HF week's
KevinLiang
FM14e_PPT_Ch14.pptx1
Brigham & Ehrhardt
Financial Management:
Theory and Practice 14e
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
CHAPTER 14
Distributions to Shareholders: Dividends and Repurchases
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
Topics in Chapter
Theories of investor preferences
Signaling effects
Residual model
Stock repurchases
Stock dividends and stock splits
Dividend reinvestment plans
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
4
Free cash flow
(FCF)
Interest
payments
(after tax)
Stock
repurchases
Principal
repayments
Dividends
Sales revenues
Operating costs and taxes
Required investments in operating capital
−
−
=
Free Cash Flow: Distributions to Shareholders
Purchase of
short-term
investments
Sources
Uses
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
Figure 1-6 in FM13.
5
What is “distribution policy”?
The distribution policy defines:
The level of cash distributions to shareholders
The form of the distribution (dividend vs. stock repurchase)
The stability of the distribution
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5
6
Distributions Patterns Over Time
The percent of total payouts as a percentage of net income has been stable at around 26%-28%.
Dividend payout rates have fallen, stock repurchases have increased.
Repurchases now total more dollars in distributions than dividends.
A smaller percentage of companies now pay dividends. When young companies first begin making distributions, it is usually in the form of repurchases.
Dividend payouts have become more concentrated in a smaller number of large, mature firms.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
Dividend Yields for Selected Industries
| Industry | Div. Yield % |
| Recreational Products | 0.97 |
| Forest Products | 1.88 |
| Software | 2.42 |
| Household Products | 1.73 |
| Food | 2.39 |
| Electric Utilities | 4.43 |
| Banks | 2.56 |
| Tobacco | 1.69 |
| Source: Reuters.com, May 2012 |
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
Do investors prefer high or low payouts?
There are three dividend theories:
Dividends are irrelevant: Investors don’t care about payout.
Dividend preference, or bird-in-the-hand: Investors prefer a high payout.
Tax effect: Investors prefer a low payout.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
9
Dividend Irrelevance Theory
Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock.
Modigliani-Miller support irrelevance.
Implies payout policy has no effect on stock value or the required return on stock.
Theory is based on unrealistic assumptions (no taxes or brokerage costs).
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
10
Dividend Preference (Bird-in-the-Hand) Theory
Investors might think dividends (i.e., the-bird-in-the-hand) are less risky than potential future capital gains.
Also, high payouts help reduce agency costs by depriving managers of cash to waste and causing managers to have more scrutiny by going to the external capital markets more often.
Therefore, investors would value high payout firms more highly and would require a lower return to induce them to buy its stock.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
11
Tax Effect Theory
Low payouts mean higher capital gains. Capital gains taxes are deferred until they are realized, so they are taxed at a lower effective rate than dividends.
This could cause investors to require a higher pre-tax return to induce them to buy a high payout stock, which would result in a lower stock price.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
12
Which theory is most correct?
Some research suggests that high payout companies have higher required returns on stock, supporting the tax effect hypothesis.
But other research using an international sample shows that in countries with poor investor protection (where agency costs are most severe), high payout companies are valued more highly than low payout companies.
Empirical testing has produced mixed results.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12
13
What’s the “clientele effect”?
Different groups of investors, or clienteles, prefer different dividend policies.
Firm’s past dividend policy determines its current clientele of investors.
Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies due to a change in payout policy.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13
14
What’s the “information content,” or “signaling,” hypothesis?
Investors view dividend changes as signals of management’s view of the future. Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable.
Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14
15
What’s the “residual distribution model”?
Find the reinvested earnings needed for the capital budget.
Pay out any leftover earnings (the residual) as either dividends or stock repurchases.
This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
15
16
Using the Residual Model to Calculate Distributions Paid
Distr. = –
Net
income
Target
equity
ratio
Total
capital
budget
Distr. = – Required equity
Net
income
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
17
Application of the Residual Distribution Approach: Data for IWT
Capital budget: $112.5 million.
Target capital structure: 20% debt, 80% equity. Want to maintain.
Forecasted net income: $140 million.
Number of shares: 100 million.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
17
18
Application of the Residual Distribution Approach
| Number of shares | 100 | 100 | 100 |
| Equity ratio (ws) | 80% | 80% | 80% |
| Capital budget | $112.5 | $112.5 | $112.5 |
| Net income | $140.0 | $90.0 | $160.0 |
| Req. equ.: (ws X Cap. Bgt.) | $90.0 | $90.0 | $90.0 |
| Dist. paid: (NI – Req. equity) | $50.0 | $0.0 | $70.0 |
| Payout ratio (Dividend/NI) | 35.7% | 0.0% | 43.8% |
| Dividend per share | $0.50 | $0.00 | $0.70 |
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
19
Investment Opportunities and Residual Dividends
Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout.
More good investments would lead to a lower dividend payout.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
19
20
Advantages and Disadvantages of the Residual Dividend Policy
Advantages: Minimizes new stock issues and flotation costs.
Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele.
Conclusion: Consider residual policy when setting target payout, but don’t follow it rigidly.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
20
21
The Procedures of a Dividend Payment: An Example
November 14: Board declares a quarterly dividend of $0.50 per share to holders of record as of December 13.
December 10: Dividend goes with stock.
December 11: Ex-dividend date.
December 13: Holder of record date.
January 3: Payment date to holders of record.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22
Stock Repurchases
Repurchases: Buying own stock back from stockholders.
Reasons for repurchases:
As an alternative to distributing cash as dividends.
