Chapter 7 Dividends and Share Repurchases Analysis
Chapter 7Dividends and Share repurchases: AnalysisPresenters
namePresenters titledd Month yyyy11. IntroductionA payout policy is
a set of principles regarding a corporations distributions to
shareholders.May be established with regard to a dividend payout, a
dividend per share, a growth in dividend per share, or any other
metric.May include stock splits and stock dividends.May include
stock repurchases. Copyright 2013 CFA Institute2Page 258
Introduction
A payout policy (also known as dividend policy) is a set of
principles regarding a corporations distributions to shareholders.
Note: Using the term payout policy encompasses repurchases, whereas
the traditional term dividend policy implies cash and stock
dividends as well as stock splits.May be established with regard to
a dividend payout, a dividend per share, a growth in dividend per
share, or any other metric.May include stock splits and stock
dividends.May include stock repurchases.
22.Dividend Policy and Company Value: TheoryCopyright 2013 CFA
Institute3LOS: Compare theories of dividend policy and explain
implications of each for share value, given a description of a
corporate dividend action.Page 258
2. Dividend Policy and Company Value: Theory
Explanations for dividend policies:Dividend are irrelevant.A
bird in the hand: Cash dividends are preferred to uncertain capital
gains.Tax argument: Investors prefer capital gains to dividends if
capital gains are taxed at a lower rate than capital gains.Other
explanations/influences: Clientele effect, signaling, and agency
cost effects. 3Dividends are irrelevantIn Miller and Modiglianis
(MM) world with no taxes, no transaction costs, and homogeneous
information, dividend policy does not affect the value of the
company.The decision of how a company finances its business is
separate from the decision of what and how much to invest in
capital projects.If an investor wants cash flow, he/she could sell
some shares.If an investor wants more risk, he/she could borrow to
invest. An investor is indifferent about a share repurchase or a
dividend.Bottom line: Dividend policy does not affect a firms
value.Copyright 2013 CFA Institute4LOS: Compare theories of
dividend policy and explain implications of each for share value,
given a description of a corporate dividend action.Pages 258260
Dividends Are Irrelevant
In MMs world with no taxes, no transaction costs, and
homogeneous information, dividend policy does not affect the value
of the company. The decision of how a company finances its business
is separate from the decision of what and how much to invest in
capital projects.If an investor wants cash flow, he/she could sell
some shares.If an investor wants more risk, he/she could borrow to
invest. An investor is indifferent about a share repurchase or a
dividend.
Market imperfections can affect conclusions because MMs world
has perfect capital markets.Note: In a perfect capital market: All
participants have the same information.There are no taxes (the key
is that the tax rates on dividends and capital gains are the
same).There are no costs to financial distress.Expectations are
homogeneous.Flotation costs associate with issuing new shares.
Bottom line: Dividend policy does not affect a firms value.
4The Bird-in-the-Hand ArgumentInvestors prefer a cash dividend
to uncertain capital gains.Hence, investors prefer the bird in the
hand.Issue: Riskiness of the stock appreciation.If this explanation
holds, a company that pays a cash dividend will have a higher value
than a similar company that does not pay a cash dividend.
Bottom line: Dividend policy affects the value of the firm.
Copyright 2013 CFA Institute5LOS: Compare theories of dividend
policy and explain implications of each for share value, given a
description of a corporate dividend action. Page 260
The Bird-in-the-Hand Argument
Investors prefer a cash dividend to uncertain capital
gains.Hence, investors prefer the bird in the hand.Issue: Riskiness
of the stock appreciation.If this explanation holds, a company that
pays a cash dividend will have a higher value than a similar
company that does not pay a cash dividend.
Bottom line: Dividend policy affects the value of the firm
5The Tax ArgumentIf dividends are taxed at a rate higher than
capital gains, investors prefer that companies reinvest cash flow
back into the firm.In other words, investors prefer the lower-taxed
capital gains to the higher-taxed cash dividends.This advocates a
zero dividend payout when dividends are taxed at a rate higher than
that of capital gains.
Bottom line: Dividend policy affects the value of the
firm.Copyright 2013 CFA Institute6LOS: Compare theories of dividend
policy and explain implications of each for share value, given a
description of a corporate dividend action.Pages 260261
The Tax Argument
If dividends are taxed at a rate higher than capital gains,
investors prefer that companies reinvest cash flow back into the
firm.In other words, investors prefer the lower-taxed capital gains
to the higher-taxed cash dividends.This advocates a zero dividend
payout when dividends are taxed at a rate higher than that of
capital gains.
Bottom line: Dividend policy affects the value of the firm.
