Dividends and Share Repurchases: Analysis

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Compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action
Dividend irrelevance. Miller and Modigliani (MM) maintain that dividend policy is irrelevant, as it has no effect on the price of a firm's stock or its cost of capital. MM's argument of dividend irrelevance is based on their concept of homemade dividends. Assume, for example, that you are a stockholder and you don't like the firm's dividend policy. If the firm's cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm's stock. If the cash dividend you received was too small, you can just sell a little bit of your stock in the firm to get the cash flow you want. In either case, the combination of the value of your investment in the firm and your cash in hand will be the same. If investors don't care about the firm's dividend policy, the firm's dividend policy will not affect the firm's stock price and, consequently, dividend policy will not affect the firm's required rate of return on equity capital. Note: this theory holds only in a perfect world with no taxes, no brokerage costs, and infinitely divisible shares. This discussion applies to the firm's total payout policy (rather than just dividend policy).

Bird in hand argument for dividend policy. Myron Gordon and John Litner, however, argue that the firm's required rate of return on equity capital decreases as the dividend payout increases. Why? Because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current (and therefore certain) dividend payments. The main argument of Gordon and Lintner is that investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of expected capital gains. They base this argument on the fact that, when measuring total return, the dividend yield component, D(1)/P(0), has less risk than the growth component g.

Tax aversion. In many countries, dividends have historically been taxed at a higher rate than capital gains. Under such a situation, according to the tax aversion theory, investors will prefer to not receive dividends due to their higher tax rates. Taken to the extreme, the tax aversion theory implies that investors would want companies to have a zero dividend payout ratio so that they will not be burdened with higher tax rates.

Conclusions from the three theories. The results of empirical tests are unclear as to which of these theories best explains the empirical observations of dividend policy. Research suggests that higher tax rates do result in lower dividend payouts. In the United States, however, the change in tax law that put dividends and capital gains on common ground is likely to make the tax aversion theory irrelevant. There is empirical support for the "bird in the hand" theory as some companies that pay dividends are perceived as less risky and specific groups of investors do prefer dividend paying stocks. MM counter this argument by saying that different dividend policies appeal to different clienteles, and that since all types of clients are active in the marketplace, dividend policy has no effect on company value if all clienteles our satisfied.
Describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey
Information asymmetry refers to differences in information available to a company's board and management as compared to the investors. Dividends convey more credible information to the investors as compared to plain statements. This is so because dividends entail actual cash flow and are expected to continue in the future. Companies refrain from increasing dividends unless they expect to continue to pay out the higher levels in the future. Similarly, companies loathe cutting dividends unless they expect that the lower levels of dividends reflect long run poorer prospects of the company in the future.

The information conveyed by dividend initiation is ambiguous. On one hand, a dividend initiation could mean that a company is optimistic about the future and is sharing its wealth with shareholders - a positive signal. On the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities - a negative signal.

An unexpected dividend increase can signal to the investors that a company's future business prospects are strong and that managers will share the success with the shareholders. Studies have found that companies with a long history of dividend increases are dominate in their industries and have high returns on assets and low debt ratios.

Unexpected dividend decreases or omissions are typically negative signals that the business is in trouble and that management does not believe that the current dividend payment can be maintained. In rare instances, however, a dividend decrease or omission could be a positive sign.
Explain how clientele effects and agency issues may affect a company's payout policy
Clientele effect. This refers to the varying dividend preferences of different groups of investors such as individuals, institutions, and corporations. The dividend clientele effect states that different groups desire different levels of dividends. Rationales for the existence of the clientele effect include:
> tax considerations. High tax-bracket investors tend to prefer low dividend payouts, while low tax-bracket investors may prefer high dividend payouts. If most investors' marginal tax rate on capital gains are lower than their marginal tax rate on dividends, the share's price is most likely to drop by less than the amount of the dividend when the share goes ex dividend.
When the stock goes ex-dividend:
change in price when the stock goes from with dividend to ex-dividend = D(1-T(dividend)) / 1-T(capital gain)
If T(dividend) is greater than T(capital gain), then the price decrease should be less than dividend.
> Requirements of institutional investors. For legal or strategic reasons, some institutional investors will invest only in companies that pay a dividend or have a dividend yield above some target threshold.
> Individual investor preferences. Some investors prefer to buy stocks so they can spend the dividends while preserving the principal.
It should be noted that the existence of dividend clienteles does not contradict dividend irrelevance theory. A firm's dividend policy would attract a certain clientele. After that, changes in the policy would have no impact as the firm would be simply swapping one clientele for another.

Agency Issues
Between shareholders and managers. Agency costs reflect the inefficiencies due to divergence of interest between managers and stockholders. One aspect of agency issue is that managers may have an incentive to overinvest. One way to reduce agency cost is to increase the pay out of free cash flow as dividends. Generally, it makes sense for growing firms to retain a larger proportion of their earnings. However, mature firms in relatively noncyclical industries do not need to hoard cash. In such cases, higher dividend payout would be welcomed by the investors resulting in increases in stock value.

