Corporate Finance - R21 - Dividends and Share Repurchase Flashcards
a. describe the expected effect of regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits, and reverse stock splits on shareholders’ wealth and a company’s financial ratios;
Cash dividend payments reduce cash as well as stockholders’ equity. This results in a lower quick ratio and current ratio, and higher leverage (e.g., debt-to-equity and debt-to-asset) ratios. Stock dividends (and stock splits) leave a company’s capital structure unchanged and do not affect any of these ratios. In the case of a stock dividend, a decrease in retained earnings (corresponding to the value of the stock dividend) is offset by an increase in contributed capital, leaving the value of total equity unchanged.
b. compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action;
Following are the three theories of investor preference:
MM’s dividend irrelevance theory holds that in a no-tax/no-fees world, dividend policy is irrelevant since it has no effect on the price of a firm’s stock or its cost of capital, because individual investors can create their own homemade dividend.
Dividend preference theory says investors prefer the certainty of current cash to future capital gains.
Tax aversion theory states that investors are tax averse to dividends and would prefer companies instead buy back shares, especially when the tax rate on dividends is higher than the tax rate on capital gains.
c. describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey;
The signaling effect of dividend changes is based on the idea that dividends convey information about future earnings from management to investors (who have less information about a firm’s prospects than management). In general, unexpected increases are good news and unexpected decreases are bad news as seen by U.S. investors.
d. explain how clientele effects and agency costs may affect a company’s payout policy;
Clientele effect refers to the varying preferences for dividends of different groups of investors, such as individuals, institutions, and corporations. Companies structure their dividend policies consistent with preferences of their clienteles. Miller and Modigliani, however, note that once all the clienteles are satisfied, changing the dividend policy would only entail changing clienteles and would not affect firm value.
Two types of agency costs affect dividend payout policies:
Agency conflict between shareholders and managers can be reduced by paying out a higher proportion of the firm’s free cash flow to equity so as to discourage investment in negative NPV projects.
Agency conflict between shareholders and bondholders occurs when shareholders can expropriate bondholder wealth by paying themselves a large dividend (and leaving a lower asset base for outstanding bonds as collateral). Agency conflict between bondholders and stockholders is typically resolved via provisions in bond indenture.
e. explain factors that affect dividend policy in practice;
Six Primary factors affect a company’s dividend payout policy:
Investment opportunities: affects the residual income available to pay as dividends.
Expected volatility of future earnings: firms are more cautious in changing dividend payout in the presence of high earnings volatility.
Financial flexibility: Firms may not increase dividends (even in presence of significant free cash flow) so as not to be forced to continue paying those dividends in the future and losing financial flexibility. Instead, firms can choose to pay out excess cash via stock repurchases.
Tax considerations: In the presence of differential tax rate on capital gains versus dividends, companies may structure their dividend policy to maximize investors’ after-tax income.
Flotation costs: Flotation cost increases the cost of external equity as compared to retained earnings. Hence, higher flotation cost would motivate firms to have a lower dividend payout.
Contractual and legal restrictions: Dividend policy may be affected by debt covenants that the firm has to adhere to. Legal restrictions in some jurisdictions limit the dividend payout of a firm.
f. calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation, dividend imputation, and split-rate tax systems;
Effective rate under double taxation = corporate tax rate + (1 − corporate tax rate) × (individual tax rate)
A split-rate system has different corporate tax rates on retained earnings and earnings that are paid out in dividends (distributed income). Under split-rate system, effective tax rate is computed the same way as double taxation but we use the corporate tax rate for distributed income as the relevant corporate tax rate in the double taxation formula.
Under a tax imputation system, taxes are paid at the corporate level but are used as credits by the stockholders. Hence, all taxes are effectively paid at the shareholder’s marginal tax rate.
g. compare stable dividend, constant dividend payout ratio, and residual dividend payout policies, and calculate the dividend under each policy;
Stable dividend policy: A company tries to align its dividend growth rate with the company’s long-term earnings growth rate to provide a steady dividend. A firm with a stable dividend policy could use a target payout adjustment model to gradually move towards its target payout.
expected increase in dividends = [(expected earnings × target payout ratio) – previous dividend] × adjustment factor
where:
adjustment factor = 1 / number of years over which the adjustment in dividends will take place
Constant payout ratio: Company defines a proportion of earnings that it plans to pay out to shareholders regardless of volatility in earnings (and consequently in dividends).
Residual dividend approach: Dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget.
Advantages: (1) easy for the company to use; (2) maximizes allocation of earnings to investment.
Disadvantages: (1) dividend fluctuates with investment opportunities and earnings; (2) uncertainty causes higher required return and lower valuation.
Longer-term residual dividend: Company forecasts its capital budget over a longer time frame and attempts to pay out the residual in steady dividend payments.
h. compare share repurchase methods;
Share repurchase methods:
Open market transactions: The firm buys back its shares in the open market.
Fixed price tender offer: The firm buys a predetermined number of shares at a fixed price, typically at a premium over the current market price.
Dutch auction: A tender offer where the company specifies a range of prices rather than a fixed price. Bids are accepted (lowest price first) until the desired quantity is filled. All accepted bids are then filled at the (higher) price of the last accepted bid.
Repurchase by direct negotiation: Purchasing shares from a major shareholder, often at a premium over market price. This method may be used in a greenmail scenario, or when a company wants to remove a large overhang in the market.
i. calculate and compare the effect of a share repurchase on earnings per share when 1) the repurchase is financed with the company’s surplus cash and 2) the company uses debt to finance the repurchase;
Repurchases made using a company’s surplus cash will lower cash and shareholders’ equity and, therefore, increase the firm’s leverage. Earnings per share may increase because there will be fewer shares outstanding.
When the company uses debt to finance the repurchase, EPS will increase if the after-tax funding cost is less than the earnings yield. However, the firm will then also have higher leverage and, therefore, a higher cost of capital, so an increase in EPS will not automatically lead to an increase in share price or in shareholder wealth
j. calculate the effect of a share repurchase on book value per share;
After a stock repurchase, the number of outstanding shares will decrease and the book value per share (BVPS) is likely to change as well. If the price paid is higher (lower) than the pre-repurchase BVPS, the BVPS will decrease (increase).
k. explain the choice between paying cash dividends and repurchasing shares;
There are five common rationales for share repurchases (versus dividends):
Potential tax advantages: When capital gains are taxed favorably as compared to dividends.
Share price support/signaling: Management wants to signal better prospects for the firm.
Added flexibility: Reduces the need for “sticky” dividends in the future.
Offsets dilution from employee stock options.
Increases financial leverage by reducing equity in the balance sheet.
l. describe broad trends in corporate payout policies;
Global trends in corporate payout policies:
A lower proportion of U.S. companies pay dividends as compared to their European counterparts.
Globally, the proportion of companies paying cash dividends has trended downwards.
Stock repurchases have been trending upwards in the United States since the 1980s and in the United Kingdom and continental Europe since the 1990s.
m. calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow;
Dividend coverage ratio = net income / dividends
FCFE coverage ratio = FCFE / (dividends + share repurchases)
n. identify characteristics of companies that may not be able to sustain their cash dividend.
For both dividend and FCFE coverage, ratios that are below industry average or trending downwards over time indicate problems for dividend sustainability
