When all the pros and cons on stock repurchases have been totaled, where do we stand? Our conclusions may be summarized as follows:
1. Because of the lower capital gains tax rate and the deferred tax on capital gains, repurchases have a significant tax advantage over dividends as a way to distribute income to stockholders. This advantage is reinforced by the fact that repurchases provide cash to stockholders who want cash while allowing those who do not need current cash to delay its receipt. On the other hand, dividends are more dependable and are thus better suited for those who need a steady source of income.
2. Because of signaling effects, companies should not vary their dividends—that would lower investors' confidence in the company and adversely affect its cost of equity and its stock price. However, cash flows vary over time, as do investment opportunities, so the "proper" dividend in the residual model sense varies. To get around this problem, a company can set its dividend low enough to keep dividend payments from constraining operations and then use repurchases on a more or less regular basis to distribute excess cash. Such a procedure would provide regular, dependable dividends plus additional cash flow to those stockholders who want it.
3. Repurchases are also useful when a firm wants to make a large shift in its capital structure, wants to distribute cash from a one-time event such as the sale of a division, or wants to obtain shares for use in an employee stock option plan.
Explain how repurchases can (1) help stockholders hold down taxes and (2) help firms change their capital structures.
What are three procedures a firm can use to repurchase its stock?
What are some advantages and disadvantages of stock repurchases?
How can stock repurchases help a company operate in accordance with the residual dividend model?
Once a company becomes profitable, it must decide what to do with the cash it generates. It may choose to retain cash and use it either to purchase additional assets or to reduce outstanding debt. Alternatively, it may choose to return the cash to shareholders. Keep in mind that every dollar that management chooses to retain is a dollar that shareholders could have received and invested elsewhere. Therefore, managers should retain earnings if and only if they can invest the money within the firm and earn more than stockholders could earn outside the firm. Consequently, high-growth companies with many good projects will tend to retain a high percentage of earnings, whereas mature companies with lots of cash but limited investment opportunities will have generous cash distributions.
This basic tendency has a major influence on firms' long-run distribution policies. However, as we saw in this chapter, in any given year several important situations could complicate the long-run policy. Companies with excess cash have to decide whether to pay dividends or repurchase stock. In addition, due to the importance of signaling and the clientele effect, companies generally find it desirable to maintain a stable, consistent dividend policy over time. The key concepts covered in this chapter are listed below:
• Dividend policy involves three issues: (1) What fraction of earnings should be distributed? (2) Should the distribution be in the form of cash dividends or stock repurchases? (3) Should the firm maintain a steady, stable dividend growth rate?
• The optimal dividend policy strikes a balance between current dividends and future growth so as to maximize the firm's stock price.
• Miller and Modigliani developed the dividend irrelevance theory, which holds that a firm's dividend policy has no effect on either the value of its stock or its cost of capital.
• The bird-in-the-hand theory holds that the firm's value will be maximized by a high dividend payout ratio, because investors regard cash dividends as being less risky than potential capital gains.
• The tax preference theory states that because long-term capital gains are subject to less onerous taxes than dividends, investors prefer to have companies retain earnings rather than pay them out as dividends.
• Empirical tests of the three theories have been inconclusive. Therefore, academicians cannot tell corporate managers how a given change in dividend policy will affect stock prices and capital costs.
• Dividend policy should take account of the information content of dividends (signaling) and the clientele effect. The information content, or signaling, effect relates to the fact that investors regard an unexpected dividend change as a signal of management's forecast of future earnings. The clientele effect suggests that a firm will attract investors who like the firm's dividend payout policy. Both
Self-Test Questions factors should be considered by firms that are considering a change in dividend policy.
• In practice, most firms try to follow a policy of paying a steadily increasing dividend. This policy provides investors with stable, dependable income, and departures from it give investors signals about management's expectations for future earnings.
• Most firms use the residual dividend model to set the long-run target payout ratio at a level that will permit the firm to meet its equity requirements with retained earnings.
