W11 - Distributions to Shareholders (Theory)

Advantages of Repurchases

- A repurchase announcement may be viewed as a positive signal by investors because repurchases are often motivated by managements' belief that their firms' shares are undervalued. - The stockholders have a choice when the firm distributes cash by repurchasing stock—they can sell or not sell. + With a cash dividend, on the other hand, stock-holders must accept a dividend payment and pay the tax. + Thus, those stock-holders who need cash can sell back some of their shares, while those who do not want additional cash can simply retain their stock. + From a tax standpoint, a repurchase permits both types of stockholders to get what they want. - A repurchase can remove a large block of stock that is "overhanging" the market and keeping the price per share down. - Dividends are "sticky" in the short run because managements are reluctant to raise the dividend if the increase cannot be maintained in the future—managements dislike cutting cash dividends because of the negative signal a cut gives. + Therefore, if excess cash flows are expected to be temporary, managements may prefer to make distributions as share repurchases rather than to declare increased cash dividends that cannot be maintained. - Companies can use the residual dividend model to set a target cash distribution level, then divide the distribution into a dividend component and a repurchase component. + The dividend payout ratio will be relatively low, but the dividend itself will be relatively secure, and it will grow as a result of the declining number of shares outstanding. + This gives the company more flexibility in adjusting the total distribution than if the entire distribution were in the form of cash dividends because repurchases can be varied from year to year without sending adverse signals. + This procedure has much to recommend it, and it is an important reason for the dramatic increase in the volume of share repurchases. - Repurchases can be used to produce large-scale changes in capital structure. - Companies that use stock options as an important component of employee compensation can repurchase shares and then reissue those shares when employees exercise their options. + This avoids having to issue new shares, which dilutes earnings per share.

Payment Procedures

- Companies normally pay dividends quarterly, and if conditions permit, the dividend is increased once each year. The actual payment procedure is as follows: - Declaration date + On the declaration date, the directors meet and declare the regular dividend + For accounting purposes, the declared dividend becomes an actual liability on the declaration date. + If a balance sheet was constructed, the amount would appear as a current liability and retained earnings would be reduced by a like amount. - Holder-of-record date. + At the close of business on the holder-of-record date, the company closes its stock transfer books and makes up a list of shareholders as of that date. + If the comapny is notified of the sale before the close of business, the new owner will receive the dividend. + However, if notification is received after this date, the previous owner will receive the dividend check. · - Ex-dividend date. + To avoid conflict, the securities industry has set up a convention under which the right to the dividend remains with the stock until two business days prior to the holder-of-record date; on the second business day before that date, the right to the dividend no longer goes with the shares. + The date when the right to the dividend leaves the stock is called the ex-dividend date. + Therefore, if Buyer is to receive the dividend, Buyer must buy the stock on or before this date + If Buyer buys it on or later, Seller will receive the dividend because he or she will be the official holder of record - Payment date. + The company actually mails the checks to the holders of record on the payment date.

Dividend Irrelevance Theory

- Dividend policy has to do with the decision of whether to pay dividends versus retaining funds to reinvest, and also the decision to pay back using cash dividends or repurchase shares + The optimal dividend policy should maximise stock price. - Professors Merton Miller and Franco Modigliani (MM) advanced the dividend irrelevance theory, which stated that dividend policy has no effect on either the price of a firm's stock or its cost of capital. + MM developed their theory under a stringent set of assumptions, and under those assumptions, they proved that a firm's value is determined only by its basic earning power and its business risk. + In other words, the value of the firm depends only on the income produced by its assets, not on how that income is split between dividends and retained earnings. + Note, though, that MM assumed, among other things, that no taxes are paid on dividends, that stocks can be bought and sold with no transactions costs, and that everyone—investors and managers alike—has the same information regarding firms' future earnings. - Given their assumptions, MM argued that each shareholder can construct his or her own dividend policy. + Note, though, that in the real world, taxes and transactions costs do exist -> dividend policy may well be relevant, and investors may prefer policies that help them reduce taxes and transactions costs. - In defense of their theory, MM noted that many stocks are owned by institutional investors who pay no taxes and who can buy and sell stocks with very low transactions costs. + For such investors, dividend policy might well be irrelevant; and if these investors dominate the market and represent the "marginal investor," MM's theory could be valid in spite of its unrealistic assumptions. + Note too that for tax-paying investors, the taxes and transactions costs depend on what the individual investor's income is and how long he or she plans to hold the stock. + As a result, when it comes to investors' preferences for dividends, one size does not fit all.

