Topic 9

Dividend Policy-Part II
I. Dividend Policy and Company Value
A. MM Irrelevancy Proposition
B. The Bird-in-the-Hand Argument
C. Agency Costs and Dividends
D. The Information Content of Dividend (Signaling)
E. The Clientele Effect
II. Factors Affecting the Payout Policies
A. Investment Opportunities
B. The Expected Volatility of Future Earnings
C. Financial Flexibility
D. Tax Consideration
E. Flotation Costs
F. Contractual and Legal Restrictions
III. Payout Policies
A. Stable Dividend Policy
B. Constant Payout Policy
C. Residual Dividend Policy
IV. The Dividend vs. Share Repurchase Decision
V. Analysis of Dividend Safety
VI. Dividend Policy Framework
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Topic 9
Dividend Policy-Part II
"Values there are determined solely by "real" considerations in this case the earning power of the firm's
assets and its investment policy and not by the fruits of the earning power are "packaged" for distribution."
-Miller and Modigliani

Dividend policy deals with the process and procedures that firms employ in the determination of

an appropriate dividend policy. Of major concern is how much of the firm’s earnings should be distributed

to the shareholders in the form of cash dividends or stock repurchases. Retained earnings and dividends are

alternative uses of available net income. In evaluating potential dividend policies, managers must also

consider its capital budgeting decisions and its capital structure decisions. The interaction of these three

decisions determines the value of the firm.

Capital structure decision, discussed in topics 7 and 8, is concerned with creating value through

altering the firm’s debt ratio. The dividend policy, on the other hand, is concerned with creating value

through cash dividend, stock repurchase, or reinvesting in the firm to spur growth.

The analysis of dividend policy tries to answer the following questions:

1. Does the dividend policy affect the value of the firm?

2. Why do companies pay dividends?

3. How much should the firm payback to shareholders in the form of cash dividend or stock repurchase?

Just like capital structure, we will analyze dividend policy under perfect capital market assumption to

answer the first question. After that, these assumptions are relaxed to answer questions 2 and 3.
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I. Dividend Policy and Company Value

A. MM Irrelevancy Proposition

• Franco Modigliani and Merton Miller (MM), 1961, showed that in a world with no taxes, transaction

costs, and information available to everybody-that is, under perfect capital market assumptions-

dividend policy should have no impact on the cost of capital or on shareholders’ wealth.

• MM assumed the following perfect capital market conditions:

1. No transaction costs for buying and selling securities.

2. Large number of buyers and sellers in the market.

3. Relevant information is costless and available to all investors.

4. All investors are rational in the sense that they prefer more wealth to less and indifferent if they

receive their wealth in the form cash payment or an increase in price.

5. There is no tax differential between dividends and capital gains.

• Under these assumptions, MM present the following model

o The return of a stock is

dt+1 + Pt+1 − Pt
(1) ρt =
Pt
o It can be rearranged to

dt+1 + Pt+1
(2) Pt =
1 + ρt

o Multiply by the current number of shares, nt :

Dt+1 + nt Pt+1
(3) Vt =
1 + ρt
o In a 100% equity financed firm, there are two major sources of funds: operating cash flows,

X t , and external equity given by mt+1 Pt+1, where mt+1 is the number of new shares.

o Therefore, the total number of share at t+1 is given by:

(4) nt+1 = nt + mt+1

(4′ ) nt = nt+1 − mt+1
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o By definition, sources and uses of funds must be equal. Therefore, we have the following
identity:

(5) X t+1 + mt+1 Pt+1 ≡ It+1 + Dt+1

(5′ ) Dt+1 ≡ X t+1 + mt+1 Pt+1 − It+1

o Substitute(4′ ) into equation (3) numerator:

(6) Dt+1 + nt+1 Pt+1 − mt+1 Pt+1

o Now, substitute (5′ ) into (6):

(7) X t+1 + mt+1 Pt+1 − It+1 + nt+1 Pt+1 − mt+1 Pt+1

o Equation(3) becomes:

X t+1 + nt+1 Pt+1 − It+1

(8) Vt =
1 + ρt

∵ Dividend does not appear in equation (8) as a determinant of value.

∴ Value is independent from dividends policy.

• In page 414 of their 1961 article, MM state that: "Values there are determined solely by "real"

considerations in this case the earning power of the firm's assets and its investment policy and not by

the fruits of the earning power are "packaged" for distribution."

