LCASTOL

CHAPTER 16
DISTRIBUTION TO SHAREHOLDERS
 LCASTOL
LEARNING OBJECTIVES
CH. 16 –Distribution to Shareholders: Dividends & Share Repurchases

Learning Objectives
• Explain why some investors like the firm to pay more
dividends while other investors prefer reinvestment and the
resulting capital gains
• Discuss the various trade-offs that companies face when
trying to establish their optimal dividend policy
• Differentiate between stock splits and stock dividends
• List the advantages and disadvanatges of stock repurchase
vis-à-vis dividends from both investors’ and companies’
perspectives
USES OF NET INCOME

Reinvested
in
operating
Growth/ assets
acquisition

Payment of
debt

Dividends
 DIVIDEND POLICY
Definition
• The decision to pay out earnings versus retaining and reinvesting them.

Dividend policy includes:

• High or low dividend payout?
• Stable or irregular dividends?
• How frequent to pay dividends?
• Announce the policy?

Optimal dividend policy

• The dividend policy that strikes a balance between current dividends and future growth and maximizes the
firms stock price

P0 = D1
rs - g
FACTORS IN DETERMINING DIVIDEND POLICY

01 02
Investor Firm’s
preference for investment
dividends vs opportunities
capital gains

Firm’s target Availability &

capital cost of
structure external
capital

04 03
 DIVIDEND IRRELEVANCE THEORY
• Investors are indifferent between dividends and retention-generated capital gains.
• Investors can create their own dividend policy
– If they want cash, they can sell stock.
– If they don’t want cash, they can use dividends to buy stock.
• Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes
or brokerage costs), hence may not be true. Need an empirical test.
INVESTOR PREFERENCE: DIVIDENDS OR CAPITAL GAINS

DIVIDENDS CAPITAL GAINS

May think dividends are less risky May want to avoid transactions
than potential future capital gains costs

If so, investors would value high- Capital gains tax are due
payout firms more highly, i.e., a whenever the stock is sold.
high payout = high P0

Major shareholders need cash for Capital gains reset when

other investments transferred to beneficiaries.
Avoids taxes
INFORMATION CONTENT OR SIGNALING HYPOTHESIS
Definition
• Investors view dividend changes as signals of management’s earnings forecasts and view of the
future.
• Since managers hate to cut dividends, they won’t raise dividends unless they think the increase is
sustainable
• Cutting dividends might be a negative signal although they will be used for investments
• However, a stock price increase at time of a dividend increase could reflect higher expectations for
future EPS, not a desire for dividends.

CLIENTELE EFFECT
Definition
• Different groups of investors, or clienteles, prefer different dividend policies.
• Firm’s past dividend policy determines its current clientele of investors.
• Clientele effects impede changing dividend policy. Taxes and brokerage costs hurt investors who
have to switch companies.
 CATERING THEORY
Definition
• A theory that suggests that investors’ preference for dividends varies over time and that corporations
adapt their dividend policy to cater to the current desires of investors.
• Corporate managers are more likely to initiate dividends when dividend-paying stocks are in favor.
• Corporate managers are more likely to omit dividends when capital gains are preferred.
• Can be brought about by changes in tax rates
 RESIDUAL DIVIDEND MODEL
Definition
• A residual dividend is a dividend policy used by companies whereby the amount of dividends paid to shareholders
amounts to what profits are left over after the company has paid for its CapEx and working capital costs
• Residual dividend policies are adopted by companies to prioritize capital expenditures over immediate
shareholder dividend payments.
• Companies that maintain a residual dividend policy invest in growth opportunities from profits before paying
shareholders their dividends.
• Management adopts a residual dividend policy to invest in the company’s development, theoretically resulting in
greater long-term growth.

Methodology
• 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 .

Formula
Dividends = Net income – (Target equity ratio x Total capital budget)
 RESIDUAL DIVIDEND MODEL: AN EXAMPLE
Formula
Dividends = Net income – (Target equity ratio x Total capital budget)

Given
• Capital budget ─ P800,000
• Target capital structure ─ 40% debt, 60% equity
• Forecasted net income ─ P600,000
• How much of the forecasted net income should be paid out as dividends?

