Topic 4

What are the three ways that firms pay dividends?

- Cash Dividend
- Stock Dividend
- Stock splits

What is a cash dividend and how often are they given?

Payment of cash by the firm to its shareholders.
- Can be paid out regularly (Annual, bi-annual, quarterly, monthly)
- Can be special

What are stock dividends?

The distribution of additional shares to a firms shareholders.

What are stock splits?

issue of additional shares to the firms shareholders.

What are the dividend payment chronology?

1. Declaration date
2. Ex-dividend date
3. Record date
4. Payement date

What happens on the declaration date?

the company announces the amount and the timing of the dividend

What happens on the ex-dividend date?

Share prices drop by approximately the amount of dividends. Investors who own shares before or on the ex-dividend date will receive the dividend when its paid.

What happens on the record date?

roster of shareholders are prepared for dividend payment.

What happens on the payment date?

Checks are sent to eligible shareholders.

Name at least three restrictions on dividends

- Firms are not to pay dividends out of legal capital; the par value of common stock
- State and provincial laws may restrict firms from excess dividend payment
- lenders may restrict firms from excessive dividend payments through restrictive covenants
- Some countries (ex. Chile, Brazil) limit the minimum dividend payment as a percentage of the firms actual earnings
- Extra dividends (in addition to regular dividends) or special dividends may be used if firm wants to distribute more cash to shareholders
- DRIP (Dividend Reinvestment Plans) allows shareholders buy shares ofcompany, usually at a discount, with the dividend payment

Dividends are payed out of ________ ________ of the firm.

Retained Earnings

What is a stock repurchase?

When a firm buys a back stock from its shareholders

(T/F): Treasury stocks cannot be resold to raise funds later.

False: Treasury stocks can be resold to raise funds later.

What are the four methods of repurchasing?

- Buy shares on the market after an announcement
- tender offer to shareholders
- Dutch auction
- Private negotiation (green mail)

What is a tender offer?

A tender offer is a bid to purchase some or all of shareholders' stock in a corporation.

What is a dutch auction?

A Dutch auction (also called a descending price auction) refers to a type of auction in which an auctioneer starts with a very high price, incrementally lowering the price until someone places a bid.

What is a private negotiation (greenmail)?

Greenmail is the practice of buying enough shares in a company to threaten a hostile takeover so that the target company will instead repurchase its shares at a premium.

How do managers make dividend decisions? (Hint: there are 3)

1. Managers are reluctant to make dividend changes that might have to be reversed
2. Managers follow sticky dividends; they "smooth" dividends and hate to cut them. Dividend changes follow shifts in long run, sustainable levels of earnings.
3. Managers focus more on dividend changes than on absolute dividend levels

What does new dividends mean?

Managers are confident about future profitability

What can dividend increases mean? (Three explanations possible)

- Safer earnings; not necessarily increased future earnings
- overpriced stock
- It varies based on current and prior information about the stock

Share repurchases signal that management is_________ and it affects the _____ _____ in the market

confident; Share price

What is Miller and Modigliani's views on dividend payout policy?

Payout policy is irrelevant in perfect capital markets (No tax, transaction costs, and other frictions)

According to Miller and Modigliani, what do you do in the case of low dividend payment?

Homemade Dividends

According to Miller and Modigliani, in what situation should dividends be reinvested?

In the case of high payments

Why would investors not pay higher prices for firms with higher dividend payouts?

Because investors do not need dividends to convert shares to cash.
- Therefore dividend policy will have no impact on the firm

(Y/N): Is value added to shareholders when firms are choosing between paying dividends or repurchasing stocks?

No

When does dividend irrelevance work?

When capital budgets and capital structure is kept at a status quo.

If payout is irrelevant...

choice of payout is tactical

If payout policy is irrelevant, when should a company repurchase?

A company should repurchase when they want to retain flexibility to cut back payout if investment opportunities arise.

If payout policy is irrelevant, when should a company pay dividends?

A company should pay dividends when they want to assure the market that it will maintain a stable payout policy and payout surplus cash flow

Why should old shareholders not care if high dividend is paid out?

Old shareholders hold the same number of shares but suffer dilution
- The dilution is offset by the high dividend

Why should old shareholders not care if insufficient dividend is paid out?

If the dividend is not sufficient, old shareholders sell some of their stock to new shareholders
- There is no dilution, only fewer shares for share holders

Can every firm benefit from increasing its dividends?

no

Who are high dividend clientele/what are their needs?

they need the regular dividend to keep up with their regular expenses. It also allows them to have self discipline when they invest

Why cant a firm benefit from increasing its dividend?

Because high dividend clientele already have plenty of high dividend stock to choose from

What type of news does a dividend increase send about its cash flow and earnings?

Good news

What type of news does dividend decrease send about its cash flow and earnings?

Bad news

Why does a dividend increases signal a company's good fortune and its manager's confidence in future cash flows?

Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it

What is taxed at a higher rate, Dividends or income from capital gains?

Dividend is taxed at a higher rate than income from capital gains, even after adjusting for dividend tax credit

Tax on any potential capital gain that shareholders may incur as a result of share purchase is

- Choice of individual shareholders.
- Can be deferred until shares are sold and gains are realized

What are Other related caveats related to tax consequences of payout policy?

- Pension funds, and endowment funds do not pay any taxes on any income - they prefer high payout, in the form of dividends or share repurchases
- Corporations pay taxes on 50% of their dividend income - they prefer dividends over repurchases

What type of stocks do lightly taxed institutional investors prefer and hold?

