08. corporate finance

O8. Corporate Finance

Dividends and Share repurchases: Analysis

1. Introduction

A payout policy is a set of principles regarding a corporation’s distributions to shareholders.

–  May be established with regard to a dividend payout, a dividend per share, a growth in dividend per share, or any other metric.

–  May include stock splits and stock dividends. –  May include stock repurchases.

Copyright © 2013 CFA Ins;tute 3

2. Dividend Policy and Company Value: Theory

Dividends Are Irrelevant

•  Based on MM theories.

•  If owners want a leveraged posi;on, they can make it themselves.

Bird in the Hand

•  Cash dividends are more certain than stock apprecia;on.

Tax Argument

•  How dividends are taxed rela;ve to capital gains affects investors preferences for dividends.

Other

•  Clientele effect.

•  Signaling. •  Agency cost effects.


Dividends are irrelevant

In Miller and Modigliani’s (MM) world with no taxes, no transaction costs, and homogeneous information, dividend policy does not affect the value of the company.

–  The decision of how a company finances its business is separate from the decision of what and how much to invest in capital projects.

–  If an investor wants cash flow, he/she could sell some shares.

–  If an investor wants more risk, he/she could borrow to invest.

–  An investor is indifferent about a share repurchase or a dividend.

Bottom line: Dividend policy does not affect a firm’s value.


Dividend Policy Is Irrelevant in Perfect Capital Markets

Dividend Irrelevance—An Illustration

The Bird-in-the-Hand Argument

•  Investors prefer a cash dividend to uncertain capital gains. –  Hence, investors prefer the “bird in the hand.” –  Issue: Riskiness of the stock appreciation.

•  If this explanation holds, a company that pays a cash dividend will have a higher value than a similar company that does not pay a cash dividend.

Bottom line: Dividend policy affects the value of the firm.


The “Bird-in-the-Hand” Argument M&M versus Gordon’s Bird in the Hand Theory

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• The difference between the M&M and Gordon arguments are illustrated in Figure 22 - 5 :

– M&M argue that dividends and capital gains are perfect substitutes

The Tax Argument

If dividends are taxed at a rate higher than capital gains, investors prefer that companies reinvest cash flow back into the firm.

–  In other words, investors prefer the lower-taxed capital gains to the higher-taxed cash dividends.

–  This advocates a zero dividend payout when dividends are taxed at a rate higher than that of capital gains.

Bottom line: Dividend policy affects the value of the firm.


Relaxing the M&M Assumptions Repackaging Dividend-Paying Securities

•  Tax clienteles help to explain the financial engineering whereby different parts of the return by the firm are stripped, repackaged and sold to different investors as illustrated in Figure 22 – 7. (See the following slide)

•  Split shares are shares sold as the dividends and capital gains parts.

Relaxing the M&M Assump;ons MYW’s B Corpora;on Shares

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The Clientele Effect

•  The clientele effect is the influence of groups of investors attracted to companies with specific dividend policies. –  Clientele are simply a group of investors who have the same

preference. •  Types of clientele:

–  If an investor has a marginal tax on capital gains lower than the marginal tax on dividends, the investor prefers a return in the form of capital gains.

–  Investors who are tax exempt (e.g., pension funds) are indifferent about dividends and capital gains.

–  Some investors, by policy or restrictions, only invest in stocks that pay dividends.

•  The importance of the existence of clientele is that investors will have a preference for stocks with a specific dividend policy.

Bottom line: The clientele effect does not necessarily imply that dividends affect value. Copyright © 2013 CFA Ins;tute 13

Dividends and Signaling

•  Under MM’s theory, everyone has the same information.

•  When there is asymmetric information, dividend changes may convey information.


Posi;ve Informa;on •  Dividend ini;a;ons •  Dividend increases

Nega;ve Informa;on •  Dividend omissions •  Dividend reduc;ons

Relaxing the M&M Assumptions Welcome to the Real World!

