Chapter 16

DISTRIBUTION TO SHAREHOLERS:
DIVIDENDS AND SHARE
REPURCHASES
Dividend Policy
It is a decision that a company makes on what it
wants to do with its net income whether it wants
to retain and reinvest them (as retained earnings),
or it wants to distribute them (as dividends) to
shareholders.
Dividend policy includes:
High or low dividend payout
Stable or irregular dividend payout
Frequency of dividend payout
Announcement of dividend policy
Terms:
Target distribution ratio
Percentage of net income to be distributed as either a
cash dividend or stock repurchase, and it should be
based in large part on investors preferences for
dividends versus capital gains.
(Target) Payout ratio
The (target) percentage of net income paid out as a cash
dividend.
Optimal payout policy
A policy that must strike a balance between current cash
dividends and capital gains so as to maximize the stock
price.
Theories that explain how factors interact to
determine a firms optimal distribution policy:
Dividend irrelevance theory
Investors are indifferent on a high or low dividend
payout policy.
Bird-in-the-hand theory
Investors prefer high dividend payout policy
Dividends are chosen over capital gains
Tax preference theory
Investors prefer low dividend payout policy
Capital gains are chosen over dividends
Theories of Dividend Policy
Dividend Irrelevance Theory
Developed by Franco Modigliani and Merton Miller.
Indicates that an issuance of dividends should have little to
no impact on stock price.
Investors can create their own dividend policy:
If dividends are distributed
When investors need money, then good for them.
When investors dont need money, they can use the dividends to buy
stocks
If dividends are not distributed
When investors need money, they can sell their stock.
When investors dont need money, then good for them.
Any payout is okay, hence, dividends are irrelevant.
Based on unrealistic assumptions (no taxes, no brokerage
costs, ready buyer of stocks), hence this theory may not be
true. It needs more empirical testing.
Implication: Any payout is okay.
Theories of Dividend Policy
Bird-in-the-hand Theory
Developed by Myron Gordon and John Lintner
This theory indicates that investors think dividends are less risky
than potential future capital gains, and thus dividends are more
attractive to shareholders.
Purports that lower payouts results in higher costs of capital
(riskier); hence, investors would value high-payout firms more
highly, i.e., a high payout would result in a high P
0
.
Implication: Set a high dividend payout ratio to increase P
0
.
MM called this theory the Bird-in-the hand fallacy, as this theory
states that a firms value will be maximized by setting a high
dividend payout ratio. Yet MM sated that a firms value is
determined by the riskiness of operating cash flows and not by
the dividend payout policy.

Theories of Dividend Policy
Tax Preference Theory
First developed by Robert H. Litzenberger and Krishna
Ramaswamy.
This theory indicates that investors may prefer to have
companies retain their earnings because of various tax
advantages.
Why investors prefer low payout companies?
Long-term capital gains allow the investor to defer tax payment
until they decide to sell the stock. Taxes are not paid on the
gain until a stock is sold.
If someone holds a stock until he or she dies, no capital gains
tax is due at all


Possible stock price effects
40

30

20

10
0 50% 100% Payout
Stock Price ($)
Bird-in-the-Hand
Irrelevance
Tax preference
Possible cost of equity effects
Tax preference
Irrelevance
Bird-in-the-Hand
30

