Corporate Finance Dr.

Ridha ESGHAIER

CHAPTER 7
Distribution Policy:
Dividends and Repurchases

Payout
Repurchases

Fall 2020 1
 Dr. Ridha ESGHAIER

Chapter Plan
1. How Companies Pay Dividends?
2. Forms and effects on shareholders wealth
3. Share repurchases
4. Dividend Policy and Company value: The Theory
• Dividend Irrelevance Theory
• Bird-in-the-Hand Theory
• Tax Preference Theory
5. The “clientele” effect
6. The information content and Signaling effects
7. Dividends and Agency theory
8. The Residual model
9. Factors affecting dividend policy in practice
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Free Cash Flow is the cash flow generated from operations and is
available for distribution to all investors (debtholders and shareholders).
This chapter focuses on the distributions of FCF to shareholders in the
form of dividends and stock repurchases.

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What is “distribution policy”?

• A dividend is a distribution paid to shareholders. Dividends are
declared (i.e., authorized) by a corporation’s board of directors,
whose actions may require approval by shareholders (e.g., in most of
Europe and in China) or may not require such approval e.g., in the
United States).
• A company’s cash dividend payment and share repurchase policies,
taken together, constitute its payout policy. Both entail the
distribution of the company’s cash to its shareholders, and each
affects the form in which shareholders receive the return on their
investment.
• A company’s payout policy is the set of principles guiding cash
dividends and the value of shares repurchased in any given year. The
distribution policy defines:
– The level of cash distributions to shareholders
– The form of the distribution
– The stability of the distribution 4
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I. How Companies Pay Dividends?

Dividend payouts follow a set procedure. To understand it, first we'll
define the following terms:
1. Declaration Date
The declaration date is the day the company's board of directors
announces the approval of the next dividend payment to shareholders. It
is simply an announcement – no dividends are paid on the declaration
date
2. Ex-Dividend Date
The ex-dividend date is the date on which investors are cut off from
receiving a dividend. If, for example, an investor purchases a stock on the
ex-dividend date, that investor will not receive the dividend. This date is
two business days before the holder-of-record date. The reason why the
ex-dividend date is two days earlier than the record date is because it
takes three days for a trade to ‘settle’ – for cash and shares to legally trade
hands. This is why you must purchase three days in advance of the record
date (or one day in advance of the ex-dividend date) to receive the
dividend payment in question. 5
The ex-dividend date is important because from this date forward, new
stockholders will not receive the dividend, and the stock price reflects
this fact.
A stock is cum dividend, which means "with dividend”, when a company
has declared that there will be a dividend in the future but has not yet
paid it out. A stock will trade cum dividend until the ex-dividend date —
on and after which the stock trades without its dividend rights at a lower
price (ex-dividend price) as the stock price adjusts for the dividend that
the new holder will not receive.
• 3. Holder-of-Record Date
The holder-of-record (owner-of-record) date is the date on which
the stockholders who are eligible to receive the dividend are
recognized. When a firm pays a dividend, only shareholders on
record on this date receive the dividend.
• 4. Payment Date
Last is the payment date, generally within a month after the
record date. It’s the date on which the actual dividend is paid out
to the stockholders of record.
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 Dr. Ridha ESGHAIER
Application 1: Mechanics of dividends
On July 20, Microsoft declares it will pay a special dividend of $3 per
share to holders of record as of November 17, with payment on
December 2nd.
Suppose we’re looking to initiate a position in Microsoft and we want
to make sure we are eligible for the company’s next dividend payment.
As such, we need to purchase before the company’s ex-dividend date.
• The ex-dividend date is November 15 (usually two days before of
the holder-of-record date).
• As of November 15, new buyers do not have a right to the dividend.
In order to be eligible for the next dividend payment, the shares
must be purchased on November 14 or earlier.
• At the close of business on November 17, all holders of Miscrosoft's
stock are recorded, and those holders will receive the dividend.
On December 2nd, the payment date, Microsoft mails the dividend
checks to the holders of record.
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Mechanics of dividends

Dates for Microsoft’s Special Dividend

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Distribution ratio Versus Payout

ratio
• The relative mix of dividend yields and capital
gains is determined by :
– the target distribution ratio, which is the percentage
of net income distributed to shareholders through cash
dividends or stock repurchases, and
– the target payout ratio, which is the percentage of net
income paid as a cash dividend.
Notice that the payout ratio must be less than the
distribution ratio because the distribution ratio includes
stock repurchases as well as cash dividends.