Calculate portion of capital budget to be funded by equity.

Of the P800,000 capital budget, 0.6(P800,000) = P480,000 will be funded with equity.
Calculate excess or need for equity capital.
There will be P600,000 – P480,000 = P120,000 left over to pay as dividends.
Calculate dividend payout ratio.
P120,000/P600,000 = 0.20 = 20%
 RESIDUAL DIVIDEND MODEL: AN EXAMPLE
What if net income drops to P400,00 or rises to P800,000?
• 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%.
 RESIDUAL DIVIDEND POLICY
How would a change in investment opportunities affect dividends 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

Comments on dividend residual policy

Advantages
• Minimizes new stock issues and flotation costs.
Disadvantages
• Results in variable dividends
• Sends conflicting signals
• Increases risk for investor
• Doesn’t appeal to any specific clientele
Conclusion: Consider residual policy when setting long-term target payout, but don’t follow it
rigidly from year to year.
 POP QUIZ
Portland Plastics Inc. has the following data. If it follows the residual dividend model, what is its
forecasted dividend payout ratio?
 Capital budget $12,500 % Debt 40%
Net income (NI) $11,500
 
a. 25.36%
b. 28.17%
c. 31.30%
d. 34.78%

Answer: D
Capital budget $12,500
Net income (NI) $11,500
% Debt 40%
% Equity = 1.0 – %Debt = 60%
Equity needed to support the capital budget = % Equity × Capital budget $7,500
Dividends paid = NI − Equity needed if positive, otherwise $0.0. $4,000
 
Payout ratio = Dividends paid/NI = 34.78% 
 SETTING DIVIDEND POLICY
EXTERNAL CONSIDERATIONS
GENERAL STATE
OF THE ECONOMY
Uncertainty about future economic
and business conditions may lead to
retention of all or part of the profits in
the company. During the periods of STATE OF CAPITAL
prosperity the management may be 01 MARKETS
more liberal in dividend payment
If the state of capital market is
03 relatively comfortable and raising funds
from different sources, the
management may tempt to declare
TAXES & REGULATIONS high dividends. In case of slump in
Dividend policy is also affected in part capital market, the situation will be
by tax policy of the Government. Tax completely different.
incentives may lead to liberal dividend
policy
02
 SETTING DIVIDEND POLICY
INTERNAL CONSIDERATIONS

NATURE &
MATURITY OF COMPANY

INVESTMENT OPPORTUNITIES & OWNERSHIP & CONTROL

INVESTOR PREFERENCES

RESTRICTIONS IN
ACCESS TO CAPITAL DEBT AGREEMENTS

REPAYMENT OF DEBT
LIQUIDITY OF THE COMPANY
 SETTING DIVIDEND POLICY
05

Estimate annual Set target payout

needs based on the residual
04
model

Forecast capital needs 03

over a planning
horizon (ie. 5 years) Set a target capital
structure
02

Generally, some dividend growth rate

emerges. Maintain target growth rate if
01 possible, varying capital structure
somewhat if necessary.

Determine growth
 POP QUIZ

Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio?
 
a. Its earnings become more stable.
b. Its access to the capital markets increases.
c. Its research and development efforts pay off, and it now has more high-return investment
opportunities.
d. Its accounts receivable decrease due to a change in its credit policy.

Answer: C
 
 DIVIDEND REINVESTMENT PLAN (DRIPs)
Definition
• Shareholders can automatically reinvest their dividends in shares of the
company’s common stock. Get more stock than cash.
• Very useful for some investors

Types
Open market purchase plan

DRIPs
• 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 plan
• 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.
 STOCK DIVIDENDS VS STOCK SPLITS
Stock Dividend Stock Split
Definition Dividend in the form of equity shared Division of equity shares
When there is no cash liquidity with the To reduce the market price of the share
Purpose company
Issued from the free reserves Only increase in the number of shares, no
Issued from change in the book value of issued shares
Additional shares are allotted to existing Already held shares are divided
Shares shareholders
No types • Forward stock split
Type • Reverse stock split

• 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 2:1. Shareholders number of
shares is multiplied by 2
• 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 investor’s wealth unchanged.
 STOCK SPLITS
When and why should a firm consider
splitting its stock?
• 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.
• On average, stocks tend to outperform the
market in the year following a split.