25

20

15

10

5
0 50% 100% Payout
Cost of Equity (%)
Which theory is most correct?
Empirical testing has not been able to determine which
theory, if any, is correct.
Thus, managers use judgment when setting policy.
Analysis is used, but it must be applied with judgment.
Investors cannot be seen to uniformly prefer either higher
or lower dividends. However, individual investors do have
strong preferences.
Both evidence and logic suggests that
investors prefer firms that follow a stable,
predictable dividend policy.
Other issues that have a bearing on
optimal dividend policy
Information Content or Signaling Hypothesis
Signal is an action taken by management that
provides clues to investors about how
management views the firms prospects.
Clientele Effect
Information Content or Signaling Hypothesis
A dividend increase announcement is often accompanied
by an increase in stock price. Cutting dividends sends a
negative signal to investors.
Managers wont raise dividends unless they think raise is
sustainable.
Investors view dividend increases as signals of
managements view of the future.
A stock price increase at time of a dividend increase could
reflect higher expectations for future EPS, not a desire for
dividends.
Stock price changes indicates that there is an important
information content in dividend announcements.
Clientele Effect
Clientele refers to different groups of investors, or clienteles
that prefer different dividend policies. Clientele effect is the
tendency of a firm to attract a set of investors that like its
dividend policy.
A firm establishes a dividend policy and then attracts a specific
clientele that is drawn to this dividend policy. Thus, the firms
past dividend policy determines its current clientele of
investors.
A firm can change from one dividend payout policy to another
and let stockholders who dont like the new policy sell to other
investors who do. However, clientele effects impede or hinders
changing dividend policy. Taxes and brokerage costs hurt
investors who have to switch companies.



Importance of Dividend Stability
Many stockholders rely on dividends to meet
expenses, and they would be seriously
inconvenienced if the dividend stream were
unstable.
Reducing dividends could send negative
and/or incorrect signals to investors, who may
interpret the dividend cut to mean that the
companys future earnings prospects have
been diminished.
Components of Dividend Stability
How dependable is the growth rate?
Can we count on at least receiving the current
dividend in the future?
Investors prefer stocks
that pay more
predictable dividends
to stocks that pay the
same average amount
of dividends but in a
more erratic manner.
If a firm stabilizes its
dividends as much as
possible, the cost of
equity will be
minimized and the
stock price maximized.
What is a Stable Dividend Policy?
The most stable policy is a firm whose dividend
growth rate is predictable.
A companys total return (DY + CGY) would be relatively
stable over the long run, and its stock would be a good
hedge against inflation
The second most stable policy is where stockholders
can be reasonably sure that the current dividend
will not be reduced.
May not grow at a steady rate, but management will
probably be able to avoid cutting the dividend.
Establishing dividend policy in practice:
How much cash must be distributed to
shareholders?
Must follow the objective: Maximize shareholder
value
Firms cash flows really belong to shareholders, so
management should refrain from retaining income
unless it can be reinvested to produce returns
higher than shareholders could themselves earn by
investing the cash in investments of equal risk
Optimal Payout ratio is a function
of four factors:
Investors preferences for dividends vs. capital
gains
Firms investment opportunities
Firms target capital structure
Availability and cost of external capital
Factors influencing dividend policy decisions
Constraints:
Bond indentures (may restrict dividend distribution)
Preferred stock restrictions (may restrict dividend distribution)
Impairment of capital rule (dividends must be paid out of profits and not from a corporations
capital. Liquidating dividends can be paid out of capital but must be indicated as such and
must not reduce capital below the limits stated in debt contracts.)
Availability of cash (Shortage amount of cash may restrict dividend distribution. However, the
ability to borrow can offset this factor)
Penalty tax on improperly accumulated earnings (may boost dividend distribution. Relevant
only to privately owned firms)
Investment opportunities:
Number of profitable investment opportunities (More opportunities = lower payout)
Possibility of accelerating or delaying projects (Availability of real options permits adherence
to a more stable dividend policy)
Alternative sources of capital:
Cost of selling new stock (high cost of new equity, lower payout so that there will be more RE)
Ability to substitute debt for equity (high ability to swap debt for equity = higher payout)
Control (want control = reluctant to sell stock = retain more earnings)
Residual dividend model
A model based on the premise that investors prefer to
have a firm retain and reinvest earnings rather than pay
them out in dividends if the rate of return the firm can
earn on reinvested earnings exceeds the rate of return
investors can obtain for themselves on other
investments of comparable risk.
It is less expensive for the firm to use retained earnings
than it is to issue new common stock.
This policy minimizes flotation costs
and equity signaling costs, hence
minimizes the WACC
Steps for a firm using the residual policy:
Determine the optimal capital budget
Determine the amount of equity needed to finance the
optimal capital budget, given the firms target capital
structure
Use retained earnings to meet equity requirements to
the extent possible.
Make distributions (dividends or stock repurchases)
only if more earnings are available than are needed to
support the optimal capital budget.

