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Key Facts > Anslysis Of Dividends > Flashcards

Anslysis Of Dividends Flashcards

1
Q

What types of dividend would an asset sale or divestment lead to

A

Special (irregular) dividend

Liquidating dividend

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2
Q

What type of dividend pays in excess of cumulative retained earnings?

A

Liquidating dividend

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3
Q

Which type of dividend is a “return OF capital”

A

Liquidating dividend

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4
Q

Which type of dividend is paid in shares

A

Stock dividend

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5
Q

How are stock dividends taxed?

Why?

A
  1. They are not usually taxedl
  2. All shareholders receive these but there is no taxable gain.
  3. The market value of the firm does not usually change, so the share price usually declines.
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6
Q

What is the effect on investor base of high stock price and minimum order size

A

Reduces small investor participation.

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7
Q

Give 3 reasons companies consider stock dividends desirable

A
  1. Encourage long term investing - reducing cost of equity
  2. Reduces share price to better trading range - and lowers cost of minimum order
  3. Helps increase stocks float - increasing liquidity. Which has positive effects on cost of equity.
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8
Q

In which country are stock dividends popular

A

China

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9
Q

What ratio of stock split is the same as a 100% stock dividend

A

A 2 for 1

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10
Q

What is the difference between a stock split and a reverse stock split

A
  1. A stock split increases number of shares and reduces price per share
  2. A reverse stock split reduces number of shares and increases price per share
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11
Q

Give 5 points that explain the effect of non cash dividends on accounting ratios

A
  1. No outflow of cash
  2. Do not affect “current ratio”
  3. Do not affect “quick ratio”
  4. Equity side of balance sheet is unchanged becayse the decrease in retained earnings is offset by an increase in issued (paid in) share capital.
  5. There does not affect the “leverage ratio”
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12
Q

What is the motivation for a reverse stock split

A

Attract institutional investors and mutual funds because they shun low priced stocks

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13
Q

What is the accounting effect of cash dividends

A
  1. Reduces cash this lowers the quick and current ratios
  2. Cash dividends that reduce retained earnings lower shareholders equity, this causes the Debt to Equity ratio to increase.
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14
Q

What are the 4 theories of dividend policy

A
  1. Dividend irrelevance
  2. Dividend preference (bird in hand)
  3. Tax aversion
  4. Clientelle effect
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15
Q

Give 4 points to describe MM dividend irrelevance theory

A
  1. Based on the idea Investors can create their “home made dividend” policy and dont care about the firms dividend policy
  2. Investors can decide the dividends they receive by buying stock (if dividend received is too high) or selling stock if cash received is too low.
  3. Really this applies to payout policy rather than dividend policy
  4. Only works in a “no tax and no transaction cost” world
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16
Q

In 4 points explain the implications of MM dividend irrelevancy theory that conflict with dividend preference (bird in hand) theory

A
  1. MM implies share price will not change because of dividend policy.
  2. Because dividend policy does not affect price, it does not affect required return to equity Re.
  3. Gorden & Lintner say Re decreases as dividend payout increases. Because a dividend is more certain than using retained earnings to generate a future capital gain.
  4. MM counters bird in hand by saying the clientelle effect shows that multiple dividend policies exist yet all clienteles are satisfied, firms are simply swapping one clientele for another.
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17
Q

Explain the Tax Aversion theory of dividends in 3 points

A
  1. Historically when Div Tax > CGT, investors shunned dividends.
  2. Past research suggested dividends fall as dividend tax increases
  3. Since 2003 in the US CGT=Div Tax
    making theory irrelevant
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18
Q

Explain clientelle theory of dividends in 6 points including the implication on dividend irrelevance theory

A
  1. Where CGT <> Div Tax different investors have different preferences
  2. Firms tailor their dividend policies to the preferences of the Investor clientelle
  3. Institutional investor preferences. Growth vs dividend yield funds
  4. Individual investor preferences. Receiving dividends while keeping principal capital invested in stocks.
  5. Changing dividend policy changes clientelle not stock price.
  6. Does not contradict dividend irrelevance because it promotes stable dividend policy not a change of stock price.
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19
Q

List two agency problems that impact dividend policy

A
  1. Between Managers and Shareholders

2. Between Bondholders and Shareholders.

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20
Q

Does the clientelle effect contradict dividend irrelevance theory.