6The Clientele EffectThe clientele effect is the influence of
groups of investors attracted to companies with specific dividend
policies.Clientele are simply a group of investors who have the
same preference.Types of clientele:If an investor has a marginal
tax on capital gains lower than the marginal tax on dividends, the
investor prefers a return in the form of capital gains.Investors
who are tax exempt (e.g., pension funds) are indifferent about
dividends and capital gains.Some investors, by policy or
restrictions, only invest in stocks that pay dividends.The
importance of the existence of clientele is that investors will
have a preference for stocks with a specific dividend policy.Bottom
line: The clientele effect does not necessarily imply that
dividends affect value.Copyright 2013 CFA Institute77Dividends and
SignalingUnder MMs theory, everyone has the same information.When
there is asymmetric information, dividend changes may convey
information.
Copyright 2013 CFA Institute8LOS: Describe types of information
(signals) that dividend initiations, increases, decreases, and
omissions may convey.Pages 265268
Dividends and Signaling
Under MMs theory, everyone has the same information. Therefore,
dividends do not signal anything.When there is asymmetric
information, dividend changes may convey information: Positive
information: Initiations and increasesNegative information:
Omissions and decreasesSome evidence suggests that increasing a
dividend attracts attention to the stock. Companies do brag about
their record of dividend payments (consistency, growth, etc.).
Companies that tend to grow their dividends consistently tend to be
dominant in their industry, have global operations, have a high
return on assets, and have low financial leverage. Examples:
Proctor & Gamble (PG), Diebold (DBD), Johnson & Johnson
(JNJ), Coca-Cola (KO)Cutting dividends are generally negative
signals. J.C. Penney (JCP) stopped its dividend in 2013. Deutsche
Telekom announced a reduction in 2012 (effective 2013 and
2014).CenturyLink (CTL) announced a cut its dividend in Feb
2013.Telecom Italia (TT) announced a cut in its dividend in Feb
2013.Vale SA announced a dividend cut in 2013.
8Agency costs and Dividend policyThe separation of ownership and
management in a corporation may lead to suboptimal
investment.Management may invest in negative NPV projects to
enhance the companys size or managements control.Jensens free cash
flow hypothesis is that having free cash flow tempts management to
make investments that are not positive NPV.Paying dividends or
interest on debt uses this free cash flow and averts an agency
issue.If a companys debt has a restriction on paying dividends, it
may avoid the issue of paying dividends (thus benefiting owners)
and may increase the risk to bondholders.
Bottom line: Dividends may reduce agency costs and, therefore,
increase the value of the firm.Copyright 2013 CFA Institute9LOS:
Explain how clientele effects and agency issues may affect a
companys payout policy.Pages 268271
Clientele and Agency Influence on Dividend Policy
The separation of ownership and management in a corporation may
lead to suboptimal investment. Management may invest in negative
NPV projects to enhance the companys size or managements
control.Jensens free cash flow hypothesis is that having free cash
flow tempts management to make investments that are not positive
NPV. Paying dividends or interest on debt uses this free cash flow
and averts an agency issue.If a companys debt has a restriction on
paying dividends, it may avoid the issue of paying dividends (thus
benefiting owners) and may increase the risk to bondholders.
Bottom line: Dividends may reduce agency costs and, therefore,
increase the value of the firm
93. Factors Affecting Dividend policyCopyright 2013 CFA
Institute10LOS: Explain factors that affect dividend policy.Pages
271272
3. Factors Affecting Dividend Policy
Investment opportunitiesExpected volatility of future
earningsFinancial flexibilityTax considerationsFlotation
costsContractual and legal restrictions
10Factors affecting dividend policyInvestment opportunities:A
company with more investment opportunities will pay out less in
dividends.A company with fewer investment opportunities will pay
out more in dividends.Expected volatility of future
earnings:Companies with greater earnings volatility are less likely
to increase dividendsa greater chance of not maintaining the
increased dividend.Financial flexibility:Companies seeking more
flexibility are less likely to pay dividends or to increase
dividends because they want to preserve cash.
Copyright 2013 CFA Institute11LOS: Explain factors that affect
dividend policy.Pages 272273
Factors Affecting Dividend Policy
Investment opportunities: A company with more investment
opportunities will pay out less in dividends.A company with fewer
investment opportunities will pay out more in dividends.A company
in the mature phase of the companys life cycle is more likely to
pay dividend than a company in the growth stage.Expected volatility
of future earnings:Companies with greater earnings volatility are
less likely to increase dividendsa greater chance of not
maintaining the increased dividend.Financial flexibility: Companies
seeking more flexibility are less likely to pay dividends or to
increase dividends because they want to preserve cash.11Factors
affecting dividend policyTax considerationsThe tax rate on
dividends and how dividends are taxed relative to capital gains
affect investors preferences and, hence, companies dividend
policy.Flotation costsThese costs make it more expensive to use
newly issued stock instead of internally generated funds.Smaller
companies face higher flotation costs.Contractual and legal
restrictionsForms of restrictions:Impairment of capital ruleBond
indenturesRequirement of preferred sharesCopyright 2013 CFA
Institute12LOS: Explain factors that affect dividend policy.Pages
273278
Factors Affecting Dividend Policy
Tax considerations The tax rate on dividends and how dividends
are taxed relative to capital gains affect investors preferences
and, hence, companies dividend policy.Note: Tax systems are
discussed later in presentation.
