Ch. 14 -13ed Stock Divs & RepurchMaster

7/29/2019 Ch. 14 -13ed Stock Divs & RepurchMaster

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CHAPTER 14

Distributions to Shareholders:

Dividends and Repurchases


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Topics in Chapter Theories of investor preferences

Signaling effects

Residual model

Stock repurchases

Stock dividends and stock splits Dividend reinvestment plans


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Free cash flow(FCF)

Interestpayments(after tax)

Stockrepurchases

Principalrepayments

Dividends

Sales revenues

Operating costs and taxes

Required investments in operating capital

=

Free Cash Flow: Distributions to Shareholders

Purchase ofshort-terminvestments

Sources

Uses


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What is distribution policy? 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


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Distributions Patterns Over

Time The percent of total payouts a a percentage of net

income has been stable at around 26%-28%. Dividend payout rates have fallen, stock repurchases have

increased. Repurchases now total more dollars in distributions than

dividends.

A smaller percentage of companies now paydividends. When young companies first begin making

distributions, it is usually in the form of repurchases. Dividend payouts have become more concentrated in

a smaller number of large, mature firms.


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Dividend Yields for Selected

IndustriesIndustry Div. Yield %

Recreational Products 0.02

Forest Products 0.91Software 0.32

Household Products 0.62

Food 0.04

Electric Utilities 1.10

Banks 0.21

Tobacco 0.45

Source: Yahoo Industry Data, March 2009


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Do investors prefer high or low

payouts? There are three dividend theories:

Dividends are irrelevant: Investors dont

care about payout.

Dividend preference, or bird-in-the-hand:Investors prefer a high payout.

Tax effect: Investors prefer a low payout.


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Dividend Irrelevance Theory Investors are indifferent between dividends

and retention-generated capital gains. Ifthey want cash, they can sell stock. If they

dont want cash, they can use dividends tobuy stock.

Modigliani-Miller support irrelevance. Implies payout policy has no effect on stock

value or the required return on stock. Theory is based on unrealistic assumptions

(no taxes or brokerage costs).


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Dividend Preference (Bird-in-

the-Hand) Theory Investors might think dividends (i.e., the-

bird-in-the-hand) are less risky than potentialfuture capital gains.

Also, high payouts help reduce agency costsby depriving managers of cash to waste andcausing managers to have more scrutiny bygoing to the external capital markets more

often. Therefore, investors would value high payout

firms more highly and would require a lowerreturn to induce them to buy its stock.


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Tax Effect Theory Low payouts mean higher capital gains.

Capital gains taxes are deferred until

they are realized, so they are taxed at alower effective rate than dividends.

This could cause investors to require a

higher pre-tax return to induce them tobuy a high payout stock, which wouldresult in a lower stock price.


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Which theory is most correct? Some research suggests that high payout

companies have higher required returns onstock, supporting the tax effect hypothesis.

But other research using an internationalsample shows that in countries with poorinvestor protection (where agency costs are

most severe), high payout companies arevalued more highly than low payoutcompanies.

Empirical testing has produced mixed results.


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Whats the clientele effect? Different groups of investors, or clienteles,

prefer different dividend policies.

Firms past dividend policy determines itscurrent clientele of investors.

Clientele effects impede changing dividendpolicy. Taxes & brokerage costs hurtinvestors who have to switch companies dueto a change in payout policy.


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Whats the information content,

or signaling, hypothesis? Investors view dividend changes as

signals of managements view of the

future. Managers hate to cut dividends,so wont raise dividends unless theythink raise is sustainable.

Therefore, a stock price increase attime of a dividend increase could reflecthigher expectations for future EPS, not

a desire for dividends.


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Whats the residual

distribution model? Find the reinvested earnings needed for

the capital budget.

Pay out any leftover earnings (theresidual) as either dividends or stockrepurchases.

This policy minimizes flotation andequity signaling costs, hence minimizesthe WACC.


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Using the Residual Model to

Calculate Distributions Paid

Distr. = Net

income

Target

equityratio

Total

capitalbudget

Distr. = Required equityNetincome


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Application of the ResidualDistribution Approach: Data for SSC

Capital budget: $112.5 million.

Target capital structure: 20% debt,

80% equity. Want to maintain.

Forecasted net income: $140 million.

Number of shares: 100 million.


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Application of the ResidualDistribution Approach

Number of shares 100 100 100

Equity ratio (ws) 80% 80% 80%

Capital budget $112.5 $112.5 $112.5

Net income $140.0 $90.0 $160.0

Req. equ.: (ws X Cap. Bgt.) $90.0 $90.0 $90.0

Dist. paid: (NI Req. equity) $50.0 $0.0 $70.0

Payout ratio (Dividend/NI) 35.7% 0.0% 43.8%

Dividend per share $0.50 $0.00 $0.70


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Investment Opportunities andResidual Dividends

Fewer good investments would lead tosmaller capital budget, hence to a

higher dividend payout. More good investments would lead to a

lower dividend payout.


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Advantages and Disadvantages ofthe Residual Dividend Policy

Advantages: Minimizes new stockissues and flotation costs.

Disadvantages: Results in variabledividends, sends conflicting signals,increases risk, and doesnt appeal to

any specific clientele. Conclusion: Consider residual policy

when setting target payout, but dont

follow it rigidly.


