Finance Test Chapter 17

Payable (or Distribution) date

(Generally about a month after the record date) the firm pays dividends

How does share price change after dividends are paid out in a perfect capital market?

***In a Perfect Capital Market, when a dividend is paid, the share price drops by the amount of the dividend***

How does share price change with share repurchases in a perfect capital market?

***In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the cum-dividend price if a dividend were paid instead***

Would managers acting in the interests of long-term shareholders be more likely to repurchase shares if they believe the stock is undervalued or overvalued?

If managers believe the stock is currently undervalued, a share repurchase is a positive NPV investment. Managers will clearly be more likely to repurchase shares if they believe the stock to be undervalued.

Motivation for a stock split

If the price of a stock is too high, they perform a stock split to lower the price to a level in range for smaller investors

Reverse Stock Split

If the price of the stock is too low, a firm can perform a Revere Stock Split which decreases to number of shares outstanding and results in a higher stock price!

True or False: When a firm repurchases its own shares, the price rises due to the decrease in the supply of shares outstanding.

False. When a firm repurchases its own shares, the supply of shares is reduced, but the value of the firm's assets declines when it spends its cash to buy the shares. If the firm repurchases its shares at their market prices, these two effects offset each other, and the share price is unchanged

Dutch Auction

The firm lists different prices at which it is prepared to buy shares, and shareholders indicate how many shares they are willing to sell at each price. The firm then pays the lowest price at which it can buy back its desired number of shares.

Record Date Ex-Dividend Date

The firm pays dividends to all shareholders as of the Record Date. Because it takes three days for shares to be registered, only shareholders who purchase the stock at least THREE DAYS PRIOR to the Record Date receive the dividend!! Any time after three days before the record date in known as the Ex-Dividend Date! Anyone who purchases stock on or after the ex-dividend date will not receive the dividend

Payout Policy

The way a firm chooses between the alternative ways to distribute free cash flow to equity holders 1) Retain •Invest in New Projects •Increase Cash Reserves 2) Pay Out •Repurchase Shares •Dividends

Declaration Date

To issue a dividend, the firm's board of directors must authorize the amount per share that will be paid on the Declaration Date

Tender Offer

• A public announcement • A specified amount of outstanding securities • A pre-specified price (typically at a 10%-20%) • A pre-specified period of time (about ~20 days) • If shareholders do not tender enough shares, the firm may cancel the offer and no buyback occurs

Share Repurchases

• An alternative way to pay cash to investors

Types of Share Repurchases

• Open Market Repurchase • Tender Offer • Dutch Auction • Targeted Repurchase • Greenmail

Greenmail

A firm avoids a threat of takeover and removal of its management by a major shareholder by buying out the shareholder, often at a premium.

Open market repurchase

A firm buys its own shares in the open market • 95% of all repurchases are open market

Targeted Repurchase

A firm purchases shares directly from a specific shareholder

Liquidating Dividend

A return of capital to shareholders from a business operation that is being terminated

In a perfect capital market, how important is the firm's decision to pay dividends versus repurchase shares?

As Modigliani and Miller make clear, the value of a firm ultimately derives from its underlying free cash flow. A firm's free cash flow determines the level of payouts that it can make to its investors. In a perfect capital market, whether these payouts are made through dividends or share repurchases does not matter. 17

MM Dividend Irrelevance

In perfect capital markets, holding fixed the investment policy of a firm, the firm's choice of dividend policy is irrelevant and does not affect the initial share price.

What's the investor's preferred method of payout in a perfect capital market?

In perfect capital markets, investors are INDIFFERENT between the firm distributing funds via dividends or share repurchases. ___________________________ By reinvesting dividends or selling shares, they can replicate either payout method on their own. - If the firm repurchases shares and the investor wants cash, the investor can raise cash by selling shares (homemade dividend.) - If the firm pays a dividend and the investor would prefer stock, they can use the dividend to purchase additional shares.

