Chapter 14: Dividends

Question 1

Distribution policy

Answer 1

sets the level of cash distributions (dollar amount) and the form of distributions (dividends and stock repurchases)

Question 2

Five “good” ways to use free cash flow

Answer 2

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

Question 3

negative use of FCF

Answer 3

essentially a source of FCF in that it provides rather than uses FCF

Question 4

situations that lead to stock repurchases

Answer 4

• 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

Question 5

ways stock can be repurchased

Answer 5

• 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

Question 6

how can a company change its intrinsic value of operations

Answer 6

• change the cost of capital
• change the expected future free cash flows

Question 7

optimal distribution policy

Answer 7

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)

Question 8

target distribution ratio

Answer 8

the percentage net income distributed to shareholders through cash dividends or stock repurchases

Question 9

target payout ratio

Answer 9

the percentage of net income paid as a cash dividend

(inherently less than the distribution ratio)

Question 10

High distribution ratio + high payout ratio

Answer 10

company pays large dividends and has small (or zero) stock repurchases

dividend yield is relatively high, low expected capital gain

Question 11

large distribution ratio but small payout ratio

Answer 11

company pays low dividends but regularly repurchases stocks

dividend yield = low
expected capital gain = higher

Question 12

Low distribution ration

Answer 12

company inherently has a low payout ratio

low dividend yield
hopefully high capital gain yield

Question 13

dividend irrelevance theory

Answer 13

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

Question 14

assumptions of dividend irrelevance theory

Answer 14

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

Question 15

what aspects of stock trading might negate dividend irrelevance theory

Answer 15

• taxes of dividends and capital gains
• brokerage costs to sell shares

Question 16

Dividend preference theory

Answer 16

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

Question 17

how a high payout policy affects agency costs

Answer 17

• 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

Question 18

tax effect theory

Answer 18

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

Question 19

dividend tax penalty

Answer 19

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)

Question 20

empirical relationship between dividend yield and rate of return

Answer 20

shown that firms with higher dividend payouts also have higher required returns (supports tax effect hypothesis)

Question 21

effect of divided penalty on dividend payments

Answer 21

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

Question 22

special dividend

Answer 22

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.

Question 23

why would frequent dividend policy switching be inefficient

Answer 23

• 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

Question 24

clientele effect

Answer 24

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.

Question 25

information content hypothesis

Answer 25

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.

Question 26

why might a firm choose to retain earnings even if it doesn’t have an immediate use for the cash

Answer 26

internal equity (reinvested earnings) is cheaper than external equity (common stock issuance) because it avoids flotation costs and adverse signals

Question 27

Factors that determine the optimal distribution ratio for a firm

Answer 27

• investors preferences for dividends vs capital gains
• firm’s investment opportunities
• firm’s target capital structure
• availability and cost of external capital

Question 28

Residual distribution model

Answer 28

firms pay dividends only when more earnings are available than needed to support the optimal capital budget

Question 29

Steps to establish a target distribution ration under a residual distribution model

Answer 29

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

Question 30

Distributions for a given year under a residual distribution policy

Answer 30

Distributions = net income - additions to retained earnings needed to finance new investments
aka
Distributions = net income - (target equity ratio x total capital budget)

Question 31

distribution ratio

Answer 31

= dividends/ net income

Question 32

what happens if the residual distribution model is followed strictly

Answer 32

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

Question 33

practical use of the residual distribution model to avoid fluctuating dividends

Answer 33

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

Question 34

low-regular-dividend-plus-extras policy

Answer 34

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.