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17

Sharing Firm Wealth:


Dividends, Share
Repurchases,
and Other Payouts
Finance 3rd Edition

Cornett, Adair, and Nofsinger


Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Introduction
Taxation of capital distributions
Different treatments for capital gains versus

dividends and interest payments


Differing tax rates for shareholders

17-2

Dividends versus Capital Gains


Use the constant growth formula to choose

between paying cash dividend or stock


repurchase

17-3

Dividends versus Capital Gains


Firms that pay out high percentages of

current earnings have less capital to fund


future growth

17-4

Dividends versus Capital Gains


Firms that keep more retained earnings

have less to pay current dividends


Recommend firms retain earnings to extent
they can make project investments with as
high return as investors could earn
elsewhere at similar risk

17-5

Dividend Irrelevance Theory


Modigliani and Miller
In perfect world the decision to pay or not

to pay dividends does not matter

17-6

Dividend Irrelevance Theory


Reminder: The perfect world assumes
No taxes
No transaction costs
Perfectly competitive markets
Completely rational investors

17-7

Dividend Irrelevance Theory


In M&Ms perfect world, paying dividends

reduces each shares value by the dividend


amount
If the firm chooses not to pay dividends,

investors who want dividends can sell their


shares to realize income not supplied by
dividends

17-8

Dividend Irrelevance Theory


In 2003, tax rates on capital gains and most

dividends lowered
Dividends now more attractive relative to

capital gains

17-9

Why Some Investors Favor Dividends


Bird-in-the-hand theory
Dividends less risky, more attractive to risk-

averse investors than future capital gains


Bird-in-the-hand fallacy
Most investors invest dividends in similar firms
Firms risk profile determined by asset cash

flows not dividend payout policy

17-10

Why Some Investors Favor Capital Gains


At the same tax rates, capital gains have

more choice in timing of cash flows


All shareholders pay taxes on dividends
Only selling shareholders incur taxes on

realized capital gains when a growing firm


retains earnings

17-11

Other Dividend Policy Issues


Tangible effects
Risks
Taxation
Cash flow timing

Also intangible effects

17-12

The Information Effect


Firms hesitate to increase dividends unless

they can be maintained


Analysts interpret dividend increases as

positive signal about firms future cash


flows

17-13

The Clientele Effect


Investors (clientele) have different desires

about taxability and timing of firm payouts


Payout policies of different firms attract
different investor groups

17-14

Corporate Control Issues


Shareholders with large stakes in the firm

may dictate dividend payout policy


Closely-held companies may retain more

earnings as owners try to minimize the


effect of double taxation

17-15

Real-World Dividend Policy


Basic dividend policy
Pay out surplus cash flow as dividends after

investing in positive net present value projects

17-16

The Residual Dividend Model


Also known as the free cash flow theory of

dividends
Assumes that cash flow, beyond that

needed to invest in positive NPV projects,


is paid out as dividends

17-17

Extraordinary Dividends
Firms divide dividends into two classes to

manage
1) Ordinary dividends (relatively low)
2) Extraordinary dividends (periodic, extra)
Firms forego extraordinary when needed

17-18

Dividend Payment Logistics


Declaration date
Board of directors announces intention to pay a

dividend
Firm records the liability on its books

Ex-dividend date
The first day that shares trade without dividend

attached

17-19

Dividend Payment Logistics


Record date
Firm identifies the owners of record to begin

addressing payments
Record date is set several business days after

ex-dividend date to allow time for registration


process
Payment date
Firm sends out the dividends

17-20

Effect of Dividends on Stock Prices


Stock prices increase as the next dividend

approaches
Stock prices fall by the present value of the

dividend once the stock goes ex-dividend

17-21

Stock Dividends and Stock Splits


Both increase shares outstanding without

changing total market value of owners


equity
Both will decrease the stock price

17-22

Stock Dividends
Pro-rata distribution of new shares to

current stockholders
Example: A 20 percent stock dividend would

increase the number of shares held by each


shareholder by 20 percent

17-23

Stock Splits
Company exchanges new shares for old

shares
Each old share usually converts into more
than one new share

17-24

Stock Splits
Alter par value of firms stock on companys

books
Do not cause shift in owners equity
accounts

17-25

Stock Dividends/Splits Effect on Stock Prices


Firms want shares to trade in price range
Stock dividend or split brings stock price back in

range
Investors like to trade in 100 share round

lots

17-26

Stock Repurchases
Firm buys shares of own stock on stock

exchange like any investor


Open-market stock repurchase
May take months or years

17-27

Advantages of Repurchases
Can offer an efficient way to return money

to shareholders
Reduction or cessation of repurchases not

seen as a negative

17-28

Disadvantages of Repurchases
Can make firm vulnerable to litigation from selling

shareholders
Management may have undisclosed information about

good future prospects for firm


Overpayments for shares result in share dilution
IRS penalties if proven the repurchase was

primarily to avoid dividend taxation

17-29

Effect of Repurchases on Stock Prices


Advantages outweigh the disadvantages

Repurchasing companies produce

significant excess returns for several


years after repurchase

17-30

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