Cum-Dividend

Just before the ex-dividend date, the stock is said to trade Cum-Dividend! After the stock goes ex-dividend, new buyers will not receive the current dividend, and the share price will reflect only dividends paid in subsequent years!

What possible signals does a firm give when it cuts its dividend?

Positive Signal: =Firm might cut its dividend to exploit new positive-NPV investment opportunities. In this case, the dividend decrease might lead to a positive stock price reaction. Negative Signal: =When a firm cuts the dividend, it gives a negative signal to investors that the firm does not expect that earnings will rebound in the near term and so it needs to reduce the dividend to save cash

Signaling with Share Repurchases

Share repurchases are a credible signal that the shares are UNDERPRICED, because if they are overpriced a share repurchase is costly for current shareholders.

Payout preference and the Clientele Effect

Since tax rates vary by income, jurisdiction, and whether a stock is held in a retirement account, etc... Firms may attract different groups of investors depending on their dividend policy! Clientele Effect: =When the dividend policy of a firm reflects the tax preference of its investor clientele

Consequences for stock dividends

Stock dividends are not taxed, so from both the firm's and shareholders' perspectives, there is no real consequence to a stock dividend

What is the difference between a stock dividend and a stock split?

Stock dividends of 50% or higher are generally referred to as stock splits. In both cases, a firm does not pay out any cash to shareholders.

Dividend Signaling Hypothesis

The idea that dividend changes reflect managers' views about a firm's future earning prospects! _____________________________ • Increasing dividends: A POSITIVE SIGNIAL to investors that management expects to be able to afford the higher dividend for the foreseeable future CAUTION, • A firm might cut its dividend to exploit new positive-NPV investment opportunities! This would be a positive signal with decreased dividend.

Dividend Smoothing

The practice of maintaining relatively constant dividends (firm change dividends infrequently and dividends are much less volatile than earnings.)

Dividend-Capture Theory

The theory that absent transaction costs, investors can trade shares at the time of the dividend so that non-taxed investors receive the dividend _____________________________ An implication of this theory: we should see large trading volume in a stock around the ex-dividend day, as high-tax investors sell and low-tax investors buy the stock in anticipation of the dividend, and then reverse those trades just after the ex-dividend date.

Taxes on dividends and capital gains

Well, shareholders must pay taxes on the dividends they receive AND they must also pay capital gains taxes when they sell their shares. HOWEVER, dividends are usually taxed HIGHER than capital gains! In fact, long-term investors can defer paying capital gains tax by not selling!

Stock Split (Stock Dividend)

When a company issues a dividend in shares of stock rather than cash to its shareholders

Return of Capital

When a firm, instead of paying dividends out of current earnings (or accumulated retained earnings), pays dividends from other sources, such as paid-in-capital or the liquidation of assets!

Signaling with Payout Policy

When firm managers have better information that investors do regarding the future prospects of a firm, their payout decisions may signal this!

Dividend Puzzle

When firms continue to issue dividends despite their tax disadvantage!

Optimal Dividend Policy with Taxes

When the tax rate on dividends is greater than the tax rate on capital gains, shareholders will pay lower taxed if a firm uses SHARE REPURCHASES rather than dividends! Optimal Choice: Pay no dividends at all

Under what conditions will investors have a tax preference for share repurchases rather than dividends?

While many investors have a tax preference for share repurchases rather than dividends, the strength of that preference depends on the difference between the dividend tax rate and the capital gains tax rate that they face. If Td* > 0, share repurchase... Td* = (Td - Tg)/(1-Tg)

Stock Dividends and Split

With a stock dividend, a firm does not pay out any cash to shareholders... As a result, the total market value of the firm's equity is unchanged.... The only thing that is different is the number of shares outstanding... Since the total value of equity stays the same.... and the number of shares outstanding increases.... (Total Value of Equity)/(# Shares Outstanding) = Share Price The SHARE PRICE DECREASES proportionately with the size of the split!!