finance 338 test 3
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.
stock dividends and stock split
Both 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."
Repurchases:
Buying own stock back from stockholders
investment timing option
By waiting, a better-informed decision can be made adds value to the project and reduces its risk.
Investment Opportunities and Residual Dividends
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. Ex: Microsoft (they never paid dividends until a decade ago after their last product they thrived with) Microsoft is a cash cow
stock split
Firm increases the number of shares outstanding, say 2:1. Sends shareholders more shares
stock dividend
Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for each 100 shares owned. instead of paying in cash you pay in stock
new stock plan
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. Opportunity to have same return on equity without increase in price (discount) Very profitable for investors 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 NYSE listed companies have a DRIP. Useful for investors.
pecking order theory
Firms use internally generated funds first, because there are no flotation costs or negative signals. If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals. If more funds are needed, firms then issue equity.
setting dividend policy
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.
investment timing options
Gives companies the option to delay a project rather than implement it immediately. This option to wait allows a company to reduce the uncertainty of market conditions before it decides to implement the project
Three ways to purchase:
Have broker/trustee purchase on open market over period of time. Make a tender offer to shareholders. Make a block (targeted) repurchase.
implications for managers: Take advantage of tax benefits by issuing debt, especially if the firm has:
High tax rate Stable sales Low operating leverage
tax effect theory
Low payouts mean higher capital gains. Capital gains taxes are deferred until they are realized, so they are taxed at a lower effective rate than dividends. This could cause investors to require a higher pre-tax return to induce them to buy a high payout stock, which would result in a lower stock price.
signaling theory
MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would: - Sell stock if stock is overvalued. - Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal. Implications for managers?
trade-off theory
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.
Market timing theory
Managers try to "time the market" when issuing securities. They issue equity when the market is "high" and after big stock price run ups. They issue debt when the stock market is "low" and when interest rates are "low." The issue short-term debt when the term structure is upward sloping and long-term debt when it is relatively flat.
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 positive signal--management thinks stock is undervalued.
summary of empirical tests
Taxes certainly affect dividend policies chosen by companies. Evidence that investors prefer to avoid taxation . Some evidence that investors require higher pre-tax returns on stocks with big dividend payouts
distribution patterns over time
The % of total payouts as 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 pay dividends. 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.
A repurchase has no effect on stock price
The announcement of an intended repurchase might send a signal that affects stock price, and the previous events that led to cash available for a distribution affect stock price, but the actual repurchase 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 the stock price, they would all sell short the stock the day before, which would drive down the stock price.
business risk uncertainty
Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs. Product and other types of liability. Degree of operating leverage (DOL).
Business risk:
Uncertainty in future EBIT, NOPAT, and ROIC. Depends on business factors such as competition, operating leverage, etc.
Dividend Reinvestment Plan (DRIP)
an investment plan that allows the investor to automatically reinvest stock dividends in the same company's stock without paying any brokerage fees Shareholders can automatically reinvest their dividends in shares of the company's common stock. Get more stock than cash. There are two types of plans: Open market New stock
target distribution ratio
determines the relative mix of dividends and capital gains Percentage of net income distributed to shareholders through cash dividends or stock repurchases. The actual distribution ratio can vary from the target year to year, but the average actual distribution ratio over time should match the target.
optimal distribution policy
distribution policy that maximizes the value of the firm by choosing the optimal level and form of distributions (dividends and stock repurchases).
if a company has a large __ but a small payout ratio, then it pays low dividends but regularly repurchases stock, resulting in a low dividend yield but a higher expected capital gain yield
distribution ratio
a project's variance is higher than a stock's because of __
diversification effects
combination of a high distribution ratio and a high payout ratio means that a company pays large __ and has small (or zero) __
dividends; stock repurchases
decision node
each circle represents a decision point A place in a decision tree at which managers can make a decision based on the situation occurring at that point. Called a node because additional paths branch out, with each branch corresponding to the possible decisions.