Effect on Stock Prices

- On average, the price of a company's stock rises shortly after it announces a stock split or dividend. - One reason that stock splits and stock dividends may lead to higher prices is that investors often take stock splits and dividends as signals of higher future earnings. + Because only companies whose managements believe that things look good tend to split their stocks, the announcement of a stock split is taken as a signal that earnings and cash dividends are likely to rise. + Thus, the price increases associated with stock splits and dividends may be the result of a favorable signal for earnings and dividends. - By creating more shares and lowering the stock price, stock splits may also increase the stock's liquidity. + This tends to increase the firm's value. - There is evidence that stock splits change the mix of shareholders. + The proportion of trades made by individual investors tends to increase after a stock split, whereas the proportion of trades made by institutional investors tends to fall.

Stock Splits

- Some of its earnings have been paid out in dividends, but some also were retained each year, causing its earnings per share and the stock price to grow. + When a "normal" P/E ratio was applied, the resulting market price was so high that few people could afford to buy a "round lot" of shares. + This limited demand for the stock and thus kept the firm's total market value below what it would have been if more shares at a lower price had been outstanding. - Optimal means that if the price is within this range, the price/earnings ratio (and hence the firm's value) will be maximized. + Many observers believe that the best range for most stocks is from $20 to $80 per share. + A two-for-one stock split - doubling the number of shares outstanding, halving the earnings and dividends per share, and thereby lowering the stock price. + Each stockholder would have more shares, but each share would be worth less. + Stock splits can be split in varying proportions—for example, the stock can be split two-for-one, three-for-one, one-and-a-half-for-one, or any other way.

Dividends Versus Capital Gains: What Do Investors Prefer?

- When deciding how much cash to distribute, financial managers must keep in mind that the firm's objective is to maximize shareholder value. + Consequently, the target payout ratio—defined as the percentage of net income to be paid out as cash dividends—should be based in large part on investors' preferences for dividends versus capital gains + This preference can be considered in terms of the constant growth stock valuation model (P^0 = D1/(rs-g) - If the company increases the payout ratio, this will raise D1 alone, will cause the stock price to rise. + However, if D1, which, taken is raised, less money will be available for reinvestment, which will cause the expected growth rate to decline; and that will tend to lower the stock's price. + Therefore, any change in the payout policy will have two opposing effects. + As a result, the optimal dividend policy must strike the balance between current dividends and future growth that maximizes the stock price.

Stock Repurchases

- Stock Repurchases Transactions in which a firm buys back shares of its own stock, thereby decreasing shares outstanding, increasing EPS, and, often, increasing the stock price. - There are three principal types of stock repurchases: + (1) situations where the firm has cash available for distribution to its stockholders, and it distributes this cash by repurchasing shares rather than by paying cash dividends; + (2) situations where the firm concludes that its capital structure is too heavily weighted with equity, and it sells debt and uses the proceeds to buy back its stock; and + (3) situations where the firm has issued options to employees, and it uses open market repurchases to obtain stock for use when the options are exercised. - Stock that has been repurchased by a firm is called treasury stock. + If some of the outstanding stock is repurchased, fewer shares will remain outstanding. + Assuming that the repurchase does not adversely affect the firm's future earnings, the earnings per share on the remaining shares will increase, resulting in a higher market price per share. + As a result, capital gains will have been substituted for dividends.

Stock Dividends and Stock Splits

- Stock dividends were originally used in lieu of regular cash dividends by firms that were short of cash. + Today, though, the primary purpose of stock dividends is to increase the number of shares outstanding and thus to lower the stock's price in the market. + Stock splits have a similar purpose.

Disadvantages of Repurchases

- Stockholders may not be indifferent between dividends and capital gains, and the stock price might benefit more from cash dividends than from repurchases. + Cash dividends are generally dependable, but repurchases are not. - The selling stockholders may not be fully aware of all the implications of a repurchase, or they may not have all the pertinent information about the corporation's present and future activities. + This is especially true in situations where management has good reason to believe that the stock price is well below its intrinsic value. + However, firms generally announce repurchase programs before embarking on them to avoid potential stockholder suits. - The corporation may pay too high a price for the repurchased stock, to the disadvantage of remaining stockholders. + If its shares are not actively traded and if the firm seeks to acquire a relatively large number of shares of its stock, the price may be bid above its intrinsic value and then fall after the firm ceases its repurchase operations.

The Effects of Stock Repurchases

- The company's EPS increased, but there was a corresponding drop in its P/E ratio. + One reason the P/E ratio may drop is that the repurchase works to increase the company's debt ratio (as there are now fewer shares of stock outstanding). + Because of the higher debt ratio, shareholders may consider the stock to be riskier. + As a result, the future earnings are discounted at a higher rate, which reduces the P/E ratio. - In reality, companies often have to pay a premium in order to get shareholders to sell their shares back to the company. + For a variety of reasons, the stock's price might change as a result of the repurchase operation, rising if investors viewed it favorably and falling if they viewed it unfavorably.

