CH13 PPT BrighamFM1CE Dividen

PowerPoint Presentation
prepared by
Traven Reed
Canadore College
chapter 13
Distributions to
Shareholders: Dividends
and Repurchases
Corporate Valuation and
Distribution to Shareholders
CH13
Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-3

Topics in Chapter
CH13
• Distribution level and firm value

• Theories of investor preferences
• Signaling effects
• Residual model
• Stock repurchases
• Stock dividends and stock splits
• Dividend reinvestment plans

What is “distribution policy”?
CH13
• The distribution policy defines:

– The level of cash distributions to
shareholders
– The form of the distribution (dividend
vs. stock repurchase)
– The stability of the distribution

Dividend Yields for Selected
Countries
CH13
World Stock Market (Index) Div. Yield %

Egypt 17.0
New Zealand 4.6
Argentina 3.4
Britain (FTSE All Share) 3.1
France 2.7
Canada (S&P/TSX Comp) 2.5
United States (S&P 500) 1.9
Japan 1.4
India (BSE-500) 0.7
Do investors prefer high or low
payouts? There are three theories:
CH13
• Dividends are irrelevant: Investors

don’t care about payout.
• Bird-in-the-hand: Investors prefer a
high payout.
• Tax preference: Investors prefer a
low payout, hence growth.

Dividend Irrelevance Theory
CH13
• Investors are indifferent between

dividends and retention-generated
capital gains. If they want cash, they
can sell stock. If they don’t want cash,
they can use dividends to buy stock.
• Modigliani-Miller support irrelevance.
• Theory is based on unrealistic
assumptions (no taxes or brokerage
costs), hence may not be true. Need
empirical test.
Bird-in-the-Hand Theory
CH13
• 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
stock price.

Tax Preference Theory
CH13
• Low payouts mean higher capital

gains. Capital gains taxes are
deferred.
• This could cause investors to prefer
firms with low payouts, i.e., a high
payout results in a low stock price.

Implications of 3 Theories for
Managers
CH13
Theory Implication
Irrelevance Any payout OK
Bird-in-the-hand Set high payout
Tax preference Set low payout

Impacts on Stock Price and
CH13
Cost of Equity

Empirical Results of the
Dividend Theories
CH13
• Empirical testing has not been able to

determine which theory, if any, is correct.
Thus, managers use judgment when
setting policy.
• The portion of dividend-paying
companies has declined
• Payout ratio remains stable at about
26% to 28%
• Older firms tend to pay cash dividends

“Clientele effect”
CH13
• 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 & brokerage
costs hurt investors who have to switch
companies due to a change in payout
policy.
Information Content, or
Signaling hypothesis?
CH13
• Investors view dividend changes as

signals of management’s view of the
future. Managers hate to cut
dividends, so won’t raise dividends
unless they think raise is sustainable.
• Therefore, a stock price increase at
time of a dividend increase could
reflect higher expectations for future
EPS, not a desire for dividends.
Implications for
CH13
Dividend Stability
• Clientele effect and information content
hypotheses imply that investors prefer
stable dividends
• A stable policy means the regular cash
dividends should grow at a steady,
predictable rate
• Reducing dividends to make funds
available for capital investment could
send incorrect signals to investors

What’s the “residual
distribution model”?
CH13
• Find the reinvested earnings

needed for the capital budget.
• Pay out any leftover earnings (the
residual) as either dividends or
stock repurchases.
• This policy minimizes flotation and
equity signaling costs, hence
minimizes the WACC.
Using the Residual Model to
Calculate Distributions Paid
CH13
[( )( )]
Net Target Total
Distr. = – equity capital .
income
ratio budget
This long-run target distribution ratio

allows firms to meet equity requirements
with retained earnings.

Residual Distribution Model:
Illustration
CH13
• Capital budget: $800,000 (given).

• Target capital structure: 40% debt,
60% equity. Need to be maintained.
• Forecasted net income: $600,000
• If all distributions are in the form of
dividends, how much of the
$600,000 should we pay out as
dividends?
Residual Distr. Model:(cont’d)
CH13
• Of the $800,000 capital budget,

0.6($800,000) = $480,000 must be
equity to keep at target capital structure.
So 0.4($800,000) = $320,000 will be
debt.
• With $600,000 of net income, the
residual is $600,000 - $480,000 =
$120,000 = dividends paid.
• Payout ratio = $120,000/$600,000
= 0.20 = 20%
How would a drop in NI to $400,000
affect the dividend? A rise to $800,000?
CH13
• NI = $400,000: Need $480,000 of

equity, so should retain the whole
$400,000. Dividends = 0
• NI = $800,000: Dividends =
$800,000 - $480,000 = $320,000.
Distribution ratio (i.e. payout) =
$320,000/$800,000 = 40%

Investment Opportunities and
Residual Dividends
CH13
• 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 should be retained only if
the company can invest them in
positive NPV projects.
Advantages and Disadvantages
of the Residual Dividend Policy
CH13
• Advantages: Minimizes new stock

issues and flotation costs.
• Disadvantages: Results in unstable
dividends, sends conflicting signals,
increases risk, and doesn’t appeal
to any specific clientele.
• Conclusion: Consider residual
policy when setting target payout,
but don’t follow it rigidly.
Dividend Payment Procedures
CH13
• Declaration date, Nov/8/08: Board

declares a quarterly dividend of $0.50
per share payable to holders of record
on Dec/12/08 payable on Jan/2/09
• Dividend goes with stock, Dec/09/08
• Ex-dividend date, Dec/10/08
• Holder of record date, Dec/12/08
• To get the dividend, transactions must
be completed on or before Dec/09/08
Stock Repurchases
CH13
• Repurchases: Buying own stock back

from stockholders.
• 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.
Stock Repurchases versus
CH13
Cash Dividends