Why?

A

No. It clientelle effect does not contradict dividend irrelevance theory

Because it promotes stable dividend policy.

Whereas a change in dividend policy would merely cause a change in clientelle

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21
Q

Explain information content of continued dividends

A
  1. More credible than plain financial statements
  2. Dividends are expected to be “sticky” - a stable indicator of belief of manangement in future performance.
  3. Management refrains from increasing a dividend level that cannot be maintained and would lead to a cut in dividends in the future.
  4. Therefore an increased dividend is usually positive.
  5. However, initiating a dividend can be a sign of a lack of growth opportunities.
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22
Q

What are two common implications of a dividend initiation

A
  1. Management believe in future growth

2. There is a lack of growth opportunities for excess cash.

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23
Q

What is the effect of an unexpected dividend increase on stock price. Why?

A
  1. Positive
  2. Signals that future prospects are strong.
  3. Companies with a history of dividend increases tend to be dominant with high ROA and low debt ratios.
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24
Q

What is the effect of unexpected dividend decrease or omission

A
  1. Usually indicates the firm is in trouble.

2. However, it may indicate positive growth investment opportunities.

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25
Q

Explain MM interpretation of clientelle effect

A
  1. Changing dividend policy does not change firm value

2. Because once all clientelles are satisfied different dividend policies merely switch clientelle.

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26
Q

Why do clientelle effects influence dividend policy

A
  1. Tax preference where CGT <> DIV TAX or where dividends are double taxed (US).
  2. Individuals (high tax bracket) prefer low dividends
  3. Institutions / corporates prefer high dividends.
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27
Q

Describe 6 factors that define optimal dividend payout ratio

A
  1. Tax considerations - Investors’ preferences for dividends versus capital gains.
  2. The firm’s investment opportunities.
  3. Financial flexibility and the firm’s target capital structure.
  4. Flotation costs and the availability and cost of external capital.
  5. Expected volatility of future earnings.
  6. Contractual and legal restrictions
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28
Q

Explain the residual dividend model.

A
  1. The dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm’s optimal capital budget.
  2. The residual dividend policy minimizes the costs to the company of raising outside funds
  3. It does not provide a stable cash flow to the investors and most investors prefer stable dividends.
29
Q

Explain the agency problem between management and shareholders on dividend policy

A
  1. Managers have incentive to over-invest.
  2. This may lead to negative NPV projects.
  3. Growing firms usually retain earnings
  4. Mature firms should not hoard cash and should payout.
30
Q

Explain the agency problem between shareholders and bond holders

A
  1. A large dividend can reduce the asset base available to bomdholders.
  2. This is a transfer of risk from shareholders to bondholders.
31
Q

How are agency conflicts between stock and bondholders usually resolved?

A

Bond indenture provisions:

  1. Restrictions on dividends
  2. Maintenance of certain balance sheet ratios.
32
Q

What is the effect of “Tax considerations - Investors’ preferences for dividends versus capital gains.” on dividend policy?

A

Maximise investors after tax income:

  1. Investors are concerned with after tax returns.
  2. If CGT
33
Q

What is the effect on dividend policy of “ The firm’s investment opportunities.”

A

Affects the residual income available for dividends because:

  1. Firms need to react quickly for investment opportunities.
  2. If availability of suitable positive NPV projects is high then dividend payout will be lower
34
Q

Explain how a firms “Financial flexibility and target capital structure.” affects dividend payout policies

  1. Expected volatility of future earnings.
  2. Contractual and legal restrictions
A

Favours stock repurchases because:

  1. A firm may need to access cash flow rather than continue to pay the same dividends in order to
    (A) deal with liquidity issues during a contraction.
    (B) Take advantage of investment opportunities
  2. Stock purchases are therefore preferable to dividends since these do not set future expections with shareholders of a continuing dividend.
35
Q

Do stock repurchase plans impact financial flexibility?