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Dividend Yield Versus

Capital Gains Yield
• A high distribution ratio and a high payout ratio mean that a
company pays large dividends and has small (or zero) stock
repurchases. In this situation, the dividend yield is relatively
high and the expected capital gain is low.
• If a company has a large distribution ratio but a small payout
ratio, then it pays low dividends but regularly repurchases
stock, resulting in a low dividend yield but a relatively high
expected capital gain yield.
• If a company has a low distribution ratio, then it must also have
a relatively low payout ratio, again resulting in a low dividend
yield and, it is hoped, a relatively high capital gain.

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II. Dividends: Forms and effects on

shareholders wealth
Companies can pay dividends in a number of ways.
• Cash dividends can be distributed to shareholders
through regular, extra (also called special or irregular),
or liquidating dividends.
When a company distributes a cash dividend per share,
in a perfect capital market the price of the shares drops
by the amount of the dividend per share distributed

• Other forms of dividends include stock dividends and

stock splits.
In this section, we will review the different forms that
dividends can take and explain their impact on both the
shareholder and the issuing company.
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II.1. Regular Cash Dividends

Many companies choose to distribute cash to their
shareholders on a regular schedule. The customary
frequency of payment, however, may vary among
markets.
• In the United States and Canada, most companies
that pay dividends choose a quarterly schedule of
payments.
• In Europe and Japan, the most common choice is
to pay dividends twice a year (i.e., semiannually).
• Elsewhere in Asia, companies often favor paying
dividends once a year (i.e., annually)
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• Most companies that pay cash dividends strive to maintain or

increase their dividends. A record of consistent dividends over a
long period of time is important to many companies and
shareholders because it is widely interpreted as evidence of
consistent profitability. At a minimum, most dividend- paying
companies strive not to reduce dividends when they are
experiencing temporary problems.
• Regular dividends, and especially increasing regular dividends,
also signal to investors that their company is growing and will
share profits with its shareholders. Perhaps more importantly,
management can use dividend announcements to communicate
confidence in the company’s future. Accordingly, an increase in
the regular dividend (especially if it is unexpected) often has a
positive effect on share price.
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 II.2. Extra or Special (Irregular)
Dividends Dr. Ridha ESGHAIER

• An extra dividend or special dividend (also known as an

irregular dividend) is a dividend paid by a company that does
not pay dividends on a regular schedule or a dividend that
supplements regular cash dividends with an extra payment.
These extra dividend payments may be brought about by
special circumstances.
• Companies, particularly in cyclical industries, have sometimes
chosen to use special dividends as a means of distributing more
earnings only during strong earnings years. During economic
downturns, when earnings are low or negative, cash that might
otherwise be used for dividends is conserved.
• For example, a company may choose to declare a small regular
dividend and then, when operating results are good, declare an
extra dividend at the end of the year. 14
 Application 2: extra dividends Dr. Ridha ESGHAIER

TLSN is the leading provider of telecommunication services in Sweden

and Finland. TLSN’s financial data are reported in Swedish krona (SEK).
In October 2017, TLSN’s board of directors modified its dividend policy,
stating that the he ordinary dividend shall be at least 40% of net
income attributable to shareholders of the parent company. In
addition, excess capital shall be returned to shareholders, after the
Board of Directors has taken into consideration the company’s cash at
hand, cash flow projections and investment plans in a medium term
perspective, as well as capital market conditions.
1. Calculate the cash dividend payout ratio for 2018 and 2017.
2. Assuming the board’s new dividend policy became effective in 2018,
calculate the amount of the annual ordinary dividend on the basis of
TLSN’s minimum payout policy in 2018 and the amount that could be
considered an extra dividend.

2018 2017
Shares outstanding 4,490.5 million 4,490.5 million
Earnings per share SEK4.23 SEK4.23
Cash dividends per share SEK1.80 SEK4.00
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Solution Application 2
Q1. With the same number of shares outstanding,
the dividend payout ratio on a per share basis is
dividends per share divided by earnings per share.
• For 2018: SEK1.80/SEK4.23 = 42.6%
• For 2017: SEK4.00/SEK3.94 = 101.5%
Q2. Under a policy of 40% of earnings, the
minimum amount of dividends would be :
SEK4.23 × 0.40 = SEK1.69.
The amount of the extra dividend would then be
SEK1.80 – SEK1.69 = SEK0.11.

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II.3. Liquidating Dividends

• A dividend may be referred to as a liquidating dividend
when a company:
• Goes out of business and the net assets of the company
(after all liabilities have been paid) are distributed to
shareholders;
• Sells a portion of its business for cash and the proceeds are
distributed to shareholders;
• Or pays a dividend that exceeds its accumulated retained
earnings (impairs stated capital).