implications for managers: If manager has asymmetric information regarding firm's future prospects, then avoid issuing __ if actual prospects are better than the market perceives
equity
direct method
estimate the rate of return for each possible outcome and then calculate the variance of those returns
Many firms, especially those with growth options and asymmetric information problems, tend to maintain __
excess borrowing capacity
T/F: a firm's business risk is largely det. by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses
false
T/F: since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC
false
T/F: since debt financing raises the firm's financial risk, increasing the debt ratio will always increase WACC
false
T/F: since the firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect its cost of equity
false
T/F: the dividend irrelevance theory, proposed by Miller and Modigliani, says that provided a firm pays at least some dividends, how much it pays does not affect either its cost of capital or its stock price
false
which have the biggest impact on the cost of capital? operating plans financing plans working capital policies shareholder distributions
financing plans
company follows a strict residual dividend policy. what would most likely lead to an increase in the firm's dividend per share?
firm's NI increases
an option's value is higher/lower the longer its time to expiration?
higher
dividend irrelevance theory
holds that dividend policy has no effect on either the price of a firm's stock or its cost of capital. argued that the firm's value is determined only by its basic earning power and its business risk MM argued that the value of the firm depends only on the income produced by its assets, not on how this income is split between dividends and retained earnings.
which is likely to encourage a company to raise its target debt ratio? a) increase in personal tax rate b) increase in company's operating leverage c) fed tightens interest rates to fight inflation d) increase in corporate tax rate
increase in corporate tax rate
Under MM with corporate taxes, the firm's value __ continuously as more and more debt is used
increases
A company can change its __ of operations only if it changes its cost of capital or expected future free cash flows
intrinsic value
Valuing a real option requires __, both to formulate the model and to estimate the inputs
judgment
high payouts lead to?
less risk (less unsure about future gains) & reduces potential agency issues --> reduce agency cost --> reduce equity --> may increase value of operations
MM theory implies that beta changes with ?
leverage
the option to delay is valuable only if it ?
more than offsets any harm that might result from delaying most valuable to firms with proprietary technology, patents, licenses, or other barriers to entry, because these factors lessen the threat of competition valuable when market demand is uncertain, but it is also valuable during periods of volatile interest rates, because the ability to wait can allow firms to delay raising capital for a project until interest rates are lower
Selling short-term investments is a positive/negative use of FCF?
negative
if a firm adheres strictly to the residual div policy, then if its optimal capital budget requires the use of all retained earnings for the year, then the firm should pay:
no dividends to common stockholders
stock repurchases
occur when a company buys some of its own outstanding stock
which have the biggest impact on free cash flow? operating plans financing plans working capital policies shareholder distributions
operating plans
any project that reduces the set of future opportunities destroys __ value
option
coefficient of variation of the underlying asset's price at the time the __ expires
option
strategic options
options that often deal with strategic issues. Also called real options, embedded options, and managerial options. they are often associated with large, strategic projects rather than routine maintenance projects
5 possible procedures to deal with real options
Use discounted cash flow (DCF) valuation and ignore any real options by assuming their values are zero. Use DCF valuation and include a qualitative recognition of any real option's value. Use decision-tree analysis. Use a standard model for a financial option. Develop a unique, project-specific model using financial engineering techniques
special dividend
Used when favorable circumstances allow a firm to make a one-time cash payment to shareholders, in addition to any other dividends it pays A dividend paid, in addition to the regular dividend, when earnings permit. Firms with volatile earnings may have a low regular dividend that can be maintained even in years of low profit (or high capital investment) but is supplemented by an extra dividend when excess funds are available
options values
Value of opportunities to modify a project after its implementation, including expansion, contraction, or delay. Also includes additional opportunities that a project provides to a firm, such as introduction of complementary product line. so projects that expand the firm's set of opportunities have positive options values
MM: zero taxes
Vl = Vu MM assume: (1) no transactions costs; (2) no restrictions or costs to short sales; and (3) individuals can borrow at the same rate as corporations. MM prove that if the total CF to investors of Firm U and Firm L are equal, then arbitrage is possible unless the total values of Firm U and Firm L are equal: VL = VU. Because FCF and values of firms L and U are equal, their WACCs are equal. Therefore, capital structure is irrelevant.
implications for managers: Avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has:
Volatile sales High operating leverage Many potential investment opportunities Special purpose assets (instead of general purpose assets that make good collateral)
The impact of capital structure on value depends upon the effect of debt on:
WACC and FCF
benefits of holding a large amount of short term investments?
a large holding reduces the risk of financial distress should there be an economic downturn. if growth opportunities turn out to be better than expected, short-term investments provide a ready source of funding that does not incur the flotation or signaling costs due to raising external funds
downside of holding a large amount of short term investments?
a potential agency cost: If a company has a large investment in marketable securities, then managers might be tempted to squander the money on perks (such as corporate jets) or high-priced acquisitions.