A

No. They are not sticky.

They do not set expectations for continuing dividends.

36
Q

What is the impact of “Flotation costs and the availability and cost of external capital.” on dividend policy?

  1. Expected volatility of future earnings.
  2. Contractual and legal restrictions
A
  1. Companies with retained earnings will prefer to use that for new investment opportunities instead of dividends because it is a lower cost than raising new equity through issuance.
  2. New issuance costs are 3-7%
  3. Impact on share price due to increased float can be substantial.
  4. These costs encourage a lower dividend payout.
37
Q

What is the effect of “Expected volatility of future earnings.” on dividend policy.

A

Firms are more cautious about increasing dividends when earnings are expected to be volatile because:

  1. If earnings are expected to be volatile, dividend payout would vary if ratio is constant.
  2. Firms would prefer not to set expectations with regular dividends or increases since they may not be maintained or may be reversed.
38
Q

What is the effect on dividend policy by “Contractual and legal restrictions”

A

These limit the dividend payout to an investor that would breach either:

  1. Certain debt covenants.
  2. Impairment of capital rule where dividends cannot exceed retained earnings.
39
Q

What is the “impairment of capital rule”

A

Dividend payout must be less than retained earnings

40
Q

Describe two stable dividend policies

A
  1. Constant Payout Ratio: rarely used.

2. Target Payout Adjustment Model

41
Q

Describe the Target Payout Adjustment Model

A

Change in dividends =

[(Earnings x TPR)- Previous dividend] x (1/n)

42
Q

Describe the Residual Dividend Model

A

Dividends are paid out of earnings left over after the capital budget is financed.

Dividend=
Retained earnings
- equity part of capital budget

43
Q

Give two advantages of the residual dividend model

A
  1. Simple to apply

2. Financial Flexibility to pursue investment projects

44
Q

Give two disadvantages of the residual dividend model

A
  1. Investment opportunities and earnings vary year to year.

2. This results in Volatile dividends

45
Q

Name 4 share buyback methods

A
  1. Open market transactions
  2. Fixed price tender offer
  3. Dutch auction
  4. Repurchase by direct negotiation
46
Q

Describe “open market” share repurchases

A
  1. Most flexible
  2. No fixed price
  3. No obligation
47
Q

Describe “fixed price tender offer” share repurchase

A
  1. Tender offer to buy a fixed number of shares.
  2. At a fixed price, usually a premium.
  3. If response from shareholders to tender is over supply, the buyback will be prorata per shareholder
48
Q

Explain a Dutch Auction share repurchase

A
  1. Tender offer
  2. A range of prices
  3. Offers a minimum price for a particular number of shares
  4. Each shareholder responds with its own offer and quantity.
  5. The highest accepted bid price will be the price paid for all shareholders.
49
Q

Hpw can a shareholder increase chance of inclusion in a Dutch auction share repurchase

A
  1. Offer many shares at a low price
50
Q

Describe a share repurchase by direct negotiation

A
  1. Purchase of shares from a major shareholder
  2. Usually at a premium but sometimes at a discount
  3. Used in Greenmail - so a hostile bidder goes away
  4. May be used to remove overhang in the market that is holding back share price appreciation
51
Q

What are the balance sheet effects of a share repurchase with existing company cash.

What is the effect on EPS and share price

A
  1. Cash (Assets) reduced
  2. Retained earnings (shareholders equity) reduced
  3. Leverage ratios up (Debt to Assets & Debt to Equity)
  4. Fewer shares outstanding
  5. If the resulting earnings yield is higher than the cash yield the EPS will increase and share price should increase
52
Q

What are the balance sheet effects of a share repurchase with borrowed funds.

