Chapter 13_Dividends and share buy back_revised 13112021.pptx

Corporate Financial Strategy
Chapter 13
Dividends and buy-backs

Learning objectives
1. Set out the main arguments in favour of and against companies
paying dividends.
2. Identify different types of dividend policy.
3. Explain why companies might prefer to undertake periodic share
purchases rather than pay dividends.
4. Understand why different types of investor might have a preference for
either dividends or buyouts.
2

Dividends and buy-backs: contents
 Dividend policy context - introduction
 Dividend strategy and the life cycle model
 Some factors that might affect dividend policy
 Signalling effect of a change in dividends
 Reasons for companies to buy back their own shares
 Lintner: target dividend pay-out ratio
3

Introduction
 The main question is :
− Is Shareholder’s wealth affected by co. dividend policy? It is not asking whether the
dividends matter (of course they do)
− Whether the chosen policy matter and impacted SH’s wealth? The chosen policy
include:
• Paying a constant annual dividend
• Paying out a constant proportion of annual earnings
• Increasing dividend in line with the annual rate of inflation
• Paying out what’s left after financing all future investment – the residual policy (from the
context of life cycle model)
− The key factors to consider in relation to dividend payment/strategy/policy:
1) Modligiani and Millier’s (M&M) dividend irrelevant theory
2) The interest of SH (or the clientele effect and the bird in the hand argument)
3) The signaling effect or information content of dividends
4) The CASH of the entity (how much cash left after allocation of other +ve NPV projects) –
firm should only invest in +ve NPV projects (why? CF > Cost = then only firm can create
return to SH above the required return – disc factor)
4

1) M&M - Irrelevance of Dividend
Policy
 MM (1961) argued that in an ideal capital market, dividend is irrelevant
as long as the firm’s capital investments and debt policy are fixed.
− In this context, dividends are defined as being the residual cash flow item after
company has decided on its investment and borrowing plans.
− Investment and capital structure decisions are completely independent of the
decision to PAY dividend or NOT.
 Dividend payments are simply financed over the time by a
combination of excess retained earnings and if necessary, new
equity financing.
 Since investors do not need dividends, they will NOT pay higher prices
for firms with higher dividend payouts.
 In other words, dividend policy will have no impact on the value of
the firm (and thus decreasing the value per share in direct
proportion to the dividend received). Investors could choose to sell
shares in order to realize fund, and do not need the declaration
dividend to facilitate this. 5

 Firm’s value is indifferent (similar) with regard to any dividend
policy/strategy:
 Summary of MM:
− Return to SH : 1) dividend paid; 2) capital gain
− Div decision depends on HOW the return is delivered:
• how much annual earnings to be paid out and to RETAIN so that can be reinvested with in
the co (gives return in a form of CAPITAL GAIN)
− Dividend decision does not affect the RISK of shares, it does not affect return to SH.
All dividend decision is to split up between dividends and capital gains.
− DO SHs MIND how the return is to be SPLIT UP? Answer is : NO, if we
assume(assumption): 1) there are no taxes; 2) shares can be bought and sold free
of any transaction costs
6

− Argument (reason) : SH can manufacture a DIV POLICY irrespective of the co
policy. Ex. If a person is holding shares for income, but the company withholds a
dividend, the SH can sell the shares to replace the lost income
• If dividend were taxed and capital gain is tax free – SH would mind how their return is
delivered- they STRONGLY PREFERED return as CAPITAL GAIN
• If investors have to incur additional cost to realise the capital gain in order to turn them into
income, definitely they WOULD MIND. Therefore, they STRONGLY PREFERED their
return to be delivered in a form of DIVIDEND rather than CAPITAL GAIN.
• MM suggests that SHAREHOLDERS ARE INDIFFERENT between DIVIDENDS
AND CAPITAL GAINS, and so the DIVIDEND STRATEGY the co pursues is
IRRELEVANT
7