• A dividend reinvestment plan (DRIP) allows stockholders to have the company automatically use dividends to purchase additional shares. DRIPs are popular because they allow stockholders to acquire additional shares without brokerage fees.
• Legal constraints, investment opportunities, availability and cost of funds from other sources, and taxes are also considered when firms establish dividend policies.
• A stock split increases the number of shares outstanding. Normally, splits reduce the price per share in proportion to the increase in shares because splits merely "divide the pie into smaller slices." However, firms generally split their stocks only if (1) the price is quite high and (2) management thinks the future is bright. Therefore, stock splits are often taken as positive signals and thus boost stock prices.
• Under a stock repurchase plan, a firm buys back some of its outstanding stock, thereby decreasing the number of shares, but leaving the stock price unchanged. Repurchases substitute low-taxed capital gains for high-taxed dividends.
14-1 Define each of the following terms:
a. Optimal dividend policy b. Dividend irrelevance theory; bird-in-the-hand theory; tax preference theory c. Information content, or signaling, hypothesis; clientele effect d. Residual dividend model; extra dividend e. Declaration date; holder-of-record date; ex-dividend date; payment date f. Dividend reinvestment plan (DRIP)
g. Stock split; stock dividend; stock repurchase
14-2 How would each of the following changes tend to affect aggregate (that is, the average for all corporations) payout ratios, other things held constant? Explain your answers.
a. An increase in the personal income tax rate.
b. A liberalization of depreciation for federal income tax purposes—that is, faster tax write-offs.
c. A rise in interest rates.
d. An increase in corporate profits.
e. A decline in investment opportunities.
f. Permission for corporations to deduct dividends for tax purposes as they now do interest charges.
g. A change in the Tax Code so that both realized and unrealized capital gains in any year were taxed at the same rate as dividends.
14-3 Discuss the pros and cons of having the directors formally announce what a firm's dividend policy will be in the future.
14-4 What is the difference between a stock dividend and a stock split? As a stockholder, would you prefer to see your company declare a 100 percent stock dividend or a two-for-one split? Assume that either action is feasible.
14-5 Would it ever be rational for a firm to borrow money in order to pay dividends? Explain.
14-6 "Executive salaries have been shown to be more closely correlated to the size of the firm than to its profitability. If a firm's board of directors is controlled by management instead of by outside directors, this might result in the firm's retaining more earnings than can be justified from the stockholders' point of view." Discuss the statement, being sure (a) to discuss the interrelationships among cost of capital, investment opportunities, and new investment and (b) to explain the implied relationship between dividend policy and stock prices.
14-7 One position expressed in the financial literature is that firms set their dividends as a residual after using income to support new investment.
a. Explain what a residual dividend policy implies, illustrating your answer with a table showing how different investment opportunities could lead to different dividend payout ratios.
b. Think back to Chapter 13, where we considered the relationship between capital structure and the cost of capital. If the WACC-versus-debt-ratio plot was shaped like a sharp V would this have a different implication for the importance of setting dividends according to the residual policy than if the plot was shaped like a shallow bowl (or a flattened U)?
14-8 Indicate whether the following statements are true or false. If the statement is false, explain why.
a. If a firm repurchases its stock in the open market, the shareholders who tender the stock are subject to capital gains taxes.
b. If you own 100 shares in a company's stock and the company's stock splits 2 for 1, you will own 200 shares in the company following the split.
c. Some dividend reinvestment plans increase the amount of equity capital available to the firm.
d. The Tax Code encourages companies to pay a large percentage of their net income in the form of dividends.
e. If your company has established a clientele of investors who prefer large dividends, the company is unlikely to adopt a residual dividend policy.
f. If a firm follows a residual dividend policy, holding all else constant, its dividend payout will tend to rise whenever the firm's investment opportunities improve.
Self-Test Problem (Solution Appears in Appendix A)
ST-1 Components Manufacturing Corporation (CMC) has an all-common-equity capital structure.
