Corporate Finance: Dividends and Buybacks

Question 1

Dividend Irrelevance Theory

Answer 1

• With no taxes and efficient market investors could create thier own dividends
  1. Stock volatility cold make this difficult
  2. Transaction costs are also an issue
  3. If dividends are taxed at higher rate than cap gains then investors should favor low dividend stocks

Question 2

Expected Decrease in Share Price after Ex-Dividend

Answer 2

Pw - Px = (1 - Td) / (1 - Tcg) X D

Pw - Px: Right to get the div vs. no div

Td, Tcg: Tax on dividends vs. tax on capital gains

D: Dividend

- If D=$1 then formula tells you how much that $1 is worth in capital gains

Question 3

Implications of Expected Share Price Change after ex-Dividend

Answer 3

1. If Td = Tcg then the stock should drop by the amount of the dividend
2. If Td > Tcg then the stock will drop by less than the dividend
3. If Td < Tcg then the stock will fall by more than the dividend

Question 4

Double Taxation regime formula for ETR

Answer 4

ETR = CTR + [(1-CTR) X MTRd]

• • ETR: Effective Tax Rate*
• • CTR: Corporate Tax Rate*
• • MTRd: Marginal Tax Rate on dividends*

Question 5

Dividend Imputation System formula for ETR

Answer 5

ETR = Tliability of Investor / Pretax NI

(CTr * Pretax NI) - (InvestorTr * Pretax NI) = Net tax credit/liability

Question 6

Split Rate Tax System Formula for ETR

Answer 6

ETR = CTrD + [(1-CTrD) X MTrD]

Corporate Tr on Divs: .20
Corporate Tr on RE: .35
Invstrs Marginal Tr on Divs: .15

.15 = .20 + [(.80) X .15]

Question 7

Dividend Policy Types: Stable (formula for growth)

Answer 7

Stable dividend policy: Don’t raise it until you are sure you can sustain it.

Expected Dividend increase = +ΔNI X Target P.O. X Adjustment Factor

Adjustment Factor = 1/N (n= number of years adjustment will take place)

Question 8

Dividend Policy Types (Constant Dividend Payout) Formula

Answer 8

• A constant % of EPS

Question 9

Dividend Policy Types (Residual) formula

Answer 9

1. NI - [(Project investments) X (% of equityrequired for project))] = Dividend
2. NI - [Capex Spending X % of equity in D/E ratio] = Dividend

Question 10

Effect of Share Buybacks on BS and IS

Answer 10

1. If earnings yield is less than debt costs EPS falls
2. If BB is financed with assets, leverage increases EPS may also fall if those assets could have returned at least the company’s WACC.

Question 11

Dividend Payout Ratio vs. Dividend Coverage Ratio

Answer 11

DPO: Dividends / NI

DCR: NI / Dividends

Question 12

Free Cash Flow to Equity Coverage Ratio

Answer 12

FCFE CR = FCFE / [Dividends + ShareBB]

FCFE = CFO - FCinv + NetBorrowing

1. If ratio is greater than 1 then company is retaining earnings
2. Less than 1 then company is borrowing cash to pay dividends+BB