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Howdividendpolicy companyvalue
Reading 13: Key Concepts Payoutpolicy
SCHWESERNOTES - BOOK 2 coverageratio
sharerepurchases EPs unify the
CA
LOS 13.a
1 see It
Cash dividend payments reduce cash as well as stockholders' equity. This results in a lower quick ratio and current ratio, and higher
leverage (e.g., debt-to-equity and debt-to-asset) ratios. Stock dividends (and stock splits) leave a company's capital structure unchanged
and do not a!ect any of these ratios. In the case of a stock dividend, a decrease in retained earnings (corresponding to the value of the
stock dividend) is o!set by an increase in contributed capital, leaving the value of total equity unchanged.
LOS 13.b
Following are the three theories of investor preference:
MM's dividend irrelevance theory holds that in a no-tax/no-fees world, dividend policy is irrelevant since it has no e!ect on the
EPS
encourager longterm
investing
price of a firm's stock or its cost of capital, because individual investors can create their own homemade dividend.
a
Dividend preference theory says investors prefer the certainty of current cash to future capital gains.
Tax aversion theory states that investors are tax averse to dividends and would prefer companies instead buy back shares,
especially when the tax rate on dividends is higher than the tax rate on capital gains.
LOS 13.c
adjustmarketprice
The signaling e!ect of dividend changes is based on the idea that dividends convey information about future earnings from
management to investors (who have less information about a firm's prospects than management). In general, unexpected increases are
good news and unexpected decreases are bad news as seen by U.S. investors.
LOS 13.d
Two types of agency costs a!ect dividend payout policies:
Agency conflict between shareholders and managers can be reduced by paying out a higher proportion of the firm's free cash flow
to equity so as to discourage investment in negative NPV projects.
Agency conflict between shareholders and bondholders occurs when shareholders can expropriate bondholder wealth by paying
themselves a large dividend (and leaving a lower asset base for outstanding bonds as collateral). Agency conflict between
bondholders and stockholders is typically resolved via provisions in bond indenture.
LOS 13.e
Six primary factors a!ect a company's dividend payout policy:
1. Investment opportunities: A!ect the residual income available to pay as dividends.
2. Expected volatility of future earnings: Firms are more cautious in changing dividend payout in the presence of high earnings
volatility. misalignment incentives of
overinvest
3. Financial flexibility: Firms may not increase dividends (even
ifrewardedbyfirmsize
in the presence of significant free cash flow) so as not to be forced to
continue paying those dividends in the future and losing financial flexibility. Instead, firms can choose to pay out excess cash via
stock repurchases.
4. Tax considerations: In the presence of di!erential tax rate on capital gains versus dividends, companies may structure their
dividend policy to maximize investors' after-tax income.
profile
5. Flotation costs: Flotation cost increases the cost of external equity as compared to retained risk
earnings. Hence, higher flotation cost
would motivate firms to have a lower dividend payout.
shareholderpaying themselves
6. Contractual and legal restrictions: Dividend divsfromriskydebt
policy may be a!ected by debt covenants that the firm has to adhere to. Legal
restrictions in some jurisdictions limit the dividend payout of a firm.
LOS 13.f
E!ective rate under double taxation = corporate tax rate + (1 − corporate tax rate) × (individual tax rate)
A split-rate system has di!erent corporate tax rates on retained earnings and earnings that are paid out in dividends (distributed
depends onsustainability earnings of
income). Under a split-rate system, e!ective tax rate is computed the same way as double taxation but we use the corporate tax rate for
distributed income as the relevant corporate tax rate in the double taxation formula.
Under a tax imputation system, taxes are paid at the corporate level but are used as credits by the stockholders. Hence, all taxes are
e!ectively paid at the shareholder's marginal tax rate.
costs
flotation
higher retained
use instead
earnings longdius
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Page 1 of 3
, LOS 13.g
Stable dividend policy: A company tries to align its dividend growth rate with the company's long-term earnings growth rate to provide a
steady dividend. A firm with a stable dividend policy could use a target payout adjustment model to gradually move toward its target
payout.
expected increase in dividends = [(expected earnings × target payout ratio) – previous dividend] × adjustment factor
where:
pagenetof
adjustment factor Corp rate =Personalrate
1 / number of years over which the adjustment in dividends will take place
Constant payout ratio: A company defines a proportion of earnings that it plans to pay out to shareholders regardless of volatility in
earnings (and consequently in dividends).
LOS 13.h
Global trends in corporate payout policies:
1. Globally, the proportion of companies paying current
cash dividends
target div div
has trended downward.