High-yield stocks

What type of stocks do retail investors prefer?

Low-yield stocks

what type of individuals prefer low-yield stocks

- High-income individuals
- But taxes don't deter high-income individuals to hold substantial investments in high-yield stocks

Why do growing firms need all the cashflow they generate?

to fund new opportunities

The mature firms do not have a lot of investment opportunities, what do their cashflows look like?

They generate a lot of cashflow from existing operations every year (cash cow).

Questions for CFOs to answer regarding payout:

1. Is the company generating positive free cash flow after making all investments with positive NPV s, and is the positive free cash flow likely to continue?
2. Is the firm's debt ratio prudent?
3. Are the company's holdings of cash a sufficient cushion for unexpected setbacks and a sufficient war chest for unexpected opportunities?

What agency problem can excess cash lead to?

empire building, perks taking behaviour by management

How do investors want excess cash to be spent in order to ensure managers don't spend wastefully?

dividends or share repurchase

Why may manager pay heed to investor preferences?

- To ensure continuity of their tenure at the firm as the threat of falling strike price is a legitimate threat

What is a more credible assurance of continued payout in future?

Dividends

What is flexible and cannot be trusted to happen regularly in future?

Share repurchases

Why do managers with stock options prefer share repurchases?

Because the market price of share increases with repurchases and their options become deeper in the money

What two types of decisions are kept separate?

Financing and investing decisions

A project should be treated on a stand alone basis meaning mode of financing is...

irrelevant

Why do you adjust the discount rate?

to adjust for the riskiness of the project

What are the frictions that come with making the decision between financing or investing decisions?

- Capital rationing: Soft vs hard
- Taxes: choice of financing adding value
- Flotation costs when outside financing is needed
- signal to the market/asymmetric information
- Managing financial slack and agency issues

What is capital rationing?

the process through which companies decide how to allocate their capital among different projects, given that their resources are not limitless

What is soft capital rationing?

It is based on the internal policies of the company

What is hard capital rationing?

refers to the restraints put on a company by outside entities, such as banks or other lenders.

the discount rate used to evaluate a project uses _____ -tax cost of debt

after

What is WACC?

Firm wide discount rate

What is the WACC formula?

rD * (1-Tc) * (D/V) + [rE * (E/V)]

What does D represent and how is it calculated?

Market value of debt; Number of bods outstanding * price of bonds

What does E represent and how is it calculated?

Market value of equity; Outstanding shares * price per share

What is rD and rE?

Cost of debt and equity if they are to be raised now.

rD

- Return to be paid for issuing new debt;
- YTM on existing bonds;
- YTM of bonds with similar feature

rE

return to be paid to equity-holders; based on CAPM or DDM and similar models

What is TC?

Marginal tax rate of the firm. Tax to be paid on additional dollar of income.

Projects carrying 'similar (average) risk' compared to existing projects of the firm should be evaluated using WACC without adjustment. What types of projects do these include?

- Replacement projects
- Minor expansion projects

Should projects carrying 'similar (average) risk' compared to existing projects of the firm should be evaluated using WACC with or without adjustments?

without

What type of WACC should Projects carrying 'different risk' compared to existing projects of the firm use?

Adjusted WACC

When should you adjust upwards?

for riskier projects - projects involving new product, new technology, new market segment, new industry

When should you adjust downwards?

for less risky projects - government mandated projects, ESG investments required and partially funded by government, etc.

WACC is constant

a) True
b) false

b) false

When is WACC constant?

It is constant for average projects if the nature of business and mode of financing remain stable.

When will WACC change?

When /if:
- Business risk of the firm changes (beta)
- Financial risk of the firm changes (mode of financing changes 'D/E')

When would firms use different WACCs

When evaluating projects in different divisions

When can you use WACC or derivates of WACC to evaluate a project?

- If the risk of the project is comparable to the risk of the existing projects (stable business risk)
- When the D/E is actively maintained (stable financial risk)

Immediate source of funds or the source of funds used to finance any project is not important because:

- A projects contribution to the firms borrowing capacity is vital
- A project fully financed by debt will not use a lower WACC (as debt is cheaper), rather using debt reduces the future borrowing capacity of the firm

As D/E changes, the cost of debt and cost of equity changes as well because:

- Cost of debt increases as the financial distress cost increases with the level of debt
- Cost of equity increases with increased debt as the financial risk of equity holders increases

Why might a manager want to value their own firm?

- M&A
- Divestment of a business segment
- IPO share price
- Under/over-valuation by the market before the distribution decision

How does valuation work? (3 steps)

1. Calculate FCF for unlevered firm (without the effects of interest expense); calculate taxes without the effect of interest expenses; usually for a period of 5-10 years

2. Estimate the terminal value (aka horizon value) at the end of the projected number of years; the terminal growth rate assumption is critical

3. Discount these estimates FCF and terminal value by WACC

What is FCF?

The amount of cash a firm can payout to its investors after making all the available positive NPV projects

What is the assumption associated with FCF?

an all-equity (unlevered) firm

What are the two ways of calculating FCF?

1. FCF = profit after tax + depreciation - Capital investments (investment in fixed assets) - changes in net working capital (investments in working capital)

2. FCF = EBITDA - tax - capital investments(investments in fixed assets) - changes in net working capital (investments in working capital)

How do you find terminal value?

Use an estimated perpetual growth rate to find terminal value