Between shareholders and bondholders. For firms financed by debt as well as equity, there may be an agency conflict between shareholders and bondholders. When there is risky debt outstanding, shareholders can pay themselves a large dividend, leaving the bondholders with a lower asset-base as collateral. Typically, agency conflict between stockholders and bondholders is resolved via provisions in the bond indenture.
Explain factors that affect dividend policy
A company's dividend payout policy is the approach a company follows in determining the amount and timing of dividend payments to shareholders. Six primary factors affect a company's dividend payout policy:
1. Investment opportunities. Availability of positive NPV investment opportunities and the speed with which the firm must react to the opportunities determines the amount of cash the firm must keep on hand. If the firm faces many profitable investment opportunities and has to react quickly to capitalize on the opportunities, dividend payout would be low.
2. Expected volatility of future earnings. Firms tie their target payout ratio to long-run sustainable earnings and are reluctant to increase dividends unless reversal is not expected in the near future. Hence, when earnings are volatile, firms are more cautious in changing dividend payout.
3. Financial flexibility. Firms with excess cash and a desire to maintain financial flexibility may resort to stock repurchases instead of dividends as a way to pay out excess cash. Since stock repurchase plans are not considered sticky, they don't entail reduction in financial flexibility going forward.
4. Tax considerations. Investors are concerned about after tax returns. Investment income is taxed by most countries; however, the ways that dividends are taxed vary widely from country to country. Generally, in countries where capital gains are taxed at a favorable rate as compared to dividends, high tax bracket investors prefer low dividend payouts, and low tax bracket investors prefer a high dividend payouts.
5. Flotation costs. When a company issues new shares of common stock, a flotation cost of 3% to 7% is taken from the amount of capital raised to pay for investment bankers and other costs associated with issuing the new stock. Since retained earnings have no such fee, the cost of new equity capital is always higher than the cost of retained earnings. Larger companies typically have lower flotation costs as compared to smaller companies. Generally, the higher the flotation cost, the lower the dividend payout, given the need for equity capital and positive NPV projects.
6. Contractual and legal restrictions. Companies may be restricted from paying dividends either by legal requirements or by implicit restrictions caused by cash needs of the business. Common legal and contractual restrictions on dividend payments include:
> The impairment of capital rule. A legal requirement in some countries mandates that dividends paid cannot be in excess of retained earnings.
> Debt covenants. These are designed to protect bondholders and dictate things a company must or must not do.
Calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation, dividend imputation, and split-rate tax systems
Double taxation system. Dividends paid in the United States are taxed according to what is called a double taxation system. Earnings are taxed at the corporate level regardless of whether they are distributed as dividends, and dividends are taxed again at the shareholder level. Since a dollar in earnings distributed as dividends is first taxed at the corporate level, with the after-corporate tax amount taxed at the individual level, we can calculate the total effective tax rate as:
effective tax rate = corporate tax rate + (1 - corporate tax rate) (individual tax rate)

Split rate corporate tax system taxes earnings distributed as dividends at a lower rate than earnings that are retained. The effect is to offset the higher tax rate applied to dividends at the individual level. The calculation of the effective tax rate under a split rate system is similar to computation of the effective tax rate under double taxation except that the corporate tax rate applicable would be the corporate tax rate for distributed income. Earnings that are distributed as dividends are still taxed twice but at a lower corporate tax rate.

Under an imputation tax system, taxes are paid at the corporate level but are attributed to the shareholder, so that all taxes are effectively paid at the shareholder rate. Shareholders deduct their portion of the taxes paid by the corporation from their tax return. If the shareholder tax bracket is lower than the company rate, the shareholder would receive a tax credit equal to the difference between the two rates. If the shareholder's tax bracket is higher than the company's rate, the shareholder pays the difference between the two rates. Under an imputation system, the effective tax rate on the dividend is simply the shareholder's marginal tax rate.

See examples for each.
Compare stable dividend, constant dividend payout ratio, and residual dividend payout policies, and calculate the dividend under each policy
Stable dividend policy. The stable dividend policy focuses on a steady dividend payout, even though earnings may be volatile from year-to-year. Companies that use a stable dividend policy typically look at a forecast of their long run earnings to determine the appropriate level for the stable dividend. This typically means aligning the company's dividend growth rate with the company's long-term earnings growth rate.
A stable dividend policy could be gradually moving towards a target dividend payout ratio. A model of gradual adjustment is called a target payout ratio adjustment model. If company earnings are expected to increase and the current payout ratio is below the target payout ratio, an investor can estimate future dividends through the following formula:
Expected dividend = (previous dividend)+[(expected increase in EPS)x(target payout ratio)x(adjustment factor)]
adjustment factor = 1/ Number of years over which the adjustment in dividends will take place
See examples.

