Reading 38 LOS's Flashcards
LOS 38a: Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on shareholders’ wealth and a company’s financial ratios
Cash Dividends
Regular Cash Dividends
Most companies pay out cash dividends to shareholders on a regular schedule.
Companies strive to maintain or increase their cash dividen payouts as they send important messages about the company to investors and potential investors
- A record of consistent dividends over a period of time idicates that the company is consistently profitable
- A trend of increasing regular dividends over time indicates that the company is doing well and is willing to share profits with shareholders
- An increase in a company’s regular dividend, especially if unexpected, can send a very strong message out to investors and usually has a positive effect on share price
Dividend Reinvestment PLans (DRPs)
a DRP is a system that allows investors to reinvest all or a portion of cash dividends received from a company in shares of the company. There are 3 types:
- Open Market DRPs, in which the company purchases shares from the open market
- New-Issue DRPs or scrip dividend schemes, in which the company issues the additional shares instead of repurchasing them
- Plans where companies are premitted to obtain additional shares through open-market purchases or new issuances
Advantages to the Company:
- The shareholder base is diversified as smaller investors gain easier access to additional shares in the company
- They may encourage long-term investment in the company by building investor loyalty
- New issue DRPs allow companies to raise equity capital without incurring flotation costs
Advantages to the Shareholders:
- Shareholders can accumulate shares in the company using dollar-cost averaging
- DRPs are a cost-effective means for small investors to purchase additional shares in the company
- There are no transaction costs associated with obtaining shares thru DRP
- Shares offered in a DRP are sometimes issued to shareholders at a discount to the market price
Disadvantages to Shareholders:
- In jurisdictions where capital gains are taxed, investors must keep record of the cost basis of shares received to accurately compute gains and losses when shares are sold.
- If new shares are isssued at a discount, shareholders that do not participate in the DRP tend to suffer dilution
Extra or Special Dividend
refers to a dividend payment by a company that does not usually pay dividends or a dividend payment on top of the company’s regular dividend.
Liquidating Dividends
A dividend payment is known as a liquidating dividend when:
- A company goes out of business and its net assets are distributed to shareholders
- A company sells off a portion of its business and distributes that proceeds to shareholders
- A company pays out a dividend that is greater than its retained earnings
Stock Dividends
A stock dividend or a bonus issue occurs when a company issued additional common shares in the company to shareholders.
Stock dividends do not affect an investor’s proportionate ownership of a company. A stock dividend basically just divides the market value of a firm’s equity into smaller pieces
Advantages of Paying Out Stock dividends:
- With more shares outstanding there is a greater chance of more small shareholders owning the stock, which broadens the company’s shareholder base
- Stock dividends could bring the stock market price into the “optimal range” ($20 -$80 in the US) , where investors are attracted to stock
Differences between Stock Dividends and Cash Dividends for the Company
Cash dividends reduce assets and shareholders equity, causing liquidity and leverage ratios to deteriorate. Stock dividends do not have any effect on a company’s capital structure. Retained earnings fall, but there is an offsetting increase in contributed capital.
Stock Splits
Stock splits are similar to stock dividends in that they increase the total number of shares outstanding and have no economic effect on the company.
An important difference between the two is that a stock dividend results in a transfer of retained earning to contributed capital, whereas a stock split has no impact on any shareholders’ equity accoutns.
Companies typically announce stock splits when the stock price has appreciated significantly. Issuing the split helps bring the price of the stock down,
A reverse stock split increases the share price and reduces the number of shares outstanding.