Residual Dividend Model
Should be used by firms to help set their long-run
target payout ratios, but not as a guide to the payout in
any one year, because investment opportunities and
earnings vary year to year.
Advantage:
Minimizes new stock issues and flotation costs
Disadvantage:
Results in variable dividends, sends conflicting signals, increases
risk, and doesnt appeal to any specific clientele.
Conclusion:
Consider residual policy when setting target payout, but dont
follow it rigidly.

Residual Dividend Model
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budget
capital
Total

ratio
equity
Target
- Income Net Dividends
Capital budget $800,000
Target capital structure 40% debt, 60% equity
Forecasted net income $600,000
How much of the forecasted net income should be paid out as
dividends?
What is the dividend payout ratio?
How much of the forecasted net income should be paid out as
dividends and what is the dividend payout ratio if net income
drops to $400,000? How about if NI rises to $800,000?
Problem 16-1: Residual Dividend Model
Axel Telecommunications has a target capital structure that
consists of 70% debt and 30% equity. The company anticipates
that its capital budget for the upcoming year will be $3,000,000.
If Axel reports net income of $2,000,00 and it follows a residual
dividend payout policy, what will be its dividend payout ratio?



Problem 16-6: Residual Dividend Model
Welch Company is considering three independent projects, each of
which requires a $5 million investment. The estimated internal rate
of return and cost of capital for these projects are presented here:
Cost of Capital IRR
Project H (high risk) 16% 20%
Project M (medium risk) 12% 10%
Project L (low risk) 8% 9%

Note that the projects costs of capital vary because the projects have
different levels of risk. The companys optimal capital structure calls
for 50% debt and 50% common equity. Welch expects to have net
income of $7,287,500. If Welch establishes its dividends from the
residual model, what will be its payout ratio?



How would a change in investment opportunities
affect dividend under the residual policy?
Few good investments higher dividend payout
More good investments lower dividend payout
Setting the dividend policy
Forecast capital needs over a planning horizon,
often 5 years. (Todays dividend decisions are
constrained by policies set in the past, hence setting
a policy for the next five years necessitates a review
of the current situation).
Set a target capital structure.
Estimate annual equity needs.
Set target payout based on the residual model.
Generally, some dividend growth rate emerges.
Maintain target growth rate if possible, varying
capital structure somewhat if necessary.

Dividend Payment Procedures:
Declaration date
BODs declares the dividend. It is the date on which a firms directors
issue a statement declaring a dividend.
Amount of dividend to be paid is set, holder-of record date is set, and
payment date is set.
Holder-of-record date
Stock transfer books of the corporation are closed. Those listed on the
books on this date are the holders of record who will receive the
announced dividends.
Ex-dividend date
Usually two business days before holder-of-record date. Shares
purchased after the ex-dividend date are not entitled to the dividend.
Payment date
The day when dividend checks are actually mailed to the holders of
record.
Dividend Reinvestment Plan
A plan where stockholders can automatically reinvest dividends
received back into the shares of the companys stock. Therefore,
stockholders get more stock than cash.
Income tax on the amount of the dividends must still be paid even
through stock, rather than cash, is received.
Two types of DRIPs:
Open market (plans involving already old stock that is already
outstanding).
Dollars to be reinvested are turned over to trustee, who buys shares on the open
market.
Brokerage costs are reduced by volume purchases.
Convenient, easy way to invest, thus useful for investors.
New stock (plans involving newly issued stock)
Firm issues new stock to DRIP enrollees (usually at a discount from the market
price), keeps money and uses it to buy assets.
Firms that need new equity capital use new stock plans.
Firms with no need for new equity capital use open market purchase plans.
Most NYSE listed companies have a DRIP. Useful for investors.