ALTERNATIVE DIVIDEND It has 200,000 shares of $2 par value common stock outstanding. When CMC's founder, who POLICIES • • • •
was also its research director and most successful inventor, retired unexpectedly to the South
Pacific in late 2002, CMC was left suddenly and permanently with materially lower growth expectations and relatively few attractive new investment opportunities. Unfortunately, there was no way to replace the founder's contributions to the firm. Previously, CMC found it necessary to plow back most of its earnings to finance growth, which averaged 12 percent per year. Future growth at a 5 percent rate is considered realistic, but that level would call for an increase in the dividend payout. Further, it now appears that new investment projects with at least the 14 percent rate of return required by CMC's stockholders (rs = 14%) would amount to only $800,000 for 2003 in comparison to a projected $2,000,000 of net income. If the existing 20 percent dividend payout were continued, retained earnings would be $1.6 million in 2003, but, as noted, investments that yield the 14 percent cost of capital would amount to only $800,000.
The one encouraging thing is that the high earnings from existing assets are expected to continue, and net income of $2 million is still expected for 2003. Given the dramatically changed circumstances, CMC's management is reviewing the firm's dividend policy.
a. Assuming that the acceptable 2003 investment projects would be financed entirely by earnings retained during the year, calculate DPS in 2003, assuming that CMC uses the residual dividend model.
b. What payout ratio does your answer to part a imply for 2003?
c. If a 60 percent payout ratio is maintained for the foreseeable future, what is your estimate of the present market price of the common stock? How does this compare with the market price that should have prevailed under the assumptions existing just before the news about the founder's retirement? If the two values of P0 are different, comment on why.
RESIDUAL DIVIDEND MODEL
EXTERNAL EQUITY FINANCING
RESIDUAL DIVIDEND POLICY
Axel Telecommunications has a target capital structure that consists of 70 percent debt and 30 percent equity. The company anticipates that its capital budget for the upcoming year will be $3,000,000. If Axel reports net income of $2,000,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio?
Gamma Medical's stock trades at $90 a share. The company is contemplating a 3-for-2 stock split. Assuming that the stock split will have no effect on the total market value of its equity, what will be the company's stock price following the stock split?
Northern Pacific Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by 40 percent with a $10 million investment in plant and machinery. The firm wants to maintain a 40 percent debt-to-total-assets ratio in its capital structure; it also wants to maintain its past dividend policy of distributing 45 percent of last year's net income. In 2002, net income was $5 million. How much external equity must Northern Pacific seek at the beginning of 2003 to expand capacity as desired?
Petersen Company has a capital budget of $1.2 million. The company wants to maintain a target capital structure which is 60 percent debt and 40 percent equity. The company forecasts that its net income this year will be $600,000. If the company follows a residual dividend policy, what will be its payout ratio?
The Wei Corporation expects next year's net income to be $15 million. The firm's debt ratio is currently 40 percent. Wei has $12 million of profitable investment opportunities, and it wishes to maintain its existing debt ratio. According to the residual dividend model, how large should Wei's dividend payout ratio be next year?
After a 5-for-1 stock split, the Strasburg Company paid a dividend of $0.75 per new share, which represents a 9 percent increase over last year's pre-split dividend. What was last year's dividend per share?
The Welch Company is considering three independent projects, each of which requires a $5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented below:
Project H (high risk): Project M (medium risk): Project L (low risk):
Cost of capital = 16%; IRR = 20% Cost of capital = 12%; IRR = 10% Cost of capital = 8%; IRR = 9%
Note that the projects' cost of capital varies because the projects have different levels of risk. The company's optimal capital structure calls for 50 percent debt and 50 percent common equity. Welch expects to have net income of $7,287,500. If Welch bases its dividends on the residual model, what will its payout ratio be?