2) The INTEREST OF SHAREHOLDERS
 It is critical that a business satisfies the needs of its SHAREHOLDERS
with its DIVIDEND POLICY. If they feel that the DIVIDEND POLICY
does not satisfy the expectation, they will sell the shares and causing
the share prices to fall.
 2 important points to consider:
− Clientele effect
• There are differential tax treatment of dividends and capital gains, and there are transaction
costs on share dealing
• SH are concern as to HOW their return is delivered to them by the company. Thus, the
company should follow a CONSISTENT dividend policy so that they gather to them a
clientele of SHs who like that particular policy
− Bird in the hand theory – investors generally have strong preference for dividends.
Why? Because Dividend is CERTAIN and INVESTORS prefer a certain DIVIDEND
now, to the PROMISE of UNCERTAIN FUTURE DIVIDENDS (arising from the
retaining and re-investing earnings)
8

Dividend Clienteles (Grouping)
 Dividend clientele - a group of a company's stockholders who share a similar view
about the company's dividend policy.
 The clientele effect - the movement in a company's stock price according to the
demands and goals of its investors.
 These investor demands come in reaction to a tax, dividend, or other policy change
or corporate action which affects a company's shares.
 For example:
− Some individuals face with low taxes prefers dividend for the income.
− Some individuals with high taxes have long term investment horizons, have no
need for additional cash income.
− Some would prefer to hold shares that pay little or no dividends.
− Some may be either low or high tax brackets, require dividend for cash income
 That is why co. payment of dividend (dividend policy) need to also consider the
clientele effect.
 Because if the firm adopts a dividend policy that attracts to investors (whose
preferences are not satisfied by firms currently in the market) then the firm may
increase its market value.
 If existing firms collectively satisfy all dividend clienteles, dividend clientele
equilibrium is achieved.
 According the clientele hypothesis, firm’s dividend policy influence the firm’s
ownership structure and can affect the equilibrium expected return on the
firm’s stock, i.e. cost of equity capital.
9
9

3) The SIGNALING EFFECT or INFORMATION CONTENT OF
DIVIDEND
 The disclosure of information that is accessible to the general public occurs
when a dividend is announced.
 Investors read ‘signals’ into the company’s dividend decision and that these
signals say as much about the company’s future financial performance as they
say about its past financial performance
 Investors do indeed read signals into the dividend decision, then the dividend
decision becomes important: it becomes important for the company not to give
the WRONG SIGNAL.
 2 STRONG SIGNALs:
− A reduction in the dividend/share signals that the company in financial
difficulties
− A failure to pay out any dividend at all signals that the company is vary close
to receivership.
 A CO. must take great care when setting dividend levels and ensure that the
market is fully informed of future prospects. (Lirtner model – dividend
smoothing)
10

The information content of dividend
changes
 What information is conveyed on a dividend change?
 Dividend change reveals new information to the market about the
management’s assessment of the firm’s long-term earnings prospects.
 3 facets of agency theory explain this
− Dividend increase reveals that firm’s mechanism have succeeded in curbing
management’s penchant for empire building
− Dividend increase indicates the threats from external have persuaded
management to disgorge free cash flow.
− Dividend increase for levered firm constitutes expropriation of wealth from the
firm’s creditors (firm’s creditor is claiming assets from the levered firm)
11

The Smoothing Phenomenon – constant dividend payment
 When the Co decides on the dividend policy, firm’s equity will be
affected such as:
 It reduces the amount of internal equity available for future investments
 It increases the probability that the firm will have to sell new equity if new
investments should be funded with equity.
 It increases the firm’s leverage (issuance of new debts).
 Because of these reasons, the firm normally adopts a residual
dividend payout policy – dividends should be paid only if the
company has excess cash after all the above concerns are
taken into account.
 Dividend per share that highly fluctuate (will not look good) as
investors confused about co’s div policy and the future direction of
the co. This will give a bad signal to investors on the
performance of the co.
 Thus, co. prefers dividend smoothing policy using Dividend
Smoothing Model
12

