Corporate Financial Strategy

Chapter 13

Dividends and buy-backs

Corporate Financial Strategy4th edition

Dr Ruth Bender

Corporate Financial Strategy

Dividends and buy-backs: contents

Learning objectives Dividend strategy and the life cycle model Some factors that might affect dividend policy Signalling effect of a change in dividends Reasons for companies to buy back their own shares Lintner: target dividend pay-out ratio

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Learning objectives

1. Set out the main arguments in favour of and against companies paying dividends.

2. Identify different types of dividend policy.

3. Explain why companies might prefer to undertake periodic share purchases rather than pay dividends.

4. Understand why different types of investor might have a preference for either dividends or buyouts.

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Dividend strategy and the life cycle model

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Cash availability Profit availability

Dividend policy

Launch No spare cash available. All cash is needed for investment in developing the business.

None. Probably making losses.

Nil dividend pay-out.

Growth Cash is needed for development and investment in growing market share.

May be profitable. Nil dividend pay-out is preferable. However, new shareholders might prefer a nominal pay-out.

Maturity The company is now cash positive and has fewer opportunities to invest in profitable growth.

Profitable. A medium to high dividend pay-out is preferred.

Decline The company is cash positive, with no reinvestment potential.

May be profitable; has retained profits.

Full pay-out of available cash as dividend, even in excess of current profits.

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Some factors that might affect dividend policy

Tax regimeTo avoid agency issues of holding too much spare cashSignalling mechanism to the market

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Signalling effect of a change in dividends

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Interpretation Increase the dividend level

Decrease the dividend level

 

Good news The company is prospering, and we can afford to pay out more of our profits without damaging our prospects.

The company has changed its strategy and the directors see these very profitable investment opportunities, which will provide more shareholder value than will mere payment of dividends.

Bad news The directors have run out of ideas for profitable growth.

Profits and cash flow are falling, and the company is facing trouble in the foreseeable future.

  Increasing the dividend level could be seen as a signal of advancing one stage in the life cycle.

Decreasing the dividend level could be seen as a signal of moving back one stage in the life cycle.

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Reasons for companies to buy back their own shares

To increase epsTo increase management’s percentage holdingMore flexible than paying a dividendTo buy out weaker shareholdersTo give shareholder a choice of how they get their returnTo offset eps dilution from share option exercise

To improve management’s business focus by gearing upTo reduce the cost of capital

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Apply to buy-backs but not dividends

Apply to buy-backs and to dividends

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Lintner: target dividend pay-out ratio

Research by Lintner indicated that companies have a target dividend pay-out ratio, but that they never actually pay that full amount. He suggested that companies determine their annual dividend based on the following formula:

DIV1 – DIV0 = a × {(r × eps1) – DIV0}

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DIV0 is the dividend paid last year

DIV1 is the dividend to be paid this year

eps1 is the earnings per share this year

r is the target dividend pay-out ratio

a is an adjustment factor.