CHAPTER 18

Distributions to Shareholders:
Dividends and Repurchases

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Topics in Chapter
 Theories of investor preferences
 Signaling effects
 Residual model
 Stock repurchases
 Stock dividends and stock splits
 Dividend reinvestment plans

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What is “distribution policy”?
 The distribution policy defines:
 The level of cash distributions to
shareholders
 The form of the distribution (dividend vs.
stock repurchase)
 The stability of the distribution

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Dividend Yields for Selected
Industries
Industry Div. Yield %
Major Airlines 0.0
Biotechnology 0.1
Software 1.0
Chemicals 2.9
Food 3.0
Electric Utilities 3.4
Banks 3.6
Tobacco 5.5
Source: Yahoo Industry Data 4
Do investors prefer high or low
payouts? There are three theories:
 Dividends are irrelevant: Investors don’t
care about payout.
 Bird-in-the-hand: Investors prefer a
high payout.
 Tax preference: Investors prefer a low
payout, hence growth.

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Dividend Irrelevance Theory
 Investors 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.
 Modigliani-Miller support irrelevance.
 Theory is based on unrealistic assumptions
(no taxes or brokerage costs), hence may not
be true. Need empirical test.
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Bird-in-the-Hand Theory
 Investors think dividends are less risky
than potential future capital gains,
hence they like dividends.
 If so, investors would value high payout
firms more highly, i.e., a high payout
would result in a high stock price.

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Tax Preference Theory
 Low payouts mean higher capital gains.
Capital gains taxes are deferred.
 This could cause investors to prefer
firms with low payouts, i.e., a high
payout results in a low stock price.

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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

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Which theory is most correct?
 Empirical testing has not been able to
determine which theory, if any, is
correct.
 Thus, managers use judgment when
setting policy.
 Analysis is used, but it must be applied
with judgment.

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What’s the “clientele effect”?
 Different groups of investors, or clienteles,
prefer different dividend policies.
 Firm’s past dividend policy determines its
current clientele of investors.
 Clientele effects impede changing dividend
policy. Taxes & brokerage costs hurt
investors who have to switch companies due
to a change in payout policy.

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What’s the “information content,”
or “signaling,” hypothesis?
 Investors view dividend changes as signals of
management’s view of the future. Managers
hate to cut dividends, so won’t raise
dividends unless they think raise is
sustainable.
 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 “residual
distribution model”?
 Find the reinvested earnings needed for
the capital budget.
 Pay out any leftover earnings (the
residual) as either dividends or stock
repurchases.
 This policy minimizes flotation and equity
signaling costs, hence minimizes the
WACC.
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Using the Residual Model to
Calculate Distributions Paid

Net
Distr. = income–
[( )( )]
Target
equity
ratio
Total
capital .
budget

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Data for SSC
 Capital budget: $800,000. Given.
 Target capital structure: 40% debt,
60% equity. Want to maintain.
 Forecasted net income: $600,000.
 If all distributions are in the form of
dividends, how 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. So
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?

 NI = $400,000: Need $480,000 of

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Investment Opportunities and
Residual Dividends
 Fewer good investments would lead to
smaller capital budget, hence to a
higher dividend payout.
 More good investments would lead to a
lower dividend payout.

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Advantages and Disadvantages of
the Residual Dividend Policy
 Advantages: Minimizes new stock issues and
flotation costs.
 Disadvantages: Results in variable dividends,
sends conflicting signals, increases risk, and
doesn’t appeal to any specific clientele.
 Conclusion: Consider residual policy when
setting target payout, but don’t follow it
rigidly.

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Stock Repurchases
 Repurchases: Buying own stock back from
stockholders.

 Reasons for repurchases:

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Advantages of Repurchases
 Stockholders can tender or not.
 Helps avoid setting a high dividend that
cannot be maintained.
 Repurchased stock can be used in takeovers
or resold to raise cash as needed.
 Income received is capital gains rather than
higher-taxed dividends.
 Stockholders may take as a positive signal--
management thinks stock is undervalued.

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Disadvantages of Repurchases
 May be viewed as a negative signal (firm has
poor investment opportunities).
 IRS could impose penalties if repurchases
were primarily to avoid taxes on dividends.
 Selling stockholders may not be well
informed, hence be treated unfairly.
 Firm may have to bid up price to complete
purchase, thus paying too much for its own
stock.

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Setting Dividend Policy
 Forecast capital needs over a planning
horizon, often 5 years.
 Set a target capital structure.
 Estimate annual equity needs.
 Set target payout based on the residual
model.
 Generally, some dividend growth rate
emerges. Maintain target growth rate if
possible, varying capital structure somewhat
if necessary.

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Stock Dividends vs. Stock
Splits
 Stock dividend: Firm issues new shares
in lieu of paying a cash dividend. If
10%, get 10 shares for each 100 shares
owned.
 Stock 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 should a firm consider
splitting its stock?
 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 the optimal range.
 Stock splits generally occur when
management is confident, so are
interpreted as positive signals.
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What’s a “dividend reinvestment
plan (DRIP)”?
 Shareholders can automatically reinvest
their dividends in shares of the
company’s common stock. Get more
stock than cash.
 There are two types of plans:
 Open market
 New stock

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Open Market Purchase Plan
 Dollars to be reinvested are turned over
to trustee, who buys shares on the
open market.
 Brokerage costs are reduced by volume
purchases.
 Convenient, easy way to invest, thus
useful for investors.

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New Stock Plan
 Firm issues new stock to DRIP
enrollees, keeps money and uses it to
buy assets.
 No 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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