These points illustrate that a liquidating dividend is a return

of capital rather than a distribution from earnings or
retained earnings.

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II.4. Stock Dividends

• Stock dividends are a non- cash form of dividends.
With a stock dividend (also known as a bonus issue of
shares), the company distributes additional shares
(typically 2–10% of the shares then outstanding) of its
common stock to shareholders instead of cash.
• Although the shareholder’s total cost basis remains the
same, the cost per share held is reduced.
• For example, if a shareholder owns 100 shares with a
purchase price of $10 per share, the total cost basis
would be $1,000. After a 5% stock dividend, the
shareholder would own 105 shares of stock at a total
cost of $1,000. However, the cost per share would
decline to $9.52 (=$1,000/105).
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• Superficially, the stock dividend might seem an improvement
on the cash dividend from both the shareholders’ and the
company’s point of view. Each shareholder ends up with more
shares, which did not have to be paid for, and the company did
not have to spend any actual money issuing a dividend.
Furthermore, stock dividends are generally not taxable to
shareholders because a stock dividend merely divides the “pie”
(the market value of shareholders’ equity) into smaller pieces.
• The stock dividend, however, does not affect the shareholder’s
proportionate ownership in the company because other
shareholders receive the same proportionate increase in
shares.
• Additionally, the stock dividend does not change the value of
each shareholder’s ownership position because the increase in
the number of shares held is accompanied by an offsetting
decrease in earnings per share, and other measures of value
per share, resulting from the greater number of shares
outstanding. 19
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Application 3: Stock Dividend

The table below shows the impact of a 3% stock dividend to a
shareholder who owns 10% of a company with a market value of
$20 million.
As one can see, the market value of the shareholder’s wealth does not
change, assuming an unchanged price- to- earnings ratio (the ratio
of share price, P, to earnings per share, E, or P/E).

Assumed unchanged

Stock Price P = P/E x E

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Companies that regularly pay stock dividends see some advantages to this form of
dividend payment. It favors long-term investors, which, in turn, may lower the company’s
cost of equity financing.
A traditional belief is that a lower stock price will attract more investors, all else
equal. US companies often view the optimal share price range as US$20 to US$80. For a
growing company, a systematic stock dividend will be more likely to keep the stock in the
“optimal” range.
From a company’s perspective, the key difference between a stock dividend and
a cash dividend is that a cash dividend affects a company’s capital structure, whereas a
stock dividend has no economic impact on a company.
• Cash dividends reduce assets (because cash is being paid out) and shareholders’
equity (by reducing retained earnings).
- All else equal, liquidity ratios such as the cash ratio (cash and short- term marketable
securities divided by current liabilities) and current ratio (current assets divided by current
liabilities) should decrease, reflecting the reduction in cash.
- Financial leverage ratios, such as the debt-to-equity ratio (total debt divided by total
shareholders’ equity) and debt-to-assets ratio (total debt divided by total assets), should
also increase.
• Stock dividends, on the other hand, do not affect assets or shareholders’ equity.
Although retained earnings are reduced by the value of the stock dividends paid (i.e., by
the number of shares issued × price per share), contributed capital increases by the
same amount (i.e., the value of the shares issued). As a result, total shareholders’
equity does not change.
Neither stock dividends nor stock splits (which are discussed in the next section)
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affect liquidity ratios or financial leverage ratios.
Dr. Ridha ESGHAIER
II.5. Stock Splits
In a stock split, firm increases the number of shares outstanding by
sending shareholders more shares.

• For example, if a company announces a 2-for-1 stock split, each

shareholder will be issued an additional share for each share
currently owned. Thus, a shareholder will have twice as many shares
after the split as before the split. Therefore, earnings per share (and
all other per share data) will decline by half, leaving the P/E and
equity market value unchanged.
• Assuming the corporation maintains the same dividend payout ratio
as before the split, dividend yield (annual dividends per share
divided by share price) will also be unchanged.
• Apart from the effect of any information or benefit that investors
perceive a stock split to convey, stock splits (like stock dividends)
should be neutral in their effect on shareholders’ wealth.
Stock splits are similar to stock dividends in that they have no
economic effect on the company and the shareholders’ total cost
basis does not change. 22
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Application 4: Stock Split
The table below shows an example of a 2-for-1 split and its impact on stock price,
earnings per share, dividends per share, dividend payout ratio, dividend yield, P/E,
and market value.

As can be seen, a 2-for-1 stock split is basically the same as a 100% stock
dividend because all per share data have been reduced by 50%. The only
difference is in the accounting treatment: Although both stock dividends and stock
splits have no effect on total shareholders’ equity, a stock dividend is accounted
for as a transfer of retained earnings to contributed capital. A stock split, however,
does not affect any of the balances in shareholder equity accounts. 23
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When should a firm consider splitting

its stock?