2. Stock repurchases have been trending upward ofyeartoadjust
noin the United States since the 1980s and in the United Kingdom and continental
Europe since the 1990s.
LOS 13.i
Share repurchase methods:
1. Open market transactions: The firm buys back its shares in the open market.
2. Fixed-price tender o!er: The firm buys a predetermined number of shares at a fixed price, typically at a premium over the current
market price.
3. Dutch auction: A tender o!er where the company specifies a range of prices rather than a fixed price. Bids are accepted (lowest
price first) until the desired quantity is filled. All accepted bids are then filled at the (higher) price of the last accepted bid.
4. Repurchase by direct negotiation: Purchasing shares from a major shareholder, often at a premium over market price. This
method may be used in a greenmail scenario, or when a company wants to remove a large overhang in the market.
LOS 13.j
Repurchases made using a company's surplus cash will lower cash and shareholders' equity and, therefore, increase the firm's leverage.
Earnings per share may increase because there will be fewer shares outstanding.
When the company uses debt to finance the repurchase, EPS will increase if the after-tax funding cost is less than the earnings yield.
However, the firm will then also have higher leverage and, therefore, a higher cost of capital, so an increase in EPS will not automatically
lead to an increase in share price or in shareholder wealth.
LOS 13.k
After a stock repurchase, the number of outstanding shares will decrease and the book value per share (BVPS) is likely to change as well.
If the price paid is higher (lower) than the pre-repurchase BVPS, the BVPS will decrease (increase).
LOS 13.l
proteasthiacy
There are five common rationales for share repurchases (versus dividends):
1. Potential tax advantages: When capital gains are taxed favorably as compared to dividends.
2. Share price support/signaling: Management wants to signal better prospects for the firm.
3. Added flexibility: Reduces the need for "sticky" dividends in the future.
4. O!set dilution from employee stock options.
5. Increase financial leverage by reducing equity in the balance sheet.
i
LOS 13.m
Dividend coverage ratio = net income / dividends
FCFE coverage ratio = FCFE / (dividends + share repurchases)
LOS 13.n
I
dependerelativetooldBUPS
For both dividend and FCFE coverage, ratios that are below industry averages or trending downward over time indicate problems for
dividend sustainability.
outstandingshares
4Sep's
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Page 2 of 3
Howdividendpolicy companyvalue
Reading 13: Key Concepts Payoutpolicy
SCHWESERNOTES - BOOK 2 coverageratio
sharerepurchases EPs unify the
CA
LOS 13.a
1 see It
Cash dividend payments reduce cash as well as stockholders' equity. This results in a lower quick ratio and current ratio, and higher
leverage (e.g., debt-to-equity and debt-to-asset) ratios. Stock dividends (and stock splits) leave a company's capital structure unchanged
and do not a!ect any of these ratios. In the case of a stock dividend, a decrease in retained earnings (corresponding to the value of the
stock dividend) is o!set by an increase in contributed capital, leaving the value of total equity unchanged.
LOS 13.b
Following are the three theories of investor preference:
MM's dividend irrelevance theory holds that in a no-tax/no-fees world, dividend policy is irrelevant since it has no e!ect on the
EPS
encourager longterm
investing
price of a firm's stock or its cost of capital, because individual investors can create their own homemade dividend.
a
Dividend preference theory says investors prefer the certainty of current cash to future capital gains.
Tax aversion theory states that investors are tax averse to dividends and would prefer companies instead buy back shares,
especially when the tax rate on dividends is higher than the tax rate on capital gains.
LOS 13.c
adjustmarketprice
The signaling e!ect of dividend changes is based on the idea that dividends convey information about future earnings from
management to investors (who have less information about a firm's prospects than management). In general, unexpected increases are
good news and unexpected decreases are bad news as seen by U.S. investors.
LOS 13.d
Two types of agency costs a!ect dividend payout policies:
Agency conflict between shareholders and managers can be reduced by paying out a higher proportion of the firm's free cash flow
to equity so as to discourage investment in negative NPV projects.
Agency conflict between shareholders and bondholders occurs when shareholders can expropriate bondholder wealth by paying
themselves a large dividend (and leaving a lower asset base for outstanding bonds as collateral). Agency conflict between
bondholders and stockholders is typically resolved via provisions in bond indenture.