Low-Regular-Dividend-plus Extras
The policy of announcing a low-regular dividend
that can be maintained no matter what, and then
when times are good, paying a designated extra
dividend.
Offered by companies, especially in cyclical
industries, that have difficulty maintaining in bad
times a dividend that is really too low in good times.
This is a good way for companies to deal with
information asymmetry and manage shareholder
expectations.
Recap on dividend policy:
Dividend policy decisions are truly exercises in informed judgment,
not decisions quantified based on rules.
Firms should try to establish a rational dividend policy & stick with it.
Dividend policy can be changed but this can cause problems and
negative implications for stock prices:
Inconvenience the firms existing shareholders.
Send unintended signals.
Convey the impression of dividend instability.
However, economic circumstances do change and occasionally, such
changes dictate that a firm should alter its dividend policy.
Dividend policy still remains one of the most judgmental decisions
that firms must make, so it must always be set by the BODs. Financial
staff analyzes the situation and makes a recommendation, but the
the board makes the final decision.

Factors influencing dividend policy:
Constraints
Bond indentures
Preferred stock restrictions
Impairment of capital rule
Availability of cash
Improperly accumulated earnings tax (IAET)
Investment Opportunities
Number of profitable investment opportunities
Possibility of accelerating or delaying projects.


Factors influencing dividend policy:
Alternative Sources of Capital
Cost of selling new stock (Flotation cost)
Ability to substitute debt for equity
Control
Effects on Dividend Policy on rs
Stockholders desire for current versus future
income
Perceived riskiness of dividends versus capital
gains
Tax advantage of capital gains
Information content of dividends (signaling)

Stock Repurchases (Treasury Stock)
Buying own stock back from stockholders.
It has the effect of decreasing shares outstanding,
increasing EPS and often increasing the stock price due
to positive signaling.
An alternative to dividends for transmitting cash to
shareholders.
Principal types of repurchases:
Firms has cash available or it has one-time cash from asset
sales and distributes cash by repurchasing shares rather than
by paying cash dividends.
Large capital structure change. Firm concludes that its capital
structure is too heavily weighted with equity so it sells debt and
uses the proceeds to buy back its stock.
Effects of Repurchase:
ADC expects to earn P4.4 million in 2011 and
50% of this amount has been allocated for
distribution to shareholders. There are 1.1
million shares outstanding and the market
price is P20 a share. ADC believes that it can
either use the $2.2 million to repurchase
100,000 of its shares through a tender offer at
P22 a share or else pay a cash dividend of P2 a
share.
Advantages of Repurchases:
Stockholders can tender or not.
Helps avoid setting a high dividend that cannot be maintained.
Repurchased stock can be used in takeovers or resold to raise cash
as needed.
Income received is capital gains rather than higher-taxed
dividends.
Stockholders may take as a positive signal--management thinks
stock is undervalued.
Repurchase can remove a large block of stock overhanging the
market.
Companies that grant a large number of options to purchase stock
can avoid ownership dilution.
More flexibility in adjusting the total distribution that it would if
the entire distribution were in the form of cash dividends.
Disadvantages of Repurchases
Are not as dependable as cash dividends; therefore, the
stock price may benefit more from cash dividends.
May be viewed as a negative signal (firm has poor
investment opportunities).
IRS could impose penalties if repurchases were primarily to
avoid taxes on dividends.
Selling stockholders may not be well informed, hence be
treated unfairly.
Selling stockholders may not be aware of all the
implications of the repurchase, therefore repurchases are
usually announced in advance.
Firm may have to bid up price to complete purchase, thus
paying too much for its own stock. This will be the
disadvantage to the remaining stockholders.