• Investment determines firm value and dividend is simply the residual of investment and operating cash

flows. Therefore, payout policy is irrelevant from investors’ perspective because investors can create

“homemade” dividends. In other words, dividends irrelevancy theory is that dividend policy does not

affect the required rate of return on equity.

• To understand the MM dividends irrelevancy provision, consider a company with a given capital budget

(i.e. it accepted all the projects with positive NPV) and its operating with an optimal capital structure.

• If the company decided to pay out all its earnings as dividends, then the company could issue additional

shares to finance its capital budget. This financing will keep the capital structure unchanged.
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• The value of the newly issued shares would exactly offset the value of the dividend.

• Thus, if a company paid out a dividend that represent 5% of equity, its share price is expected to drop

by 5%.

• Intuitively, dividends irrelevancy follows from the concept of “homemade dividend.”

• Consider a stockholder who is holding 1,000 shares that are trading at $20 per share. His total wealth

is $20,000

• If the company distributes $1 cash dividend, then he will receive $1,000 in cash and the stock price will

drop to $19. His total wealth remains unchanged, $20,000 ($1,000+$19,000)

• Alternatively, the investor can achieve the same cash flow by selling 50 shares to get the $1,000. The

value of the remaining 950 shares is $19,000. Thus, the total wealth of the investor is $20,000.

• Since the investor can produce the same cash flow by himself, then there is not of value in paying

dividends.

B. The Bird-in-the-Hand Argument

• Benjamin Graham (1934), John Lintner (1962), and Myron Gordon (1963) argue that even under

perfect capital market assumptions, investors prefer a dollar of dividends to a dollar of potential capital

gain.

• A dollar of capital gain is riskier than a dollar of dividend. This argument is known as the “bird-in-the-

hand” argument because it is parallel to the proverb “A bird in the hand is worth two in the bush.”.

• By assuming that given an amount of dividends is less risky than the same amount of capital gain, the

argument is that a company pays dividends will have a lower cost of equity capital than an otherwise

similar company that does not pay dividends.

• The lower the cost of equity, the higher the stock price.

• However, the problem with this argument is that investors can achieve the same cash flow immediately

by selling some of the firm’s shares, as shown in the homemade dividends example.

• Therefore, the firm does not add value by paying altering dividend policy.
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C. Agency Costs and Dividends

• In large public corporations, there is a substantial separation between managers and shareholders.

• In such an environment, it is common that agents (the managers) and principals (the shareholders) face

an acute agency problem. Because managers have an incentive to maximize their own benefits at the

expense of the shareholders.

• Empirical evidence shows that CEOs of large corporations get higher pay. Thus, they have an incentive

to increase the size of the firm rather than the value of the firm.

• One managerial incentive of a particular concern is negative NPV projects.

• Managers may accept negative NPV projects because they increase the size of the firm, in terms of

sales or assets, while they generate negative economic value.

• This problem can be made less severe by reducing the cash in the hands of managers by the payment

of dividends.

• By paying out the FCFE to shareholders, managers will have less resources available to them and this

will restrain their ability to take negative NPV projects.

• Note that it makes sense for growing companies in industries characterized by rapid change to hold

cash and pay low or not dividends, but it does not make sense in large, mature, companies in relatively

noncyclical industries.

• In general, there is an empirical support for the market reaction to dividend changes announcements to

be stronger for companies with greater potential for over investment than for companies with less

potential for over investment.

• These findings suggest that dividend has an impact on the firm value through the reduction of agency

costs.

• If the company is financed with debt, there is another dimension to the problem.

• Paying dividends can increase the agency problem between equity and debt holders. When a company

has a risky debt, the payment of dividends reduces the cash cushion available to pay the debt holders.
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• In this case, paying large cash dividend will lead to an underinvestment problem and wealth will be

transferred from debt holders to equity holders.

• This issue can be mitigated by including a covenant in the bond indenture that limits the distribution of

dividends.

• Some covenants specify the dividend payout ratio or minimum levels of EBITDA and/or EBIT

coverage of interest charges.

• Other covenants focus on balance sheet strength, for example, by specifying a maximum value for the

ratio of debt ratio or debt to fixed assets.

D. The Information Content of Dividend (Signaling)

• MM (1961, page 430) suggest that empirical evidence documenting the influence of dividend policy

on stock price may be due to the fact that dividends changes contain informational content regarding

the firm’s future earnings prospects.