Dividends versus Stock
CH13
Repurchases
• Ignoring possible tax effects and signals,
the total market value of equity is the
same whether a firm pays dividends or
repurchases stock
• The purchase itself does not change the
stock price although it does reduce the
number of outstanding shares
• The total return to the shareholders is
the same

Advantages of Repurchases
CH13
• 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.
• Income received is capital gains rather
than higher-taxed dividends.
• Stockholders may take as a positive
signal--management thinks stock is
undervalued.
Disadvantages of
Repurchases
CH13
• May be viewed as a negative signal (firm

has poor investment opportunities).
• CRA could impose penalties if
repurchases were primarily to avoid
taxes on dividends.
• Selling stockholders may not be well
informed, hence be treated unfairly.
• Firm may have to bid up price to
complete purchase, thus paying too
much for its own stock.
Setting Dividend Policy
CH13
• Forecast capital needs over a planning

horizon, often 5 years.
• Set a target capital structure.
• Estimate annual equity needs.
• Set target payout based on the residual
model.
• Generally, some dividend growth rate
emerges. Maintain target growth rate if
possible, varying capital structure
somewhat if necessary.

Constraints on Dividend
CH13
Payments
• Bond indentures
• Preferred stock restrictions
• Legal constraints
– Capital impairment restriction
– Net earning restriction
– Insolvency restriction
• Availability of cash

Stock Dividends vs. Stock Splits
CH13
• 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. Sends
shareholders more shares.
• They are conceptually the same, and
neither create any real economic value.

A 10% Stock Dividend
CH13
• A shareholder with 100 shares will

receive 10 additional shares
• A 100% stock dividend, a
shareholder with 100 shares will
receive 100 additional shares.
• A stock dividend is in reality just a
small stock split.
• Accounting treatments greatly differ
A 2-for-1 Stock Split
CH13
• Existing shareholders receive an

additional share for each share they
already own
• There will then be twice as many shares
outstanding, with each share worth half of
the previous market value.
• Each shareholder retains his proportionate
share of ownership of the company
• Initially at least, the EPS and DPS will also
be half of their former levels.
Stock Dividends
vs. Stock Splits
CH13
• 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.
• But splits/stock dividends may get us to
an “optimal price range.”
When should a firm consider
splitting its stock?
CH13
• There’s a widespread belief that the

optimal price range for stocks is
$10 to $50
• Stock splits can be used to keep
the price in the optimal range.
• Stock splits generally occur when
management is confident, so are
interpreted as positive signals.
What’s a “dividend reinvestment
plan (DRIP)”?
CH13
• Shareholders can automatically

reinvest their dividends in shares of
the company’s common stock.
• Reinvested dividends are treated as
taxable income by CRA although no
cash is actually received.
• There are two types of plans:
– Open market
– New stock
Open Market Purchase Plan
CH13
• 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
CH13
• Firm issues new stock to DRIP

enrollees, keeps money and uses it
to buy assets.
• No fees are charged, plus sells
stock at discount of 5% from market
price, which is about equal to
flotation costs of underwritten stock
offering.
New Stock Plan (cont’d)
CH13
• Optional investments sometimes

possible, up to $150,000 or so.
• Firms that need new equity capital
use new stock plans.
• Firms with no need for new equity
capital use open market purchase
plans.
• Most TSX listed companies have a
DRIP. Useful for investors.

CH13 PPT BrighamFM1CE Dividen

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH13 PPT BrighamFM1CE Dividen

Uploaded by

Copyright:

Available Formats

PowerPoint Presentation

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-3

• Distribution level and firm value

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-4

• The distribution policy defines:

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-5

World Stock Market (Index) Div. Yield %

• Dividends are irrelevant: Investors

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-7

• Investors are indifferent between

• Investors think dividends are less

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-9

• Low payouts mean higher capital

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-10

Irrelevance Any payout OK

Bird-in-the-hand Set high payout

Tax preference Set low payout

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-11

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-12

• Empirical testing has not been able to

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-13

• Different groups of investors, or

• Investors view dividend changes as

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-16

• Find the reinvested earnings

This long-run target distribution ratio

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-18

• Capital budget: $800,000 (given).

• Of the $800,000 capital budget,

• NI = $400,000: Need $480,000 of

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-21

• Fewer good investments would lead

• Advantages: Minimizes new stock

• Declaration date, Nov/8/08: Board

• Repurchases: Buying own stock back

• Reasons for repurchases:

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-26

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-27

• Stockholders can tender or not.

• May be viewed as a negative signal (firm

• Forecast capital needs over a planning

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-30

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-31

• Stock dividend: Firm issues new shares

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-32

• A shareholder with 100 shares will

• Existing shareholders receive an

• Both stock dividends and stock splits

• There’s a widespread belief that the

• Shareholders can automatically

• Dollars to be reinvested are turned

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 13-38

• Firm issues new stock to DRIP

• Optional investments sometimes

You might also like