Dividend Preference (Bird-in-the-Hand) Theory
a stock's risk declines as dividends increase: A return in the form of dividends is a sure thing, but a return in the form of capital gains is risky shareholders prefer dividends and are willing to accept a lower required return on equity
growth options
add value to a project resembles a call option on a stock, because it gives a company the opportunity to "purchase" a successful follow-on project at a fixed cost if the value of the project is greater than the cost.
abandonment option
allows a company to reduce a project's capacity or drop the project entirely if market conditions deteriorate.
abandonment options
allows a company to reduce the capacity of its output in response to changing market conditions. This includes the option to contract production or abandon a project if market conditions deteriorate too much.
which is correct when debt financing is used? a) the % change in EBIT will be equal to a given % change in NI b) the % change in NI relative to the % change in EBIT will depend on the interest rate charged on debt c) the % change in NI will be greater than the % change in EBIT d) the % change in sales will be greater than % change in EBIT, which in turn will be greater than % change in NI
the % change in NI will be greater than the % change in EBIT
which is correct? a) the capital structure that minimizes the interest rate on debt also maximizes the expected EPS b) the capital structure that minimizes the req return on equity also maximizes the stock price c) the capital structure that minimizes the WACC also maximizes the price per share of C/S d) the capital structure that also gives a firm the best credit rating also maximizes the stock price
the capital structure that minimizes the WACC also maximizes the price per share of C/S
payment date
the date on which a firm actually pays a cash dividend to those owning the stock two business days prior to the holder of record date.
payout ratio must be less than the distribution ratio because ?
the distribution ratio includes stock repurchases as well as cash dividends
if December 20 is date of record, does the new owner or previous owner receive the dividend if they find out before Dec 20?
the new owner receives the dividend (even if the new owner subsequently sells the stock before the actual dividend payment
if December 20 is date of record, does the new owner or previous owner receive the dividend if they find out after Dec 20?
the previous owner gets the dividend check (even though the previous owner no longer owns the stock).
options
the right (but not the obligation) to take some action in the future
real options
they involve real, rather than financial, assets are opportunities for management to change the timing, scale, or other aspects of an investment in response to changes in market conditions. These opportunities are options in the sense that management can, if it is in the company's best interest, undertake some action; management is not required to undertake the action. These opportunities are real (as opposed to financial) because they involve decisions regarding real assets—such as plants, equipment, and land—rather than financial assets like stocks or bonds. Four examples of real options are investment timing options, growth options, abandonment options, and flexibility options.
T/F: Firm doesn't have to complete its announced intent to repurchase.
true
T/F: Sometimes companies will deliberately increase debt to above target to take advantage of unexpected investment opportunity.
true
T/F: Stock price is unchanged by actual repurchase
true
T/F: a firm's capital structure does not affect its calculated FCF, because FCF reflects only operating cash flows
true
T/F: financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were issued
true
T/F: if Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal
true
T/F: if a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not follow the strict residual div policy
true
T/F: if a firm adopts a residual distribution policy, distributions are determined as a residual after funding the capital budget. Therefore, the better the firm's investment opportunities, the lower its payout ratio should be
true
T/F: increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. however, this still may lower the WACC
true
T/F: the announcement of an increase in the cash dividend should, according to the signaling hypothesis, lead to an increase in the price of a firm's stock
true
T/F: the trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing
true
T/F: very often, a company's stock price will rise when it announces that it plans to commence a share repurchase program, consistent with signaling hypothesis
true
T/F: After big stock price run ups, debt ratio falls, but firms tend to issue equity instead of debt.
true Inconsistent with trade-off model. Inconsistent with pecking order. Consistent with windows of opportunity
T/F: firms with higher dividend payouts also have higher required returns
true investors require a higher pre-tax return to induce them to buy the stock
T/F: The announcement of an intended repurchase might send a signal that affects stock price, and the previous change in capital structure affects stock price, but the repurchase itself has no impact on stock price
true 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 the stock price, they would all sell short the stock the day before, which would drive down the stock price.