Problem 16-3: Stock Repurchases
Beta Industries has net income of $2,000,000, and it has
1,000,000 shares of common stock outstanding. The companys
stock currently trades at $32 a share. Beta is considering a plan
in which it will use available cash to repurchase 20% of it shares
in the open market. The repurchase is expected to have no
effect on net income or the companys P/E ratio. What will be
Betas stock price following the stock repurchase?



Stock dividends versus Stock splits
Stock dividend
A dividend paid in the form of additional shares of
stock rather than in cash.
Stock split
An action taken by a firm to increase the number
of shares outstanding, such as doubling the
number of shares outstanding by giving each
stockholder two new shares for each one formerly
held.

Stock dividends versus Stock splits
DIFFERENCE
Stock dividend
Firm issues new shares in lieu of paying a cash
dividend. If 10%, get 10 shares for each 100
shares owned.
Stock split
Firm increases the number of shares outstanding,
say 2:1. Sends shareholders more shares.

Stock dividends versus Stock splits
SIMILARITIES
Both increase the number of shares outstanding, so
the pie is divided into smaller pieces.
Unless the stock dividend or split conveys
information, or is accompanied by another event
like higher dividends, the stock price falls so as to
keep each investors wealth unchanged.
But splits/stock dividends may get us to an optimal
price range. this is because stock splits and
dividends more often than not send a positive
signal to shareholders.


Effects of stock dividends and stock
splits on stock price:
On average, the price of a companys stock rises shortly after an
announcement of stock dividend or stock split, and this is due to
a signal of expected higher future earnings. (Conversely it falls
shortly after an announcement of a reverse stock split).
If higher future earnings or dividend increase is not announced
later, stock price will drop back to the earlier level.
Stock splits tend to increase the stocks liquidity and which lead
to an increase in the firms value.
Stock splits tend to change the mix of shareholders. After a
split, there is more proportion of individual investors and less
proportion of institutional investors.

When and why should a firm consider
splitting its stock?
Theres a widespread belief that the optimal price
range for stocks is $20 to $80. Stock splits can be
used to keep the price in this optimal range.
Stock splits generally occur when management is
confident, so are interpreted as positive signals.
On average, stocks tend to outperform the market in
the year following a split.
Problem 16-2: Stock Split
Gamma Medicals stock trades at $90 a share. The
company is contemplating a 3-for-2 stock split.
Assuming that the stock split will have no effect on the
market value of its equity what will be the companys
stock price following the stock split?



Problem 16-4: Stock Split
After a 5-for-1 stock split, Strasburg Company paid a
dividend of $0.75 per new share, which represents a
9% increase over last years pre-split dividend. What
was last years dividend per share?



Problem 16-8: Alternative Dividend Policies
Rubenstein Bros. Clothing is expecting to pay an annual
dividend per share of $0.75 out of annual earnings per
share of $2.25. Currently, Rubenstein Bros. stock is
selling for $12.50 per share. Adhering to the
companys target capital structure, the firm has $10
million in assets, of which 40% is funded by debt.
Assume that the firms book value of equity equals its
market value. In past years, the firm has earned an
ROE of 18%, which is expected to continue this year
and into the foreseeable future.
Problem 16-8: Alternative Dividend Policies
a. Based on that information, what long-run growth can the firm be
expected to maintain?
b. What is the stocks required return?
c. If the firm changed its dividend policy and paid an annual dividend of
$1.50 per share, financial analysts would predict that the change in
policy will have no effect on the firms stock price or ROE. Therefore,
what must be the firms new expected long-run growth rate and
required return?
d. Suppose instead that the firm has decided to proceed with its original
plan of disbursing $0.75 per share to shareholders, but the firm intends
to do so in the form of a stock dividend rather than a cash dividend. The
firm will allot new shares based on the current stock price of $12.50. In
other words, for every $12.50 in dividends due to shareholders, a share
of stock will be issued. How large will the stock dividend be relative to
the firms current market capitalization?
e. If the plan in Part d is implemented, how many new shares of stock will
be issued and by how much will the companys EPS be diluted?