Reading 27 - Dividends and Share Repurchases : Analysis

Question 1

What does Dividend irrelevance mean according to MM ?

Answer 1

That dividend policy has no effect on the price of a firm’s stock or its cost of capital

Question 2

What is the bird-in-hand argument for dividend policy ?

Answer 2

Investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of expected captial gains.

Question 3

What is the tax-aversion theory regarding dividends?

Answer 3

Investors will prefer to not receive dividends due to their higher tax rates

Question 4

What is information asymmetry?

Answer 4

The differences in information available to a company’s board and management (insiders) as compared to the investors (outsiders)

Question 5

Why can information conveyed by the dividend initiation be viewed as ambiguous?

Answer 5

A positive sign : Could mean that company is optimistic about its future

A negative sign : The company has a lack of profitable reinvestment opportunities

Question 6

What is the clientele effect?

Answer 6

That different groups desire different levels of dividends

Question 7

What are the 3 rationales for the existence of the clientele effect on dividends?

Answer 7

1. Tax considerations
2. Requirements of institutional investors
3. Individual investor preferences

Question 8

How do you calculate the change in stock price when the stock goes from with dividend to ex-dividend?

***Critical Concept******

Answer 8

Question 9

Intuitive Surgical is planning on declaring $12 in dividends. The tax rates for dividends and capital gains are below. Compute the expected drop in share price when the stock goes ex-dividend

Tax rate on dividends : 30%

Tax rate on capital gains : 15%

Answer 9

Question 10

What are the two kinds of agency issues regarding dividend policy?

Answer 10

1. Between shareholders and managers
2. Between shareholders and bondholders

Question 11

What is one way to reduce agency conflicts between shareholders and managers?

Answer 11

To increase the payout of free cash flow as dividends

Question 12

What is one way to reduce agency conflicts between shareholders and bondholders?

Answer 12

Is resolved via provisions in the bond indenture. These provisions may include restrictions on dividend payment, maintenance of certain balance sheet ratios, and so on.

Question 13

What are the 6 primary factors that affect a company’s dividend payout policy?

Answer 13

1. Investment opportunities
2. Expected volatility of future earnings
3. Financial flexibility
4. Tax considerations
5. Floatation costs
6. Contractual and legal restrictions

Question 14

What are some of the reasons why stockholders may not prefer a higher dividend payout, even if the tax rate on dividends is more favorable?

Answer 14

1. Taxes on dividends are paid when the dividend is received, while capital gains taxes are paid only when shares are sold
2. The cost basis of shares may receive a step up in valuation at the shareholder’s death. This means capital gains taxes may not be paid at all
3. Tax-exempt institutions, such as pension funds and endowments, will be indifferent between dividends or capital gains.

Question 15

What is a double-taxation system?

***Critical Concept******

Answer 15

Earnings are taxed at the corporate level regardless of whether they are distributed as dividends, and dividends are taxed again at the shareholder level

Question 16

How do you calculate the effective tax rate in a double-taxation system?

***Critical Concept******

Answer 16

= corporate tax rate + (1-corporate tax rate)(individual rate rate)

Question 17

A U.S. company’s annual earnings are $300, and the corporate tax rate is 35%. Assume that the company pays out 100% of its earnings are dividends. Calculate the effective tax rate on a dollar of corporate earnings paid out as dividends assuming 15% tax rate on dividend income…..

Answer 17

= 0.35 +(1-0.35)(0.15) = 0.4475 = 44.75%

Question 18

What is a split-rate corporate tax system?

Answer 18

Taxes earnings distributed as dividends at a lower rate than earnings that are retained.

Question 19

What is an imputation tax system?

***Critical Concept******

Answer 19

Taxes are paid at the corporate level but are attributed to the shareholder, so that all taxes are effectively paid at the shareholder rate.

Question 20

What is a Franking Credit?

Answer 20

If dividends are taxed at the corporate level at a higher rate than an indvidual would pay the investor receives a “credit” for the difference.

Can all be the opposite way in which you owe additional tax if you rate is higher than the corporate rate

***occurs in a Dividend Imputation Tax System*****

Question 21

What is the formula to calculate expected dividends in the future?

Answer 21

**The adjustment factor = 1 / # of yrs over which the adjustment in dividends will take place

Question 22

What is a residual dividend model?

Answer 22

dividends are based on earning less funds the firm retains to finance the equity portion of its capital budget

Question 23

What are the 4 steps to determine the target payout ratio for the Residual Dividend model?