Stock splits occur when the company think that its

stock price is too high which limit the number of
investors who could buy the stock and thus keep
the firm’s total market value below what it could be
if there were more shares outstanding, at a lower
more marketable price range.

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What Effect of stock split on Stock

Prices?
• There’s a widespread belief that the optimal price range for stocks is
$20 to $80. if the stock is within this range, the firm’s value will be
maximized.
• Stock splits can be used to keep the price in the optimal range.
• In general, stock splits (as well as stock dividend) generally occur when
management is confident, so are interpreted as positive signals.
• On average, the price of a company’s stock rises shortly after it
announces a stock split or a stock dividend (due to positive signal).
• However, if during the next few months it does not announce an
increase in earnings and dividends, then its stock price will drop back
to the earlier level.

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• Much less common than stock splits are reverse stock splits. A reverse stock
split increases the share price and reduces the number of shares outstanding—
again, with no effect on the market value of a company’s equity or on
shareholders’ total cost basis.
• Just as a high stock price might lead a company to consider a stock split, so too
a low stock price may lead a company to consider a reverse stock split. The
objective of a reverse stock split is to increase the price of the stock to a higher,
more marketable range.

Application 5: In March 2009, Citigroup, a major US- based global bank,

was in severe financial distress and required significant US government
investment to avoid bankruptcy. Citigroup announced it would seek shareholder
approval for up to a 1-for-30 reverse split. At that time, the stock was perilously
close to the $1 a share minimum price required for continued listing on the
NYSE. In July 2009, the reverse split had not yet taken place but the shares
were trading at $2.90.
If the reverse split were to take place when the share price was $2.90,
find the expected stock price after a 1-for-30 reverse split, assuming no
other factors affect the split.

SOLUTION:
If the price was $2.90 before the reverse split, for every 30 shares, a
shareholder would have 1 share priced at 30 × $2.90 = US$87. 26
 Dr. Ridha ESGHAIER

III. Share Repurchases

• A share repurchase (or buyback) is a transaction in which a
company buys back its own shares. It occurs when a company
asks stockholders to tender their shares for repurchase by the
company.
• Unlike stock dividends and stock splits, share repurchases use
corporate cash. Hence, share repurchases can be viewed as
an alternative to paying cash dividends in that it is another
method of returning cash to investors.
• Shares that have been issued and subsequently repurchased
are classified as treasury shares (treasury stock) if they may
be reissued or canceled shares if they will be retired; in
either case, they are not then considered for dividends,
voting, or computing earnings per share.
• Usually there is a premium offered to induce shareholders
to sell to realize capital gains and pay taxes
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 Share Repurchase Methods
There are four main ways that companies repurchase shares, listed in
order of importance.
1. Open-Market Repurchase.
2. Fixed-Price Tender Offer.
3. Dutch Auction Tender Offer.
4. Repurchase by direct negociation

1. Open-Market Repurchase:
• The firm announces a plan to repurchase a desired number of shares
over a time period using “standard” market transactions. This
method of share repurchase is the most common.
• Open market repurchases are the most flexible option for a
company because there is no legal obligation to undertake or
complete the announced repurchase program ( for example
because of an unexpected cash needs for liquidity, capital
expenditures …)
• on average Stock price increases by 2-3%
Dr. Ridha ESGHAIER 28
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2. Fixed Price Tender Offer:

• Buy back a fixed number of shares at a specified fixed price during a
specified period of time.
• Sometimes a company will make a fixed price tender offer to
repurchase a specific number of shares at a fixed price that is typically
at a premium to the current market price. If more than the maximum
number of shares are tendered, shares are acquired on a pro rata
basis.
For example, if a stock is selling at $37 a share, a company might offer to
buy back 200,000 of its 5 million shares from current shareholders at $40.
If shareholders tender 400,000 shares to the company, the company will
typically buy back a pro rata amount from each shareholder (half the
shares tendered by each shareholder).
Evidence on fixed price tender offers:
– Typical premium 20% over market.
– Stock rises 11% when announced (good for signaling purposes).

