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CHAPTER 18
Distributions to Shareholders:
Dividends and Repurchases

 Theories of investor preferences

 Signaling effects
 Residual model
 Stock repurchases
 Stock dividends and stock splits
 Dividend reinvestment plans
 Free Cash Flow: Distributions
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to Shareholders
Sales revenues

− Operating costs and taxes

− Required investments in operating capital

Free
Freecash
cashflow
flow = Sources
(FCF)
(FCF)

Uses

Interest
Principal Stock
Stock Purchase of
payments Dividends
Dividends short-term
repayments repurchases
repurchases
(after tax) investments
2
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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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Definitions

Distribution ratio
The percentage of net income
distributed to shareholders through cash
dividends or stock repurchases
Payout ratio
The percentage of net income paid as a
cash dividend.
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Dividend Payment procedures

 Dividends are normally paid quarterly

1. Declaration date.
2. Holder-of-record date
3. Ex-dividend date.
4. Payment date
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The Procedures of a Dividend
Payment: An Example
November 11: Board declares a quarterly
dividend of $0.50 per share to holders of
record as of December 10.
December 7: Dividend goes with stock.
December 8: Ex-dividend date.
December 10: Holder of record date.
December 31: Payment date to holders of
record.

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Stock Repurchase Procedures

 Stock repurchases occur when a company
buys back some of its own outstanding stock
 Stock repurchases are usually made in one of
three ways.
1. Through a broker on the open market.
2. Through a tender offer.
3. The firm can purchase a block of shares
from one large holder on a negotiated basis

7
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Patterns of Cash Distributions
Over Time
 Total cash distributions of net income have
remained stable at around 26%-28%.
 Dividend payout rates have fallen, stock
repurchases have increased.
 Repurchases now total more dollars in
distributions than dividends.
 A smaller percentage of companies now pay
dividends. When young companies first begin
making distributions, it is usually in the form of
repurchases.
 Dividend payouts have become more concentrated
in a smaller number of large, mature firms.
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Dividend Yields for Selected Industries

Industry Div. Yield %
Airline 0.2
Software & Programming 0.3
Biotechnology & Drugs 0.3
Restaurants 1.0
Chemical Manufacturing 2.2
Paper & Paper Products 2.7
Electric Utilities 4.4
Tobacco 5.6
Source: Yahoo Industry Data
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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.
 Implies payout policy has no effect on
stock value or the required return on
stock.
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Dividend Irrelevance Theory

 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 and are willing to
accept a lower required return on equity.
 Also, high payouts help reduce agency
costs by depriving managers of cash to
waste and causing managers to have more
scrutiny by going to the external capital
markets more often.
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Bird-in-the-Hand Theory

 If so, investors would value high

payout firms more highly, i.e., a high
payout would result in a high P0.
 Myron Gordon and John Lintner
support Bird-in-the-Hand
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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 P0.
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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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Possible Stock Price Effects

Stock Price ($)

Bird-in-Hand
40

30 Irrelevance

20
Tax preference
10

0 50% 100% Payout

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Possible Cost of Equity Effects

Cost of equity (%)

Tax Preference
20

15 Irrelevance

10 Bird-in-Hand

0 50% 100% Payout

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Which theory is most correct?
 Some research suggests that high payout
companies have higher required returns
on stock, supporting the tax effect
hypothesis.
 But other research using an international
sample shows that in countries with poor
investor protection (where agency costs
are most severe), high payout companies
are valued more highly than low payout
companies.

19
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Which theory is most correct?

 Empirical testing has produced

mixed results, so 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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IMPLICATIONS FOR DIVIDEND
STABILITY
 Maximizing stock price probably
requires a firm to maintain a steady
dividend policy. Because sales and
earnings are expected to grow for
most firms, a stable dividend policy
means a company’s regular cash
dividends should also grow at a
steady, predictable rate
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DIVIDEND STABILITY