Chapter 16

Question 1

2 ways for a corporation to pay out to investors?

Answer 1

Dividends and buying back shares

Question 2

When are dividends increased and why?

Answer 2

Difficult to cut back dividends tf managers rarely increase them unless they are confident they can be maintained

Question 3

Why might firms opt for paying investors back by buying back shares?

Answer 3

Tax advantaged and more flexible

Question 4

What is a cash dividend?

Answer 4

Payment of cash to SHs by firm

Question 5

Ex-dividend date = ?

Answer 5

Date that divides when stockholder is entitled to dividend payment
Stock often worth less if its going to miss this date for the buyer tf price falls by roughly the size of the dividend

Question 6

What is the record date?

Answer 6

The person who owns a stock on this date receives the dividend

Question 7

4 steps of paying a dividend?

Answer 7

1) BofD declares a dividend
2) Stock price falls on ex-dividend date
3) Payment to all stockholders that are registered
4) Checks mailed to shareholders on payment date

Question 8

What are DRIPS?

Answer 8

Dividend reinvestment plans

Question 9

How often at dividends usually paid?

Answer 9

Quarterly

Question 10

What are stock dividends and stock splits? What do they do?

Answer 10

SDs: Give stockholders an additional x shares per y share they own for free
SSs: Issue of additional shares to firm’s stockholders

Both methods decrease value/share and keep market value the same

Question 11

What is a stock repurchase?

Answer 11

Firm buys back stock from shareholders

Question 12

What are the 4 methods of stock repurchase and explain them if need be?

Answer 12

1) Buy shares on market (rules in place to prevent stock price manipulation)
2) Tender offer to shareholders (offer to buy back shares for maybe 20% above market price)
3) Dutch auction (shareholders submit offers to firm and they calculate the lowest price they can buy back the desired number of shares)
4) Private negotiation (greenmail)

Question 13

3 themes found in dividend policy?

Answer 13

1) Managers reluctant to make a change in dividnds that may have to be reversed (tf may borrow/issue new shares to payout)
2) Managers ‘smooth’ payments to avoid having to reduce dividends (follow firm’s LR trend in growth)
3) More focus on the changes in a dividends level than its absolute value from investors perspective

Question 14

Explain the information content of dividends?

Answer 14

Change in dividend levels signal to investors info about the firm tf increase often leads to an increase in the firm’s share price and vice versa
Asymmetric info here can lead to moral hazards from managers
Tf signal sent is also relative to previous dividend changes in the firm and what they meant

Question 15

Different views on dividends vs repurchases?

Answer 15

Right: argues that investors pay more for firms with generous, stable dividends
Left: argues repurchases are better because:
-higher stock prices
-capital gains have been taxed at a lower effective rate than dividends
Miller and Modigliani (MM): argues choice between dividends and repurchases has no effect on value (see notes and understand example!)

Question 16

2 steps to calculating market capitalization?

Answer 16

Calculate aggregate value of all shares:
1) Forecast and discount free cash flow paid out to SHs
2) Calculate price/share
(see book and notes)

Question 17

How to calculate dividends per share?

Answer 17

Calculate the present value of dividends per share, taking into account the increased growth rate of div/share caused by declining no. shares as they are repurchased (see notes again don’t get)

Question 18

V IMPORTANT

Answer 18

Check top of 2nd page of ch16 notes to check i know and understand it all!!!

Question 19

If a firm has surplus cash=0 and borrowing is fixed, but they want to impress investors by paying a larger dividend, how can they do this? Explain the implication of this.

Answer 19

They have to print more shares and sell them
Since new SHs will only part with their cash if you offer shares as much as they cost, there must be a transfer of wealth from old SHs to new SHs
Tf the new SHs get shares at ex-dividend price, the old SHs lose the value of the dividend on their shares tf the capital loss bourne by old SH is offest by the extra cash dividend they received
SUMMARY: firms that sell shares to pay dividends are just recycling cash! (read notes just below, is important stuff also)

Question 20

2 evaluative points regarding analysis just done on dividend payouts?