T/F: Lost value from being above target is bigger than lost value from being below target.
true (When above target, distress costs rise very rapidly)
staged decision tree
type of capital budgeting analysis that models the decisions that management can make about the project after the project has started as a decision tree.
bu?
unlevered beta beta of a firm when it has no debt
financial engineering
use of option pricing and derivative pricing techniques to create and determine the value of a new financial security or to determine the value of a real option embedded in a project.
A company's __ policies determine its level of short-term investments, such as T-bills or other marketable securities.
working capital
which determine the target level of marketable securities? operating plans financing plans working capital policies shareholder distributions
working capital policies
Firms have targets, but don't make quick corrections when stock price changes cause their __ to change
debt ratios
because there is no possibility of losing money under the __ option, this decision also lowers the project's risk
delay
Financial risk:
Additional business risk concentrated on common stockholders when financial leverage is used. Depends on the amount of debt and preferred stock financing
If a company's FCF is negative, then its __ of FCF must also be negative
"uses"
At optimal capital structure, $1 debt adds about __ to value on average
$0.10 to $0.20
holder-of-record date is important because it ?
determines the ex-dividend date, which determines who gets the dividend.
Stock repurchases are usually made in one of 3 ways.
(1) A publicly owned firm can buy back its own stock through a broker on the open market. (2) The firm can make a tender offer, under which it permits stockholders to send in (that is, "tender") shares in exchange for a specified price per share. In this case, the firm generally indicates it will buy up to a specified number of shares within a stated time period (usually about two weeks). If more shares are tendered than the company wants to buy, purchases are made on a pro rata basis (3) The firm can purchase a block of shares from one large holder on a negotiated basis. This is a targeted stock repurchase
frequent switching would be inefficient because of:
(1) brokerage costs (2) the likelihood that stockholders who are selling will have to pay capital gains taxes (3) a possible shortage of investors who like the firm's newly adopted dividend policy
3 theories of investor preferences for dividend yield versus capital gains:
(1) the dividend irrelevance theory (2) the dividend preference theory (also called the "bird-in-the-hand" theory) (3) the tax effect theory.
Black-Scholes option pricing model requires five inputs:
(1) the risk-free rate (2) the time until the option expires (3) the strike price (4) the current price of the stock (5) the variance of the stock's rate of return. Therefore, we need to estimate values for those five inputs
3 dividend theories
1) Dividends are irrelevant: Investors don't care about payout. 2) Dividend preference, or bird-in-the-hand: Investors prefer a high payout. 3) Tax effect: Investors prefer a low payout
2 reasons why stock price appreciation still is taxed more favorably than dividend income:
1) an increase in a stock's price isn't taxable until the investor sells the stock, whereas a dividend payment is taxable immediately; a dollar of taxes paid in the future has a lower effective cost than a dollar paid today because of the time value of money. So even when dividends and gains are taxed equally, capital gains are never taxed sooner than dividends. 2) if a stock is held until the shareholder dies, then no capital gains tax is due at all: The beneficiaries who receive the stock can use its value on the date of death as their cost basis and thus completely escape the capital gains tax.
3 situations can lead to stock repurchases:
1) company may decide to increase its leverage by issuing debt and using the proceeds to repurchase stock 2) many firms have given their employees stock options, and companies often repurchase their own stock to sell to employees when employees exercise the options. In this case, the number of outstanding shares reverts to its pre-repurchase level after the options are exercised. 3) company may have excess cash. This may be due to a one-time cash inflow, such as the sale of a division, or the company may simply be generating more free cash flow than it needs to service its debt.
