CHAPTER 7
DIVIDENDS AND SHARE
REPURCHASES: ANALYSIS
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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.
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2. DIVIDEND POLICY AND COMPANY VALUE:
THEORY
Dividends Are
Irrelevant
Bird in the
Hand
• Based on
MM theories.
• If owners
want a
leveraged
position, they
can make it
themselves.
• Cash
dividends are
more certain
than stock
appreciation.
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Tax Argument
• How
dividends are
taxed relative
to capital
gains affects
investors
preferences
for dividends.
Other
• Clientele
effect.
• Signaling.
• Agency cost
effects.
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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.
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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.
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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 highertaxed 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.
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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.
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DIVIDENDS AND SIGNALING
• Under MM’s theory, everyone has the same information.
• When there is asymmetric information, dividend changes may convey
information.
Positive Information
• Dividend initiations
• Dividend increases
Negative Information
• Dividend omissions
• Dividend reductions
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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.
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3. FACTORS AFFECTING DIVIDEND POLICY
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Investment
Opportunities
Expected
Volatility of
Future Earnings
Financial
Flexibility
Tax
Considerations
Flotation Costs
Contractual and
Legal
Restrictions
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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.
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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
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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
Taxation
Earnings taxed at
corporate level and
dividends taxed at
shareholder level
Effective tax on
dividends =
51.25%
Dividend
Imputation
Earnings taxed at
corporate level and
tax credit at
shareholder level
Effective tax on
dividends = 25%
Split-Rate
System
Earnings distributed
are taxed at a lower
rate than retained
earnings
Effective tax on
dividends = 46%
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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:
Target
Increase in
Adjustment
Increase in
=
×
×
earnings
payout ratio
dividends
factor
- Common
• Constant dividend payout: Constant dividend payout ratio
- Uncommon
• Residual dividend payout: Pay out earnings remaining after capital
expenditures
- Uncommon
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EXAMPLE: PAYOUT POLICIES
Consider the financial information for Apple, Inc. (AAPL)
Fiscal Year Ending
9/29/2012
9/24/2011
9/25/2010
Net income (millions)
$41,773
$25,922
$14,014
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
Increase in earnings
$15,851
$11,900
Multiply by target
0.10
0.10
Multiply by adjustment factor
0.30
0.30
$475.53
$357.24
Dividends
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EXAMPLE: PAYOUT POLICIES
2. What are dividends for FY2011 and FY2012 if the company followed a
constant dividend payout at 6%?
Fiscal Year Ending
9/29/2012
9/24/2011
Net income (millions)
$41,773
$25,922
0.06
0.06
$2,506
$1,555.32
Multiply by 6%
Dividends
3. What are dividends for FY2011 and FY2012 if the company followed the
residual payout policy?
Fiscal Year Ending
9/29/2012
9/24/2011
Net income (millions)
$41,773
$25,922
9,402
7,452
$32,371
$18,470
Less: capital expenditures
Dividends
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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.
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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.
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DIVIDEND COVERAGE RATIOS
Dividend coverage ratios:
Dividend coverage ratio =
FCFE coverage ratio =
Net income
Dividends
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:
$200
Dividend coverage ratio =
= 5 times
$50
FCFE coverage ratio =
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$180 − $60
$220
=
= 4.4 times
$40 + $10
$50
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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.
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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.
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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.
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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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