Reasons Some Investors Prefer Dividends

- The principal conclusion of MM's dividend irrelevance theory is that dividend policy does not affect either stock prices or the required rate of return on equity, rs + Myron Gordon and John Lintner argued that rs declines as the dividend payout is increased because investors are less certain of receiving the capital gains that should result from retaining earnings than they are of receiving dividend payments. + MM called the Gordon-Lintner argument the bird-in-the-hand fallacy (a firm's value will be maximized by setting a high dividend payout ratio) because in MM's view, most investors plan to reinvest their dividends in the stock of the same or similar firms and, in any event, the riskiness of the firm's cash flows to investors in the long run is determined by the riskiness of operating cash flows, not by dividend payout policy. + Bird-in-Hand Theory: Investors may think dividends obtained today are less risky than potential future capital gains, hence investors prefer dividends. (Set high payout) - Keep in mind, however, that MM's theory relied on the assumption that there are no taxes or transactions costs, which means that investors who prefer dividends could simply create their own dividend policy by selling a percentage of their stock each year. + If they want cash, they can sell stock. + If they do not want cash, they can use dividends to buy stock. + In reality, most investors face transactions costs when they sell stock, so investors who are looking for a steady stream of income would logically prefer that companies pay regular dividends.

Dividend Reinvestment Plans

- There are two types of DRIPs: (1) plans that involve only old, already-outstanding stock and (2) plans that involve newly issued stock. + In either case, the stockholder must pay taxes on the amount of the dividends even though stock rather than cash is received. - Under an "old stock" plan, the company gives the money that stockholders who elect to use the DRIP would have received to a bank, which acts as a trustee. + The bank then uses the money to purchase the corporation's stock on the open market and allocates the shares purchased to the participating stockholders' accounts on a pro rata basis. + The transactions costs of buying shares (brokerage costs) are low because of volume purchases, so these plans benefit small stockholders who do not need current cash dividends. - A "new stock" DRIP invests the dividends in newly issued stock; hence, these plans raise new capital for the firm. + No fees are charged to stockholders, and some companies have offered stock at discounts of 1% to 10% below the actual market price. + The companies offer discounts because they would have incurred flotation costs if the new stock had been raised through investment banks. - One interesting aspect of DRIPs is that they are forcing corporations to reexamine their basic dividend policies. + A high participation rate in a DRIP suggests that stockholders might be better served if the firm simply reduced cash dividends, which would save stockholders some personal income taxes. + Companies switch from old stock to new stock DRIPs depending on their need for equity capital.

Earnings, Cash Flows, and Dividends

- We normally think of earnings as being the primary determinant of dividends, but cash flows are actually more important. + For example, the earnings payout ratio (defined as DPS = EPS) averaged 62% over the entire 29 years, but it exceeded 100% on several occasions. + Above 100%, paying out more than earned. All else equal, the higher the payout, the riskier the dividend + Below 100%, earning enough to pay the dividend. All else equal, the lower the payout, the safer the dividend. - Its dividend is dependable, and it grows at a steady rate. + Earnings are relatively volatile, but cash flows are more stable, and those stable cash flows are responsible for the steady dividends. + When earnings change dramatically, either up or down, dividends are likely to follow with a lag while management determines whether the earnings change is likely to continue.

Reasons Some Investors Prefer Capital Gains

- While dividends reduce transactions costs for investors who are looking for steady income from their investments, dividends increase transactions costs for other investors who are less interested in income and more interested in saving money for the long-term future. + These long-term investors want to reinvest their dividends, and that creates transactions costs. + Given this concern, a number of companies have established dividend reinvestment plans that help investors automatically reinvest their dividends. - One key advantage is that taxes must be paid on dividends the year they are received, but taxes on capital gains are not paid until the stock is sold. + Due to time value effects, a dollar of taxes paid in the future has a lower effective cost than a dollar of taxes paid today. + Apart from this advantage, the tax rate on dividends has often been higher than the tax rate on capital gains + There are also favorable capital gains tax treatment on inherited stock. - To the extent that dividends have a tax disadvantage relative to capital gains, shareholders prefer capital gains (Low payout).