Dividends and Signalling –  Under conditions of information asymmetry, shareholders and

the investing public watch for management signals (actions) about what management knows.

–  Management is therefore very cautious about dividend changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)

Relaxing the M&M Assumptions The Signalling Model

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Agency costs and Dividend policy

•  The separation of ownership and management in a corporation may lead to suboptimal investment. –  Management may invest in negative NPV projects to enhance

the company’s size or management’s control. •  Jensen’s free cash flow hypothesis is that having free cash

flow tempts management to make investments that are not positive NPV. –  Paying dividends or interest on debt uses this free cash flow and

averts an agency issue. •  If a company’s debt has a restriction on paying dividends, it

may avoid the issue of paying dividends (thus benefiting owners) and may increase the risk to bondholders.

Bottom line: Dividends may reduce agency costs and, therefore, increase the value of the firm. Copyright © 2013 CFA Ins;tute 17

3. Factors Affecting Dividend policy

Investment Opportuni;es

Expected Vola;lity of

Future Earnings

Financial Flexibility

Tax Considera;ons

Flota;on Costs Contractual and Legal Restric;ons


Factors affecting dividend policy

•  Investment opportunities: –  A company with more investment opportunities will

pay out less in dividends. –  A company with fewer investment opportunities will

pay out more in dividends. •  Expected volatility of future earnings:

–  Companies with greater earnings volatility are less likely to increase dividends—a greater chance of not maintaining the increased dividend.

•  Financial flexibility: –  Companies seeking more flexibility are less likely to

pay dividends or to increase dividends because they want to preserve cash. Copyright © 2013 CFA Ins;tute 19

Factors affecting dividend policy

•  Tax considerations –  The tax rate on dividends and how dividends are

taxed relative to capital gains affect investors’ preferences and, hence, companies’ dividend policy.

•  Flotation costs –  These costs make it more expensive to use newly

issued stock instead of internally generated funds. –  Smaller companies face higher flotation costs.

•  Contractual and legal restrictions –  Forms of restrictions:

•  Impairment of capital rule •  Bond indentures •  Requirement of preferred shares


Tax Systems and Dividend Policy

Consider a company that has earnings before tax of $100 million and pays all its earnings as dividends. The company’s tax rate is 35%, and individual shareholders have a marginal tax rate of 25%. In countries with a split-rate system, dividends are taxed at 28% at the corporate level.


Double Taxa;on

Earnings taxed at corporate level and dividends taxed at shareholder level

Effec;ve tax on dividends = 51.25%

Dividend Imputa;on

Earnings taxed at corporate level and

tax credit at shareholder level

Effec;ve tax on dividends = 25%

Split-‐Rate System

Earnings distributed are taxed at a lower rate than retained

earnings

Effec;ve tax on dividends = 46%

4. Payout Policies

•  Stable dividend policy: Constant dividend with occasional dividend increases –  Increases may represent an adjustment to a target payout ratio. –  In theory (John Lintner’s), companies may adjust to the target

using an adjustment factor that is less than or equal to 1.0: █■Increase in@dividends  = █■Increase in@earnings  × █■Target @payout ratio  × █■Adjustment@factor 

–  Common •  Constant dividend payout: Constant dividend payout ratio

–  Uncommon •  Residual dividend payout: Pay out earnings remaining after

capital expenditures –  Uncommon


Example: Payout Policies

Consider the financial information for Apple, Inc. (AAPL)

1. What are dividends for FY2011 and FY2012 if the company followed a stable dividend policy, with a target dividend payout of 10% and an adjustment factor of 0.3?


