
 Tax Preference Theory

• Firstly, unlike dividend, long-term capital gains

allow the investor to defer tax payment until they
decide to sell the stock. (taxes are not paid until the
stock is sold).

• Because of time value effects, tax paid immediately

has a higher effective capital cost than the same tax
paid in the future.

14-17
 Tax Preference Theory
• Secondly, long term capital gains are generally taxed at
lower rate (20%). Whereas dividend income can be taxed
up to 38.6%.

• Therefore wealthy investors might prefer that companies

retain the earnings which would lead to increase in stock
price.

• Thus lower taxed capital gains are substituted for higher

taxed dividends.

14-18
 Tax Preference Theory
• Finally, if a stockholder dies, no capital gains tax is
collected at all.

• The beneficiary who receive the stock can use the

stock’s value on the death day as their cost basis and thus
completely escape the capital gains tax.

14-19
 Possible stock price effects
Stock Price ($)
Bird-in-the-Hand
40

30 Irrelevance

20
Tax preference
10

0 50% 100% Payout

14-20
*Which theory is most correct?
• Empirical testing has not been able to determine which
theory, if any, is correct.
• Thus, managers use judgment when setting policy.
• Analysis is used, but it must be applied with judgment.

• Investors preference changes over time.

• Investors would like to know what is the dividend policy of
the firm.

14-21
 *What’s the “information content,” or
“signaling,” hypothesis?

• Dividend increase generally leads to an increase in

price and vice versa.

• 1) This might be interpreted as that investors prefer

dividend to capital gain- supporting BIH.

• 2) However, MM argue that a dividend increase as

a “signal” to investor that the firm’s management
forecast future earnings. 14-22
*What’s the “information content,”
or “signaling,” hypothesis?

• Thus MM argue that investor’s reaction to dividend

announcements do not necessarily show that investors prefer
dividends to retained earnings.

• Rather, the fact that the stock price changes merely indicate
that there is an important information, or signaling, content in
dividend announcement.

14-23
What’s the “information content,” or
“signaling,” hypothesis?
• Managers hate to cut dividends, so they won’t raise
dividends unless they think raise is sustainable.

• So, investors view dividend increases as signals of

management’s view of the future earnings-MM

• Therefore, a stock price increase at time of a dividend

increase could reflect higher expectations for future EPS,
not (necessarily) a desire for dividends-MM

14-24
 What’s the “clientele effect”?
• Different groups of investors, or clienteles, prefer different
dividend policies.
• Retired individual?
• A man in his peak earnings years?

• Firm’s past dividend policy determines its current clientele

of investors.
• Clientele effect slows down the change in dividend policy.
Taxes & brokerage costs hurt investors who have to switch
companies.

14-25
 What’s the “clientele effect”?
• If the firm changes its dividend policy, then stockholder who do
not like the new policy will switch to the other firm and will
(probably) sell his shares to those individuals who do.

• However frequent switching would be inefficient because

• 1) Brokerage Cost
• 2) The likelihood that that the stock holder who is selling his
share will have to pay capital gain tax.
• 3) A possible shortage of investors who like the new firm’s
policy.
• Therefore responsibility comes on the management.
• One clientele is as good as other-one policy is as good as the other.
14-26
 Dividend Stability

•Read from the book

14-27
Setting the target payout ratio:
The Residual Dividend Model

14-28
What is the “Residual Dividend Model”?
• A model in which the dividend paid is set equal to net income
minus the amount of retained earnings necessary to finance
the firm’s optimal capital budget.
• Recall: R.E is cheaper than external equity (new common
stock)
• This encourages firms to retain earnings and thus reduce the
likelihood that the firm will have to issue common stock at a
later date to fund future investment projects.

14-29
• For a given firm the optimal payout ratio is a function of
four factors
• 1)investor’s preferences for dividends vs capital gains
• 2)the firm’s investment opportunities
• 3)its target capital structure
• 4)the availability and cost of external capital

• Residual model

14-30
 A firm using RDM would follow
these four steps
• 1) Determine the optimal capital budget
• 2)Determine the amount of equity required to finance
the optimal capital budget (debt and equity-optimal
capital structure)
• 3)to the extent possible, use retained earnings to supply
the equity required.
• 4) pay dividends only, if more earnings are available
than are needed to support the optimal capital budget.