Lintner’s Dividend Smoothing Model
 In sharp contrast to the previous argument, the real world firms
that pay dividends appear to go to great pains to smooth dividends
over time.
 This smoothing tendency is first modelled by Lintner (1956).
 Adjustment rate and target ratio could be estimated thru OLS
13
1
1
1 *







t
t
t
t
t
DIV
EARN
DIV
DIV
DIV 


Lintner: target dividend pay-out ratio
Research by Lintner indicated that companies have a target dividend pay-
out ratio, but that they never actually pay that full amount. He suggested
that companies determine their annual dividend based on the following
formula:
DIV1 – DIV0 = a × {(r × eps1) – DIV0}
14
DIV0 is the dividend paid last year
DIV1 is the dividend to be paid this year
eps1 is the earnings per share this year
r is the target dividend pay-out ratio
a is an adjustment factor.

Effect on Dividend Smoothing Phenomenon
 Working insight 13.3 - effect on dividend
smoothing phenomenon (which is crucial to
manage the bad signal affecting the market).
− CO. dividend policy is 50% of annual profit.
Yr0 dividend paid – RM35M
− Yearly profit - yr 1 – 100M, yr2-120M, yr3-
110M, yr4-150M, Yr-5-130M
 50% pay out ratio – dividend fluctuate , as
compared to smooth dividend policy. If the co.is
not doing good in any year, it will lead to a fall in
dividend- disastrous in market sentiment (i.e it
will give a bad signal to the market)
 Smoothed dividend policy – annual dividend is
increased by 15% each year – a figure which
management believe to be covered by forecast
profit eg. Yr 2 = (40 x 0.15) = 6 + 40= 46; Yr 3 =
(46 x 0.15) = 6.9 + 46= 52.3.
 Rate of 15% is consistently applied on the
dividend recurring every year. It’s a way of
managing shareholders expectation.
15
Policy Yr 1 2 3 4 5
Profit after
tax
100 120 110 150 130
Dividend
using 50%
pay-out ratio
50 60 55 75 65
Smoothed
dividend
policy
40 46 53 61 70

4) The cash needs of the entity
 It is important to consider the impact on investment and financing
decisions when considering dividend policy.
 Different types of business will have different cash needs and will
therefore have to set their dividend, investment and financing policies
accordingly,
 For example;
− A small co or poor credit rating will often struggle to raise finance from external
sources, so its cash needs might have to be met by restricting the amount of
dividends it pay out
− A growing company will have many potential investment opportunities. The cash
needs for these new investments will have to be met by balancing dividend policy
alongside external finance sources
− A well established, stable company might well be cash rich, in which case it might be
able to afford to pay out large dividend without compromising its internal cash needs.
16

Overview of Dividend strategy and the life cycle model – the
availability of CASH
17
Cash availability Profit
availability
Dividend policy
Launch No spare cash available. All
cash is needed for investment
in developing the business.
None. Probably
making losses.
Nil dividend pay-out.
Growth Cash is needed for
development and investment
in growing market share.
May be profitable. Nil dividend pay-out is
preferable. However,
new shareholders
might prefer a
nominal pay-out.
Maturity The company is now cash
positive and has fewer
opportunities to invest in
profitable growth.
Profitable. A medium to high
dividend pay-out is
preferred.
Decline The company is cash positive,
with no reinvestment potential.
May be profitable; has
retained profits.
Full pay-out of
available cash as
dividend, even in
excess of current
profits.

Constraint payment of dividend are depending on two
factors:
− Ability to afford the cash outflow from the company
− Existence of distributable profit
The strategy is translated as in the above table.
− Based on the model , those who seeks dividend are likely to be
attracted to mature or declining companies
− Those who are preferring return on capital gain look to their earlier
stage companies. However, this hold completely not true, co also pays
the dividend at the earlier stage to attract potential investors.
18

In real world – how to reconcile this differing view of dividend
policy
 Factors to consider:
− What dividends are the shareholders expecting (clientele effect)
− What are the cash needs
− What dividend did the company pay last year? Consider the signal that a dividend
announcement will give
 Other factors:
− Is it legal to payout dividend?
− Is the cash available to payout dividend
− Do we have minimum gearing ratio imposed on the company as a financial covenant
in a debt agreement
− What is the tax impact of shareholders of paying dividend
− What investment opportunities that the co face
− How difficult or expensive is it to raise external finance
− What has been the rate of inflation (and what dividend increase is neede to maintain
the purchasing power of last years dividend)?
− What has been the capital gain or loss in the share price over the last year?
19