What is the effect on EPS and share price

A
  1. If additional debt is used, after tax earings will fall which will negatively impact EPS
  2. If earnings yield is greater than after tax cost of debt EPS will rise because of fewer shares but less rise than if idle cash is used.
  3. Leverage ratios will still increase.
  4. However, the risk of the firm will increase the cost of capital so share price cannot be guaranteed to rise
53
Q

What is the effect of a share repurchase on BVPS?

How is the book value per share impacted by repurchase price

A
  1. Number of outstanding shares falls after a stock repurchase
  2. If price paid for repurchase > previous price per share the BVPS will fall
  4. If price paid for repurchase < previous price per share the BVPS will increase.
54
Q

Name 5 reasons for share repurchase instead of dividends

A
  1. Tax advantages
  2. Support share price
  3. Flexibility
  4. Offsetting dilution due to employee stock
  5. Increasing financial leverage
55
Q

Explain the tax advantages for a share repurchase vs a cash dividend

A
  1. When CGT
56
Q

Explain the share price support / signalling by a share repurchase vs a cash dividend

A
  1. Repurchase of stock signals to investors that management outlook is positive
57
Q

Explain the “added flexibility” from a share repurchase vs a cash dividend

A
  1. Managers can market time share repurchases which reduces need for stocky dividends.
  2. By setting a small sustainable dividend retained earnings will increase. Lower sticky component.
  3. Leftover retained earnings can be used for share repurchases - a less volatile strategy than paying cash dividends
58
Q

Explain how employee dilution is offset by a share repurchase vs a cash dividend

A
  1. When emloyees exercise stock options new shares are issued. This dilutes EPS
  2. Stock repurchases offsets the increase in number of shares.
59
Q

Explain how management can achieve optimal capital structure through share repurchase vs a cash dividend

A
  1. share repurchase reduces equity and cash assets on the balance sheet
  2. Financial leverage increases.
  3. Increase in Debt to equity and debt to assets.
  4. Using debt to finance share repurchase can magnify this by increasing debt as well as reducing equity.
60
Q

List 4 broad trends in dividend payout policies

A
  1. Lower propertion of US companies pay dividends than European companies
  2. Globally, in developed markets the proportion of companies paying dividends has reduced
  3. Proportion of companies repurchasing shares in US has increased since 1980s
  4. Proportion of companies repurchasing shares in UK and EI has increased since 1990s
61
Q

What are the two most important predictors of dividend reliability

A
  1. FCFE / (Dividend + repurchases)

2. Net Income / dividend

62
Q

Explain “Dividend Safety”

A

The probability of dividends continuing at the current rate

63
Q

Explain Dividend Coverage Ratio (DCR)

A
  1. Inverse of Dividend Payout ratio
  2. NI / Dividends
  3. The lower the DCR the higher the risk of cutting dividends
  4. Compare this company DCR with the average sector DCR in same industry
  5. This does not consider share repurchases
64
Q

Explain FCFE coverage ratio

A
  1. The ratio of FCFE over dividends and cost of share repurchases
  2. FCFE coverage ratio < 1 this is unsustainable because cash reserves are being drawn down.
65
Q

Explain the information transfer of dividend surprises

A

Trabsfer of information from management to shareholders and investors

66
Q

How can you discourage the tendancy for management to over-invest in low NPV projects

A

Pay out an increased proportion of FCFE as dividends or through share repurchases

67
Q

What are 2 indicators of dividend uncertainty

A
  1. Reducing productive capital expenditure or adding debt for repurchases or dividends
  2. High dividend payout ratio compared with the past or current bond yields
68
Q

What are the inplications of FCFE Coverage ratio of

Equal to 1
Greater than 1
Less than 1

A

=1 means Distributing all cash to shareholders

> 1 meabs Retaining earnings to increase liquidity

<1 is Not sustainable. Eating into liquidity.

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