LOS 13.e
Six primary factors a!ect a company's dividend payout policy:
1. Investment opportunities: A!ect the residual income available to pay as dividends.
2. Expected volatility of future earnings: Firms are more cautious in changing dividend payout in the presence of high earnings
volatility. misalignment incentives of
overinvest
3. Financial flexibility: Firms may not increase dividends (even
ifrewardedbyfirmsize
in the presence of significant free cash flow) so as not to be forced to
continue paying those dividends in the future and losing financial flexibility. Instead, firms can choose to pay out excess cash via
stock repurchases.
4. Tax considerations: In the presence of di!erential tax rate on capital gains versus dividends, companies may structure their
dividend policy to maximize investors' after-tax income.
profile
5. Flotation costs: Flotation cost increases the cost of external equity as compared to retained risk
earnings. Hence, higher flotation cost
would motivate firms to have a lower dividend payout.
shareholderpaying themselves
6. Contractual and legal restrictions: Dividend divsfromriskydebt
policy may be a!ected by debt covenants that the firm has to adhere to. Legal
restrictions in some jurisdictions limit the dividend payout of a firm.
LOS 13.f
E!ective rate under double taxation = corporate tax rate + (1 − corporate tax rate) × (individual tax rate)
A split-rate system has di!erent corporate tax rates on retained earnings and earnings that are paid out in dividends (distributed
depends onsustainability earnings of
income). Under a split-rate system, e!ective tax rate is computed the same way as double taxation but we use the corporate tax rate for
distributed income as the relevant corporate tax rate in the double taxation formula.
Under a tax imputation system, taxes are paid at the corporate level but are used as credits by the stockholders. Hence, all taxes are
e!ectively paid at the shareholder's marginal tax rate.
costs
flotation
higher retained
use instead
earnings longdius
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Page 1 of 3
, LOS 13.g
Stable dividend policy: A company tries to align its dividend growth rate with the company's long-term earnings growth rate to provide a
steady dividend. A firm with a stable dividend policy could use a target payout adjustment model to gradually move toward its target
payout.
expected increase in dividends = [(expected earnings × target payout ratio) – previous dividend] × adjustment factor
where:
pagenetof
adjustment factor Corp rate =Personalrate
1 / number of years over which the adjustment in dividends will take place
Constant payout ratio: A company defines a proportion of earnings that it plans to pay out to shareholders regardless of volatility in
earnings (and consequently in dividends).
LOS 13.h
Global trends in corporate payout policies:
1. Globally, the proportion of companies paying current
cash dividends
target div div
has trended downward.
2. Stock repurchases have been trending upward ofyeartoadjust
noin the United States since the 1980s and in the United Kingdom and continental
Europe since the 1990s.
LOS 13.i
Share repurchase methods:
1. Open market transactions: The firm buys back its shares in the open market.
2. Fixed-price tender o!er: The firm buys a predetermined number of shares at a fixed price, typically at a premium over the current
market price.
3. Dutch auction: A tender o!er where the company specifies a range of prices rather than a fixed price. Bids are accepted (lowest
price first) until the desired quantity is filled. All accepted bids are then filled at the (higher) price of the last accepted bid.
4. Repurchase by direct negotiation: Purchasing shares from a major shareholder, often at a premium over market price. This
method may be used in a greenmail scenario, or when a company wants to remove a large overhang in the market.
LOS 13.j
Repurchases made using a company's surplus cash will lower cash and shareholders' equity and, therefore, increase the firm's leverage.
Earnings per share may increase because there will be fewer shares outstanding.
When the company uses debt to finance the repurchase, EPS will increase if the after-tax funding cost is less than the earnings yield.
However, the firm will then also have higher leverage and, therefore, a higher cost of capital, so an increase in EPS will not automatically
lead to an increase in share price or in shareholder wealth.
LOS 13.k
After a stock repurchase, the number of outstanding shares will decrease and the book value per share (BVPS) is likely to change as well.
If the price paid is higher (lower) than the pre-repurchase BVPS, the BVPS will decrease (increase).
LOS 13.l
proteasthiacy
There are five common rationales for share repurchases (versus dividends):
1. Potential tax advantages: When capital gains are taxed favorably as compared to dividends.
2. Share price support/signaling: Management wants to signal better prospects for the firm.
3. Added flexibility: Reduces the need for "sticky" dividends in the future.
4. O!set dilution from employee stock options.
5. Increase financial leverage by reducing equity in the balance sheet.
i
LOS 13.m
Dividend coverage ratio = net income / dividends
FCFE coverage ratio = FCFE / (dividends + share repurchases)
LOS 13.n
I
dependerelativetooldBUPS
For both dividend and FCFE coverage, ratios that are below industry averages or trending downward over time indicate problems for
dividend sustainability.
outstandingshares
4Sep's
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Page 2 of 3