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3. Dutch Auction Tender Offer: Dr. Ridha ESGHAIER
• A Dutch auction is also a tender offer to existing shareholders, but
instead of specifying a fixed price for a specific number of shares, the
company stipulates a range of acceptable prices.
• A Dutch auction uncovers the minimum price at which the company can
buy back the desired number of shares with the company paying that
price to all qualifying bids.
For example, if the stock price is $37 a share, the company would offer to
buy back 200,000 shares in a range of $38 to $40 a share. Each shareholder
would then indicate the number of shares and the lowest price at which he
or she would be willing to sell. The company would then begin to qualify
bids beginning with those shareholders who submitted bids at $38 and
continue to qualify bids at higher prices until 200,000 shares had been
qualified. That price might be $39. Shareholders who bid between $38 and
$39, inclusive,would then be paid $39 per share for their shares.
Evidence on Dutch auctions:
– More discretion in the number of shares.
– Premium paid is lower than fixed price tender offers: 13%.
– Stock prices increase on average by 8%. 30
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4. Repurchase by direct negotiation.

• In some markets, a company may negotiate with a major
shareholder to buy back its shares, often at a premium to the
market price.
• The company may do this to keep a large block of shares from
overhanging the market (and thus acting to dampen the share
price). A company may try to prevent an “activist” shareholder
from gaining representation on the board of directors.

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Advantages of Repurchases
• Unlike in cash dividend, Stockholders have the choice,
they can sell or not sell, according to their need of cash.
• Helps avoid setting a high dividend that cannot be
maintained.
• Repurchased stock can be resold to raise cash as needed.
• Income received is capital gains rather than higher-taxed
dividends. (keeping in mind that capital gains taxes
are lower than taxes on 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).
• Government 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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Reasons for repurchases:
• As an alternative to distributing cash as dividends.
• Want to obtain shares for use in an employee stock option plan and avoid
issuing new shares.
• To make a large capital structure change without increasing the firm’s debt
load.
• Unlike in cash dividend, the share price after the repurchase remains the
same, since the share repurchase itself does not change the stock price.
• it can offer value to its stockholders, as it typically has the effect of
increasing the price of a stock at the time of the announcement.
Other effects of share repurchases
• Concentration of ownership
Share repurchases increase the stock ownership of the equity holders
who do not sell. This contributes to a better alignment of the incentives
of management.
• Protection against hostile takeovers
- Concentrating ownership makes takeovers more difficult. Share
repurchases buy stocks from the shareholders who value them the
least. Those who would be more willing to sell.
- Successfully signaling the true value of the firm when it is undervalued
(for example by repurchasing shares at a premium) increases the cost
of a takeover, and therefore reduces its probability.
Dr. Ridha ESGHAIER
Application 6 :
Price Effect of a cash dividend and Stock Repurchase
A company has assets with a market value of $500 million, $50 million of which
are cash. It has debt of $200 million, and 10 million shares outstanding.
Assume perfect capital markets.
a. What is its current stock price?
b. If the company distributes $50 million as a dividend, what is the dividend per
share and what will its share price be after the dividend is paid?
c. If instead, the company distributes $50 million as a share repurchase, what
will its share price be once the shares are repurchased?
d. What will its new market debt-equity ratio be after either transaction?
Solution:
a. share price = ($500M – $200M)/10M = $30
b. Dividend per share = $50M / 10M = $5 per share
New share price after dividend is paid= ($500M – $50M – $200M)/10M = $25
Or New share price = current price – dividend per share = $30 - $5 = $25
c. Nber of shares repurchased = $50M /$30 = 1.666667M shares
Nber of remaining shares =10M – 1.666667M = 8.333333M shares
New Share price after the repurchase = ($500M – $50M – $200) /8.333333M = $30
d. after cash dividend D/E = $200M /($25x10M) = 0.8x
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after stock repurchase D/E = $200M /($30x8.333333M) = 0.8x
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IV. Dividend Policy and Company

value: The Theory
• A company can change its value of operations only if
it changes the cost of capital or investors’
perceptions regarding expected free cash flow. This is
true for all corporate decisions, including the
distribution policy.
Is there an optimal distribution policy that
maximizes a company’s intrinsic value?
• The answer depends in part on investors’ preferences
for returns in the form of dividend yields versus
capital gains.

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Dividend Policy and Company

value: The Theory
Since the early 1960s, financial theorists have debated the extent
to which dividend policy—the strategy a company follows to
determine the amount and timing of dividend payments—should
and does matter to a company’s shareholders.
We examine three theories of investor preferences for
dividend yield versus capital gains:
Dividends are irrelevant: Investors don’t care about payout
(dividend).
Bird-in-the-hand (or Dividend Preference Theory): Investors
prefer a high payout.
Tax preference: Investors prefer a low payout, hence growth
(Capital Gains).
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a. Dividend Irrelevance Theory

