15 - Analysis of Dividends and Share Repurchases Flashcards
Types of dividends include the following:
Regular cash dividends
Extra or special (irregular) dividends
Stock splits
Liquidating dividend
DRPs offer shareholders a number of potential advantages.
allow for purchase of additional shares with no transaction costs.
allow shareholders to benefit from cost averaging.
sometimes offered to DRP participants at a discount to market price.
Liquidating dividend
when the whole firm or part of the firm is sold, or when dividends in excess of cumulative retained earnings are paid
Stock dividend
non-cash dividend paid in the form of additional shares.
No affect on ratios
Dividend irrelevance theory
Merton Miller and Franco Modigliani (MM) maintain that dividend policy is irrelevant, as it has no effect on the price of a firm’s stock or its cost of capital. MM’s argument of dividend irrelevance is based on their concept of homemade dividends.
Bird-in-hand (dividend preference theory) argument for dividend policy
investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of expected capital gains
Tax aversion theory for dividend policy
investors would want companies to have a zero dividend payout ratio so that they will not be burdened with higher tax rates.
Agency costs - Shareholders and manager
One aspect of agency issue is that managers may have an incentive to overinvest (“empire building”).
Agency costs
inefficiencies due to divergence of interests
One way to reduce agency cost - Shareholders and manager
increase the payout of free cash flow as dividends
Agency costs - Between shareholders and bondholders
When there is risky debt outstanding, shareholders can pay themselves a large dividend, leaving the bondholders with a lower asset base as collateral.
One way to reduce agency cost - Between shareholders and bondholders
provisions in the bond indenture
double-taxation system formula
effective tax rate = corporate tax rate + (1 − corporate tax rate)(individual tax rate)
split-rate corporate tax system
taxes earnings distributed as dividends at a lower rate than earnings that are retained
imputation tax system
taxes are paid at the corporate level but are attributed to the shareholder, so that all taxes are effectively paid at the shareholder rate
double-taxation system
Earnings are taxed at the corporate level regardless of whether they are distributed as dividends, and dividends are taxed again at the shareholder level
stable dividend policy
focuses on a steady dividend payout, even though earnings may be volatile from year to year
target payout adjustment model
A stable dividend policy could be gradually moving towards a target dividend payout ratio
Target Payout Adjustment Model formula
expected increase in dividends = [(expected earnings × target payout ratio) − previous dividend] × adjustment factor
where:
adjustment factor = 1 / number of years over which the adjustment in dividends will take place
Four common methods are used for share buybacks
Open market transactions (most flexible)
Fixed price tender offer (very quick)
Dutch auction (not as quick)
Repurchase by direct negotiation
Fixed price tender offer
firm buys a predetermined number of shares at a fixed price, typically at a premium over the current market price.
typically buy back a prorated number of shares from each shareholder responding to the offer.
Dutch auction
tender offer in which the company specifies not a single fixed price but rather a range of prices.
a shareholder can increase the chance of having their tender accepted by offering shares at a low pric
Repurchase by direct negotiation
purchasing shares from a major shareholder, often at a premium over market price.
Often used in greenmail scenarios
greenmail scenario
where a hostile bidder is offered a premium to go away
effect of a share repurchase on earnings per share when the repurchase is financed with the company’s surplus cash
Repurchases made using a company’s surplus cash will lower cash and shareholders’ equity, increasing the firm’s leverage.
earnings per share may increase (depending on the amount of cash used) because there will be fewer shares outstanding
effect of a share repurchase on earnings per share when the company uses debt to finance the repurchase.
If the repurchase was financed with additional debt offerings, the reduction in net income from the (after-tax) cost of the borrowed funds must also be factored in to determine the new impact on earnings per share.
Calculate the effect of a share repurchase on book value per share.
After a stock repurchase, the number of outstanding shares will decrease and the book value per share (BVPS) is likely to change as well. If the price paid is higher (lower) than the pre-repurchase BVPS, the BVPS will decrease (increase).
There are five common rationales for share repurchases (versus dividends):
1 - Potential tax advantages - When the tax rate on capital gains is lower than the tax rate on dividend income
2- Share price support/signaling
3 - Added flexibility
4 - Offsetting dilution from employee stock options
5 - Increasing financial leverage - When funded by new debt, share repurchases increase leverage.
Dividend safety
evaluate the probability of dividends continuing at the current rate for a company
FCFE coverage ratio
FCFE coverage ratio = FCFE / (dividends + share repurchases)
dividend coverage ratio
net income/dividends
dividend payout ratio
dividends/net income
