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CHAPTER 14
Distributions to Shareholders:
Dividends and Share Repurchases

nTheories of investor preferences

nSignaling effects
nResidual model
nDividend reinvestment plans
nStock dividends and stock splits
nStock repurchases
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What is “dividend policy”?

nIt is the decision to pay out earnings

versus retaining and reinvesting
them. Dividend policy includes:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
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Do investors prefer high or low

payouts? There are three theories:

nDividends are irrelevant: Investors

don’t care about payout.
nBird in the hand: Investors prefer a
high payout.
nTax preference: Investors prefer a
low payout, hence growth.
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Dividend Irrelevance Theory

nInvestors are indifferent between

dividends and retention-generated
capital gains. If they want cash, they
can sell stock. If they don’t want cash,
they can use dividends to buy stock.
nModigliani-Miller support irrelevance.
nTheory is based on unrealistic
assumptions (no taxes or brokerage
costs), hence may not be true. Need an
empirical test.
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Bird-in-the-Hand Theory

nInvestors think dividends are less

risky than potential future capital
gains, hence they like dividends.
nIf so, investors would value high
payout firms more highly, i.e., a
high payout would result in a high
P0 .

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Tax Preference Theory

nRetained earnings lead to long-

term capital gains, which are taxed
at lower rates than dividends: 20%
vs. up to 39.6%. Capital gains
taxes are also deferred.
nThis could cause investors to
prefer firms with low payouts, i.e.,
a high payout results in a low P0.

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Implications of 3 Theories for

Managers

Theory Implication
Irrelevance Any payout OK
Bird in the hand Set high payout
Tax preference Set low payout

But which, if any, is correct???

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Possible Stock Price Effects

Stock Price ($)

Bird-in-Hand
40

30 Irrelevance

20
Tax preference
10

0 50% 100% Payout

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 14 - 9

Possible Cost of Equity Effects

Cost of equity (%)

Tax Preference
20

15 Irrelevance

10 Bird-in-Hand

0 50% 100% Payout

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Which theory is most correct?

nEmpirical testing has not been able

to determine which theory, if any, is
correct.
nThus, managers use judgment
when setting policy.
nAnalysis is used, but it must be
applied with judgment.
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What’s the “information content,” or

“signaling,” hypothesis?

n Managers hate to cut dividends, so they

won’t raise dividends unless they think
raise is sustainable. So, investors view
dividend increases as signals of
management’s view of the future.
n Therefore, a stock price increase at time
of a dividend increase could reflect
higher expectations for future EPS, not
a desire for dividends.
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What’s the “clientele effect”?

nDifferent groups of investors, or

clienteles, prefer different dividend
policies.
nFirm’s past dividend policy determines
its current clientele of investors.
nClientele effects impede changing
dividend policy. Taxes & brokerage
costs hurt investors who have to
switch companies.
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What is the “residual dividend model”?

nFind the retained earnings needed

for the capital budget.
nPay out any leftover earnings (the
residual) as dividends.
nThis policy minimizes flotation and
equity signaling costs, hence
minimizes the WACC.

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Using the Residual Model to Calculate

Dividends Paid

éæ T arg et öæ Total ö ù
Dividends = Net - êç equity ÷ç capital ÷ ú.
income êç ÷ç ÷ú
ëè ratio øè budget ø û

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Example of Residual Dividend Model

nCapital budget: $800,000. Given.

nTarget capital structure: 40% debt,
60% equity. Want to maintain.
nForecasted net income: $600,000.
nHow much of the $600,000 should
we pay out as dividends?
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Of the $800,000 capital budget,

0.6($800,000) = $480,000 must be equity
to keep at target capital structure.
[0.4($800,000) = $320,000 will be debt.]
With $600,000 of net income, the residual
is $600,000 – $480,000 = $120,000 =
dividends paid.
Payout ratio = $120,000/$600,000
= 0.20 = 20%.
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How would a drop in NI to $400,000

affect the dividend? A rise to $800,000?

nNI = $400,000: Need $480,000 of

equity, so should retain the whole
$400,000. Dividends = 0.
nNI = $800,000: Dividends =
$800,000 – $480,000 = $320,000.
Payout = $320,000/$800,000 = 40%.