4 steps of dividend payment procedure
1) declaration date 2) holder-of-record date 3) ex-dividend date 4) payment date
valuing real options
1) if a project has an embedded real option, then management should at least recognize and articulate its existence 2) we know that a financial option is more valuable if it has a long time until maturity or if the underlying asset is very risky. If either of these characteristics applies to a project's real option, then management should know that its value is probably relatively high. 3) management might be able to model the real option along the lines of a decision tree
5 uses of FCF
1) interest payments (after tax) 2) principal repayments 3) dividends 4) stock repurchases 5) purchase of short-term investments
4 examples of real options
1) investment timing options 2) growth options 3) abandonment options 4) flexibility options.
types of growth options
1) lets a company increase the capacity of an existing product line 2) allows a company to expand into new geographic markets 3) the opportunity to add new products, including complementary products and successive "generations" of the original product
2 agency problems with debt financing
1) managers can use corporate funds for non-value maximizing purposes. The use of financial leverage: - Bonds "free cash flow." - Forces discipline on managers to avoid perks and non-value adding acquisitions 2) potential for "underinvestment". - Debt increases risk of financial distress. - Therefore, managers may avoid risky projects even if they have positive NPVs.
The use of dividends versus stock repurchases has changed dramatically during the past 30 years, how?
1) total cash distributions as a percentage of net income have remained fairly stable at around 26% to 28%, but the mix of dividends and repurchases has changed 2) companies today are less likely to pay a dividend 3) he aggregate dividend payouts have become more concentrated in the sense that a relatively small number of older, more established, and more profitable firms accounts for most of the cash distributed as dividends
3 MM theories
1) zero tax 2) corporate taxes 3) corporate and personal taxes
Bankruptcies are costly- costs can be up to __ of firm value
10% to 20%
he right to the dividend remains with the stock until __ business days prior to the holder-of-record date
2
Empirical Tests: Uncertainty about tax laws leads to changes in dividends.
2010 and 2012: Fear of tax increases on dividends. Comparing late 2010 and 2012 (great uncertainty) with late 2009 and 2011: -Additional special dividends of over $7 billion. -176 companies moved up payment dates from beginning of next year to late in 2010 and 2012 before rates changed. -Over $12 billion in sooner-than-normal regular dividend payments. -Companies with higher insider ownership were more likely to pay special dividends or accelerate payment dates. This evidence doesn't directly support the tax effect hypothesis, but it does show that taxes affect payout policies.
For average firm financed with 25% to 30% debt, this adds about __ to the total value.
3-6%
Average speed of adjustment from current capital structure is about __% per year
30%
Speed is about __% per year for firms with high cash flow.
50%
Speed is about __% for firms with high cash flow that are above target
70%
the value of an option is higher if the current value of the underlying asset is high relative to its __
strike price
decision tree
A form of project analysis in which possible future possible scenarios for cash flows are identified for each year in the project's life and in which managers can make decisions at future dates depending on the actual scenario occurring at that future date. It is called a decision tree because there are branches beginning at Year 0 (e.g., three possible scenarios) and because managers can make a decision at a future time (e.g., abandon the project or increase capacity, depending on the level of demand at that time), which leads to additional branches based on that decision
defined contribution plans
Contributions to the plan are known but the future benefits depend on the plan's investments.
MM: corporate taxes
Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms. Therefore, more CF goes to investors and less to taxes when leverage is used. In other words, the debt "shields" some of the firm's CF from taxes. MM show that the total CF to Firm L's investors is equal to the total CF to Firm U's investor plus an additional amount due to interest deductibility: CFL = CFU + rdDT. What is value of these cash flows? Value of CFU = VU MM show that the value of rdDT = TD Therefore, VL = VU + TD. If T=40%, then every dollar of debt adds 40 cents of extra value to firm
Empirical Tests: International Evidence on Taxes and Payouts
Different countries have different tax laws, with some countries taxing dividends more heavily than capital gains. This "dividend tax penalty" can be measured for different countries. Research shows that in countries with relatively low dividend tax penalties: -More companies pay dividends -Dividend payments are larger In countries with relatively high dividend tax penalties: -More companies repurchase stock This evidence doesn't directly support the tax effect hypothesis, but it does show that taxes affect payout policies
clientele effect
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. -Bound to see large amount of sell off (downward price pressure in equity) if you change dividend policy
open market purchase plan
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.