Tesla does a 5-for-1 stock split in August 2020,

splitting the price from $2,213 to $444 per share
 POP QUIZ

Statement 1: A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same
effect on the firm's stock price.
Statement 2: A “reverse split” reduces the number of shares outstanding.
a. Both statements are true
b. Both statements are false
c. Only statement 1 is true
d. Only statement 2 is true

Answer: A
 
 STOCK REPURCHASES
Definition
• A share repurchase (or stock buyback) happens when
a company uses some of its cash to buy shares of its
own stock on the open market from stockholders
over a period of time

Reasons for repurchases

• As an alternative to distributing cash as dividends.
• To make a large capital structure change.
• To obtain stock for use when employee stock options
are exercised
• Boost the price of the stock and improve financials
(ROA, ROE, EPS, etc)
 STOCK REPURCHASES: AN EXAMPLE
Given: Market Value Balance Sheet
• 100,000 shares outstanding
Excess cash 300,000 Debt 300,000
• Price/share = P 10
• EPS = P49,000 / 100,000 = P0.49 Other assets 700,000 Equity 700,000
• P/E Ratio = 10 / 0.49 = 20.4x Total P 1,000,000 Total P 1,000,000

Option 1: Declare P3/share dividend

• 100,000 shares outstanding Market Value Balance Sheet
• Price/share = P 7 Excess cash 0 Debt 300,000
• Shareholder wealth / share = P 7 + 3
Other assets 700,000 Equity 400,000
= P 10
• EPS = P49,000 / 100,000 = P0.49 Total P 700,000 Total P 700,000
• P/E Ratio = 7 / 0.49 = 14.3x
 STOCK REPURCHASES: AN EXAMPLE

Option 2: Repurchase 30,000 shares

at P 10 each Market Value Balance Sheet
• 70,000 shares outstanding Excess cash 0 Debt 300,000
• Price/share = Shareholder
wealth/share = P 10 Other assets 700,000 Equity 400,000
• EPS = P49,000 / 70,000 = P 0.7 Total P 700,000 Total P 700,000
• P/E Ratio = 10 / 0.7 = 14.3x
 STOCK REPURCHASES
Stockholders can tender
or not.
Helps avoid setting a high
dividend that cannot be
maintained
Repurchased stock can
be used in takeovers or
resold to raise cash as
needed.
Remove a large block of
overhanging stock
depressing stock price
Stockholders may take as
a positive signal;
management thinks stock
is undervalued
May be viewed as a
negative signal (firm has
poor investment
opportunities)
Selling stockholders may
not be well informed,
hence be treated unfairly.
Firm may have to bid up
price to complete
PROS CONS purchase, thus paying too
much for its own stock.
IRS could impose penalties
if repurchases were
primarily to avoid taxes on
dividends
 POP QUIZ

Which of the following statements is CORRECT?

 
a. One disadvantage of dividend reinvestment plans is that they increase transactions costs for
investors who want to increase their investment in the company.
b. One advantage of dividend reinvestment plans is that they enable investors to postpone paying
taxes on the dividends credited to their account.
c. Stock repurchases can be used by a firm that wants to increase its debt ratio.
d. One advantage of an open market dividend reinvestment plan is that it provides new equity capital
and increases the shares outstanding.

Answer: C
 
 POP QUIZ

Which of the following statements is NOT CORRECT?

 
a. Stock repurchases can be used by a firm as part of a plan to change its capital structure.
b. After a 3-for-1 stock split, a company's price per share should fall, but the number of shares
outstanding will rise.
c. A company can repurchase stock to distribute a large one-time cash inflow, say from the sale of a
division, to stockholders without having to increase its regular dividend.
d. Stockholders pay no income tax on dividends if the dividends are used to purchase stock through a
dividend reinvestment plan.

Answer: D