• In a 1961 paper, Miller and Modigliani (“MM”) argued that in a world without
taxes, transaction costs, and equal (“symmetric”) information among all
investors—that is, under perfect capital market assumptions—a company’s
dividend policy should have no impact on its cost of capital or on shareholder
wealth (stock’s value).
• Modigliani-Miller support irrelevance. Dividend vs. Share Repurchases are
irrelevant. They argued that the value of the firm depends only on the income
produced by its assets, not on how this income is split between dividends and
retained earnings.
• According to this 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.
• This theory is based on unrealistic assumptions;
– Investment is held constant.
– No tax advantage to dividends versus capital gains.
– Firms behave as price-takers.
– No information asymmetry.
– Managers act in shareholders’best interest.
– No transaction costs and no entry barriers. 38
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Intuition for the irrelevance

• Perfect markets implies investors are indifferent about how
they get their money. So changing dividends just shifts
how the money gets back to stockholders.
• Since investors do not need dividends to convert shares to
cash, they will not pay higher prices for firms with higher
dividends.
• In other words, dividend policy will have no impact on the
value of the firm because investors can create whatever
income stream they prefer by using homemade dividends.
If the shareholders want cash now and the firm
doesn’t pay dividends then they can sell some of the
shares that they have.
If the shareholders prefer to keep the money
invested in company but the firm has paid a dividend,
then they can use cash (dividend) to buy more shares. 39
 Dr. Ridha ESGHAIER
MM dividend irrelevance theory
Application 7: Homemade Dividend
• Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
• Bob Investor owns 80 shares and prefers a $3 dividend.
• Bob’s homemade dividend strategy:
Sell 2 shares ex-dividend at an ex-dividend price = $42 - $2 = $40
homemadedividends $3 Dividend
Cash from dividend 80x$2= $160 80x$3= $240
Cash from selling stock 2x40 =$80 $0
Total Cash $240 $240
Value of Stock $40 × 78 = $39 × 80 =
Holdings $3,120 $3,120
$42-$3

• In the above example, Bob Investor began with a total wealth of $3,360 =
80 shares x 42$
• After a $3 dividend, his total wealth is still $3,360 = 80 shares x 39$ +$240
• After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still
$3,360 = 78 shares x 40$ + $160
 Dr. Ridha ESGHAIER
Application 8: Genron Corp’s board is meeting to decide how to pay out $20
million in excess cash to shareholders. The firm expects to generate future free
cash flows of $48 million per year in perpetuity. Genron has no debt. Its equity
cost of capital equals its unlevered cost of capital of 12%. The firm has 10
million shares outstanding.
Q1. Suppose the firm chooses to pay a special dividend, what happens to its
stock price?
Solution
• With 10 million shares outstanding, Genron can pay a $20M/10M: $2
dividend immediately.
• Using future FCFs of $48 million per year, the firm anticipates paying a
dividend of $48M/10M: $4.80 per share each year thereafter.
• Cum-dividend price:
Pcum = Current Dividend + (Future Dividends) = 2 + 4.8/0.12 = 2 + 40 = $42

• Ex-dividend price:
Pex = (Future Dividends) = 4.8/0.12 = $40

A stock is cum dividend, which means "with dividend," when a company has
declared that there will be a dividend in the future but has not yet paid it out. A
stock will trade cum dividend until the ex-dividend date — after which the stock
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trades without its dividend rights.
 Dr. Ridha ESGHAIER

Q2. Suppose the firm chooses use $20 million to engage in share
repurchases, what happens to its stock price?

• With an initial share price of $42, Genron will repurchase 476,000 shares.
$20 million ÷ $42 per share = 0.476 million shares
• This will leave only 10 million - 0.476 million = 9.524 million shares outstanding

• After the repurchase, the future dividend would rise to $5.04 per share.
$48 million ÷ 9.524 million shares = $5.04 per share

• Genron’s share price is PRepurchase = 5.04 / 0.12 = $42

The price does not change!

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 Dr. Ridha ESGHAIER

b. Bird-in-the-Hand Theory
“A bird in the hand is worth two in the bush.“
– A bird in the hand: certain dividends
– A bird in the bush: uncertain capital gains
Gordon (1963) and Lintner (1962) developed the bird-in-hand theory as a
counterpoint to the Modigliani-Miller dividend irrelevance theory.
– MM irrelevance: Investors are indifferent to whether their returns from
holding stock arise from dividends or capital gains.
– Bird-in-hand: Investors prefer stocks with high dividend payouts due to
uncertainty associated with capital gains compared to dividends, and as a
result these stocks command a higher market price.
Gordon and Lintner have argued that, even under perfect capital markets
assumptions, investors think dividends are sure things, then are less risky
than potential future capital gains from reinvesting earnings, hence they like
dividends. If so, investors would value high payout firms more highly,
A high payout would result in a high stock price.
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 Dr. Ridha ESGHAIER

c. Tax Preference Theory

• Low payouts mean higher capital gains
• In a country that taxes dividends at higher rates than
capital gains, taxable investors should prefer
companies that pay low dividends and reinvest
earnings in profitable growth opportunities
• Also, capital gains taxes are deferred, so have a
lower effective cost than the dividend taxes (paid
sooner)
• This could cause investors to prefer firms with low
payouts, and high Capital Gains.
A high payout results in a low stock price.