DIVIDEND POLICY IN PRACTICE
 4 DIVIDEND POLICY
− Stable Dividend – paying a constant growing dividend each year
− Constant payout ratio- paying out a constant proportion of equity earning
− Zero dividend policy – all surplus earnings are invested back into the business: it is
common in growth stage, should be reflected in increased SP. When opportunity are
exhausted, cash will start accumulate, a new div policy will be required
− Residual dividend policy – A dividend is paid only if no further positive NPV projects
available. This may be popular for firms:
• In the growth phase ; with out easy access to alternative sources of funds
• However, cash flow is unpredictable for the investor; gives constantly changing signals
regarding management expectation.
20

Some factors that might affect dividend policy
 Tax regime
− Dividend policy are influenced by tax system, both corporate and personal. SHs
might prefer to receive capital gains(which are taxed at lower rate), rather than
dividends which are taxed at a high-rate
 Agency theory - To avoid agency issues of holding too much spare cash
− Co. with surplus cash – 3 options because, surplus cash will make investors worry
(potential to misused)
• invest in positive NPV project
• Waste it on – ve NPV project
• Distribute it back to shareholders.
− Distributing in a form of dividend - +ve sign of good corporate governance.
 Signalling mechanism to the market
− Announcement of dividend as a signalling mechanism to the market.
• For example, a company announcement of an increase in dividend payout is an indication
of positive future prospects.
• Companies that pay the highest dividends are, or should be, more profitable those paying
smaller dividends.
21

 A case example – Coca-Cola Corporation
− increasing dividends can be indicative of a higher future stock price.
− Coca-Cola Corporation (KO) has been increasing its dividend for over 50 years and
began paying dividends in 1920. However, despite the consistent increase in
dividends, KO's revenue has declined in recent years as sugary sodas have fallen
out of favor with consumers. In Q1 of 2016, KO generated $10 billion in revenue
while in Q1 of 2019, the company generated $8 billion in revenue—a 20% decline.
Annual profit or net income was $6.5 billion in 2016 and approximately $6.4 billion in
2018.
− Although the company was profitable each year, profits and revenue didn't increase
every year despite higher dividends. However, from the chart below, we can see that
the stock price rose from nearly $41 in 2016 to $50 in 2018.
− Each year dividends increased, outlined at the bottom of the chart, which supports
the theory that increasing dividends can be indicative of a higher future stock price.
22

SCRIP/BONUS DIVIDENDs and Share Repurchase
 Introduction:
− Scrip dividend – share holders are offered bonus shares Free of Charge as an
alternative to CASH DIVIDEND
− They are useful when co wishes to RETAIN CASH in the business or where SH wish
to reinvest dividends in the company but to avoid brokerage fees of buying shares.
There maybe tax advantages.
• If SH opt for bonus shares, has effect of capitalizing reserves. Reserves reduce and Share
capita increase
• Disadvantages – Share price and EPS are likely to fall due to the greater number of shares
in issue, although the overall value of each SH remain unchanged
− Share repurchase – a return surplus cash to shareholders
• It tends to be used when the company has no positive NPV projects to invest, so it return
the cash to shareholders so that they can make better use of it rather than it sitting ideal in
the company
• Share repurchase vs. One-off large dividend
− A company may decide to use one-off large dividend to return surplus cash.
− Share repurchase is unlikely to have impact on SP but only the no of share issue
− Adv of share repurchase – investor can choose whether or not to sell shares;
− avoid risk of false dividend signal
23

Repurchase of Stock
Instead of declaring cash dividends, firms can rid of excess cash
through buying shares of their own stock.
Recently share repurchase has become an important way of
distributing earnings to shareholders.
The repurchased shares are held in the balance sheet as ‘treasury
stock’ and can later be reissued at an appropriate market price.
Chapter 9 - Dividend Policy 24

