Dividend & Share Repurchase (Analysis) (R23)
Share Repurchase Methods
Share Repurchase Methods: 1) Buy in the open market -- no legal obligation to go through with it; authorization can last for many years; cost effective since it can be executed when share price is attractive 2) Fixed price tender offer -- buy fixed number of shares at a fixed price; pro rata shares purchased from each seller; very quick 3) Dutch auction -- company specifies range of acceptable prices; sellers specify price at which they will sell; company accepts lowest bid and then higher and higher bids until repurchase goal has been met 4) Direct negotiation -- company negotiates direclty with major shareholder
Dividends: Dividend Preference Theory (Bird in the Hand Argument)
Shareholders prefer certainty of cash dividends to an equivalent amount of capital gains because dividends are less risky than capital gains. Miller and Modigliani counter the bird-in-the-hand argument by saying that paying or increasing current dividends has no impact on the risk of future cash flows; cash dividends only lower the ex-dividend price of the share.
Stable Dividend Policy
Stable Dividend Policy: Companies aim to pay out a regular stream of dividends and only increase the dividend when expected future profitability suggests that a dividend increase would be sustainable. Amount of dividend is unaffected by short-term volatility in earnings AND/OR the company's investment opportunities. See the Target Payout Ratio Adjustment Model (Lintner Model)
Stock Dividends
Stock Dividend: when a company issues additional common shares to shareholders instead of cash. Stock dividends favor long-term investors which lowers cost of equity (re) Stock dividends result in an increase in the stock's float, which improves share liquidity and lowers share price volatility
Stock Split
Stock splits are similar to stock dividends in that they INCREASE the total # OF SHARES OUTSTANDING, REDUCE the SHARE PRICE, and have no overall economic effect on the company (market value and P/E ratio do not change) However, unlike a stock dividend, a stock split has NO impact on shareholders' equity accounts whatsoever. Companies typically announce stock splits after a period during which the stock price has appreciated significantly to bring it down into a more marketable range. Many investors however, see a stock split announcement as a signal for future stock price appreciation. A reverse stock split INCREASES the SHARE PRICE and REDUCES the # OF SHARES OUTSTANDING. Similar to stock splits, the aim of a reverse stock split is to bring the stock price into a more marketable range.
Dividend Irrelevance Theory (Miller & Modigliani Dividend Theory)
The Dividend Irrelevance Theory (Miller and Modigliani - MM) states that dividends have no impact on on a company's cost of capital or company value UNDER PERFECT CAPITAL MARKETS (no taxes, no transaction costs, and symmetric information) This does not hold up in the real world.
Lintner Model (Target Payout Ratio Adjustment Model)
The Target Payout Ratio Adjustment Model (aka Lintner Model) is a form of Stable Dividend Policy. Under the Lintner Model, gradual adjustments are made toward a target payout ratio based on long-term sustainable earnings, managers are concerned with dividend changes but not the level of the dividend, and companies will only cut or eliminate a dividend in extreme circumstances. Expected Increase In Dividends = (expected earnings * target payout ratio - previous DIVIDEND) * adjustment factor Adjustment Factor = 1/n where n = the number of years over which the adjustment will take place Payout Ratio = proporation of earnings that the company will pay out as dividends.
Ex-Dividend Share Price and Taxes
The change in share price when it goes ex-dividend (Pw-Px) will be equal to the amount of the dividend (D) if the tax on dividends (Td) and the tax on capital gains (Tcg) is the same. Pw - Px = [(1-Td)/(1-Tcg)]*D Pw → share price with right to receive dividend Px → share price w/o right to receive dividend Td → tax on dividends Tcg → tax on capital gains D → amount of dividend If Td > Tcg then (Pw-Px) < D If Td < Tcg then (Pw-Px) > D Stated differently, the drop in the price of a share when it goes ex-dividend is equal to: D × [(1-Td)/(1-Tcf)]
Expected Dividend Under Stable Dividend Policy
Under the stable dividend policy, the expected dividend = previous dividend + expected increase expected increase = (expected earnings - previous earnings) × target payout ratio × 1/n n → number of years over which the adjustment toward the target dividend payout ratio will take place
Stock Repurchase Using Idle Cash
When a company repurchases stock with idle cash, the HIGHER the price at which it repurchases its stock relative to the current market price, the LESS SIGNIFICANT the increase in EPS. Using cash to repurchase shares will result in increased debt ratios since equity is decreasing.