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 Dr. Ridha ESGHAIER

Implications of the three

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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 Dr. Ridha ESGHAIER

Possible stock price effects

Stock Price ($)

Bird-in-the-Hand
40

30 Irrelevance

20
Tax preference
10

0 50% 100% Payout

 Dr. Ridha ESGHAIER

Possible cost of equity effects

Cost of Equity (%)

30
25 Tax preference
20
15 Irrelevance
10
5 Bird-in-the-Hand

0 50% 100% Payout

 Dr. Ridha ESGHAIER

Which theory is most correct?

• Empirical testing has not been able to determine which

theory, if any, is correct.
• The evidence from these studies is mixed as to whether
the average investor uniformly prefers either higher or
lower distribution levels, other research does show that
individual investors have strong preferences. Also, other
research shows that investors prefer stable, predictable
dividend payouts.
• Thus, managers use judgment when setting policy.
• Analysis is used, but it must be applied with judgment.

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 Dr. Ridha ESGHAIER

V. Dividend policy and firm’s

“clientele” of investors
Another factor that may affect a company’s dividend policy is a
clientele effect. In this context, a clientele effect is the existence
of groups of investors (clienteles) attracted to (and drawn to
invest in) companies with specific dividend policies. Different
groups of investors, or clienteles, prefer different dividend
policies.
• For example, some retired investors may have a preference for
higher current income and prefer to hold stocks with relatively
high dividend payouts and yields.
• Alternatively, other investor groups, such as younger workers
with a long time horizon, might favor owning shares of
companies that reinvest a high proportion of their earnings for
long-term capital growth and thus prefer stocks that pay little
or no dividends.
• Firm’s past dividend policy determines its current clientele
of investors. 49
 Dr. Ridha ESGHAIER

The “clientele” effect

• Management should be hesitant to change its

dividend policy, because a change might cause
current shareholders to sell their stock, forcing the
stock price down. Such a price decline might be
temporary but might also be permanent
• “Clientele effects” impede changing dividend policy.
Taxes and brokerage costs hurt investors who have
to switch companies due to a change in payout
policy.

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 Dr. Ridha ESGHAIER

VI. The information content, or

“signaling” hypothesis
• A situation of asymmetric information raises the possibility
that dividend increases or decreases may affect share price
because they may convey new information about the company.
A company’s board of directors and management, having more
information than outside investors, may use dividends to signal
to investors about (i.e., convey information on) the company’s
prospects. A company’s decision to initiate, maintain, increase,
or cut a dividend may convey more credible information than
positive words from management because cash is involved.
• 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. 51
 Dr. Ridha ESGHAIER

Empirical evidence on dividends

Announcements of dividend changes:

• +0.73% abnormal return for increases.

• -1.19% abnormal return for decreases.
• +1.01% abnormal return for increases > 25%.
• - 6.35% abnormal return for decreases < -25%.
• Initiation of Dividends: + 3.9%.
• Omission of Dividends: - 9.5%.

Investors like it when firms start paying dividends and

really hate it when they stop doing it!
Likewise, investors react positively when dividend
payments are increased and negatively when they are
reduced

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 Dr. Ridha ESGHAIER

VII. Payout Policy and Agency theory

• Dividend payments and share repurchases leave

management with less money to waste in poor
acquisitions and negative NPV projects.
• Payout policy is an alternative to debt for reducing FCF.
• Managers dislike (Shareholders like) dividends (and
share repurchases).
• Evidence around the world: countries with stronger
shareholders‘ rights have higher dividends.
• Payment of dividends can help reduce the agency
conflicts between managers and shareholders, but it
can worsen conflicts of interest between shareholders
and debtholders.
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 Dr. Ridha ESGHAIER

VIII. The Residual distribution model

• Under this model a firm follows theses two

steps when establishing its target distribution
ratio:
– 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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 Dr. Ridha ESGHAIER

Using the Residual Model to

Calculate Distributions Paid

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

Retained Earnings needed to

finance new investments
And maintain the target capital
structure
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 Dr. Ridha ESGHAIER
Application 9:

• A company estimates its capital needed for

new investments to be $800,000.
• Its target capital structure is 40% debt, 60%
equity that wants to maintain.
• Its forecasted net income is $600,000.
Q1. 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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Solution:

• to keep at target capital structure, of the $800,000 capital

budget:
– 60%($800,000) = $480,000 must be equity.
– So 40%($800,000) = $320,000 will be debt.