Share repurchase impact on Shareholders’ ownership in the
organization
 A share repurchase scheme should be regarded as a one-off
discretionary dividend offer to shareholders. For example:
− Working Insight 13.4
• Cash Rich holding pls has Rm100m in surplus cash. Currently has 500m shares trading at
the market price of RM2 each.
• The co. is not declaring dividend, but announce to repurchase its existing shares – to
purchase 10% shares at RM2 per share.
• Ownership structure Before the purchase: For holders of 10m shares they would sell 1m
(10%x10m) and receive RM2m (1m x RM2).
• Ownership structure After the repurchase, they own 9m (10m-1m) – but this represent the
same 2% of the company which they owned before the deal.
9 m / 450 m = 2% ; 10 m / 500 m = 2%
Note: repurchase of shares will not change % of the shareholders’ ownership in the co.
25

Dividend vs Repurchase – Co may decide to pay dividend
or share repurchase .
A company has 100,000 shares outstanding. It has excess cash of RM300,000
(or RM3 per share)
i) Consider paying this amount as dividends.
Forecast of earnings after dividends = RM450,000 per year or
RM4.50/share.
P/E for comparable companies = 6 times
Implying shares of the company should sell at RM4.50 x 6 = RM27
i) Consider using the extra cash to repurchase some of its own stock.
Let say a tender offer of RM30 per share is made. Therefore, the company
can purchase 10,000 shares. Remaining shares = 90,000
EPS will increase to RM450,000/90,000 = RM5 per share
Price per share = RM5 x 6 = RM30

Dividend vs Repurchase
Comparison of the 2 alternatives:
With dividends = Each shareholder owns a share worth RM27
Receives a dividend of RM3
Total RM30
With stock repurchase: Each shareholder will have a share worth
RM30 (RM450,000/90,000shares x RM6)
Conclusion : In a perfect market, the firm is indifferent between
a dividend payment and a share repurchase.

Relationship between EPS and Market Value
1. In repurchase, EPS increases because the number of shares
outstanding reduced. If repurchase is financed with debt, EPS
will increase if the ratio of earnings to price is greater than the
interest rate.
2. However, the total value to the shareholders is still the same,
either under dividend payment or under stock repurchase as
shown below:
 Both are RM2,700,000
Dividend =
100,000 shares x
RM27/sh.
Repurchase= 90,000
shares x RM30/sh.

Stock Repurchase Mechanics
 3 methods of repurchase
− Open-market repurchase
− One time basis using Dutch auction
− One time basis using fixed price
 In Dutch auction, the firm solicits and collects sell offers from
shareholders after establishing an acceptable range of offer prices.
 In fixed-price tender, the firm also solicits and collects sell offers from
shareholders but the firms announces in advance both price
(invariably substantially in excess of current market price) and
number of shares
29

Stock Repurchase and effects
 By repurchasing, the firm reduces the number of its outstanding
shares.
 Repurchased shares become treasury shares which can be resold
later or reissued.
 The 6 effects are:
− Firm’s assets are reduced because a portion of the firm’s cash assets flow out.
− Firm’s equity base is reduced.
− Firm has debt outstanding
− Market price of firm’s stock may rise
− May reduce liquidity by reducing the number of free-floating shares.
30

Impact on EPS
Original financial
statements Impact of dividend Impact of buy-back
£m £m £m
Operating profit 130 130 130
Interest income 20 0 0
Profit before tax 150 130 130
Taxation (50) (43) (43)
Profit after tax 100 87 87
Dividends paid (50) (443) (43)
Retained profits 50 (357) 43
Number of shares 500 500 300
eps, £ 0.200 0.173 0.289
31
Number of shares in issue (m) 500
Current share price, £ 2.00
Surplus cash (£m) 400

Stock repurchases vs Dividends
 Stock repurchase differs from dividends in that cash dividend are paid to
all shareholders in equal amounts and the thus the market value of the
all shares falls by an amount related to the per share amount whereas
stock repurchase uses cash to retire outstanding shares of any investors
who choose to sell their shares to the firm.
 Cash dividend is treated as income whereas stock repurchase is
considered capital gain.
32