• Thus, changes in dividend payments represent a signal to investors concerning the future earnings and

cash flows of the company.

• For a signal to exist, there must a cost for the signal that cannot be mimicked by other entities that do

not have the same attributes. Therefore, the question that arise is: what is the cost of paying dividends?

• When a firm pays dividends, it incurs transactions costs and it may seek external financing to pursue

future investments (Bhattacharaya, 1979).

• Miller and Rock (1985) suggest that high-quality firms will increase dividends to the level that it might

reduce investments to show the quality of their firm. This signal cannot be mimicked by low-quality

firms.

• These models make the following empirical predictions:

1. Dividend changes should be followed by subsequent earnings changing in the same direction.

2. Unanticipated dividend changes should be accompanied by stock-price changes in the same

direction
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3. Unanticipated changes in dividends should be followed by revisions in the market’s expectations

of future earnings in the same direction as the dividend change.

• Healy and Palepu (1988) show that firm initiating (omitting) dividend have positive (negative) earnings

changes for at least one year before and the year of the dividend policy changes. Also, the study shows

that the stock price reacts positively (negatively) to dividend initiation (omission). These findings are

consistent with the signaling models.

• These findings suggest that dividend announcements can help to resolve some information asymmetry

between insiders and outsiders, which in turn will help to reduce securities mispricing.

• Many companies take pride in their record of consistently increasing dividends over a long period of

time.

• Standard &Poor’s identifies “Dividend Aristocrats”, which are companies with a record of increasing

dividends in consecutive years. The number of years ranges between 5 to 25 years.

• Examples of these companies: Procter & Gamble, Nestle, Wal-Mart, and Exxon Mobil.

• Companies that consistently increase their dividends seem to share certain characteristics:

o Dominant or niche position in their industry.

o Global operations

o Relatively high ROA

o Relatively low debt ratio

• These factors, clearly, indicate strong financial health.

• However, dividend initiation and omission, however, should be analyzed with caution.

• For many companies that are in financial stress, dividend cut is viewed as a positive rather than a

negative signal.

• For example, in 2009 J.P. Morgan cut its quarterly dividend from 38 cents to 5 cents per share. The

stock price increased because of the dividend cut because the market received this action as the firm is

increasing its cash balances to face the coming recession.

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• Another example is the Microsoft 2003 dividend initiation. Most technology companies have high R&D

requirements and some are capital intensive. In addition, they have high business risk because of the

rapid changes in the product landscape.

• These conditions suggest a policy with no or low dividend payout, so the internally generated funds are

directed towards products development to maintain competitive position and above average returns.

• When Microsoft announced its dividend on July 20, 2004, the stock price increased by 3%. However,

two days later when the company announced its quarterly earnings, the stock price fell back to where

it had been before the dividend announcement because the earnings fell short of expectations.

• This story tells about the information effect of the dividend initiation announcement on setting market

expectation.

E. The Clientele Effect

• For broadly-held firms, dividend policies attract investor groups with preferences for those payout

policies.

• Thus, the clientele effect theory of dividends suggests that maintaining a steady policy will account for

the preferences of a firm's stockholders.

• In other words, high payout firms will attract investors desiring high dividend yields while low payout

firms will appeal to shareholders that prefer earnings retention and greater price appreciation.

II. Factors Affecting the Payout Policies

• Board of directors and mangers spend considerable time setting dividend policy despite the lack of

clear guidance from finance theory.

• However, there are several factors that are often cited as relevant to dividend policy selection in

practice. These factors are: 1) investment opportunities, 2) the expected volatility of earnings, 3)

financial flexibility, 4) tax consideration, 5) flotation costs, and 6) contractual and legal restrictions.

• These factors are interrelated and the increase of one factor may diminish another.
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A. Investment Opportunities

• A company with many investment opportunities will tend to pay less dividend than a company with

fewer opportunities because the former has more used to internally generated cash flows.

• The speed by which a company needs to respond to investment opportunities is influenced by the

industry in which the company operates.

• A company with the ability to delay the initiation of projects without penalty may be willing to pay out

more in dividends than a company that needs to act immediately.

• For example, technology companies pay low dividends because having internally generated funds

available to act on profitable projects is essential to the company survival.

• For utility companies, on the other hand, there typically fewer such opportunities and for which change

is much slower, higher dividend payouts are observed.