LOS 38b: Describe the dividend payment chronology, including the significance of declaration, holder-of-record, ex-dividend, and payment dates
Declaration Date- This is the date on which a company announces a particular dividend. The company also announces the holder-of-record date and the payment date on the declaration date
Ex-dividend date- This is the first day that share trades without the dividend. Any investor who holds the stock on the ex-dividend date or who purchased it the day before the ex-dividend date is entitled to receive the dividend. On the ex-dividend date, the share price is adjusted for the amount of the dividend
Holder-of-record date- This date is the date at which a shareholder listed in the company’s records will be entitled to receive the upcoming dividend. The length of the period between the holder-of-record and ex-dividend date depends on the trade settlemnet cycle of a particular exchange. For example, in the US, trades settle 3 days after execution, so there would be a 2day gap between the ex-dividend and holder dates
Payment Date- this is the date on which the company actually mails out or transfers the dividend payment to shareholders
LOS 38c: Compare share repurchase methods
Share Repurchases vs Cash Dividends
- Just because a company authorizes a share repurchase, it does not mean they have to go through with it, whereas with dividends they are obligated once declared
- Cash dividends are distributed to shareholders in proportion to their ownership percentage. Repurchases generally do not distribute cash in such a manner
Arguments for Share Repurchases
- They send out a signal to the market that management believes that the company’s stock is undervalued, or that management will suppoort the stock price
- They offer the company flexibility in its cash distributions
- There is a tax advantage to distributing cash through repurchases in markets where capital gains are taxed at a lower rate than dividends
- They can be used to limit the increase in the number of shares outstanding when a significatn number of employee stock options have been exercised.
Share Repurchase Methods
- Buy in the open market- under this method, the company repurchases shares from the open market. Buying in the open market offers the company flexibility as there is no legal obligation to go through with the entire repurchase once it has been authorized. This method is also cost effective as the company can choose to execute the trades when the price impact is likely to be minimal and when the stock is attactively priced
- Buy back a fixed number of shares at a fixed price This type of repurchase is known as a fixed price tender offer.The company offers to buy a fixed number of shares at a fixed price on a fixed date.
- Dutch Auction- instead of specifying a fixed price for all the shars that the company wants to buy back, under a Dutch auction the company specifies a range of acceptable prices. Shareholders looking to sell indicate at which price and how many shares they will sell. The company accepts the lowest bids and works its way up until its purchased what it wants to.
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Repurchase by direct negotiation This occurs when a company negotiates directly with a major shareholder to buy back its shares. This may occur because:
- A larger shareholder wants to sell off its shares and the company wants to prevent the large block of shares from overhanging the market and depressing share price
- the company wants to buy out a large shareholder to prevent it from gaining representation on the company’s board of directors
LOS 38d: Calculate and compare the effect of share repurchase on earnings per share when 1) the repurchase is financed with the company’s excess cash and 2) the company uses debt to finance the repurchase.
Share repurchases have an effect on a company’s balance sheet and income statement. If they are repurchased with cash, assets and shareholders equity decline. If they are purchased by issuing debt, then liabilities will go up as shareholders equity goes down.
Share repurchases may increase, decrease, or have no effect on EPS
- If the funds used to finance the repurchase are generate internally, a repurchase will increase EPS only if the funds would not have earned the company’s cost of capital if they were retained by the company
- If borrowed funds are used to finance the repurchase, and the after-tax cost of borrowing is greater than the companys earning yields, EPS will fall
- If borrowed funds are used to finance the repurchase, and the after-tax cost of borrowing is lower than the company’s earnings yield, EPS will rise
LOS 38e: Calculate the effect of a share repurchase on book value per share
To calculate reduce both the total book value of equity and the number of shares outstanding by the amount of repurchased stocks and their total capitalization.
- When the market price is greater than the book value per share, book value per share will decrease after the repurchase
- When the market price is lower than the book valye per share, book value per share will increase after the repurchase
LOS 38f: Explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholder’s wealth, all else being equal.
The idea that the impact on shareholder wealth will be the same whether through a cash dividend or a share repurchase, assumes that:
- Dividends are received as soon as the shares go ex-dividend
- Tax implications of dividends and repurchases are the same
- The information content of the two policies does not differ
- THe company can purchase any number of shares at current market price
Concluding remarks:
Many investors believe that on average, share repurchases have a net positive effect on shareholder wealth. Studies have shown that repurchase announcements have been accompanied by significatn positive excess returns around the announcement date and for the next few years. Similarly, unexpected increases in dividends are also frequently associated with positive excess returns