Flotation costs These costs make it more expensive to use newly
issued stock instead of internally generated funds.Smaller
companies face higher flotation costs.
Contractual and legal restrictions Forms of
restrictions:Impairment of capital ruleThe impairment of capital
rule is a legal restriction on paying dividends if there is not a
minimum amount of equity capital. Bond indenturesRequirement of
preferred shares (that is, preference in preferred stock dividends
before common stock dividends)
12Tax Systems and Dividend PolicyConsider a company that has
earnings before tax of $100 million and pays all its earnings as
dividends. The companys tax rate is 35%, and individual
shareholders have a marginal tax rate of 25%. In countries with a
split-rate system, dividends are taxed at 28% at the corporate
level.Copyright 2013 CFA Institute13LOS: Calculate and interpret
the effective tax rate on a given currency unit of corporate
earnings under double-taxation, split-rate, and tax imputation
dividend tax regimes.Pages 274276
Tax Systems and Dividend Policy
Double taxation (U.S.) Earnings are taxed at corporate level;
dividends are taxed at shareholder level.Effective tax on dividends
= ($35 + $16.25) $100 = 51.25%Formula for 100% of earnings in
dividends: Tax rate = tcorporate+ tshareholder (tcorporate
tshareholder) = 35% + 25% 8.75% = 51.25%
Dividend imputation (Australia, New Zealand, United Kingdom,
France) Earnings are taxed at corporate level; tax credit at
shareholder level.Effective tax on dividends = ($30 + $5) $100 =
25%Tax calculated by shareholder = ($100 0.25) = $25 | Applying
what the corporation paid = $25 $30 = $5 refund
Split-rate system Earnings distributed are taxed at a lower rate
than retained earnings. Effective tax on dividends = ($28 + $18)
$100 = 46%Formula, for 100% of earnings in dividends: Tax rate =
tcorporate payout + tshareholder (tcorporate payout tshareholder) =
28 + 25% 7% = 46%
134. Payout PoliciesCopyright 2013 CFA Institute1414Example:
Payout PoliciesConsider the financial information for Apple, Inc.
(AAPL)
What are dividends for FY2011 and FY2012 if the company followed
a stable dividend policy, with a target dividend payout of 10% and
an adjustment factor of 0.3?
Copyright 2013 CFA Institute15Fiscal Year
Ending9/29/20129/24/20119/25/2010Net income
(millions)$41,773$25,922$14,014Fiscal Year
Ending9/29/20129/24/2011Increase in earnings$15,851$11,900Multiply
by target0.100.10Multiply by adjustment
factor0.300.30Dividends$475.53$357.24LOS: Compare stable dividend,
target payout, and residual dividend policies and calculate the
dividend under each policy.Pages 279284
Example: Payout Policies
Consider the financial information for Apple, Inc. (AAPL).
What are dividends for FY2011 and FY2012 if the company followed
a stable dividend policy, with a target dividend payout of 10% and
an adjustment factor of 0.3?
Key: Multiply the increase in earnings (from the prior year) by
the target payout ratio and the adjustment factor.Note: the higher
the adjustment factor, the higher in the dividends for this company
if earnings are increasing.
15Example: Payout PoliciesWhat are dividends for FY2011 and
FY2012 if the company followed a constant dividend payout at
6%?
What are dividends for FY2011 and FY2012 if the company followed
the residual payout policy?
Copyright 2013 CFA Institute16Fiscal Year
Ending9/29/20129/24/2011Net income (millions)$41,773$25,922Less:
capital expenditures9,4027,452Dividends$32,371$18,470Fiscal Year
Ending9/29/20129/24/2011Net income (millions)$41,773$25,922Multiply
by 6%0.060.06Dividends$2,506$1,555.32LOS: Compare stable dividend,
target payout, and residual dividend policies and calculate the
dividend under each policy.Pages 279284
Example: Payout Policies
What are dividends for FY2011 and FY2012 if the company followed
a constant dividend payout at 6%?Dividends increase as earnings
increase (and fall as earnings fall).
What are the dividends for FY2011 and FY2012 if the company
followed the residual payout policy?Dividend are variable because
of earnings variability and the lumpiness of capital
expenditures.