B. The Expected Volatility of Future Earnings

• Since cutting dividends is viewed negatively by the market, managers are very reluctant to cut dividends

and they tend to smooth dividends.1

• Therefore, the greater the volatility of the earnings, the greater the risk that a given dividend increase

cannot be sustained.

• Thus, when earnings are volatile, we expect companies to be more cautious in the size and frequency

of dividend increases.

C. Financial Flexibility

• In 2009, GE announced that it will reduce its dividend payment from $0.31 to $0.10. This was the first

dividend cut in the previous 71 years. GE Chairman Jeffery Immlet stated:

“We made the decision to cut the dividend because it is a prudent measure to further enhance our
balance sheet and provide us with flexibility for potential future opportunities. It is the right,
precautionary action to keep the company safe and secure in the difficult operating environment
we see today. We believe it further strengthens our Company for the long-term, while still
providing attractive dividend.”

1
This behavior is confirmed in a survey conducted by Brav et al. (2005)
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• This example shows that companies may reduce or omit dividends to obtain the financial

flexibility associated with having substantial cash.

• A company with substantial cash holdings is in a relatively strong position to meet unexpected

operating needs and to exploit investment opportunities with minimum delays.

• Financial flexibility can be important in times of limited access to credit and during economic

contractions.

• When financial flexibility is important, companies may decide to distribute money to shareholders

through stock repurchases.

• Stock repurchases, as you recall from the previous topic, do not involve a commitment to be fully

executed. In addition, stock repurchases do not establish the same expectations about dividend

continuation.

D. Tax Considerations

• Different countries tax corporate dividend in a wide variety of ways. Some tax both capital gain

and dividend income. Others tax dividends or capital gains.

• There are three main taxation methods: double taxation, split-rate and imputation.

• The double taxation method. In this system, corporate earnings are taxed at the corporate level

regardless of whether they are distributed as dividends or not. If they are distributed as dividends,

they are taxed again at the shareholders’ level.

• The effective tax rate under the double taxation method is given by:

Effective Tax Rate = Tc + (1 − Tc )(TP )

• The split-rate tax system. This system taxes corporate earnings at the corporate level, then they

are taxed at the shareholders’ level but at a lower rate.

• The effective tax rate is calculated using the same formula as the double taxation method.
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• The dividend imputation tax system. Under this system, a corporation’s earnings are first taxed at

the corporate level. When those earnings are distributed as dividends, shareholders receive a tax

credit if his tax bracket is lower than the corporate tax rate.

• However, if the tax rate of the investor is higher than the corporate tax rate, he pays the difference

between the two rates.

• Under this system, the effective tax rate is equal to the individual tax rate.

• The following example shows the calculation of the effective tax rate under each system.

Example: The Effective Tax Rate Under Taxation Systems

Case1: A Company earns $300 and pays the whole amount as annual dividends. The corporate tax rate is 35%.
Calculate the effective tax rate assuming 35% tax rate on dividend income.

Earnings $300
Tax @ 35% -105
Dividends (100% payout) 195
Tax on Dividends @ 35% -68.25
After-tax dividend to investor 126.75

300 − 126.75
The effective tax rate = = 57.75%
300
Alternatively:

Effective Tax Rate = Tc + (1 − Tc )(TP ) = 0.35 + (1 − 0.35)(0.35) = 57.75%

Case2: the tax rate on the dividend is 15%.

Earnings $300
Tax @ 35% -105
Dividends (100% payout) 195
Tax on Dividends @ 15% -29.25
After-tax dividend to investor 165.75

Effective Tax Rate = Tc + (1 − Tc )(TP ) = 0.35 + (1 − 0.35)(0.15) = 44.75%

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Example: The Effective Tax Rate Under Taxation Systems, Cont’d

Case3: If two investors, investor 1 and investor 2, hold the stock and their personal tax rates are 30% and 40%,
respectively. Calculate the effective tax rate if these investors are taxed under the imputation tax system.

Investor 1 Investor 2
Pretax Income $300 Pretax Income $300
Tax @ 35% -90 Tax @ 35% -105
NI After Tax $210 NI After Tax $195
Dividends (100% payout) $210 Dividends (100% payout) 195
Shareholder Taxes $45 Shareholder Taxes $120
Less Tax Credit for Coproate Payment -90 Less Tax Credit for Coproate Payment -105
Tax Due from Shareholder -45 Tax Due from Shareholder 15

Since the investors are taxed under the imputation tax system, then they will receive a tax return equal to the
corporate tax rate. Therefore, their effective tax rates are 20% and 40%, respectively.

