CHAPTER 17
Distributions to Shareholders:
Dividends and Repurchases
1
Topics in Chapter 17




Theories of investor preferences
Signaling effects
Residual model
Stock repurchases
2
What is “distribution policy”?

The distribution policy defines:



The level of cash distributions to
shareholders (how much)
The form of the distribution (dividend vs.
stock repurchase)
The stability of the distribution
3
Impact of dividends on stock
returns

Returns to shareholders:
dividends & capital gains.
The level of dividends might not affect the
total (pretax) return on stock: higher
dividends result in lower capital gains and
vice versa. However, dividend policy can
affect stock price if investors prefer a
particular policy.
4
Investor Preferences

Investor preferences should guide a
firm’s distribution policy. Investors pay
a higher price (and accept a lower
return) for the common stock of firms
whose dividend policies they prefer.
5
Theories of investor preferences
toward dividends



Bird-in-the-hand: Investors prefer a
high payout.
Tax preference: Investors prefer a low
payout, hence growth.
Dividends are irrelevant: Investors don’t
care about payout.
6
Bird-in-the-Hand Theory


Investors think dividends are less risky
than potential future capital gains,
hence they like dividends.
If true, investors prefer firms with high
payouts: high payout results in a high
stock price.
7
Tax Preference Theory


Low payouts mean higher capital gains.
Capital gains taxes are deferred.
As a result, investors prefer firms with
low payouts: low payout results in a
high stock price.
8
Dividend Irrelevance Theory

According to this theory, investors are
indifferent between dividends and retentiongenerated capital gains. If they want cash,
they can sell stock. If they don’t want cash,
they can reinvest dividends.
9
Implications of 3 Theories for
Dividends
Theory
Implication
Bird-in-hand
Set high payout
Tax preference
Set low payout
Irrelevance
Any payout OK
10
Which theory is most correct?


Empirical testing has not been able to
determine which theory, if any, is
correct.
Some investors prefer high dividends,
some prefer capital gains, and some
don’t care.
11
The clientele effect



Different investors 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.
12
The signaling hypothesis


A dividend increase is viewed as a
signal that management is optimistic
about the firm’s future.
Therefore, a stock price increase at
time of a dividend increase could reflect
higher expectations for future EPS, not
a desire for dividends.
13
The residual distribution
model



How much retained earnings are
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.
14
Advantages and Disadvantages of
the Residual Dividend Policy



Advantages: Minimizes new stock
issues and flotation costs.
Disadvantages: Dividends fluctuate as
earnings and investment opportunities
vary.
Conclusion: Consider residual policy
when setting target payout, but don’t
follow it rigidly.
15
Stock Repurchases


Repurchases: Buying firm’s own stock from
stockholders.
Reasons for repurchases:
 Alternative to cash dividends.
 Dispose of one-time cash from an asset
sale.
 To make a large capital structure change.
16
Advantages of Repurchases





Stockholders can tender or not.
Avoids 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
dividends (potential tax advantage).
Stockholders may take as a positive signal-management thinks stock is undervalued.
17
Setting Dividend Policy





Forecast capital needs over a planning
horizon, often 5 years.
Set 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.
18