Why some firms choose stock repurchases over dividends
1. Flexibility: Dividend is viewed as a commitment to their
stockholders and are quite hesitant to reduce an existing dividend.
Repurchases do not represent similar commitment. Firm with a
permanent increase in cash flow is likely to increase its dividends
payment. Conversely, a firm whose cash flow increase is only
temporary is likely to repurchase shares of stock.
2. Repurchase as investment when managers believe that the stock
price is temporarily depressed
3. Taxes: The tax rate on dividend is higher than taxes payable
under repurchases. Repurchases is associated with a lower
effective tax rate since one can defer the tax until the gains are
realized, but taxes are incurred when dividends are paid.

Reasons for companies to buy back their own shares
 To increase eps
 To increase management’s percentage holding
 More flexible than paying a dividend
 To buy out weaker shareholders
 To give shareholder a choice of how they get their return
 To offset eps dilution from share option exercise
 To improve management’s business focus by gearing up
 To reduce the cost of capital
34
Apply to buy-backs but not dividends
Apply to buy-backs and to dividends

JOURNAL ARTICLES
35

Information Asymmetry and Signalling
 A signalling model is based on the idea that firms with exceptionally
high value cannot easily convey that value to the market for 2
reasons:
 Because such information is generally strategic in nature
 Difficult to devise a credible signal
 Therefore, a high value company must devise a credible and
affordable signal that lower-value firms would find prohibitively
expensive to mimic.
 Several authors have developed theoretical models in which
dividends are an effective signal of a firm’s true value in a market
beset by information asymmetry.
 As in every signal model, the signal must be costly to prevent mimicking.
 The reasons why dividends are a costly signal varies.
− Bhattacharya (1979) - increase cost of issues shares in the future
− Miller and Rock’s (1985) – forgone investment projects
− John and William’s (1985) and Bernheim’s (1991) – higher taxes on dividends than
capital gains.
36

Dividend changes and future profitability
 Watts and Gonedes (1978) found no evidence of dividend changes and
firm’s future earnings.
 Benartzi, Michaely and Thaler (1997) also find no evidence that dividend
increasing firms have higher earnings.
 Brook, Charlton and Hendershott (1998) find firms with large permanent
cash flow tend to boost their dividends.
37

Dividend changes and Subsequent Capital Expenditures
 Yoon and Starks (1995) attempted to determine the source of wealth
effects surrounding dividend change announcements.
− Dividend increase represents management’s signal that the firm’s investment
opportunity has improved- cash flow signalling hypothesis posits a positive
relationship between dividend changes with capital expenditure changes.
− Dividend increase represents management is being disciplined to pay a higher
dividend – free cash flow hypothesis posits a negative relationship between
dividend changes with capital expenditure changes.
38

Dividend changes and Wealth Redistributions
For levered firm, the theory suggests 2 alternative hypothesis
about market’s positive and negative reactions to
announcements of a dividend increase and a dividend decrease,
respectively.
The Information Content (IC) hypothesis which posits that
announcement conveys information about the value of the firm –
that is higher than the market expected for dividend increase and
lower than the market expected for dividend cut/decrease.
The Wealth Redistribution (WR) hypothesis which posits that
dividend increase constitutes an expropriation of wealth from the
firm’s creditors.
Both hypothesis predicts stock price will move in the same
direction as the announced dividend change.
39

Dividend initiations and omissions
A dividend initiation or omission is a radical change in a firm’s
dividend policy.
According to evidence, the market generally welcomes the
firm’s announcement that it will initiate dividends.
All studies have found out average announcement period
abnormal return is not only positive but also quite substantial.
40

 Dividend omissions are qualitatively different from dividend cuts
because they represent a change in dividend policy rather than
simply the amount.
 Studies have found that market generally reacts very negatively to
dividend omission (Ghosh and Wooldridge, 1988; Healy and Palepu,
1988; Michaely, Thaler and Womack, 1995).
 Christie (1994) found dividend-omitting firms have abnormal returns
of -6.94%, on average.
41

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