E. Flotations Costs

• Flotation costs include the fees that the company pays to go public and the possible decline in the

market price that results from raising equity.

• Aggregate flotation costs are higher (as a percentage from the total proceeds) for smaller

companies than for larger companies.

• Flotation costs make it expensive for companies to raise new equity capital than to use their own

internally generated funds.

• As a result, many companies try to avoid paying a level of dividend that create the need to raise

new equity to finance positive NPV projects.

F. Contractual and Legal Restrictions

• Generally, there are three types of regulations on the payment of dividends by firms:

1. The capital impairment restriction stipulates that dividends cannot be paid out of capital. Capital

is typically defined as either the common stock account or that account together with other

contributed capital in excess of the par value of the common stock.

2. The net earnings restriction stipulates that dividends must be paid only out of present and past net

earnings.
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3. The insolvency restriction states that dividends cannot be paid when a firm is insolvent, when the

firm's liabilities exceed its assets. This is to protect the creditors of the firm.

• Restrictive covenants in bond indentures, loan agreements, lease contracts, and preferred stock

agreements may prohibit or limit dividend payments.

III. Payout Policies

• A dividend policy is the strategy that a company follows to determine the amount and timing of dividend

payments.

• There are three main dividend policies: 1) stable dividend policy, 2) constant dividend payout policy,

and 3) residual dividend policy.

A. Stable Dividend Policy

• This dividend policy is the most common. Companies that use a stable dividend policy base their

dividend payout on a long-term forecast of sustainable earnings and increase dividends when earnings

have increases to sustainably high level.

• Thus, if the path to long-term sustainable earnings is expected to be a slow growth, the dividends would

be expected to grow slowly over time, almost independently from the spikes in earnings.

• If sustainable earnings were not expected to grow over time, the corresponding dividends would be

level (i.e. not growing).

• A stable dividend policy typically involves low uncertainty for shareholders about the level of future

dividend.

• Table 9.1 shows the dividend paid by a company that follows a stable dividend policy.

Table 9.1
Year EPS DPS ΔDPS DPO Growth
2011 $2.20 $0.78 35%
2012 $3.75 $0.92 $0.14 25% 18%
2013 $2.82 $1.12 $0.20 40% 22%
2014 $3.69 $1.37 $0.25 37% 22%
2015 $0.68 $1.50 $0.13 221% 9%
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• As the table shows, dividends is increasing steadily over the years even while earnings declined

significantly in 2015. This indicates that the company believes that this drop is only temporal and

earnings are expected to grow in the future.

• A stable dividend policy can be modeled as a process of gradual adjustment towards a target payout

ratio based on long-term sustainable earnings.

• A target payout ratio is a goal that represents the proportion of earnings that the company intent to pay

to shareholders as dividends over the long term.

• The target payout adjustment model can be used to understand the stable payout policy.2 The model

reflects three basic conclusions about dividend:

1. Companies have a target payout ratio, based on long-term sustainable earnings

2. Managers are more concerned with dividend changes than the level of dividend
3. Companies will cut or eliminate dividend only in extreme circumstances or as last resort.
• Consider a company with payout ratio that is below the target payout ratio and earnings are expected

to increase.

• The expected increase in the dividend can be estimated as the product of three quantities:

1. The expected increase in earnings next year.

2. The target payout ratio.

3. An adjustment factor.

The adjustment factor is one divided by the number of years over which the company will reach the

target payout ratio.

The Expected Increase in Dividend=

Expected Increase in Earnings × Target Payout Ratio × Adjustment Factor
• The expected dividend is:
Expected Dividend= Last Dividend + Expected Increase in Dividend

2
The model is developed by John Lintner (1956).
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Example: Stable Dividend Policy-Target Payout Adjustment Model

Last year NMS reported $2 and paid dividend of $0.4. For this year, the company is expecting to earn $2.8. The
company is expecting to reach a target payout ratio of 30% over 5 years. What is the expected dividend for the
current year? What is the expected percentage increase in dividend compared to earnings?

Solution

Expected Dividend=

Last Dividend + ( Expected Increase in Earnings × Target Payout Ratio × Adjustment Factor )

1
= $0.4 + (($2.8 − $2.0) × 30% × ) = $0.45
5
Earnings are expected to increase by 40% while dividend is expected to increase by 12.5%

B. Constant Payout Dividend 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 dividend, and the amount of those dividends would vary

directly with earnings.