Dividend Reinvestment Plan (DRP)
A Dividend Reinvestment Plan (DRP) allows an investor to reinvest all or a portion of their cash dividend back into shares of the company. Three types of DRPs: 1) Open market: company purchases shares on behalf of investor in the open market 2) New-issue (scrip dividend schemes): company issues additional shares instead of purchasing them 3) Combo: investor can get shares through open market or new issuance
Marginal Investor
A Marginal Investor is an investor that is VERY likely to be part of the next trade in the stock. Marginal investors are very important for price formation.
Cash Dividend
A cash dividend will result in: - an outflow of cash DECREASING A COMPANY'S LIQUIDITY ratios and INCREASING DEBT-to-ASSETS ratio - REDUCE RETAINED EARNINGS (shareholders equity) and INCREASE THE DEBT-to-EQUITY ratio
Extra (Special or Irregular) Dividend
Issued outside of regularly scheduled dividends, or by a company that doesn't issue dividends normally.
Debt to Equity: find debt and equity proportion
Proportion of debt = (D/E) / [1+(D/E)] Proportion of equity = 1 - [(D/E) / [1+(D/E)]
Advantages of DRP for the Company
Advantages of a Dividend Reinvestment Program for the company are that the shareholder base is diversified, it encourages long term investment, and the company can raise equity capital w/o incurring flotation costs.
Advantages & Disadvantages of DRP for Shareholders
Advantages of a Dividend Reinvestment Program for the shareholder are that shares can be accumulated in a cost-effective manner, no transaction costs, and shares can sometimes be obtained at a discount through a DRP. Disadvantages of a DRP for the shareholder are increased record keeping for tax purposes, taxation of dividends even though they are reinvested in the company, and potential dilution of the shares is DRP shares are issued at a discount.
Stock Dividends Affect
After a stock dividend EPS goes down: EPS post stock dividend = (EPS pre stock dividend * total # shares before stock dividend) / total # shares post stock dividend Stock price goes down: Stock price post stock dividend = (stock price pre stock dividend * shares before stock dividend) / total # shares post stock dividend Market value: does not change P/E: does not change NO AFFECT on liquidity or solvency ratios
Dividend Impact on Liquidity/Solvency
Cash dividends reduce assets (cash) and shareholders' equity (retained earnings). When a company pays out cash dividends, not only do liquidity ratios deteriorate, but leverage ratios (e.g., debt-assets and debt-equity ratios) also worsen. Stock dividends do not have any effect on a company's capital structure. Retained earnings fall by the value of stock dividends paid, but there is an offsetting increase in contributed capital so there is no change in shareholders' equity. Stock dividends have no impact on a company's liquidity and solvency ratios.
Signalling (Dividend Actions Conveying Information)
Changes in dividends may convey new information about a company. Initiation or Increase: positive signal; increases stock price Cuts or omissions: negative signal (could possibly be that managment wishes to use retained earnings to take advantage of opportunities); decreases stock price
Constant Dividend Payout Ratio Policy
Constant Dividend Payout Ratio Policy Under this policy the company will distribute a constant percentage of net income as dividends. Companies that wish to reflect the cyclical nature of their businesses in their dividend payments adopt this policy.
Clientele Effect
Different clients prefer different dividend policies. Some prefer steady cash inflow (retirees) while others prefer long term gains. Investors lean toward investing in companies that match their desired policies. It does not imply that a change in dividend policy has an effect on shareholder wealth (so it does not contradict dividend irrelevance); it only determines the types of investors that hold the company's stock.
Dividend Coverage Ratio
Dividend Coverage Ratio = Net Income / Dividends
Dividend Payout Policies
Dividend Payout Policies: 1) Stable Dividend Policy 2) Constant Dividend Payout Ratio Policy 3) Residual Dividend Policy
Dividend Payout Ratio
Dividend Payout Ratio = % of earnings distributed as dividends / total earnings (aka net income) HIGHER dividend payout ratio (lower dividend coverage ratio) INCREASES the risk of a dividend cut or omission. Growth companies are likely to have a lower dividend payout ratio compared to stable, mature companies.