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How would a change in investment

opportunities affect dividend under the
residual policy?

nFewer good investments would

lead to smaller capital budget,
hence to a higher dividend payout.
nMore good investments would lead
to a lower dividend payout.

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Advantages and Disadvantages of the

Residual Dividend Policy

nAdvantages: Minimizes new stock

issues and flotation costs.
nDisadvantages: Results in variable
dividends, sends conflicting signals,
increases risk, and doesn’t appeal to
any specific clientele.
nConclusion: Consider residual policy
when setting target payout, but don’t
follow it rigidly.
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What’s a “dividend reinvestment plan

(DRIP)”?

nShareholders can automatically

reinvest their dividends in shares of
the company’s common stock. Get
more stock than cash.
nThere are two types of plans:
lOpen market
lNew stock
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Open Market Purchase Plan

nDollars to be reinvested are turned

over to trustee, who buys shares on
the open market.
nBrokerage costs are reduced by
volume purchases.
nConvenient, easy way to invest, thus
useful for investors.
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New Stock Plan

nFirm issues new stock to DRIP

enrollees, keeps money and uses it
to buy assets.
nNo fees are charged, plus sells
stock at discount of 5% from market
price, which is about equal to
flotation costs of underwritten stock
offering.
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nOptional investments sometimes

possible, up to $150,000 or so.
nFirms that need new equity capital
use new stock plans.
nFirms with no need for new equity
capital use open market purchase
plans.
nMost NYSE listed companies have a
DRIP. Useful for investors.
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Setting Dividend Policy

nForecast capital needs over a planning

horizon, often 5 years.
nSet a target capital structure.
nEstimate annual equity needs.
nSet target payout based on the
residual model.
nGenerally, some dividend growth rate
emerges. Maintain target growth rate if
possible, varying capital structure
somewhat if necessary.
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Dividend Payout Ratios for

Selected Industries
Industry Payout ratio
Banking 36.62
Computer Software Services 15.61
Drug 41.49
Electric Utilities (Eastern U.S.) 64.47
Internet n/a
Restaurants 19.29
Semiconductors 10.78
Steel 26.92
Tobacco 54.90
*None of the internet companies included in the
Value Line Investment Survey paid a dividend.
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Stock Repurchases

Repurchases: Buying own stock back

from stockholders.
Reasons for repurchases:
nAs an alternative to distributing cash
as dividends.
nTo dispose of one-time cash from an
asset sale.
nTo make a large capital structure
change.
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Advantages of Repurchases
n Stockholders can tender or not.
n Helps avoid setting a high dividend that
cannot be maintained.
n Repurchased stock can be used in take-
overs or resold to raise cash as needed.
n Income received is capital gains rather
than higher-taxed dividends.
n Stockholders may take as a positive
signal--management thinks stock is
undervalued.
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 14 - 28

Disadvantages of Repurchases

nMay be viewed as a negative signal (firm

has poor investment opportunities).
nIRS could impose penalties if
repurchases were primarily to avoid
taxes on dividends.
nSelling stockholders may not be well
informed, hence be treated unfairly.
nFirm may have to bid up price to
complete purchase, thus paying too
much for its own stock.
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Stock Dividends vs. Stock Splits

nStock dividend: Firm issues new

shares in lieu of paying a cash
dividend. If 10%, get 10 shares for
each 100 shares owned.
nStock split: Firm increases the
number of shares outstanding, say
2:1. Sends shareholders more
shares.
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Both stock dividends and stock splits

increase the number of shares
outstanding, so “the pie is divided into
smaller pieces.”
Unless the stock dividend or split
conveys information, or is accompanied
by another event like higher dividends,
the stock price falls so as to keep each
investor’s wealth unchanged.
But splits/stock dividends may get us to
an “optimal price range.”
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When and why should a firm consider

splitting its stock?

n There’s a widespread belief that the optimal

price range for stocks is $20 to $80. Stock
splits can be used to keep the price in this
optimal range.
n Stock splits generally occur when
management is confident, so are
interpreted as positive signals.
n On average, stocks tend to outperform the
market in the year following a split.
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