CHAPTER 7

DIVIDENDS AND SHARE

REPURCHASES: ANALYSIS
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1. INTRODUCTION
A payout policy is a set of principles regarding a corporations 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.

DIVIDENDS ARE IRRELEVANT

In Miller and Modiglianis (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 firms 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 MMs 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 companys
size or managements control.
Jensens 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 companys 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
dividendsa 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 companys 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 Lintners), companies may adjust to the target using an
adjustment factor that is less than or equal to 1.0:

- 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:

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:

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5. ANALYSIS OF DIVIDEND SAFETY

We can evaluate the safety of the dividend by examining the companys
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 companys 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 companys 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 years 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 companys past dividend record.

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