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The Procedures of a DividendPayment: An Example

November 11: Board declares aquarterly dividend of $0.50 per share to

holders of record as of December 10. December 7: Dividend goes with stock.

December 8: Ex-dividend date.

December 10: Holder of record date. December 31: Payment date to holders

of record.


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Stock Repurchases

Repurchases: Buying own stock back fromstockholders.

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.

To use when employees exercise stock options.


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The Procedures of aRepurchase

Firm announces intent to repurchase stock.

Three ways to purchase:

Have broker/trustee purchase on open marketover period of time.

Make a tender offer to shareholders.

Make a block (targeted) repurchase.

Firm doesnt have to complete its announcedintent to repurchase.


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SSC Before a Distribution:Inputs (Millions)

Value of operations $1,937.50

Short-term investments $50.00Debt $387.50

Number of shares 100.00


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Intrinsic Value BeforeDistribution

Vop $1,937.50

+ ST Inv. 50.00VTotal $1,987.50

Debt 387.50

S $1,600.00n 100.00

P $16.00


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Intrinsic Value After a $50Million Dividend Distribution

Before After Dividend

Vop $1,937.50 $1,937.50

+ ST Inv. 50.00 0.00VTotal $1,987.50 $1,937.50

Debt 387.50 387.50

S $1,600.00

$1,550.00n 100.00 100.00

P $16.00 $15.50

DPS $0.50


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Drop in Price with DividendDistribution

Note that stock price drops by dividendper share in model.

If it didnt there would be arbitrageopportunity (assuming no taxes).

In real world, stock price drops on

average by about 90% of dividend.


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A repurchase has no effect onstock price!

The announcement of an intended repurchase mightsend a signal that affects stock price, and theprevious events that led to cash available for a

distribution affect stock price, but the actualrepurchase has no impact on stock price because: If investors thought that the repurchase would increase the

stock price, they would all purchase stock the day before,which would drive up its price.

If investors thought that the repurchase would decrease thestock price, they would all sell short the stock the daybefore, which would drive down the stock price.


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Remaining Number of SharesAfter Repurchase

# shares repurchased = nPrior nPost # shares repurchased =CashRep/PPrior

nPrior nPost = CashRep/PPrior

nPost = nPrior (CashRep/PPrior)


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Remaining Number of SharesAfter Repurchase

nPost = nPrior (CashRep/PPrior)

nPost= 100 ($50/$16)

nPost= 100 3.125 = 96.875


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Intrinsic Value After a $50Million Repurchase

Before After Repurchase

Vop $1,937.50 $1,937.50

+ ST Inv. 50.000.00

VTotal $1,987.50 $1,937.50

Debt 387.50 387.50

S $1,600.00

$1,550.00n 100.00 96.875

P $16.00 $16.00

Shares rep. 3.125


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Key Points

ST investments fall because they are used torepurchase stock.

Stock price is unchanged by actual

repurchase. Value of equity falls from $1,600 to $1,550

because firm no longer owns the STinvestments.

Wealth of shareholders remains at $1,600because shareholders now directly own the$50 that was previously held by firm in STinvestments.


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Advantages of Repurchases

Stockholders can choose to sell or not.

Helps avoid setting a high dividend that

cannot be maintained. Income received is capital gains rather

than higher-taxed dividends.

Stockholders may take as a positivesignal--management thinks stock isundervalued.


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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.


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Setting Dividend Policy

Forecast capital needs over a planninghorizon, 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 ifpossible, varying capital structure somewhatif necessary.


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Stock Dividends vs. StockSplits

Stock dividend: Firm issues new sharesin lieu of paying a cash dividend. If

10%, get 10 shares for each 100 sharesowned.

Stock split: Firm increases the number

of shares outstanding, say 2:1. Sendsshareholders more shares.


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Both stock dividends and stock splits increasethe number of shares outstanding, so the pieis divided into smaller pieces.

Unless the stock dividend or split conveysinformation, or is accompanied by anotherevent like higher dividends, the stock pricefalls so as to keep each investors wealthunchanged.

But splits/stock dividends may get us to anoptimal price range.


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When should a firm considersplitting its stock?

Theres a widespread belief that theoptimal price range for stocks is $20 to

$80. Stock splits can be used to keep the

price in the optimal range.

Stock splits generally occur whenmanagement is confident, so areinterpreted as positive signals.


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Whats a dividend reinvestmentplan (DRIP)?

Shareholders can automatically reinvesttheir dividends in shares of the

companys common stock. Get morestock than cash.

There are two types of plans:

Open market New stock


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Open Market Purchase Plan

Dollars to be reinvested are turned overto trustee, who buys shares on the

open market. Brokerage costs are reduced by volume

purchases.

Convenient, easy way to invest, thususeful for investors.


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New Stock Plan

Firm issues new stock to DRIPenrollees, 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 costsof underwritten stock offering.


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Optional investments sometimespossible, up to $150,000 or so.

Firms that need new equity capital usenew stock plans.

Firms with no need for new equitycapital use open market purchase plans.

Most NYSE listed companies have aDRIP. Useful for investors.

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Ch. 14 -13ed Stock Divs & RepurchMaster