Answer 20

1) assumes new shares are sold at a fair price (EMH)

2) assumes no taxes/issue costs etc.

Question 21

Explain a factor that may affect whether a shareholder buys shares that pay dividends or does repurchases? (Rightists)

Answer 21

Clientele Effect:
Elderly SHs may look for dividends to be a steady source of cash to live on
It’s easier than selling off some of the stocks every period!

Question 22

Explain why the clientele effect wouldn’t lead to higher stock prices for firms that pay dividends?

Answer 22

Since clients who want high dividends will already have high dividend stocks, tf if they wanted more they would sell firm A’s stock for different ones, but if not then if firm A pays higher dividends anyway this means they’re just giving the client something they’re indifferent for tf won’t increase the price of the stock

Question 23

Explain another argument in favour of dividends?

Answer 23

Argument that paying dividends means managers are less likely to waste/misuse funds

Question 24

Note

Answer 24

See purple writing top of page 2 side 2

Question 25

What does the increased payout of dividends in mature firms signal?

Answer 25

That in developed economies in particular, corporate governance works

Question 26

What is the tax argument for repurchases over dividends? (Leftists)

Answer 26

Whenever capital gains are taxed less than dividends, firms should pay the lowest cash dividend they can get away with then distribute the rest of the cash in form of repurchases
If they do this, taxpaying investors will view the firm more favourably tf the value of the firm should rise
This will lead to the total cash flow retained by firm and investors combined being higher than if DIVs are paid (reduce governments ‘slice’)

Question 27

Explain two evaluative points on the leftists tax argument for repurchases over dividends?

Answer 27

1) If leftists ARE correct, why should any firm ever pay a cash dividend?
2) The difference between dividends and capital gains tax is a lot less than it was historically (eg. 2012 top rate for both was 15%)

Question 28

Explain the tax advantage (other than sometimes the size of the tax) that capital gains have over dividends?

Answer 28

In many countries, capital gains taxes can be deferred until the shares are sold, but dividend taxes are immediate
This means the longer the investors wait to sell, the lower the PV of their tax liability

Question 29

Explain the US’s tax system on SHs returns?

Answer 29

SHs returns are taxed twice, once at the corporate level (corporate tax) and once in the hands of the SH (CG/income tax)
See example notes to see how this works

Question 30

Explain Australia’s tax policy on SHs returns?

Answer 30

They allow SHs to deduct from their tax bill the share of corporate tax the firm has already paid
If CT greater than IT also allows them to get a refund
Tf acts all as one layer of tax levied on the SH

Question 31

Explain the payout policy for young firms? 2 advantages of doing this?

Answer 31

They have plenty of profitable investment opportunities tf retain and reinvest cash flow instead of borrowing/issuing new shares
Retaining cash:
a) avoids cost of issuing securities
b) minimises SHs taxes

Question 32

Explain the payout policy for firms as they mature?

Answer 32

As firms mature, positive NPV opportunities become more scarce -> cash accumulation
Investors begin to worry about excessive perks/overinvestment -> pressure on managers to pay out (page 417 for more info)

Question 33

3 questions to determine if time to send some cash back to investors?

Answer 33

1) If the firm making a positive free cash flow after making all +ve NPV investments, and is it likely to continue?
2) Is firm’s debt ratio prudent?
3) Are the firm’s holding of cash a sufficient cushion for any unexpected setbacks and a sufficient war chest for unexpected investment opportunities?

If yes to all 3 then free cash is surplus tf time to payout

Question 34

What is residual dividend policy?

Answer 34

A dividend policy whereby the firm commits to using funds to pay for capital expenditures (up til IRR=COC), and only after this point do they repay excess cash in dividends

Question 35

Explain and draw the residual dividend policy diagram?

Answer 35

x-axis: Cumulative $ investments by a company when it accepts projects in descending order of IRR (internal rates of return)
y-axis: quantity of $ from firm
MRI=marginal return on investments for each of projects available in (DCN order)
When a firm accepts the next project where IRR is below the firm’s COC, the firm is destroying value