• This policy is rarely used in practice.

• Table 9.2 shows the dividend payout of a company that follows a constant payout dividend policy.

Table 9.2
Quarter EPS ($) DPS ($) %
Q1-2015 1.20 0.48 40.0%
Q2-2015 1.80 0.72 40.0%
Q3-2015 2.20 0.88 40.0%
Q4-2015 1.40 0.56 40.0%
Q1-2016 1.55 0.62 40.0%
Q2-2016 2.00 0.80 40.0%
Q3-2016 2.15 0.86 40.0%
Q4-2016 1.98 0.79 40.0%
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• With this type of policy, dividends fluctuate with earnings. Thus, this policy is infrequently adopted in

practice.

C. Residual Dividend Policy

• In the residual dividend model, dividends are based on earnings minus funds the firm retains to finance

the equity portion of its capital budget.

• The model is based on:

o The investment opportunity schedule (IOS)

o The target capital structure

o The access and the cost of external capital

• To apply the residual dividend model, the following steps are followed:

1. Identify the optimal capital budget.

2. Determine the amount of equity needed to finance that capital budget for a given capital

structure.

3. Meet the equity requirements to the maximum extent possible with retained earnings.

4. Pay dividend with the “residual” earnings that are available after the needs of the optimal

capital budget are met.

• This model allows management to pursue profitable investment opportunities without being

constrained by dividend consideration.

• However, if a firm follows the residual dividend policy, its dividend payment may be unstable because

investment opportunities and earnings often vary from year to year. This means that dividends will

fluctuate if a firm strictly adheres to residual dividend policy.

• The distribution under residual dividend model is:

Distribution = NI − (Target Equity Ratio × Optimal Capital Budget)

Capital budgeting and capital structure and

dividends policy know the diffrence
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Example: The Residual Dividend Policy

Witten Company has $1,000 in earnings and its target debt to ratio is 0.33. This implies a capital structure of one-
third debt and two-thirds equity. The optimal capital budget of the company this year is $900.

Calculate the distribution if the company follows the residual dividend policy.

Solution:

The amount of equity in the capital budget will be financed with:

2
× $900 = $600
3
This amount of net income will go to finance the projects with positive NPV.

∴ The funds available to distribution are: $1,000 - $600=$400

IV. The Dividend vs. Share Repurchase Decision

• Theory suggests that dividend-share repurchase decision generally concludes that share repurchases are

equivalent to cash dividends of equal amount in their effect on shareholders’ wealth, CP.

• In the absence of taxes and other market imperfections, share repurchases are equivalent to cash

dividend.

Dividend and Stock Repurchases

NMS company has announced that the earnings available to common shareholders are $ 1 million. The number
of common shares outstanding is 400,000. The EPS of NMS is $2.5 (1,000/400). The market price per share is
$50 and the P/E is 20.

The firm is considering distributing $800,000 as cash dividends or repurchase shares.

A. Cash Dividends

If cash dividends are paid, the amount will be $2 per share ($800,000/400,000)

B. Repurchase Shares

If the pays $52 per share to repurchase stocks, it could repurchase 15,385 shares ($800,000/$52). Because of the
repurchase, outstanding shares reduce to 384,615 and EPS to rise to $2.6 ($1 million/384,615).

If the stock still sold at 20× earnings, its market price would rise to $52.

Result: In both cases stockholders receive $2 per share.

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• If buying back shares have the same impact as cash dividends on shareholders’ wealth, then why

companies choose to repurchase shares rather than paying cash dividends?

• There are five common rationales for choosing share repurchases over cash 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 to signal to the market that

the company views its own stock as a good investment (undervalued). This tactic is often used when a

share price is declining and management want to convey confidence in the company’s future to

investors.

3. Added flexibility. A company could declare cash dividend and periodically repurchase shares as a

supplement to the dividend. Unlike dividends, share repurchases are not long-term commitment. Since

paying cash dividend and repurchasing are economically equivalent, a company could declare a small

stable dividend and then repurchase shares with the company’s leftover earnings to effectively

implement a residual dividend policy without the negative impact of a fluctuating dividends.

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 by decreasing the percentage of equity (perhaps to move towards and

optimal capital structure).

