Chapter 16 Distribution Policy

1. Chapter 16Distribution Policy Updated 2-2015

2. Introduction Distribution policy: • Cash • Cash dividend • Share buyback • Non-cash • Stock dividend • Stock split

3. Introduction What firm can do with cash generated from operations? • Use cash to finance new investments (projects) • Use cash to pay back debt • Distribute cash back to shareholders via 3.1 Cash dividend • Cash is paid directly to shareholders 3.2 Share repurchase (buyback) • Use cash to buy back its own shares from the market • Reducenumber of outstanding shares

4. Cash Dividend & Share Buyback Impact on balance sheet: • Assets side • Cash is reduced due to cash dividend or share repurchase. • Equity side • Corresponding decrease in equity

5. Cash Dividends Dividend policy has two main attributes: • Dividend payout ratio • Amount of dividend paid relative to earnings • DPS = $2, EPS = $4, P/O ratio = $2÷ $4 = 50% • Pattern of dividends followed over time • Increase, decrease, stable dividends • From investor’s perspective, dividend stability may be almost as important as the amount of dividends received. Question 1 & 2

6. Dividend Payment Procedures Question 3

7. Share Repurchases (Buyback) How do firms buyback their shares? • Open Market Repurchase: • Firm buys its stocks on the market (thru. share buyback program) • Often buying a relatively small number of shares everyday at the going market price • Most common method • Tender Offer: • Firm makes a formal offer to buy a large number of shares at a stated price (tender price is set abovemarket price to attract sellers). • Use when firm wants to buys large number of shares very quickly • Direct Purchase from Large Investor: • Firm buys shares from one or more major shareholders on a negotiated basis. • Not used frequently

8. Individual Wealth Effects: Personal Taxes Tax rules on cash dividends & share repurchases: • 100% of cash dividends are taxable in the year in which they are received. • For share buyback, when individuals sell shares back to firm, tax is assessed only on the capital gain (difference between selling price and buying price). Q. 10: Stock repurchase & taxes Q. 11: Cash dividend & taxes

9. Non-Cash Distributions: Stock Dividends and Stock Splits • Stock dividend: • A pro-rata distribution of additional stocks to firm’s current stockholders. • Ex. Firm pays stock dividend of 1 additional stock per 10 stocks investor has. • Stock split: • Ex. 2-for-1 split • Investor receive 2 new stocks for every one old stock currently has. Stock splits & stock dividends increase total number of stocks outstanding and reducestock price per share but do notchange firm value. Question 8

10. Dividend Irrelevancy Proposition • By Modigliani & Miller: • Timing of dividend distributions does not affect firm value. • In the absence of personal taxes and transaction costs, a cash dividend is equivalent to a share repurchase (same impact on the wealth of shareholders).

11. Figure 16.2 Dividend Policy Choices Faced by Clinton Enterprises • Assume: • No debt in capital structure (all-equity firm) • Stockholder’s required return = 15% • Expected CF: Y0=$35 M; Y1=$135 M. • Dividend Policy: Pay 100% of Y0 & Y1 CF If firm has 10 million shares outstanding: Value per share = $152.39 M. ÷10 M. sh. = $15.24

12. Figure 16.2 Dividend Policy Choices Faced by Clinton Enterprises • Same expected CF: Y0=$35 M; Y1=$135 M. • Y0: Pay 150% of cash = 150%*$35 M. = $52.5 M • Issue shares worth $52.5M-$35M = $17.5M • New S/H require 15% return, then they expect to receive $17.5M*(1+15%) = $20.125M • Available cash to old S/H in Y1 = $135M-$20.125 = $114.875M • Value per share = $152.39 M.÷10 M sh. = $15.24 • No matter firm pays 100% or 150% of Y0 cash in dividends to S/H, value per share remains $15.24. • This example shows that timing of dividend payment does not affect firm value. • This was true because we held constant firm’s investment cash flows. • We also assume that new shares could be issued under the same terms as existing shares.

13. Why Distribution Policy is Important? Information conveyed by dividend announcement: • Firms tend to increase their dividends when dividends can be sustained in the future. In such case, dividend increase is clearly good news. Information conveyed by share repurchases: • Firm has generated more money than it currently needs. • Equity is currently underpriced.

14. Why Distribution Policy is Important? Information conveyed by stock splits: • The announcement of stock splits tend to generate positive stock returns. Some have suggested that firms have a preferred trading range and stock splits help bring stock prices to that trading range.

15. Residual Dividend Policy Firm firstly finances its investments using its own earnings, then dividends are paid out of the residual earnings that are not needed to finance new investment opportunities. Ex.: NI = $60 M. Investment = $24 M. Residual earnings = $60 M.- $24 M = $36 M. Dividend payments = $36 M. Payout ratio = $36 M. / $60 M = 60%

16. Exercises (End of Chapter) Q. 1: Q. 2:

17. Exercises (End of Chapter) Q. 3: Q. 10:

18. Exercises (End of Chapter) Q. 11: Q. 8:

19. Personal Summary • Write down one thing you learned in this chapter that is interesting, new, or useful to you. • ____________________________________________________________________________________________________________________________________________