Ch 14 notes: Dividends and Repurchases

Overview of Distribution Policy

  • Definition: A distribution policy outlines the cash distribution to shareholders, the form (dividends vs. stock repurchases), and the stability of distributions.

Dividends vs. Stock Repurchases

  • General Trends:

    • The percentage of total payouts to net income is stabilized at around 26%-28%.
    • Key Observations:
    • Dividend payouts have decreased while stock repurchases have risen.
    • Stock repurchases now exceed dividends in total dollar value.
    • Dividend payouts are increasingly concentrated among large, mature firms.

  • Stock Repurchases:

    • Defined as buying back own stock from shareholders.
    • Theoretically equivalent to dividends because they increase the percentage of future cash flows to remaining shareholders.
    • Reasons for Stock Repurchases:
    • Tax-free alternative for shareholders compared to dividends.
    • Strategic for handling one-time cash from asset sales or capital structure changes.
    • Helps prevent dilution from employee stock options.

  • Implications of Stock Repurchases:

    • Shareholders can decide to sell or retain stocks.
    • Helps avoid establishing high payouts that might not be sustainable.
    • Income from selling stock is treated as capital gains, which may be taxed at lower rates than dividends.
    • Could signal that management sees the stock as undervalued.

Dividend Theories

1. Dividend Irrelevance Theory (MM)
  • Suggests investors do not prefer dividends over capital gains.
  • If investors desire cash, they can sell their stocks; if they don’t, they can reinvest dividends.
  • Argues payout policies do not affect stock values or required returns, based on unrealistic assumptions (no taxes or transaction costs).
2. Bird-in-the-Hand Theory
  • Investors perceive dividends as less risky than future capital gains.
  • High payouts reduce agency costs by limiting managers’ access to cash, thus valued by investors.
3. Clientele Effect
  • Different investors (clienteles) prefer various dividend policies.
  • A firm’s past dividend policy affects its current investor clientele, making policy changes difficult.
4. Signaling Hypothesis
  • Changes in dividends reflect management’s expectations about future performance.
  • Managers are reluctant to cut dividends and will only increase if they believe sustainable growth exists.
  • A share price increase following a dividend rise may indicate optimistic expectations for future earnings per share (EPS).

Residual Dividend Policy

  • Key Steps:
    1. Calculate reinvested earnings needed for the capital budget.
    2. Pay out any remaining earnings (residual) as dividends or stock repurchases.

Distribution=Net Income−[(Target E/V)×(Capital Budget)]\text{Distribution} = \text{Net Income} - [(\text{Target E/V}) \times (\text{Capital Budget})]

  • Advantages:
    • Minimizes flotation costs from new stock issues.
    • Lowers the Weighted Average Cost of Capital (WACC).
  • Disadvantages:
    • Leads to variable dividends, potentially sending mixed signals to the market and not appealing to specific clienteles.

Strategic Dividend Planning

  • Forecasting:
    • Assess capital needs for a 5-year horizon.
    • Set a target capital structure and estimate annual equity requirements.
    • Establish target payout based on the residual model, allowing for some dividend growth if feasible.