14-31
 Under RDM
• 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.

• Div=NI-R.E required to help finance new investments

• Div=NI-(Target equity ratio)(Total capital budget)

14-32
 Residual dividend model
 Target   Total 
   
Dividends  Net Income -  equity    capital 
 ratio   budget 
  
• Capital budget = $800,000
• Target capital structure = 40% debt
• Forecasted net income = $600,000
• How much of the forecasted net income should be
paid out as dividends?

14-33
Residual dividend model

14-34
 Residual dividend model:
What if net income drops to $400,000? Rises to
$800,000?
If NI = $400,000 …
Dividends = $400,000 – (0.6)($800,000) = -$80,000.
Since the dividend results in a negative number, the firm
must use all of its net income to fund its budget, and probably
should issue equity to maintain its target capital structure.
Payout = $0 / $400,000 = 0%
If NI = $800,000 …
Dividends = $800,000 – (0.6)($800,000) = $320,000.
Payout = $320,000 / $800,000 = 40%
14-35
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.

14-36
Comments on Residual Dividend Policy

• Advantage – Minimizes new stock issues and flotation

costs.
• Disadvantages – Results in variable dividends (might
declare zero div because inv opp. were good and vice
versa)---- sends conflicting signals, and doesn’t appeal to
any specific clientele.

• Conclusion – Consider residual policy when setting target

payout, but don’t follow it rigidly.

14-37
 Stock Repurchases

• Buying back own stock from stockholders, thereby

decreasing share outstanding, increasing DPS and often
increasing the stock price.
• Reasons for repurchases:
• As an alternative to distributing cash as dividends.
• To make a large capital structure change.

14-38
 Advantages of Repurchases

• Buying back stock means that the company earnings are now
split among fewer shares, meaning higher EPS. Higher earnings
per share should command a higher stock price.

• Helps avoid setting a high dividend that cannot be maintained.

• Stockholders may take as a positive signal--management thinks

stock is undervalued.

14-39
 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.

• If the firm seeks to acquire large amount of its stocks,

(high bid), firm may pay too high price for the
repurchased stock.

14-40
 When and why should a firm consider
splitting its stock?
• The demand for the stock would be limited if the price
of the stock gets too high that it is unaffordable for the
public. (it decreases total market value of the firm)
• There’s a widespread belief that the optimal price
range for stocks is $20 to $80. Stock splits can be
used to keep the price in this optimal range.
• Stock splits generally occur when management is
confident, so are interpreted as positive signals.

14-41
 When a stock splits
• When a stock splits, it can also result in a share price
increase—even though there may be a decrease
immediately after the stock split. This is because small
investors may perceive the stock as being more affordable
and buy the stock. This effectively boosts demand for the
stock and drives up prices.
• Another possible reason is that a stock split provides a
signal to the market that the company's share price has been
increasing; people may assume this growth will continue in
the future. This further lifts demand and prices.

14-42
 Stock dividends vs. Stock splits
• Stock split: Firm increases the number of shares
outstanding, say 2:1. Sends shareholders more shares.

• Stock dividend: Firm issues new shares in lieu of paying

a cash dividend.
• Example: on a 5% stock dividend, a holder of 100 shares
would receive an additional 5 shares(without cost); on a
20% stock dividend, the same holder would receive
• Total # of shares increased, but DPS and P per share will
fall.
• Stock dividends have a tax advantage……… is not taxed
until the investor sells it 

14-43
 Stock dividends vs. Stock splits

• A stock dividend and a stock split both dilute the

stock's price.
• Stock price = firm value/ no. of share outstandings

• Both stock dividends and stock splits increase the

number of shares outstanding “the pie is divided
into smaller pieces”, decrease share price and the
firm value (market cap) does not change
14-44
 Assignment Formulae

• Retained Earnings=NI(1-payout ratio)

• Total Dividend = NI*payout ratio
• DPS=Dividends/Share outstanding
• Dividend Yield=DPS/P
• Payout Ratio=Div/NI
 Target   Total 
   
Dividends  Net Income -  equity    capital 
 ratio   budget 
  

14-45