Topic 6 - Dividend Policy - including buy backs Flashcards
What two things can firms choose to do with free cash flows?
retained or pay out
How is cash used if it is retained?
retained – invest in new projects or increase retained earnings
In what two forms is FCF paid out?
paid out – repurchase shares or pay dividends
what is meant when you say “dividends are sticky”?
dividend stability is favoured
why is dividend stability is favoured?
increase in dividends signal improved investment performance and increased cash flow, decreasing dividends send a bad signal to investors
are dividends more likely to increase or decrease?
more likely to increase than decrease
When will managers increase dividends?
dividends are only increased if the managers believe the increase in earnings can be sustained
what does Lintner discuss?
How dividends are determined
what are the key implications from Lintner’s paper?
Managers favour dividend stability because they know that changing the dividend will probably affect share price - managers only increase dividends when they believe the increase can be sustained
Investors, knowing how managers behave, interpret dividend changes as a signal about future prospects
an increase in dividends is interpreted as signalling improved investment performance and increased cash flow (vice-versa for dividend cuts)
what is the main difference between stock buybacks and paying dividends? i.e. the incentive for firms to do it
future expectation - dividends payments are expected to continue into the future whereas stock buybacks are not
What are the three schools of thought regarding dividends?
- Dividends do not matter and dividend policy does not affect value.
- Dividends are bad and increasing dividends will reduce value.
- Dividends are good and increasing dividends will increase value.
When (a) there are no tax disadvantages associated with dividends, and (b) companies can issue stock at no cost to raise equity whenever needed, which school of though prevails?
Dividends do not matter and dividend policy does not affect value - perfect capital market with no agency costs of equity i.e. firms don’t invest remain cash in bad projects, and therefore no signalling theory if extra dividends issued
what are the reasons that dividends would be bad and increasing dividends would reduce value?
If dividends have a tax disadvantage, i.e. dividends are taxed more heavily compared to capital gains
(Pb-Pa)/D=((1-t_p))/((1-t_CGT)), based on this formula when is it better to receive dividends and when is it better to receive CGT
when change in price is greater than dividend better to pay CGT than tax on dividends (as tax on dividends is higher)
if the change in price > dividends, better to pay tax on dividends than CGT (as CGT is higher)
when will increasing dividends increase value?
when dividends operate as a signal of future prospects, as it signals the company has increased CFs