In 2002 the Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 million. 2002 was a normal year, and for the past 10 years, earnings have grown at a constant rate of 10 percent. However, in 2003, earnings are expected to jump to $14.4 million, and the firm expects to have profitable investment opportunities of $8.4 million. It is predicted that Keenan will not be able to maintain the 2003 level of earnings growth—the high 2003 earnings level is attributable to an exceptionally profitable new product line introduced that year—and the company will return to its previous 10 percent growth rate. Keenan's target debt ratio is 40 percent.
a. Calculate Keenan's total dividends for 2003 if it follows each of the following policies:
(1) Its 2003 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.
(2) It continues the 2002 dividend payout ratio.
(3) It uses a pure residual dividend policy (40 percent of the $8.4 million investment is financed with debt).
(4) It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy.
b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed, but justify your answer.
c. Does a 2003 dividend of $9,000,000 seem reasonable in view of your answers to parts a and b? If not, should the dividend be higher or lower?
14-9 Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a A.LTERNATIVE DIVIDEND $3.00 dividend per share (DPS) for the past several years, and its shareholders expect the divi-pOLICIES dend to remain constant for the next several years. The company's target capital structure is 60 percent equity and 40 percent debt; it has 1,000,000 shares of common equity outstanding; and its net income is $8 million. The company forecasts that it would require $10 million to fund all of its profitable (that is, positive NPV) projects for the upcoming year.
a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget?
b. If Buena Terra follows the residual dividend model, what will be the company's dividend per share and payout ratio for the upcoming year?
c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will be available for the firm's capital budget?
d. Can the company maintain its current capital structure, maintain the $3.00 DPS, and maintain a $10 million capital budget without having to raise new common stock?
e. Suppose that Buena Terra's management is firmly opposed to cutting the dividend; that is, it wishes to maintain the $3.00 dividend for the next year. Also assume that the company was committed to funding all profitable projects, and was willing to issue more debt (along with the available retained earnings) to help finance the company's capital budget. Assume that the resulting change in capital structure has a minimal impact on the company's composite cost of capital, so that the capital budget remains at $10 million. What portion of this year's capital budget would have to be financed with debt?
f. Suppose once again that Buena Terra's management wants to maintain the $3.00 DPS. In addition, the company wants to maintain its target capital structure (60 percent equity, 40 percent debt), and maintain its $10 million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue in order to meet each of its objectives?
g. Now consider the case where Buena Terra's management wants to maintain the $3.00 DPS and its target capital structure, but it wants to avoid issuing new common stock. The company is willing to cut its capital budget in order to meet its other objectives. Assuming that the company's projects are divisible, what will be the company's capital budget for the next year?
h. What actions can a firm that follows the residual dividend policy take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?
14-10 Start with the partial model in the file Ch 14 P10 Build a Model.xls from the textbook's web
BUILD A MODIEL: sjte_ Rework Problem 14-9, parts a through g, using a spreadsheet model. R£SIDUAL D/V/DEND " " MODEL
Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous-casting process. SSC's founders, Donald Brown and Margo Valencia, had been employed in the re. „ search department of a major integrated-steel company, but when that company decided against using the new process (which Brown and Valencia had developed), they decided to strike out on their own. One advantage of the new process was that it required relatively little capital in comparison with the typical steel company, so Brown and Valencia have been able to avoid issuing See Ch 14 Show.pptand new stock, and thus they own all of the shares. However, SSC has now reached the stage where outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital structure of 60 percent equity and 40 percent debt. Therefore, Brown and Valencia have decided to take the company public. Until now, Brown and Valencia have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the firm, so dividend policy has not been an issue. However, before talking with potential outside investors, they must decide on a dividend policy.
Assume that you were recently hired by Arthur Adamson & Company (AA), a national consulting firm, which has been asked to help SSC prepare for its public offering. Martha Millon, the senior AA consultant in your group, has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions.
a. (1) What is meant by the term "dividend policy"?
(2) The terms "irrelevance," "bird-in-the-hand," and "tax preference" have been used to describe three major theories regarding the way dividend policy affects a firm's value. Explain what these terms mean, and briefly describe each theory.
(3) What do the three theories indicate regarding the actions management should take with respect to dividend policy?
