3. Dividends and Share Repurchases: Analysis Flashcards
What is DRP?
In some countries, companies can have dividend reinvestment plans (DRPs) that, at shareholders’ requests, automatically reinvest all or part if the regular cash dividend by purchasing additional shares.
- Open market DRP: when additional shares are purchased in the open market
- New Issue DRP: newly issued shares by the company (allow companies to raise additional capital without the floatation cost of a secondary offering)
Explain ‘Dividend Irrelevance’ theory.
MM’s argument of dividend irrelevance is based on their concept of homemade dividends. Assume that you are a stockholder and you don’t like the firm’s dividend policy. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s stock. If the cash dividend you received was too small, you can just sell a little bit of your stock in the firm to gret the cash flow you want. The theory holds only in a perfect world with no taxes, brokerage costs and infinitely divisible shares.
Explain the ‘Bird-in-hand argument for dividend policy’.
When MM conclude that dividends are irrelevant, they mean that investors don’t care about the firm’s dividend policy since they can create their own. Gordon and Lintner, however, argue that return on equity capital (ke) decreases as the dividend payout increases. Because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current (and therefore certain) dividends payments. Investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of expected capital gains.
Explain the ‘Tax Aversion therory’.
In many countries, dividends have historically been taxed at higher rates than capital gains. But, the change in tax law that put dividends and capital gains on common ground is likely to make the tax aversion theory irrelevant.
Explain ‘Clientele Effect Theory’.
This refers to the varying dividend preferences of different groups of investors, such as individuals, institutions, and corporations. The dividend clientele effect states that different groups desire different levels of dividends. Rationales for the existence of the clientele effect include:
- Tax considerations: high-tax-braket investors tend to prefer low dividnd payouts
- Requirements of institutional investors: for legal or strategic reasons, some institutional investors will invest only in companies that pay a dividend yield above some target threshold
- Individual investor preferences
How to calculate dP when the stock goes ex-dividend?
dP = D*(1-tD)/(1-tCG)
tD= tax rates on dividends tCG = tax rates on capital gains
Explain agency costs between shareholders and managers.
Agency costs reflect the inefficiencies due to divergence of interests between managers and stockholders. One aspect of agency issue is that managers may have an incentive to overinvest. This may lead to investment in some negative NPV projects. One way to reduce agency cost is to increase the payout of free cash flow as dividends.
Explain agency costs between shareholders and bondholders.
For firms financed by debt as well as equity, there may be an agency conflict 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. This way, there could be a transfer of wealth from bondholders to stockholders. Typicallym agency this conflict is resolved via provisions in the bond identure.
Which are the 6 factors that affect dividend policy in practice?
1) Investment opportunities
2) Expected volatility of future earnings
3) Financial flexibility
4) Tax considerations
5) Flotation costs
6) Contractual and legal restrictions
Explain the effective tax rate under:
a) Double Taxation System
b) Split-Rate Tax System
c) Dividend Imputation Systems
a) Double Taxation System: earnings are taxed at the corporate level regardless of whether they are distributed as dividend, and dividends are taxed again at the shareholder level.
Effective Tax Rate = Corporate Tax Rate + (1-Corporate Tax Rate)*(Individual Tax Rate)
b) Split-Rate System: when corporate tax system taxes earnings distributed as dividends at a lower rate than earnings that are retained. Similar to double taxation except that the corporate tax rate applicable would be the ‘corporate tax rate for distributed income’.
c) 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. Shareholders deduct their portion of the taxes paid by the corporation from their tax return. If the shareholder tax bracket is lower than the company rate, the shareholder would receive a tax credit equal to the difference between the two rates. If the sharegolde’s tax bracket is higher than the company’s rate, the shareholder pays the difference between the two rates.
Explain ‘Target Payout Ratio Adjustment Model’.
If company earnings are expected to increase and the current payout ratio is below the target payout ratio, an investor can estimate future dividends through the following formula:
Expected Dividend = (Previous Div) + [(Expected EPS) * (Target Payout Ratio) * (Adjustment Factor)]
Adjustment Factor = 1/Number of Years over Which the Adjustment in dividends will take place)
Explain ‘Residual Dividend Model’. Which are the main steps?
In the residual dividend model, dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget.
The model is based on the firm’s 1) investment opportunity schedule, 2) Target capital structure and 3) Acess to and cost of external capital.
Step 1: Identify the optimal capital budget
Step 2: Determine the amount of equity needed to finance that capital budget for a given capital structure
Step 3: Meet equity requirements to the maximum extent possible with retained earnings
Step 4: Pay dividends with the ‘residual’ earnings that are available after the needs of the optimal capital budget are supported.
Explain share repurchase and the four common methods for share buybacks.
A share repurchase is a transaction in which a company buys back its own common stock. Because shares are bought using a company’s own cash, a share repurchase can be considered an alternative to cash dividend.
- Open market transactions: are the most flexible approach, allowing a company to buy back its shares in the open market at the most favorable terms. There is no obligation on the part of the company to complete an announced buyback program. Outside the USA and Canada, method 1 is used almost exclusively.
- Fixed price tender offer: is an approach where the firm buys a predetermined number of shares at a fixed price, typically at a premium over the current market price. Although the company forgoes flexibility (the firm cannot execute its purchases at an exact opportune time), it allows a company to buy back its shares rather quickly.
- Dutch Auction: is a tender offer in which the company specifies not a single fixed price but rather a range of prices. Dutch auctions identify the minimum clearing price for the desired number of shares that need to be repurchased. Each participating shareholder indicates the price and the number of shares tendered. Bids are accepted based on lowest price first until the desired quantity is filled. The price of the last offer accepted (i.e., the highest accepted bid price) will however be the price paid for all shares tendered. Hence, a shareholder can increase the chance of having their tender accepted by offering shares at a low price. Dutch auctions also can be accomplished rather quickly, though not as quickly as tender offers.
- Repurchase by direct negotiation: entail purchasing shares from a major shareholder, often at a premium over market price. This method is often used in a greenmail scenario (where a hostile bidder is offered a premium to go away) to the detriment of the remaining shareholders. A negotiated purchase can also occur when a company wants to remove a large overhang in the market that is dampening the share price. Surprisingly, many negotiated transactions occur at a discount to market price, indicating that urgent liquidity needs of the seller motivated the transaction.
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 ???/ (???)
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)
Describe broad trends in corporate payout policies.
- A lower proportion of US companies pay dividends as compared to their European counterparts.
- Globally, in developed markets, the proportion of companies paying cash dividends has trended downwards over the long term.
- The percentage of companies making stock repurchases has been trending upwards in the United States since the 1980s and in the United Kingdom and continental Europe since 1990s.