Actual dividends of Apple, Inc. (Source: Google Finance):FY
2011: Dividends = $0FY 2012: Dividends = $2,488 | Dividend payout =
5.96% | DPS = $2.6516Cash Dividends vs. Repurchasing StockCopyright
2013 CFA Institute17Reasons for preferring repurchasing stock over
paying a cash dividendPotential tax advantagesSignalingManagerial
flexibilityOffset dilution from executive stock optionsIncrease
financial leverageA stock repurchase may be a good alternative to
an increase in cash dividends.LOS: Explain the choice between
paying cash dividends and repurchasing shares.Pages 285291
Cash Dividends vs. Repurchasing Stock
Reasons for preferring repurchasing stock over paying a cash
dividend: Potential tax advantagesSignalingManagerial
flexibilityOffset dilution from executive stock optionsIncrease
financial leverageDubious motive: Increase EPS (dubious because of
effect on required rate of return and because free cash flow is not
affected)A stock repurchase may be a good alternative to an
increase in cash dividends. 17Global Trends in Dividend
PayoutCurrent:Large, profitable companies tend to have a stable
payout policy.Smaller and/or less profitable companies tend to not
be dividend paying.Trends:In developed companies, fewer companies
pay cash dividends, but more companies are using stock
repurchases.The dividend amounts and payouts have increased for
dividend-paying companies, but the proportion of dividend-paying
companies has declined.
Copyright 2013 CFA Institute18LOS: Describe global trends in
corporate dividend policies.Pages 291292
Global Trends in Dividend Payout
Current: Large, profitable companies tended to have a stable
payout policy.Smaller and/or less profitable companies tend to not
be dividend paying.
Trends: In developed companies, fewer companies pay cash
dividends, but more companies are using stock repurchases.The
dividend amounts and payouts have increased for dividend-paying
companies, but the proportion of dividend-paying companies has
declinedNote: These trends are based on evidence prior to 2009,
which may not reflect the effects of the financial
crisis.18Dividend Coverage RatiosCopyright 2013 CFA Institute19195.
Analysis of Dividend SafetyWe can evaluate the safety of the
dividend by examining the companys ability to meet its
dividends.Safety pertains to the ability of the company to continue
to pay the dividend or maintain a growth pattern.Possible ratios:
Dividend coverage and free cash flow coverageUsing dividends plus
repurchases may be more appropriate for some firms.Values greater
than 1.0 indicate ability to meet the dividend and repurchase,
although the greater the coverage, the greater the liquidity and
ability to pay.It is sometimes difficult to predict changes in
dividend because of surprises, such as the financial crisis.
Copyright 2013 CFA Institute20LOS: Identify characteristics of
companies that may not be able to sustain their cash dividend.Pages
293297
Analysis of Dividend Safety
We can evaluate the safety of the dividend by examining the
companys ability to meet its dividends. Safety pertains to the
ability of the company to continue to pay the dividend or maintain
a growth pattern.Possible ratios: Dividend coverage and free cash
flow coverageUsing dividends plus repurchases may be more
appropriate for some firms.Values greater than 1.0 indicate ability
to meet the dividend and repurchase, although the greater the
coverage, the greater the liquidity and ability to pay.
It is sometimes difficult to predict changes in dividend because
of surprises, such as the financial crisis.
206. SummaryThere are three general theories on investor
preference for dividends: Dividend policy is irrelevant, the
bird-in-hand argument, and the tax explanation.An argument for
dividend irrelevance given perfect markets is that the corporate
dividend policy is irrelevant because shareholders can create their
preferred cash flow streams by selling any companys shares.The
clientele effect suggests that different classes of investors have
differing preferences for dividend income. Dividend declarations
may provide information to investors regarding the prospects of the
company. The payment of dividends can help reduce the agency
conflicts between managers and shareholders, but can worsen
conflicts of interest between shareholders and
debtholders.Copyright 2013 CFA Institute216. Summary21Summary
(continued)Investment opportunities, the volatility expected in
future earnings, financial flexibility, taxes, flotation costs, and
contractual and legal restrictions affect dividend policies.Using a
stable dividend policy, a company may attempt to align its dividend
growth rate to the companys long-term earnings growth rate. The
stable dividend policy can be represented by a gradual adjustment
process in which the expected dividend is equal to last years
dividend per share, plus any adjustment.With a constant dividend
payout ratio policy, a company applies a target dividend payout
ratio to current earnings.In a residual dividend policy, the amount
of the annual dividend is affected by both the earnings and the
capital investment spending.
Copyright 2013 CFA Institute226. Summary 22Summary
(continued)Share repurchases usually offer more flexibility than
cash dividends by not establishing the expectation that a
particular level of cash distribution will be maintained.Share
repurchases can signal that company officials think their shares
are undervalued. On the other hand, share repurchases could send a
negative signal that the company has few positive NPV
opportunities.The issue of dividend safety deals with the
likelihood of the dividend being continued.Early warning signs of
whether a company can sustain its dividend include the level of
dividend yield, whether the company borrows to pay the dividend,
and the companys past dividend record.
Copyright 2013 CFA Institute236. Summary 23
