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Corp Finance Theory > 6 - Dividend Policy; including share buy backs > Flashcards

6 - Dividend Policy; including share buy backs Flashcards

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1
Q

what assumption is made about dividends?

A

they are sticky

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2
Q

why may companies opt to buy back stock? 5

A

more flexibility-can repurchase one year and no the next
once off events - no expectations
increase insider control
buy back temp under valued stock
shareholders can choose if they want to participate or not

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3
Q

why may directors with options prefer buy backs to paying dividends?

A

options are not protected against price drop following a payment of dividends

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4
Q

what type of correlations is there between dividends and earnings?

A

postive correlation

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5
Q

how is dividend payout ratio calculated?

A

dividends / earnings (book measure)

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6
Q

how is dividend yield calculated?

A

dividends / stock price (market measure)

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7
Q

What does LINTNER 1956 discuss?

A

how dividends are determined

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8
Q

What are the five key assumptions that LINTNER 1956 makes?

A
  • firms have long term dividend payout ratios (5-10yrs)
  • managers focus more on dividend changes than absolute values
  • dividends change only following longterm sustainable earnings
  • managers reluctant to make dividend changes
  • managers can repurchase shares
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9
Q

what is the formula for target dividend LINTNER 1956?

A

Div1 = target ratio x EPS1

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10
Q

what is the formula for target dividend change LINTNER 1956?

A

Div1-Div0 = target ratio x EPS1 - Div0

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11
Q

what is the formula for actual dividend change LINTNER 1956?

A

Div1-Div0 = adjustment rate x (target ratio x EPS1 - Div0)

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12
Q

if dividend doesn’t increase after earnings increase what does this signal to the shareholders?

A

firms believes increase is only temporary - indicates what firm thinks of it’s performance

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13
Q

What are the 2 key implications of LINTNER 1956?

A
  • managers favour dividend stability, because changes affect share price
  • investors, knowing how managers behave, interpret dividend changes as signals on future prospects
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14
Q

what are the three schools of thought on dividends?

A
  • they are irrelevant; don’t affect value (assume cap gain tax = div tax, can issue more stock at no cost)
  • they are bad because they reduce value (tax disadvantage - prefer cap gains)
  • they are good and increase value (signal future prospects)
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15
Q

which theory does the idea that dividends don’t affect value come from? what three assumptions are made to back this

A

MM
personal taxes ignored, investors are indifferent between cap gains and dividends

  • cap gains tax = div tax
  • if too much cash paid can issue new shares, with no costs or signally consequences
  • if cash retained it is not used for bad projects
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16
Q

does MM ignore risk in regards to dividend policy? explain

A

no, MM argues efficiency, existing share holders can choose to not receive dividends or sell share, share will be at fair value, leaving funds in firm means you expect a higher return

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17
Q

what are the key implications of MM dividend policy theory? 3

A
  • dividends don’t affect stock prices
  • firms should use residual dividend policy
  • if good investment opps, not paying div won’t affect firms value
18
Q

what is the argument for dividends are bad?

A

dividends are taxed more heavily than cap gains, therefore cap gains preferred.

19
Q

what is the price change, dividends, tax rate formula?

A

Pb-Pa/ Div = (1 - to) / (1 -tcg)

price before and after
Tax on ordinary income
Tax on cap gains

20
Q

what to the values of Pb - Pa tell us? 3

A

Pb - Pa = Div (taxes are equal)
Pb - Pa < Div (to > tcg) small price drop MOST COMMON
Pb - Pa > Div (to < tcg) large price drop

21
Q

what does a small price decrease in Pb-Pa tell us?

A

Pb - Pa < Div (to > tcg)

most investors face higher tax rates on div than on cg

22
Q

what does a large price decrease in Pb-Pa tell us?

A

Pb - Pa > Div (to < tcg)

most investors face higher tax rates on cg than on div

23
Q

What is the dividend capture strategy? tax factor

A

large trading volumes around ex div day. high tax investors sell stock and low tax investors buy stock so as to receive div. trades are then reversed after ex div day

24
Q

When a firm pays dividends how can this be said to save investors money on paying cap gains tax?

A

because dividends reduce firm value when paid, so they have to pay less cap gains tax

25
Q

when tax on div is higher than cap gains, how can a firm ensure that it’s shareholders pay less tax? how does this benefit the firm?

A

repurchase shares instead of paying div

repurchase increases the value of the firm

26
Q

if the firm has excess cash why should it not pay it out in dividends? what could they do instead, but what need to be considered if this is done?

A
  • excess cash could only be temporary

- should repurchase shares as it is more flexible; consider cost of raising new equity (more expensive than debt)

27
Q

what are the arguments for dividends are good? 4

A
  • clientele argument
  • dividends as signals
  • wealth transfer
  • agency costs of equity
28
Q

what is the clientele argument for dividends being good?

A

investors invest based on their level of personal tax.
high tax bracket - invest in firms that don’t pay dividends
low tax bracket - invest in firms that do pay div

29
Q

which researchers back clientele affect? names?

A

Elton and Gruber

30
Q

What s the counter argument for clientele effect?

A

when investors are satisfied i.e. supply of div = demand of div, firms are unable to increase price by changing div policy, which is not seen is real world

31
Q

what is the signalling hypothesis? increase/decrease div?

A
  • increasing div signals to market that future CFs are strong enough to sustain new div
  • firms are very reluctant to cut div, so when they do cut market view it as extremely bad news
32
Q

How does MM counter argue the signalling hypothesis?

A

argues that divs are simply a mechanism for expectations and that it is actually the investment policy change that causes increase or decrease.

33
Q

what does signalling require to make it credible to the market and shareholders?

A

cost - i.e. higher divs, mimicking destroys value (not worth paying high divs to fool investors)

34
Q

What is the basic idea of signalling and when is it worthwhile for firms to increase dividends?

A
  • increasing dividends may signal firm quality only if good firms increase dividends enough that it is too costly forbad firms to replicate
35
Q

what happens to stock prices when there is an unexpected div announcement?

A

it increases

36
Q

What is the wealth transfer hypothesis? what theory is this consistent with?

A

bondholders don’t like dividends, as it makes debt riskier (assuming increase was not built into interest rate). it transfers wealth from bond holders to stockholders.

consistent with agency problem of debt

37
Q

What does the agency cost of equity refer to? 3

A
  • managers are assumed to be self-interested and wish to retain excess cash causing over-investment
  • forcing managers to pay dividends reduces over investment and agency costs
  • even if they have to go to the external market to raise additional funds after paying dividends, cost of issuing new equity is offset by reduction in agency costs
38
Q

what type of signal does a buyback send?

A

usually strong because shares are bought back at a premium

39
Q

how to buy backs increase the value of the remaining shares?

A

EPS ratio has a lower denominator when less stock dilution

40
Q

what three things will a firm look at when deciding between a div or buyback?

A
  1. signal - div have stronger signal as they imply commitment to future CFs
  2. value of flexibility - buybacks more flexible
  3. tax burden on shareholders - type of investors firm has
41
Q

what are the to AGENCY MODELS to explain dividends?

A

Outcome model

  • div is an outcome of legal protection
  • share holders protect themselves by forcing firms to pay divs
  • high g = low div
  • low g = high div

Substitution Model

  • divs substitute legal protection
  • firms maintain reputation

Corp Finance Theory (12 decks)

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