V. Analysis of Dividend Safety

• The analysis of dividend safety is concerned with the evaluation of the probability of dividends

continuing at the current rate for a company.

• The dividend coverage ratio which is the reciprocal of the DPO.

NI project
Dividend Coverage Ratio =
Div
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• A higher than normal dividend payout ratio (and 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 a company operates.

• Another ratio considers FCFE. That is the FCFE coverage ratio.

FCFE
FCFE Coverage Ratio = project
Dividend + Share Repurchases

• Note that unlike dividend payout ratio, the FCFE coverage ratio considers not only dividends but also

share repurchases.

• A FCFE coverage ratio significantly less than one is considered unsustainable. In such as case, the

company is drawing down its cash reserves for dividends/repurchases.

Example: Analysis of Dividend Safety

An analyst in Dodd Investment company is analyzing the dividend safety of Brees Oil Company. He is provided
with the following data:

2014 2015
NI $12,500 $14,800
FCFE $10,300 $3,250
Dividend paid $5,200 $5,200
Stock Repurchases $800 $1,800

Use the information provided to calculate the: DPO, dividend coverage ratio, and the FCFE coverage ratio in
2015.

Solution

Div $5,200
DPO = = = 35%
NI $14,800
NI $14,800
Dividend Coverage Ratio = = = 2.8
Div $5,200

FCFE $3,250
FCFE Coverage Ratio = = = 0.46
Dividend + Share Repurchases $5200 + $1,800
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VII. Dividend Policy Framework

• The following flow chart provides an analytical framework to analyze dividend policy.

How much did the firm pay out? How much could it have afforded to pay out?
What it is paid out: Dividends + Equity Repurchase
What it could have paid out: FCFE

Firms pays out too little Firm pays out too much

FCFE > Dividends + Repurchases FCFE < Dividends + Repurchases

Do you trust managers in the company What investment opportunities does

with your cash? the firm have?
Look at past project choice: Look at past project choice:
Compare: ROIC to WACC Compare: ROIC to WACC
ROIC to WACC ROIC to WACC

Firm has history of Firm has history of Firm has good Firms has poor
good project choice poor project choice project projects
and good projects
in the future
Firm should cut Firm should deal with
dividends and its investment problem
Give managers the Force managers to
reinvest more first and then cut
flexibility to keep cash justify holding cash or
dividends
and set dividends return cash to
stockholders
 21

Useful Formulas to Remember

Effective Tax Rate = Tc + (1 − Tc )(TP )

The Expected Increase in Dividend=

Expected Increase in Earnings × Target Payout Ratio × Adjustment Factor

Expected Dividend= Last Dividend + Expected Increase in Dividend

Distribution = NI − (Target Equity Ratio × Optimal Capital Budget)

NI
Dividend Coverage Ratio =
Div

FCFE
FCFE Coverage Ratio =
Dividend + Share Repurchases
22
 23

Practice Problems
Q1: Skip &Shannon Inc and First Take Com are the leading producers of football supplies in Corporate
Finance Land. Both companies’ earnings are shown in the following table:

Skip & Shannon

Year 2017 2018 2019 2020 2021 2022 2023
EPS ($) 2.5 3.2 4.1 1.3 2.2 1.6 1.8

First Take
Year 2017 2018 2019 2020 2021 2022 2023
EPS ($) 1.65 1.94 1.73 1.58 1.81 1.99 2.05

The CFOs of both companies are setting the payout policy. Both managers want to set a stable dividend
policy. Which CFO is more likely to be concerned with the expected volatility of earnings in setting the
dividend policy of his firm? Show all your work.
Q2: Elaph, Inc. is in the process of determining its optimal capital budget for next year. The following
investment projects are under consideration:

Required Expected Rate

Project Investment of Return
A $2 million 20.0%
B 3 million 15.0
C 1 million 13.5
D 4 million 13.0
E 1 million 12.5
F 3 million 12.0
G 5 million 11.5

The firm's marginal cost of capital schedule is as follows:

Amount of
Funds Raised Cost
$0 - $6 million 12.0%
$6 million - $12 million 12.5%
$12 million - $18 million 13.5%
Over $18 million 15.0%

• The company’s target capital structure is 40% debt and 60% equity.
• The company’s net income is $10 million.
If the manager will follow a residual dividend policy, what is the company’s DPO?

Answers to Selected Problems

Q1: Skip &Shannon is more likely to be concerned.

Q2: DPO = 34%