Summary of Factors Influencing Dividend Policy

1/ Constraints - Bond indentures. + Debt contracts often limit dividend payments to earnings generated after the loan was granted. + Also, debt contracts often stipulate that no dividends can be paid unless the current ratio, times-interest-earned ratio, and other safety ratios exceed stated minimums. - Preferred stock restrictions. + Typically, common dividends cannot be paid if the company has omitted its preferred dividend. + The preferred arrearages must be satisfied before common dividends can be resumed. - Impairment of capital rule. + Dividend payments cannot exceed the balance sheet item "retained earnings." + This legal restriction, known as the impairment of capital rule, is designed to protect creditors. + Without the rule, a company that is in trouble might distribute most of its assets to stockholders and leave its debtholders out in the cold. - Availability of cash. + Cash dividends can be paid only with cash. + Thus, a shortage of cash in the bank can restrict dividend payments. + However, the ability to borrow can offset this factor. - Penalty tax on improperly accumulated earnings. + To prevent wealthy individuals from using corporations to avoid personal taxes, the Tax Code provides for a special surtax on improperly accumulated income. + Thus, if the IRS can demonstrate that a firm's dividend payout ratio is deliberately being held down to help its stockholders avoid personal taxes, the firm is subject to heavy penalties. 2/ Investment Opportunities - Number of profitable investment opportunities. + As we saw in our discussion of the residual dividend model, if a firm has a large number of profitable investment opportunities, this will tend to produce a low target payout ratio and vice versa if the firm has few good investment opportunities. - Possibility of accelerating or delaying projects. + The ability to accelerate or post-pone projects permits a firm to adhere more closely to a stable dividend policy. 3/ Alternative Sources of Capital - Cost of selling new stock. + If a firm needs to finance a given level of investment, it can obtain equity by retaining earnings or by issuing new common stock. + If flotation costs (including any negative signaling effects of a stock offering) are high, re will be well above rs , making it better to set a low payout ratio and to finance through retention rather than through the sale of new common stock. + On the other hand, a high dividend payout ratio is more feasible for a firm whose flotation costs are low. - Ability to substitute debt for equity. + A similar situation holds for debt policy: If the firm can adjust its debt ratio without raising its WACC sharply, it can pay the expected dividend, even if earnings fluctuate, by additional borrowing. - Control. + If management is concerned about maintaining control, it may be reluctant to sell new stock; hence, the company may retain more earnings than it otherwise would. + However, if stockholders want higher dividends and a proxy fight looms, the dividend might be increased 4/ Effects of Dividend Policy on rs - The effects of dividend policy on rs may be considered in terms of four factors: (1) stockholders' desire for current versus future income, (2) the perceived riskiness of dividends versus capital gains, (3) the tax advantage of capital gains, and (4) the information (signaling) content of dividends.

Other Dividend Policy Issues

1/ Information Content, or Signaling, Hypothesis - An increase in the dividend is often accompanied by an increase in the stock price, while a dividend cut generally leads to a stock price decline. + MM noted that corporations are reluctant to cut dividends and thus that corporations do not raise dividends unless they anticipate higher earnings in the future to support the higher dividends. + Thus, MM argued that a higher-than-expected dividend increase is a signal to investors that management forecasts good future earnings. + Conversely, a dividend reduction, or a smaller than expected increase, is a signal that management forecasts poor future earnings. + If the MM position is correct, stock price changes after dividend increases or decreases do not demonstrate a preference for dividends over retained earnings. + Rather, such price changes simply indicate that dividend announcements have information (signaling) content about future earnings. - Managers often have better information about future prospects for dividends than public stockholders, so there is clearly some information content in dividend announcements. + However, it is difficult to tell whether the stock price changes that follow dividend increases or decreases reflect only signaling effects (as MM argue) or both signaling and dividend preference. 2/ Clientele Effect - As we indicated earlier, different groups, or clienteles, of stockholders prefer different dividend payout policies. + Such investors are frequently in low or even zero tax brackets, so taxes are of little concern. + On the other hand, stockholders in their peak earning years might prefer reinvestment because they have less need for current investment income and simply reinvest dividends received after incurring income taxes and brokerage costs. - If a firm retains and reinvests income rather than paying dividends, those stockholders who need current income will be disadvantaged. + The value of their stock might increase, but they will be forced to go to the trouble and expense of selling some of their shares to obtain cash. + On the other hand, stockholders who are saving rather than spending dividends favor the low-dividend policy: The less the firm pays out in dividends, the less these stockholders have to pay in current taxes and the less trouble and expense they must go through to reinvest their after-tax dividends. + Therefore, investors who want current investment income should own shares in high-dividend-payout firms, while investors with no need for current investment income should own shares in low-dividend-payout firms. - All of this suggests that a clientele effect exists, which means that firms have different clienteles and that the clienteles have different preferences; hence, a change in dividend policy might upset the majority clientele and have a negative effect on the stock's price. + This suggests that a company should follow a stable, dependable dividend policy so as to avoid upsetting its clientele. 3/ Borrowing from the ideas of behavioral finance, some recent research suggests that investors' preferences for dividends vary over time. - Investors sometimes have strong preferences for safety and high-dividend-paying stocks, whereas at other times they are more aggressive and seek low-dividend-paying stocks with greater potential for capital gains. + Corporate managers accommodate the shifting preferences of investors, are more likely to initiate dividends when dividend-paying stocks are in favor with investors, and are more likely to omit dividends when investors demonstrate a greater preference for capital gains. - Investors may or may not prefer dividends to capital gains; however, because of the clientele effect, they almost certainly prefer predictable dividends