Dividend Safety: FCFE Coverage Ratio
Dividend Safety can be measured using Dividend Payout Ratio and Dividend Coverage Ratio over time, as well as FCFE (Free Cash Flow to Equity) Coverage Ratio: FCFE Coverage Ratio = FCFE / [Dividends + Share Repurchases] FCFE = CFO - FCInv - ∆Net Working Capital + Net Borrowings FCFE Coverage Ratio >1 → Company is retaining some earnings to enhance liquidity (R/E ↑) < 1→ Company is eating into its liquidity to pay out dividends (this is not sustainable) = 1 → Company is distributing ALL available cash to shareholders
Dividend Yield
Dividend Yield = Dividend per Share / Stock price per Share
Dividend Tax Regimes: Double Taxation
Double Taxation of Dividends Earnings are taxed at the corporate level, and then again at the shareholder level IF they are distributed to investors as dividends. ETR = CTR + [(1-CTR) * MTRd] ETR → Effective Tax Rate on dividends CTR → Corporate Tax Rate MTRd → Investor's marginal tax rate on dividends (also known as Td) or ETR = (total earnings - after tax dividend) / total earnings
Earnings Per Share (EPS) & Earnings Yield
EPS = Net Income After Tax / Total # of Shares Outstanding EPS after Repurchase Financed by Debt = [Net Income After Tax - (Debt * Interest)] / Total Shares Outstanding AFTER Repurchase *** If the company's after-tax cost of borrowing (interest rate on debt) is HIGHER than its EARNINGS YIELD (=EPS/Stock Price), its EPS will DECREASE after the repurchase financed using debt. *** If the company's after-tax cost of borrowing is LOWER than its EARNINGS YIELD (=EPS/Stock Price), its EPS will INCREASE after the repurchase financed using debt. ***If the company's after-tax cost of borrowing equals its earnings yield, its EPS will remain the same after the share repurchase.
Homemade Dividends
Homemade Dividends are a concept that exists under the dividend irrelevance theory. Homemade Dividends are essentially 'created' by the investor by selling stock or using excess dividends (if investor believes dividends are too high) to purchase more stock. The theory of homemade dividends suggests that dividend policy is irrelevant.
Dividends: Tax Preference Theory
Investors will prefer either capital gains or dividends depending upon the tax applied to either form of earnings. Investors would also prefer share repurchases to dividends (if capital gains cannot be achieved), again depending upon the tax applied to each form of payout. Investors may prefer small dividend payments to large because capital gains are: taxed at a lower rate; or not taxed until realized. For this reason a smaller dividend may result in a higher stock price and lower cost of equity
Liquidating Dividends
Liquidating Dividends are a way for a company to distribute assets to shareholders when it goes out of business or sells off a portion of it's business. These can also be used to pay dividends in excess of earnings per share which impairs the company's stated capital. Liquidating dividends are a return of capital, not a distribution of earnings.
Market Price vs. Book Value per Share
Market Price per Share > Book Value per Share = book value per share will DECREASE after share repurchase Market Price per Share < Book Value per Share = book value per share will INCREASE after share repurchase
Number of Shares
Number of Shares Outstanding = Net Income / EPS Number of Shares Repurchased = $ amount of Repurchase / Repurchase Price
Types of Dividends
Types of Dividends: 1) Cash Dividends (regular or special; liquidating) ← reduces retained earnings and cash 2) Stock Dividends ← transfers reserves from retained earnings to contributed capital 3) Stock Splits ← has no impact on any shareholders' equity accounts
Dividend Tax Regimes: Dividend Imputation Tax System
Under a Dividend Imputation Tax System, earnings distributed as dividends are taxed only once, at the investor's marginal tax rate. Therefore the Effective Tax Rate is equal to the investor's marginal tax rate (ETR = Td) If the corporate tax rate (CTR) is greater than the investor's marginal tax rate (Td) than the investor will receive a tax credit (aka 'franking credit') If CTR < Td than the investor will have to pay in the difference between CTR and Td
Residual Dividend Policy
Under a Residual Dividend Policy, the company will FIRST utilize earnings to finance positive NPV projects consistent with its target capital structure. Any excess will be distributed as dividends. This policy increases volatility in future dividends which may mean that investors will require a higher rate of return on equity. Dividend = Residual Earnings = Earnings - (Capital budgeting x equity percentage in capital structure) or ZERO (whichever is greater)
Dividend Tax Regimes: Split-Rate Tax System
Under the Split-Rate Tax System, company's pay two separate tax rates on earnings: one tax rate on earnings kept (aka R/E) and one tax rate on earnings distributed (aka dividends) The Effective Tax Rate (ETR) = CTRd + [(1-CTRd) * MTRd] CTRd → corporate tax rate on dividends (aka earnings distributed to investors)