Fiscal Year Ending 9/29/2012 9/24/2011 9/25/2010

Net income (millions) $41,773 $25,922 $14,014

Fiscal Year Ending 9/29/2012 9/24/2011

Increase in earnings $15,851 $11,900

Mul;ply by target 0.10 0.10

Mul;ply by adjustment factor 0.30 0.30

Dividends $475.53 $357.24

Example: Payout Policies

2. What are dividends for FY2011 and FY2012 if the company followed a constant dividend payout at 6%?

3. What are dividends for FY2011 and FY2012 if the company followed the residual payout policy?



Net income (millions) $41,773 $25,922

Less: capital expenditures 9,402 7,452

Dividends $32,371 $18,470


Net income (millions) $41,773 $25,922

Mul;ply by 6% 0.06 0.06

Dividends $2,506 $1,555.32

Cash Dividends vs. Repurchasing Stock


•  Reasons for preferring repurchasing stock over paying a cash dividend –  Potential tax advantages –  Signaling –  Managerial flexibility –  Offset dilution from executive stock options –  Increase financial leverage

•  A stock repurchase may be a good alternative to an increase in cash dividends.

Global Trends in Dividend Payout

•  Current: –  Large, profitable companies tend to have a stable

payout policy. –  Smaller and/or less profitable companies tend to not

be dividend paying. •  Trends:

–  In developed companies, fewer companies pay cash dividends, but more companies are using stock repurchases.

–  The dividend amounts and payouts have increased for dividend-paying companies, but the proportion of dividend-paying companies has declined.


Dividend Coverage Ratios

Dividend coverage ratios: Dividend coverage ratio = Net income/Dividends  FCFE coverage ratio = Free cash flow to equity/(Dividends + Share repurchase)  A company has $200 million in earnings, pays $40 million in dividends, has cash flow from operations of $180 million, and had capital expenditures of $60 million. The company spent $10 million for share repurchases. Therefore:

Dividend coverage ratio = $200/$50  = 5 times

FCFE coverage ratio = $180 − $60/($40 + $10)  = $220/$50 = 4.4 times


5. Analysis of Dividend Safety

•  We can evaluate the “safety” of the dividend by examining the company’s ability to meet its dividends. –  “Safety” pertains to the ability of the company to continue to pay the

dividend or maintain a growth pattern. –  Possible ratios: Dividend coverage and free cash flow coverage

•  Using dividends plus repurchases may be more appropriate for some firms.

•  Values greater than 1.0 indicate ability to meet the dividend and repurchase, although the greater the coverage, the greater the liquidity and ability to pay.

•  It is sometimes difficult to predict changes in dividend because of “surprises,” such as the financial crisis.


6. Summary

•  There are three general theories on investor preference for dividends: Dividend policy is irrelevant, the bird-in-hand argument, and the tax explanation.

•  An argument for dividend irrelevance given perfect markets is that the corporate dividend policy is irrelevant because shareholders can create their preferred cash flow streams by selling any company’s shares.

•  The clientele effect suggests that different classes of investors have differing preferences for dividend income.

•  Dividend declarations may provide information to investors regarding the prospects of the company.

•  The payment of dividends can help reduce the agency conflicts between managers and shareholders, but can worsen conflicts of interest between shareholders and debtholders.


Summary (continued)

•  Investment opportunities, the volatility expected in future earnings, financial flexibility, taxes, flotation costs, and contractual and legal restrictions affect dividend policies.

•  Using a stable dividend policy, a company may attempt to align its dividend growth rate to the company’s long-term earnings growth rate.

•  The stable dividend policy can be represented by a gradual adjustment process in which the expected dividend is equal to last year’s dividend per share, plus any adjustment.

•  With a constant dividend payout ratio policy, a company applies a target dividend payout ratio to current earnings.

•  In a residual dividend policy, the amount of the annual dividend is affected by both the earnings and the capital investment spending.


Summary (continued)

•  Share repurchases usually offer more flexibility than cash dividends by not establishing the expectation that a particular level of cash distribution will be maintained.

•  Share repurchases can signal that company officials think their shares are undervalued. On the other hand, share repurchases could send a negative signal that the company has few positive NPV opportunities.

•  The issue of dividend safety deals with the likelihood of the dividend being continued.

•  Early warning signs of whether a company can sustain its dividend include the level of dividend yield, whether the company borrows to pay the dividend, and the company’s past dividend record.


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