Chapter 14: Dividends Flashcards
Distribution policy
sets the level of cash distributions (dollar amount) and the form of distributions (dividends and stock repurchases)
Five “good” ways to use free cash flow
1) pay interest expenses (after tax)
2) pay down principal on debt
3) pay dividends
4) repurchase stock
5) buy short-term investment/ other nonoperating assets
negative use of FCF
essentially a source of FCF in that it provides rather than uses FCF
situations that lead to stock repurchases
- company decides to increase its leverage by issuing debt and using the proceeds to repurchase stock (recapitalization)
- repurchase to have stock on hand for exercise of employee stock options
- company has excess cash
ways stock can be repurchased
- if publicly owned stock can be purchased through a broker on the open market
- firm can make a tender offer to shareholders for a price per share in a stated time
- firm can purchase blocks of shares from large holders on negotiated basis
how can a company change its intrinsic value of operations
- change the cost of capital
- change the expected future free cash flows
optimal distribution policy
the distribution policy (for free cash flow) that maximizes the value of the firm by choosing the optimal level and form of distributions (dividends vs stock repurchases)
target distribution ratio
the percentage net income distributed to shareholders through cash dividends or stock repurchases
target payout ratio
the percentage of net income paid as a cash dividend
(inherently less than the distribution ratio)
High distribution ratio + high payout ratio
company pays large dividends and has small (or zero) stock repurchases
dividend yield is relatively high, low expected capital gain
large distribution ratio but small payout ratio
company pays low dividends but regularly repurchases stocks
dividend yield = low
expected capital gain = higher
Low distribution ration
company inherently has a low payout ratio
low dividend yield
hopefully high capital gain yield
dividend irrelevance theory
holds that dividend policy has no effect on either the price of a firm’s stock or its cost of capital. Rather, the firm’s value is determined only by its basic earning power and its business risk
(value of a firm depends only on how income is produced, not how it is split between dividends and retained earnings)
ergo dividend policy does not affect a stock’s value or risk (or the required rate of return
assumptions of dividend irrelevance theory
that shareholders can construct their own dividend policy by selling shares when they want a dividend and investing undesired dividends in additional company stock
also that everyone has identical information about a company’s future earnings and vidends
what aspects of stock trading might negate dividend irrelevance theory
- taxes of dividends and capital gains
- brokerage costs to sell shares
Dividend preference theory
posits that stock risk declines as dividends increase so stockholders will prefer dividends (dividend return is sure thing, capital gain is not)
argues that dividends = lower required return on equity
how a high payout policy affects agency costs
- reduced risk managers will squander cash if cash is not there
- management must be more mindful of practices as the company will have to raise external funds more frequently and as such be under more constant scrutiny
- this environment creates less risk, meaning lower required returns on equity
tax effect theory
states that investors prefer that companies minimize dividends.
Reasoning:
- even when dividends and capital gains are taxed equally (not historically always true) capital gains are not taxed until realized, so dividends always taxed sooner
additionally - no capital gains tax if stock received from a decedent - simply now held at FMV
dividend tax penalty
tax penalty that occurs if dividends are taxed more highly than capital gains causes investors to require a higher pre-tax return on dividend paying stocks (relative to non-dividend stocks)
empirical relationship between dividend yield and rate of return
shown that firms with higher dividend payouts also have higher required returns (supports tax effect hypothesis)
effect of divided penalty on dividend payments
in countries with small dividend tax penalty more companies pay larger dividend payments. If high dividend tax penalty, companies tend to repurchase stock
consistent with tax effect theory
special dividend
a dividend paid, in addition to the regular dividend, when earnings permit. Firms with volatile earnings may have a low regular dividend that can be maintained even in years of low profit (or high capital investment) but is supplemented by an extra dividend when excess funds are available.
why would frequent dividend policy switching be inefficient
- brokerage costs
- likelihood that stockholders who are selling will have to pay capital gains taxes
- possible shortage of investors who like the firm’s newly adopted dividend policy
clientele effect
The attraction of companies with specific dividend policies to those investors whose needs are best served by those policies. Thus, companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income. Conversely, companies with low dividends will have a clientele of investors with high marginal tax rates and little need for current income.
information content hypothesis
aka dividend signaling hypothesis
A theory hypothesizing that investors regard dividend changes as “signals” of management forecasts.
- when dividends are raised, this is viewed by investors as recognition by management of future earnings increases. Therefore, if a firm’s stock price increases with a dividend increase, the reason may not be investor preference for dividends but rather expectations of higher future earnings.
- Conversely, a dividend reduction may signal that management is forecasting poor earnings in the future.
why might a firm choose to retain earnings even if it doesn’t have an immediate use for the cash
internal equity (reinvested earnings) is cheaper than external equity (common stock issuance) because it avoids flotation costs and adverse signals
Factors that determine the optimal distribution ratio for a firm
- investors preferences for dividends vs capital gains
- firm’s investment opportunities
- firm’s target capital structure
- availability and cost of external capital
Residual distribution model
firms pay dividends only when more earnings are available than needed to support the optimal capital budget
Steps to establish a target distribution ration under a residual distribution model
1) determine the optimal capital budget
2) determine the amount of equity needed to finance that budget given the target capital structure
3) use reinvested earnings to meet equity requirements to extent possible
4) pay dividends or repurchase stock only if more earnings are available than need to support the optimal capital budget
Distributions for a given year under a residual distribution policy
Distributions = net income - additions to retained earnings needed to finance new investments
aka
Distributions = net income - (target equity ratio x total capital budget)
distribution ratio
= dividends/ net income
what happens if the residual distribution model is followed strictly
because both income and capital investment opportunities would vary the dividends would also fluctuate, which investors don’t tend to like so the required return on stock would increase and the stock price would decrease
practical use of the residual distribution model to avoid fluctuating dividends
1) estimate average earnings and average investment opportunities out to some forecast horizon (say 5 years)
2) use this forecasted information and the target capital structure to find the average residual model distribution and dollars of dividends during the planning period
3) set a target payout ratio based on the average projected data
essentially use the residual policy to set long-run target distribution ratio but not to guide distribution in an indivudal year
low-regular-dividend-plus-extras policy
Dividend policy in which a company announces a low regular dividend that it is sure can be maintained; if extra funds are available, the company pays a specially designated extra dividend or repurchases shares of stock.