Constant dividend payout ratio policy. A payout ratio is the percentage of total earnings paid out as dividends. The constant payout ratio represents the proportion of earnings that a company plans to pay out to shareholders. A strict interpretation of the constant payout ratio method means that a company would pay out a specific percentage of its earnings each year as dividends, and the amount of those dividends would vary directly with earnings. This practice is seldom used.

Residual dividend model. In the residual dividend model, dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget. The model is based on the firm's investment opportunity schedule, target capital structure, and access to and cost of external capital. The following steps are followed to determine the target payout ratio:
1. Identify the optimal capital budget.
2. Determine the amount of equity to finance that capital budget for a given capital structure.
3. Meet equity requirements to the maximum extent possible with retained earnings.
4. Pay dividends with the residual earnings that are available after the needs of the optimal capital budget are supported. In other words, the residual policy implies that dividends are paid out of leftover earnings.
Advantages of the residual dividend model:
> The model is simple to use.
> The model allows management to pursue profitable investment opportunities without being constrained by dividend considerations.
Disadvantages of the residual dividend model:
> If a firm follows the residual dividend policy, its dividend payments may be unstable. Investment opportunities in earnings often vary from year-to-year. This means that dividends will fluctuate if a firm strictly adheres to a residual dividend policy.

Long-term residual dividend. Some companies try to mitigate the disadvantages of the residual dividend approach by forecasting the capital budget over a longer time frame. The leftover earnings over this longer time frame are allocated as dividends and are paid out in relatively equal amounts each year. Any excess cash flows are distributed through share repurchases.
Explain the choice between paying cash dividends and repurchasing shares
A share repurchase is a transaction in which a company buys back shares of its own common stock. Since shares are bought using a company's own cash, a share repurchase can be considered an alternative to a cash dividend.
They are five common rationales for share purchases (versus dividends):
1. Potential tax advantages. When tax rate on capital gains are lower than the tax rate on dividend income, share repurchases have a tax advantage over cash dividends.
2. Share price support/signaling. Companies may purchase their own stock, thereby signaling to the market that the company views its own stock as a good investment. Signaling is important in the presence of asymmetric information. Management can send a signal to investors that the future outlook for the company is good.
3. Added flexibility. The company could declare a regular cash dividend and periodically repurchase shares as a supplement to the dividend. Unlike dividends, share repurchases are not a long-term commitment. Since paying a cash dividend and repurchasing shares are economically equivalent, a company could declare a small stable dividend and then repurchase shares with the company's leftover earnings effectively implement a residual dividend policy without the negative impact that fluctuating cash dividends may have on the share price.
4. Offsetting dilution from employee stock options. Repurchases offset EPS dilution that results from the exercise of employee stock options.
5. Increasing financial leverage. Share repurchases increase leverage. Management can change the company's capital structure (and perhaps move toward the company's optimal capital structure) by decreasing the percentage of equity.

A share repurchase using borrowed funds will increase EPS if the after-tax cost of debt used to buy back shares is less than the earnings yield of the shares before the purchase. It will decrease EPS if the cost of debt is greater than the earnings yield, and it will not change EPS if the two are equal.

See examples.
Describe broad trends in corporate dividend policies
Dividend policy has been seen to have differences across countries and over time. This is probably to accommodate differences in investor preferences globally as well as changing investor preferences over time. The following generalizations can be made with respect to global trends in corporate dividend policies:
1. A lower proportion of US companies pay dividends as compared to their European counterparts.
2. Globally, in developed markets, the proportion of companies paying cash dividends has trended downwards over the long term.
3. The percentage of companies making stock repurchases has been trending upwards in the United States since the 1980s and in the United Kingdom and continental Europe since the 1980s.
Calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow
AND
Identify characteristics of companies that may not be able to sustain their cash dividend
Dividend safety is the metric used to evaluate the probability of dividends continuing at the current rate for a company. Traditional ratios, such as dividend payout ratio (dividends/net income) or its inverse dividend coverage ratio (net income/dividends), are typically used for this purpose. A higher than normal dividend payout ratio (and a lower than normal dividend coverage ratio) tends to typically indicate a higher probability of a dividend cut (or a lower probability of dividend sustainability).
In analyzing these ratios, we should compare the computed ratio to the average ratio for the industry and market within which a company operates. In making a qualitative judgment about a company, stable or increasing dividends are looked upon favorably, whereas companies that have cut their dividends in the past are looked upon unfavorably.

Another ratio considers free cash flow to equity (FCFE).
FCFE coverage ratio = FCFE/(dividends + share repurchases)
Note that unlike dividend payout ratio, the FCFE coverage ratio considers not only dividends but also share repurchases. If that ratio is 1, the company is returning all available cash to shareholders. If it is significantly greater than 1, the company is improving liquidity by using funds to increase cash and/or marketable securities. A ratio significantly less than 1 is not sustainable because the company is paying out more than it can afford by drawing down existing cash/marketable securities, thereby decreasing liquidity. At some point the company will have to raise new equity.

See example.

Extremely high dividend yields compared with a company's past record and current bond yields is often another warning signal that investors are predicting a dividend cut. So, 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 company's past dividend record.