Answer 23

1. Identify the optimal capital budget
2. Determine the amount of equity needed to finance that capital budget for a given capital structure
3. Meet equity requirements to the maximum extent possible with retained earnings
4. Pay dividends with the “residual” earnings that are available after the needs of the optimal capital budget are supported.

Question 24

What are some of the advantages and disadvantages of the residual dividend model?

Answer 24

Adv:

• The model is simple to use
• The model allows management to pursue profitable investment opportunities without being constrained by dividend considerations

Dis:

• The dividend payments may be unstable because investment opportunities and earnings vary from yr to yr

Question 25

What are the 5 commons rationales for share repurchases (vs dividends) ?

Answer 25

1. Potential tax advantages
2. Share price support/signaling
3. Added flexibility
4. Offsetting dilution from employee stock options
5. Increasing financial leverage

Question 26

What are the two ratios that are often classified as Dividend safety metrics?

Answer 26

1. Dividend payout ratio (dividends/net income)
2. Dividend coverage ratio (net income/dividends)

Question 27

Last yr, Diageo had earnings of $3.50 per share and paid a dividend of $0.70. In the current year, the company expects to earn $4.50 per share. The company has a 35% target payout ratio and plans to bring its dividend up to the target payout ratio over a 5-yr period.

Calculate the expected dividend for the current yr….

Answer 27

= $0.70 + [($4.50 - $3.50) * 0.35 * (1/5)]

= $0.70 + [$1.00 * 0.35 * 0.2]

= $0.70 + 0.07

= $0.77

Question 28

Suppose that the Larson Co has $1,000 in earnings and $900 in planned capital spending (representing positive NPV projects). Larson has a target debt-to-equity ratio of 0.5. Calculate the company’s dividend under the residual dividend policy……

Answer 28

*** Remeber that a D/E of 0.5 is equivalent to $1 of debt and $2 of equity

Steps:

1. If the firms invests all of its earnings that will increase its equity by $1,000, so to maintain their capital structure they must borrow $500
2. Total funds generated = $1,500, so if the capex is $900 the firm can pay dividends
3. 2/3’s of $900 (the equity portion) = $600.
4. Residual amount $1,000 (earnings) - $600 (equity portion) = $400 in dividends to be paid.

Question 29

Stargell Industries follows a strict residual dividend policy. The company has a capital budget of $3,000,000. It has a target capital structure that consists of 30% debt and 70% equity. The company forecasts that its net income will be $3,500,000. What will be the company’s expected dividend payout ratio this year?

Answer 29

In order to maintain the optimal capital structure, new projects will be financed with the same mix of debt and equity. Therefore, if the capital budget is $3,000,000 for next year the equity portion will be 70% of $3,000,000, or $2,100,000. The remainder will be financed with debt. If Net Income is $3,500,000 then dividends will be $1,400,000. (Dividends = Net Income − equity portion of capital budget = $3,500,000 − $2,100,000). The dividend payout ratio is equal to dividends divided by net income. $1,400,000 / $3,500,000 = 0.40 or 40%.

Question 30

What is the ex-dividend price?

Answer 30

The share price when the share first trades without the rights to receive an upcoming dividend

Question 31

What are some characteristics of companies that consistently increase their dividends over time?

Answer 31

• Dominant or niche positions in their industry
• Global Operations
• Relatively high return on assets
• Relatively low debt levels

Question 32

Describe Jensen’s free cash flow hypothesis……

Answer 32

****that firms with high levels of Cash flow will waste it on negative NPV projects****

By paying out all free cash flow to equity in dividends, managers would be constrained in their ability to overinvest by undertaking negative NPV projects.

Question 33

What is the catering theory?

Answer 33

Theory that predicts companies adapt their dividend policy over time to changing investor tastes.

Question 34

How do you calcuate the dividend payout ratio?

*****Critical Concept******

Answer 34

= Dividends / Net Income

Question 35

How do you calculate the dividend coverage ratio?

****Critical Concept******

Answer 35

= Net Income / Dividends

Question 36

How do you calculate the FCFE Coverage Ratio?

*****Critical Concept******

Answer 36

= FCFE / (Dividends + Share Repurchases)

Question 37

Describe what a target payout ratio is ?

Answer 37

The proportion of earnings that the company intends to pay out to shareholders as dividends over the long term

Question 38

Describe what it implies if the FCFE Coverage Ratio is >1, =1 and <1…..

Answer 38

>1 implies the company is improved liquidity by using funds to increase cash and/or marketable security

=1 implies the company is returning all available cash to shareholders

<1 is not sustainable, the company is paying out more cash than it can draw down from existing cash, reducing liquidity

Question 39

How do you calculate the debt portion of a capital structure when given just the D/E ratio?

Answer 39