(4) What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend policy?
b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects on dividend policy.
c. (1) Assume that SSC has an $800,000 capital budget planned for the coming year. You have determined that its present capital structure (60 percent equity and 40 percent debt) is optimal, and its net income is forecasted at $600,000. Use the residual dividend model approach to determine SSC's total dollar dividend and payout ratio. In the process, explain what the residual dividend model is. Then, explain what would happen if net income were forecasted at $400,000, or at $800,000.
(2) In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy?
(3) What are the advantages and disadvantages of the residual policy? (Hint: Don't neglect signaling and clientele effects.)
d. Describe the series of steps that most firms take in setting dividend policy in practice.
e. What are stock repurchases? Discuss the advantages and disadvantages of a firm's repurchasing its own shares.
f. What is a dividend reinvestment plan (DRIP), and how does it work?
g. What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits?
Lintner, John, "Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes," American Economic Review, May 1956, 97-113.
The effects of dividend policy on stock prices and capital costs have been examined by many researchers.
Hayes, Linda S., "Fresh Evidence That Dividends Don't Matter," Fortune, May 4, 1981, 351-354.
Lewellen, Wilbur G., Kenneth L. Stanley, Ronald C. Lease, and Gary G. Schlarbaum, "Some Direct Evidence on the Dividend Clientele Phenomenon," Journal of Finance, December 1978, 1385-1399.
Mukherjee, Tarun, and Larry M. Austin, "An Empirical Investigation of Small Bank Stock Valuation and Dividend Policy," Financial Management, Spring 1980, 27-31.
On stock dividends and stock splits, see
Baker, H. Kent, and Patricia L. Gallagher, "Management's View of Stock Splits," Financial Management, Summer 1980, 73-77.
Baker, H. Kent, Aaron L. Phillips, and Gary E. Powell, "The Stock Distribution Puzzle: A Synthesis of the Literature on Stock Splits and Stock Dividends," Financial Practice and Education, Spring/Summer 1995, 24-37.
McNichols, Maureen, and Ajay Dravid, "Stock Dividends, Stock Splits, and Signaling," Journal of Finance, July 1990, 857-879.
On repurchases, see
Denis, David J., "Defensive Changes in Corporate Payout Policy: Share Repurchases and Special Dividends," Journal of Finance, December 1990, 1433-1456.
Finnerty, Joseph E., "Corporate Stock Issue and Repurchase, Financial Management, Autumn 1975, 62-71.
Gay, Gerald D., Jayant R. Kale, and Thomas H. Noe, "Share Repurchase Mechanisms: A Comparative Analysis of Efficacy, Shareholder Wealth and Corporate Control Effects," Financial Management, Spring 1991, 44-59.
Klein, April, and James Rosenfeld, "The Impact of Targeted Share Repurchases on the Wealth of Non-Participating Shareholders," Journal of Financial Research, Summer 1988, 89-97.
Netter, Jeffry M., and Mark L. Mitchell, "Stock-Repurchase Announcements and Insider Transactions after the October 1987 Stock Market Crash," Financial Management, Autumn 1989, 84-96.
Pugh, William, and John S. Jahera, Jr., "Stock Repurchases and Excess Returns: An Empirical Examination," The Financial Review, February 1990, 127-142.
Stewart, Samuel S., Jr., "Should a Corporation Repurchase Its Own Stock?" Journal of Finance, June 1976, 911-921.
Wansley, James W., William R. Lane, and Salil Sarkar, "Managements' View on Share Repurchase and Tender Offer Premiums," Financial Management, Autumn 1989, 97-110.
Woolridge, J. Randall, and Donald R. Chambers, "Reverse Splits and Shareholder Wealth," Financial Management, Autumn 1983, 5-15.
For surveys of managers' views on dividend policy, see
Baker, H. Kent, Gail E. Farrelly, and Richard B. Edelman, "A Survey of Management Views on Dividend Policy," Financial Management, Autumn 1985, 78-84.