Business Risk: Uncertainty in __, __, and ___
EBIT, NOPAT, and ROIC
branch of decision tree
Each diagonal line leads to a branch of the decision tree each branch has an estimated probability
Scenario Analysis and Decision Trees
Each possible outcome is shown as a "branch" on the tree. Each branch shows the cash flows and probability of a scenario laid out as a time line The expected NPV is the weighted average of the three possible outcomes, where the weight for each outcome is its probability
401(k) retirement plans
Employees' contributions, matching contributions from the sponsoring employer (if these are included in the plan), and profits on the investments are not taxable until withdrawn. Some mutual fund investors are sheltered from taxes because their investments are made through these
holder-of-record date
If a company lists the stockholder as an owner on the holder-of-record date, then the stockholder receives the dividend.
Empirical Tests: Changes in Tax Codes
In 2005, Congress reduced the tax rate on dividends to be equal to the tax rate on capital gains. -But law was temporary and was set to expire at end of 2010 In mid-December 2010, Congress extended the tax treatment temporarily for two more years. -Set to expire at end of 2012. January 2013, Congress enacted law to "permanently" tax dividends and capital gains at 20% for high-income investors.* Lots of uncertainty in late 2010 and 2012, making them excellent
residual distribution model
In this model, firms should pay dividends only when more earnings are available than needed to support the optimal capital budget. 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.
dividend irrelevance theory
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. 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). (No asymmetric info (everyone in market has same info), Prices move due to info being put into market, No taxes: aka no cash)
Bird in Hand (dividend preference) theory
Investors might think dividends (i.e., the-bird-in-the-hand) are less risky than potential future capital gains. Also, high payouts help reduce agency costs by depriving managers of cash to waste and causing managers to have more scrutiny by going to the external capital markets more often. Therefore, investors would value high payout firms more highly and would require a lower return to induce them to buy its stock.
What's the "information content," or "signaling," hypothesis?
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. Produce more FCF to have more interest and principal to keep up with new dividends
Consider residual policy when setting __, but don't follow it rigidly.
target payout
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.
risk-neutral valuation
Method of derivative valuation that replaces the actual growth rates of asset values with the risk-free rate and then discounts the resulting cash flows at the risk-free rate. The result is the correct value of the asset (in the sense that there will be no arbitrage opportunities if asset is priced with the result of the risk-neutral valuation technique).
advantages of the Residual Dividend Policy
Minimizes new stock issues and flotation costs
growth option
Occurs if an investment creates the opportunity to make other potentially profitable investments that would not otherwise be possible, including options to expand output, to enter a new geographical market, and to introduce complementary products or successive generations of products allows a company to increase its capacity if market conditions are better than expected
dividend tax penalty
Occurs if dividends are taxed more highly than capital gains causing investors to require a higher pre-tax rate of return on dividend-paying stocks relative to non-dividend stocks.
What is operating leverage, and how does it affect a firm's business risk?
Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs relative to variable costs, the greater the operating leverage. Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline.
embedded options
Options that are a part of another project. Also called real options, managerial options, and strategic options. they are a part of the project can dramatically affect the true NPV.
managerial options
Options that give opportunities to managers to respond to changing market conditions. Also called real options. they give managers a chance to influence the outcome of a project give managers the option to influence the returns on a project
target payout ratio
Percentage of net income that company seeks to pay as a cash dividend. The actual payout ratio can vary from the target year to year, but the average actual payout ratio over time should match the target.
flexibility options
Permit a firm to alter operations depending on how conditions change during the life of the project, such as the ability to produce different products to match changing demand.
MM: corporate and personal taxes
Personal taxes lessen the advantage of corporate debt: -Corporate taxes favor debt financing since corporations can deduct interest expenses. -Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate. Use of debt financing remains advantageous, but benefits are less than under only corporate taxes. Firms should still use 100% debt. Note: However, Miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to debt.
operating breakeven equation
Qbe = fixed cost / (price per unit - variable cost)
Repurchase vs. Dividends
Repurchase - Stock price doesn't fall at time of repurchase - Number of shares falls Dividend distribution - Stock price falls by amount of dividend at time of payment - Number of shares doesn't change
Empirical Tests: Dividends and Required Returns
Research shows that investors require higher pre-tax returns on stock in high payout companies. But taxes alone can't explain the difference in required returns between high-payout companies and low-payout companies. These finding support the tax effect hypothesis, but are not conclusive.
