ch10 dividends and share repurchases

武汉科技大学财务管理基础课件

CHAPTER 10 Distributions to shareholders:Dividends and share repurchasesTheories of investor preferences Signaling effect and clientele effect Dividend policies in practice Stock dividends and stock splits Stock repurchases10-1

武汉科技大学财务管理基础课件

10.1 Theories of investor preference

Ch10 Dividends and share repurchases

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武汉科技大学财务管理基础课件

Stock Returns:

Return =

P1 - Po + D1 Po

=

P1 - Po D1 + Po Po Capital Gain Dividend Yield10-3

Ch10 Dividends and share repurchases

武汉科技大学财务管理基础课件

Dilemma: Should the firm use earnings for:a) Financing profitable capital investments? b) Paying dividends to stockholders?

Ch10 Dividends and share repurchases

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武汉科技大学财务管理基础课件

So, dividend policy really involves 2 decisions:How much of the firm’s earnings should be distributed to shareholders as dividends, and How much should be retained for capital investment?

Ch10 Dividends and share repurchases

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武汉科技大学财务管理基础课件

In other words, the purpose of dividend policy is to decide the target payout ratio, which is based on investors’ preference.

Ch10 Dividends and share repurchases

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武汉科技大学财务管理基础课件

Do investors prefer high or low dividend payouts?Three theories of investor preference

Dividend irrelevance Bird-in-the-hand Tax preference

Ch10 Dividends and share repurchases

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武汉科技大学财务管理基础课件

Dividends Irrelevance TheoryInvestors do not care about a firm’s dividend policy. With perfect markets, investors are concerned only with total returns, and do not care whether returns come in the form of capital gains or dividend yields. repurchases Ch10 Dividends and share

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武汉科技大学财务管理基础课件

Return =

P1 - Po Po

+

D1 Po

If we retain earnings for profitable investments, dividend yield will be zero, but the stock price will increase, resulting in a higher capital gain.

Ch10 Dividends and share repurchases

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武汉科技大学财务管理基础课件

Return =

P1 - Po Po

+

D1 Po

If we pay dividends, stockholders receive an immediate cash reward for investing, but the capital gain will decrease, since this cash is not invested in the firm.

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武汉科技大学财务管理基础课件

So, a firm’s dividend policy has no effect on either its value or its cost of capital.

Proposed by: M&M. Assumption: perfect markets (notaxes, no transaction costs, etc.)Ch10 Dividends and share repurchases

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武汉科技大学财务管理基础课件

Bird-in-the-hand theorySome investors may prefer a certain dividend now over a risky expected capital gain in the future. Implication: setting a high dividend payout ratio.

Return =?

P1 - Po Po

+

D1 Po10-12

Ch10 Dividends and share repurchases

武汉科技大学财务管理基础课件

Tax Preference TheoryInvestors may prefer a low dividend payout to a high one because of tax differences: Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends: 20% vs. up to 38.6% in the U.S. Dividends are taxed immediately. Capital gains are not taxed until the stock is sold. Therefore, taxes on capital gains can be deferred indefinitely.

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武汉科技大学财务管理基础课件

This could cause investors to preferfirms with low payouts.

Implication:

Set a low payout.

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武汉科技大学财务管理基础课件

Possible stock price effectsStock Price ($)

Bird-in-the-Hand 40 30 20 10 Irrelevance

Tax preference

0

Ch10 Dividends and share repurchases

50%

100%

Payout

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武汉科技大学财务管理基础课件

Possible cost of equity effectsCost of Equity (%)

3025 20 15 10 5 0Ch10 Dividends and share repurchases

Tax preference

Irrelevance

Bird-in-the-Hand 50% 100%Payout10-16

武汉科技大学财务管理基础课件

Which theory is most correct?Empirical testing has not been able to determine which theory, if any, is correct.Investor’s preference may vary over time.

Ch10 Dividends and share repurchases

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武汉科技大学财务管理基础课件

10.2 Signaling effect and clientele effect

Ch10 Dividends and share repurchases

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武汉科技大学财务管理基础课件

Signaling (information content) hypothesisInvestors regard dividend changes as signals of management’s earnings forecasts. This is because— Managers have better information about the future of thefirm. Managers hate to cut dividends, so they won’t raise dividends unless they think raise is sustainable. Investors view dividend increases as signals of management’s optimistic view of the future.

However, empirical results are mixed.Ch10 Dividends and share repurchases

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