Corporate Finance #25 - Dividends and Share Repurchases: Analysis

Question 1

Theories and implications of dividend policies

Answer 1

LOS 25.a

• dividend irrelevance - according to MM, dividend policy is irrelevant because an investor can sell shares: homemade dividends
• bird-in-the-hand argument - Gordon & Lintner claim that investors prefer dividends; certainty of dividend over uncertainty of expected capital gains i.e. D₁/P₀ has less risk than growth component, g
• tax aversion - investors prefer cap gains:
  
  • if dividends have higher tax than capital gains
  • pay cap gain taxes later than dividend taxes now

Question 2

Describe types of signaling in dividend actions by management

Answer 2

LOS 25.b

• information asymmetry - dividends convey more credible information than company FS; dividends are “sticky”
• dividend initiation - info is ambiguous:
  
  • +: optimistic about future earnings
  • -: no profitable projects
• ​unexpected dividend increase - positive:
  
  • ​future prospects good
  • evidence in real world: GE, XOM
• ​unexpected dividend decrease - mostly negative:
  
  • ​-: trouble; dividend payoutsunlikely to be maiontained
  • +: high ROE projects so reinvest over distribute

Question 3

Dividend preferance theory vs Tax perference theory

Answer 3

LOS 25.a

Dividend preference:

• investors prefer certainty of cash dividend over uncertainty of stock increase (bird-in-the-hand)
• Result: higher dividends lead to higher stock prices (lower cost of equity)

Tax preference:

• investors prefer small dividends over large because:
  
  • sometimes taxed at lower rate
  • not taxed until realized
• Result: smaller dividends lead to higher stock price and lower cost of equity

Question 4

Clientele effect on company’s dividend payout policy

Answer 4

LOS 25.c

Clientele effect due to:

• tax considerations
• requirements of instituitional investors: high dividend mutual funds, trusts
• requirements of individual investors: dividends as income vehicle

Question 5

Clientele Effect on company’s dividend payout policy due to taxation

Answer 5

LOS 25.c

Different tax groups prefer different levels of dividends:

• low tax groups prefer dividends: corporations (dividend exclusion rule), pensions
• high tax groups prefer low dividends: HNW individuals
• investor indifferent if stock price drops by d(P) at ex-div date:

d(P) = D(1 - T_D) / (1 - T_CG)

Question 6

Factors that develop a company’s dividend policy

Answer 6

LOS 25.d

• investment opportunities - low dividend payout, especially if they need funding sooner than ability to raise external capital
• expected volatility of future earnings - reluctant to change dividend payout
• financial flexibility - stock buyback with excess cash instead of raising div payout
• tax considerations - affects shareholder clientele due to tax preference
• flotation costs - high float cost –> low dividend payout; big firms pay lower float costs
• contractual & legal restrictions - examples:
  
  • impairment of capital rule (some countries forbid dividend payout > retained earnings)
  • debt covenants (protects bondholders)

Question 7

Effective tax rate on dividends

Answer 7

LOS 25.e

• double taxation (T_corpD = T_{corp_retain}) & split-rate (T_corpD < T_{corp_retain}) systems:

div effect tax rate = T_corpD + (1 - T_corpD)(T_indivD)

• imputation system - taxes paid at corp level but are attributed to (deducted by) the shareholder:

div effective tax rate = T_indivD

Question 8

Calculate stable, constant, and residual dividend payout policies

Answer 8

LOS 25.f

• stable D payout - D growth rate aligns with long-term earnings growth rate
• target payout ratio adjustment model:

E(D) = D₀ + E(g_EPS) * target D/EPS * 1/adj_yrs

• constant D payout ratio - D varies in constant proportion to EPS; rarely used
• residual D model: D = earnings - funds retained to finance equity portion of capital budget.
  Model is based on:
  
  • investment opportunity schedule
  • target capital structure
  • access to and cost of external capital

Question 9

Compare stable, constant, and residual dividend payout policies

Answer 9

LOS 25.f

• stable D payout - higher certainty of expected D growth
• constant D payout ratio - D varies in constant proportion to EPS; rarely used
• residual D model​
  
  • Pros: simple to use; allows mgmt to pursue projects without D payout constraints
  • Cons: D payments may be unstable

Question 10

Steps to determining payout ratio using residual dividend model

Answer 10

LOS 25.f

1. identify optimal capital structure
2. determine amount of equity needed given target capital structure
3. meet equity requirements to extent possible with retained earnings
4. pay dividends with the residual earnings

Question 11

Long-term residual dividend model

Answer 11

LOS 25.f

Attempt to overcome disadvantages of the residual model by smoothing out D payout variances:

• forecast capital budget out 5 to 10 years
• allocate leftover earnings as dividends
• pay out in relatively equal amounts
• distribute excess using share repurchases

Question 12

Compare impact to shareholder wealth of cash dividend vs share repurchase

Answer 12

LOS 25.g

shareholder wealth: cash dividend:

• dividend/sh = D $outlay / outstd sh
• ex-div price = (outstd sh * sh price - D $outlay) / outstd sh

shareholder wealth: share repurchase:

• new sh price =(outstd sh * sh price - total $purch) / (outstd sh - # sh purch)

NOTE: if div tax rate & cap gain tax rate are the same, then shareholder wealth unchanged wrt cash D and sh repurch

Question 13

Describe how paying dividend with borrowed funds affects EPS vs repurching with cash

Answer 13

LOS 25.g

if after-tax cost of debt < earnings yield (E/P) –> increases EPS

if after-tax cost of debt > earnings yield (E/P) –> decreases EPS

if after-tax cost of debt = earnings yield (E/P) –> no change in EPS

Question 14

Describe broad trends in corporate dividend policies.

Answer 14

LOS 25.h

1. A lower proportion of US companies pay dividends comapred to their European counterparts.
2. In global developed markets, the proportion of companies paying cash has trended down over the long run.
3. The percentage of companies that are repurchasing shares has been trending up in the US since the 1980s and in the UK and Europe since the 1990s.

Question 15

Define and describe dividend safety ratios

Answer 15

LOS 25.i, LOS 25.j

Dividend safety ratios - metrics used to evaluate the probability of dividends continuing at the current rate for a company.

dividend coverage = NI / dividends

dividend payout = dividends / NI

FCFE coverage = FCFE / (dividends + share repurch), where

FCFE = CFO - FCInv - WC