Disadvantages of the Residual Dividend Policy
Results in variable dividends, sends conflicting signals, increases risk, and doesn't appeal to any specific clientele.
distribution policy
Sets the level of cash distributions (the dollar amount) and the form of the distributions (dividends and stock repurchases).
Empirical Tests: Tax Effects versus Agency Costs
Some countries have legal system with poor investor protection. - Agency costs, such as perquisite consumption and wasteful acquisitions, are harder for investors to to prevent. - Low dividend payouts make more cash available for these activities. Research shows that in countries with poor investor protection (where agency costs are most severe), high payout companies are valued more highly than low payout companies.
Drop in Price with Dividend Distribution
Stock price drops by dividend per share in model. - If it didn't there would be arbitrage opportunity (assuming no taxes). In real world, stock price drops on average by about 90% of dividend
when should a firm consider splitting its stock?
There's a widespread belief that the optimal 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 when management is confident, so are interpreted as positive signals.
declaration date
The date on which a firm's directors issue a statement declaring a dividend. The dollar value of the declared payment is reported as a liability on the balance sheet and the retained earnings account is reduced by that amount. the declared dividend becomes an actual liability on the declaration date
ex-dividend rate
The date when the right to the dividend leaves the stock. This date was established by stockbrokers to avoid confusion, and it is two business days prior to the holder-of-record date. If the stock sale is made prior to the ex-dividend date, then the dividend is paid to the buyer; if the stock is bought on or after the ex-dividend date, the dividend is paid to the seller.
DCF Analysis with a Qualitative Consideration of the Timing Option
The discounted cash flow analysis suggests that the project should be accepted, but just barely, and it ignores the existence of a possibly valuable real option
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
why are real assets are not passive investments?
because managerial actions after an investment has been made can influence its results
Observe that this real timing option resembles a __ on a stock:
call option. A call gives its owner the right to purchase a stock at a fixed strike price, but only if the stock's price is higher than the strike price will the owner exercise the option and buy the stock
A company's __ choice determines its payments for interest expenses and debt principal
capital structure
Companies can distribute cash to shareholders via __ or __
cash dividends or stock repurchases
retired individuals, pension funds, and university endowment funds generally prefer __, so they may want the firm to pay out a high percentage of its earnings
cash income
Dividends are "sticky"
certain info content --> If issued div payout, you should stick to it so you don't upset investors
A company's value typically increases over time, even if the company is mature, which implies its __ will also increase over time if the company maintains a target capital structure.
debt
Purchasing short-term investments is a positive or negative use of FCF?
positive
Although the DCF analysis indicates that the project should be accepted, it ignores a potentially valuable __
real option
where does cash come from?
recapitalization the sale of an asset but in most cases it comes from the company's internally generated free cash flow
managers are just as interested in __ risk as in measuring it
reducing
stockholders in their peak earning years might prefer __, because they have less need for current investment income and would simply reinvest dividends received—after first paying income taxes on those dividends
reinvestment
most companies make net additions to debt over time rather than net __, even if FCF is positive
repayments
ST investments fall because they are used to __
repurchase stock
The principal conclusion of MM's dividend irrelevance theory is that dividend policy does not affect a stock's value or risk. Therefore, it does not affect the __
required rate of return on equity (rs)
Firms with many investment opportunities should maintain __, especially if they have problems with asymmetric information (which would cause equity issues to be costly).
reserve borrowing capacity
the value of an option increases with the __ of the underlying asset
risk
One way to reduce __ is to structure projects so that expenditures can be made in stages over time rather than all at once.
risk gives managers the opportunity to reevaluate decisions using new information and then to either invest additional funds or terminate the project. This type of analysis involves the use of decision trees.
Leverage magnifies __ and __
risk and return
the __ of FCF depends on a company's investment opportunities and its effectiveness in turning those opportunities into realities.
source
Tax Effect Theory
states that because long-term capital gains are subject to lower taxes than dividends, investors prefer to have companies retain earnings rather than pay them out as dividends capital gains are preferred investors prefer that companies minimize dividends.
