15 - Analysis of Dividends and Share Repurchases

Question 1

Types of dividends include the following:

Answer 1

Regular cash dividends
Extra or special (irregular) dividends
Stock splits
Liquidating dividend

Question 2

DRPs offer shareholders a number of potential advantages.

Answer 2

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.

Question 3

Liquidating dividend

Answer 3

when the whole firm or part of the firm is sold, or when dividends in excess of cumulative retained earnings are paid

Question 4

Stock dividend

Answer 4

non-cash dividend paid in the form of additional shares.
No affect on ratios

Question 5

Dividend irrelevance theory

Answer 5

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.

Question 6

Bird-in-hand (dividend preference theory) argument for dividend policy

Answer 6

investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of expected capital gains

Question 7

Tax aversion theory for dividend policy

Answer 7

investors would want companies to have a zero dividend payout ratio so that they will not be burdened with higher tax rates.

Question 8

Agency costs - Shareholders and manager

Answer 8

One aspect of agency issue is that managers may have an incentive to overinvest (“empire building”).

Question 9

Agency costs

Answer 9

inefficiencies due to divergence of interests

Question 10

One way to reduce agency cost - Shareholders and manager

Answer 10

increase the payout of free cash flow as dividends

Question 11

Agency costs - Between shareholders and bondholders

Answer 11

When there is risky debt outstanding, shareholders can pay themselves a large dividend, leaving the bondholders with a lower asset base as collateral.

Question 12

One way to reduce agency cost - Between shareholders and bondholders

Answer 12

provisions in the bond indenture

Question 13

double-taxation system formula

Answer 13

effective tax rate = corporate tax rate + (1 − corporate tax rate)(individual tax rate)

Question 14

split-rate corporate tax system

Answer 14

taxes earnings distributed as dividends at a lower rate than earnings that are retained

Question 15

imputation tax system

Answer 15

taxes are paid at the corporate level but are attributed to the shareholder, so that all taxes are effectively paid at the shareholder rate

Question 16

double-taxation system

Answer 16

Earnings are taxed at the corporate level regardless of whether they are distributed as dividends, and dividends are taxed again at the shareholder level

Question 17

stable dividend policy

Answer 17

focuses on a steady dividend payout, even though earnings may be volatile from year to year

Question 18

target payout adjustment model

Answer 18

A stable dividend policy could be gradually moving towards a target dividend payout ratio

Question 19

Target Payout Adjustment Model formula

Answer 19

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

Question 20

Four common methods are used for share buybacks

Answer 20

Open market transactions (most flexible)
Fixed price tender offer (very quick)
Dutch auction (not as quick)
Repurchase by direct negotiation

Question 21

Fixed price tender offer

Answer 21

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.

Question 22

Dutch auction

Answer 22

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

Question 23

Repurchase by direct negotiation

Answer 23

purchasing shares from a major shareholder, often at a premium over market price.

Often used in greenmail scenarios

Question 24

greenmail scenario

Answer 24

where a hostile bidder is offered a premium to go away

Question 25

effect of a share repurchase on earnings per share when the repurchase is financed with the company’s surplus cash

Answer 25

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

Question 26

effect of a share repurchase on earnings per share when the company uses debt to finance the repurchase.

Answer 26

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.

Question 27

Calculate the effect of a share repurchase on book value per share.

Answer 27

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).

Question 28

There are five common rationales for share repurchases (versus dividends):

Answer 28

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.

Question 29

Dividend safety

Answer 29

evaluate the probability of dividends continuing at the current rate for a company

Question 30

FCFE coverage ratio

Answer 30

FCFE coverage ratio = FCFE / (dividends + share repurchases)

Question 31

dividend coverage ratio

Answer 31

net income/dividends

Question 32

dividend payout ratio

Answer 32

dividends/net income