To dispose of one-time cash from an asset sale.
To make a large capital structure change.
To use when employees exercise stock options.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22
23
The Procedures of a Repurchase
Firm announces intent to repurchase stock.
Three ways to purchase:
Have broker/trustee purchase on open market over period of time.
Make a tender offer to shareholders.
Make a block (targeted) repurchase.
Firm doesn’t have to complete its announced intent to repurchase.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
24
IWT Before a Distribution: Inputs (Millions)
| Value of operations | $1,937.50 |
| Short-term investments | $50.00 |
| Debt | $387.50 |
| Number of shares | 100.00 |
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
25
Intrinsic Value Before Distribution
| Vop | $1,937.50 |
| + ST Inv. | 50.00 |
| VTotal | $1,987.50 |
| − Debt | 387.50 |
| S | $1,600.00 |
| ÷n | 100.00 |
| P | $16.00 |
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
26
Intrinsic Value After a $50 Million Dividend Distribution
| Before | After Dividend | |
| Vop | $1,937.50 | $1,937.50 |
| + ST Inv. | 50.00 | 0.00 |
| VTotal | $1,987.50 | $1,937.50 |
| − Debt | 387.50 | 387.50 |
| S | $1,600.00 | $1,550.00 |
| ÷n | 100.00 | 100.00 |
| P | $16.00 | $15.50 |
| DPS | $0.50 |
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
27
Drop in Price with Dividend Distribution
Note that stock price drops by dividend per share in model.
If it didn’t there would be arbitrage opportunity (assuming no taxes).
In real world, stock price drops on average by about 90% of dividend.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
28
A repurchase has no effect on stock price!
The announcement of an intended repurchase might send a signal that affects stock price, and the previous events that led to cash available for a distribution affect stock price, but the actual repurchase has no impact on stock price because:
If investors thought that the repurchase would increase the stock price, they would all purchase stock the day before, which would drive up its price.
If investors thought that the repurchase would decrease the stock price, they would all sell short the stock the day before, which would drive down the stock price.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
29
Remaining Number of Shares After Repurchase
# shares repurchased = nPrior − nPost
# shares repurchased =CashRep/PPrior
nPrior − nPost = CashRep/PPrior
nPost = nPrior − (CashRep/PPrior)
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
30
Remaining Number of Shares After Repurchase
nPost = nPrior − (CashRep/PPrior)
nPost = 100 − ($50/$16)
nPost = 100 − 3.125 = 96.875
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
31
Intrinsic Value After a $50 Million Repurchase
| Before | After Repurchase | |
| Vop | $1,937.50 | $1,937.50 |
| + ST Inv. | 50.00 | 0.00 |
| VTotal | $1,987.50 | $1,937.50 |
| − Debt | 387.50 | 387.50 |
| S | $1,600.00 | $1,550.00 |
| ÷n | 100.00 | 96.875 |
| P | $16.00 | $16.00 |
| Shares rep. | 3.125 |
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
32
Key Points
ST investments fall because they are used to repurchase stock.
Stock price is unchanged by actual repurchase.
Value of equity falls from $1,600 to $1,550 because firm no longer owns the ST investments.
Wealth of shareholders remains at $1,600 because shareholders now directly own the $50 that was previously held by firm in ST investments.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Repurchase vs. Dividends
Repurchase
Stock price doesn’t fall at time of repurchase
Number of shares falls
Dividend distribution
Stock price falls by amount of dividend at time of payment
Number of shares doesn’t change
33
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Repurchase vs. Dividends Over Time
34
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Price per share (Dividends) 41639 42003 42004 42368 42369 42734 42735 43099 43100 16 17.600000000000001 17.05 19.36 18.754999999999999 21.295999999999992 20.630499999999991 23.425599999999985 22.693550000000005 Price per share (Repurchase) 41639 42003 42004 42368 42369 42734 42735 43099 43100 16 17.600000000000001 17.600000000000001 19.984516129032251 19.984516129032251 22.692095733610827 22.692095733610827 25.766508703970988 25.766508703970988
35
Advantages of Repurchases
Stockholders can choose to sell or not.
Helps avoid setting a high dividend that cannot be maintained.
Income received is capital gains rather than higher-taxed dividends.
Stockholders may take as a positive signal--management thinks stock is undervalued.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
35
36
Disadvantages of Repurchases
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.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
36
37
Setting Dividend Policy
Forecast capital needs over a planning horizon, often 5 years.
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.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
37
38
Stock Dividends vs. Stock Splits
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.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
38
39
Stock Dividends vs. Stock Splits (continued)
Both stock dividends and stock splits 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 investor’s wealth unchanged.
But splits/stock dividends may get us to an “optimal price range.”
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
39
40
When should a firm consider splitting its stock?
There’s a widespread belief that the optimal price range for stocks is $20 to $80.
Stock splits can be used to keep the price in the optimal range.
Stock splits generally occur when management is confident, so are interpreted as positive signals.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
40
41
What’s a “dividend reinvestment plan (DRIP)”?
Shareholders can automatically reinvest their dividends in shares of the company’s common stock. Get more stock than cash.
There are two types of plans:
Open market
New stock
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
41
42
Open Market Purchase Plan
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.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
42
43
New Stock Plan
Firm issues new stock to DRIP enrollees, keeps money and uses it to buy assets.
No fees are charged, plus sells stock at discount of 5% from market price, which is about equal to flotation costs of underwritten stock offering.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
43
44
Optional investments sometimes possible, up to $150,000 or so.
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.
New Stock Plan
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
44