Pruitt, Stephen W., and Lawrence J. Gitman, "The Interactions between the Investment, Financing, and Dividend Decisions of Major U.S. Firms," Financial Review, August 1991, 409-430.
Asquith, Paul, and David W. Mullins, Jr., "Signalling with Dividends, Stock Repurchases, and Equity Issues," Fi-nancialManagement, Autumn 1986, 27-44.
Born, Jeffrey A., "Insider Ownership and Signals—Evidence from Dividend Initiation Announcement Effects," Financial Management, Spring 1988, 38-45.
Brennan, Michael J., and Anjan V Thakor, "Shareholder Preferences and Dividend Policy," Journal of Finance, September 1990, 993-1018.
Chang, Rosita P., and S. Ghon Rhee, "The Impact of Personal Taxes on Corporate Dividend Policy and Capital Structure Decisions," Financial Management, Summer 1990, 21-31.
DeAngelo, Harry, and Linda DeAngelo, "Dividend Policy and Financial Distress: An Empirical Investigation of Troubled NYSE Firms," Journal of Finance, December 1990, 1415-1432.
DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner, "Dividends and Losses," Journal of Finance, December 1992, 1837-1863.
Dempsey, Stephen J., and Gene Laber, "Effects of Agency and Transactions Costs on Dividend Payout Ratios: Further Evidence of the Agency-Transaction Cost Hypothesis," Journal of Financial Research, Winter 1992, 317321.
Fehrs, Donald H., Gary A. Benesh, and David R. Peterson, "Evidence of a Relation between Stock Price Reactions Around Cash Dividend Changes and Yields," Journal of FinancialResearch, Summer 1988, 111-123.
Ghosh, Chinmoy, and J. Randall Woolridge, "An Analysis of Shareholder Reaction to Dividend Cuts and Omissions," Journal of Financial Research, Winter 1988, 281-294.
Healy, Paul M., and Krishna G. Palepu, "How Investors Interpret Changes in Corporate Financial Policy," Journal of Applied Corporate Finance, Fall 1989, 59-64.
Impson, C. Michael, and Imre Karafiath, "A Note on the Stock Market Reaction to Dividend Announcements," The Financial Review, May 1992, 259-271.
Kale, Jayant R., and Thomas H. Noe, "Dividends, Uncertainty, and Underwriting Costs Under Asymmetric Information," Journal of Financial Research, Winter 1990, 265-277.
Manakyan, Herman, and Carolyn Carroll, "An Empirical Examination of the Existence of a Signaling Value Function for Dividends," Journal of Financial Research, Fall 1990, 201-210.
Peterson, David R., and Pamela P. Peterson, "A Further Understanding of Stock Distributions: The Case of Reverse Stock Splits," Journal of Financial Research, Fall 1992, 189-205.
Peterson, Pamela P., David R. Peterson, and Norman H. Moore, "The Adoption of New-Issue Dividend Reinvestment Plans and Shareholder Wealth," Financial Review, May 1987, 221-232.
Talmor, Eli, and Sheridan Titman, "Taxes and Dividend Policy," Financial Management, Summer 1990, 32-35.
Wansley, James W., C. F. Sirmans, James D. Shilling, and Young-jin Lee, "Dividend Change Announcement Effects and Earnings Volatility and Timing," Journal of Financial Research, Spring 1991, 37-49.
Woolridge, J. Randall, and Chinmoy Ghosh, "Dividend Cuts: Do They Always Signal Bad News?" Midland Corporate Finance Journal, Summer 1985, 20-32.
The following cases in the Cases in Financial Management series focus on the issues contained in this chapter:
Case 19, "Georgia Atlantic Company," Case 19A, "Floral Fragrance, Inc.," Case 19B, "Cook Transportation, Inc.," and Case 20, "Bessemer Steel Products, Inc.," which illustrate the dividend policy decision. Case 60, "Consolidated Electric," is a longer and more comprehensive case on dividend policy.
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