• With $600,000 of net income, the residual is: $600,000 -

$480,000 = $120,000 = dividends paid.
Distribution =$600,000 – (60%x $800,000) =$120,000
• Payout ratio = Dividends / Net Income
= $120,000/$600,000 = 20%.

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Q2. How would a drop in NI to $400,000

affect the dividend? A rise to $700,000?

• NI = $400,000: Need $480,000 of equity, so

should retain the whole $400,000.
Dividends = 0.
payout =0%
• NI = $700,000: Need $480,000 of equity
Dividends = $700,000 - $480,000
= $220,000
Payout = $220,000/$700,000 = 31,4%.
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 Dr. Ridha ESGHAIER

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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 Dr. Ridha ESGHAIER

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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 IX. Factors affecting dividend policy
in practice Dr. Ridha ESGHAIER

We discussed earlier theories of dividend policy and value and concluded that the
issue is, at best, unresolved. In practice, five factors are often mentioned by managers
themselves as relevant to dividend policy selection.
• Investment opportunities : All else equal, a company with many profitable
investment opportunities will tend to pay out less in dividends than a company
with fewer opportunities because the former company will have more uses for
internally generated cash flows.
• The expected volatility of future earnings : Most managers had a target payout
ratio based on long- run sustainable earnings and were reluctant to increase the
dividend if the increase might soon need to be reversed.
• Financial flexibility : Companies may not initiate, or may reduce or omit, dividends
to obtain the financial flexibility associated with having substantial cash on hand.
• Tax considerations : Taxation is an important factor that affects investment
decisions for taxable investors in particular, because it is the after- tax return that
is most relevant to investors.
• Flotation costs : Flotation costs make it more expensive for companies to raise
new equity capital than to use their own internally generated funds. As a result,
many companies try to avoid establishing a level of dividends that would create
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the need to raise new equity to finance positive NPV projects
 Dr. Ridha ESGHAIER

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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Dr. Ridha ESGHAIER
Application 10
In 2015, a Company paid dividends totaling $3.6 million on net income of $10.8
million. Note that 2015 was a normal year and that for the past 10 years, earnings
have grown at a constant rate of 10%. However, in 2016, earnings are expected to
jump to $14.4 million, and the firm expects to have profitable investment
opportunities of $8.4 million. It is predicted that the company will not be able to
maintain the 2016 level of earnings growth—the high 2016 earnings level is
attributable to an exceptionally profitable new product line introduced that year—and
the company will return to its previous 10% growth rate. its target capital structure is
40% debt and 60% equity.
a. Calculate the company’s total dividends for 2016 assuming that it follows each of
the following policies:
(1) Its 2016 dividend payment is set to force dividends to grow at the long-run growth
rate in earnings.
(2) It continues the 2015 dividend payout ratio.
(3) It uses a pure residual dividend policy (40% of the $8.4 million investment is
financed with debt and 60% with common equity).
(4) It employs a regular-dividend-plus-extras policy, with the regular dividend being
based on the long-run growth rate and the extra dividend being set according to the
residual policy.
b. Which of the preceding policies would you recommend? Restrict your choices to
the ones listed but justify your answer.
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Solution
a.
1. 2016 Dividends = (1.10) x (2015 Dividends)
= (1.10) x ($3,600,000) = $3,960,000.
2. 2015 Payout = $3,600,000/$10,800,000 = 0.33333 = 33.33% = 1/3
2016 Dividends = (1/3) x (2016 Net income)
= 1/3 x ($14,400,000) = $4,800,000.
3. Equity financing = 60% x $8,400,000 = $5,040,000.
2016 Dividends = Net income - Equity financing
= $14,400,000 - $5,040,000 = $9,360,000.
All of the equity financing is done with retained earnings as long as they are
available.
4. The regular dividends would be 10 percent above the 2015 dividends:
Regular dividends = (1+10%) x ($3,600,000) = $3,960,000.
The residual policy calls for dividends of $9,360,000. Therefore, the extra
dividend, which would be stated as such, would be
Extra dividend = $9,360,000 - $3,960,000 = $5,400,000.
An even better use of the surplus funds might be a stock repurchase.
b. Policy 4, based on the regular dividend with an extra, seems most logical.
Implemented properly, it would lead to the correct capital budget and the correct
financing of that budget, and it would give correct signals to investors.
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