Analysis of Dividends & Share Repurchases
READING 15: ANALYSIS OF DIVIDENDS AND SHARE REPURCHASES
EXAM FOCUS
The focus of the Level II exam is valuation, so pay close attention to the theories that explain how dividend policy affects company value and the signals investors get from dividend changes. Payout policy is broader than dividend policy because it includes other means (for example, special dividends and stock repurchases) by which companies can return cash to shareholders. In recent years, firms have announced plans to repurchase record numbers of shares, making share buybacks an important and timely topic. You should understand the factors that affect a firm's payout policy and be able to analyse the sustainability of dividends using coverage ratios.
MODULE 15.1: THEORIES OF DIVIDEND POLICY
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LOS 15.a: Describe the expected effect of regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits, and reverse stock splits on shareholders' wealth and a company's financial ratios.
Types of dividends:
- Regular cash dividends: Periodic dividend payments made in cash are known as regular cash dividends. Companies generally strive for stability in their regular dividends-raising them slowly and avoiding reductions. Stable or increasing regular dividends are perceived as a sign of consistent and growing profitability.
- Frequency of dividend payments: Frequency varies by market: companies in the United States and Canada typically pay dividends quarterly, while many European companies pay semiannually and many Asian companies pay annually.
- Extra or special (irregular) dividends: A cash dividend supplementing regular dividends, or a dividend by a company that normally does not pay dividends, is known as a special dividend. Special dividends are paid under unusual circumstances (for example, when the company sells off a division) and are expected to be non-recurring. Extra dividends may be paid after an especially profitable year when management does not want to commit to a permanently higher regular dividend.
- Liquidating dividend: A liquidating dividend is paid when the whole firm or part of it is sold, or when dividends are paid in excess of cumulative retained earnings (reducing stated capital). A liquidating dividend is a return of capital rather than a return on capital.
- Stock dividend: A non-cash dividend paid in the form of additional shares. After a stock dividend, shareholders hold more shares and the cost per share (basis per share) is lower while the total cost basis remains unchanged. Shareholders' proportionate ownership does not change because every shareholder receives the same percentage stock dividend. Shareholders are usually not taxed immediately on stock dividends. Because the market value of the company is unchanged, the market price per share declines proportionately, leaving the shareholder with no net gain.
- Stock dividend - numeric illustration: Imagine a company earning $100,000 annually with 100,000 shares outstanding and a market price per share of $10.
Current EPS = $100,000 / 100,000 = $1.00
Current P/E = 10.
Suppose the company declares a 10% stock dividend. After the stock dividend:
Shares outstanding = 100,000 × 1.10 = 110,000
EPS = $100,000 / 110,000 = $0.90909
If the original P/E multiple of 10 applies, the new price per share = 10 × $0.90909 = $9.0909 ≈ $9.091
Holder of 110 shares: 110 × $9.091 = $1,000, the same as before the stock dividend.
- Benefits and motivations for stock dividends: Stock dividends can encourage long-term investing and may reduce the company's cost of equity. They increase a stock's float and liquidity and can lower the market price per share to a trading range that attracts more retail investors. If a company maintains the same cash dividend per share after a stock dividend, it effectively increases total cash dividends paid; if it maintains the same total cash dividend, dividend per share decreases proportionately while dividend yield is unchanged.
- Geographic popularity: The popularity of stock dividends varies by market; for example, stock dividends are very popular in China.
- Stock splits: Similar to stock dividends but generally larger in magnitude. A two-for-one split equals a 100% stock dividend. Reverse stock splits reduce shares outstanding and increase price per share. Reverse splits are intended to bring share prices into ranges attractive to institutional investors; they are less common in Asia (reverse splits were illegal in Japan until 2001).
Accounting issues
Cash dividend payments reduce cash and stockholders' equity. This results in a lower quick ratio and current ratio, and higher leverage ratios (for example, debt-to-equity and debt-to-asset). Stock dividends, stock splits, and reverse stock splits leave the company's capital structure unchanged and do not affect these ratios. For a stock dividend, a reduction in retained earnings (equal to the value of the stock dividend) is offset by an increase in contributed capital, leaving total equity unchanged. Stock splits and reverse splits do not affect book value of equity nor the tax cost basis for shareholders.
LOS 15.b: Compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action.
Dividend irrelevance (Merton Miller and Franco Modigliani): MM maintain that dividend policy is irrelevant and does not affect a firm's stock price or its cost of capital. Their argument rests on the idea of homemade dividends: investors can adjust their own cash flows by buying or selling shares to replicate desired payout patterns. MM's dividend irrelevance result requires a perfect capital market with no taxes, no transaction costs, and infinitely divisible shares. MM's discussion pertains to the firm's total payout policy rather than only the narrow dividend policy.
Bird-in-the-hand (dividend preference) argument - Gordon and Lintner: Gordon and Lintner argue that the required rate of return on equity (rs) decreases as dividend payout increases because investors prefer the certainty of current dividends over the uncertainty of future capital gains. They assert that the dividend yield component, D1 / P0, has less risk than the growth component g. The argument is often called the bird-in-the-hand theory: a bird in the hand (current dividend) is worth more than two in the bush (expected capital gains).
Tax aversion: When dividends are taxed at higher rates than capital gains, investors prefer lower dividend payouts and more reliance on capital gains. Historical U.S. tax rates (1970s and 1990s) illustrate how differential taxation can affect investor preferences. Under extreme tax aversion, investors would prefer zero dividend payouts to avoid higher taxes. Real-world constraints-such as legal limits on accumulating earnings and changes in tax law (for example, the 2003 U.S. tax change that lowered individual tax rates on qualified dividends)-mitigate the pure tax-aversion outcome.
Conclusions from theory and evidence: Empirical results are mixed. Research indicates higher tax rates on dividends tend to reduce dividend payouts. Evidence also supports the bird-in-the-hand idea for some firms and investor groups. MM respond by noting that different dividend policies appeal to different investor clienteles; if all clienteles are active, dividend policy may not affect firm value when clienteles are satisfied.
LOS 15.c: Describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey.
Information asymmetry exists between corporate insiders (board and management) and outside investors. Dividends convey more credible information than verbal statements because dividends are actual cash flows and are expected to be sticky (likely to continue). Managers typically avoid increasing dividends unless they expect to maintain the higher level in the future, and they avoid cutting dividends unless long-run prospects have deteriorated.
Dividend initiation: Ambiguous signal. Initiating a dividend may signal management's optimism about future prospects (positive), or it may signal a lack of profitable reinvestment opportunities (negative).
Unexpected dividend increase: Usually a positive signal that future business prospects are strong; companies with long histories of dividend increases often have high returns on assets and low debt ratios.
Unexpected dividend decrease or omission: Typically a negative signal indicating trouble and management's expectation that the current dividend cannot be maintained. In rare cases a cut can be positive if management prefers to reinvest earnings in profitable projects that yield greater shareholder value than distributing cash.
LOS 15.d: Explain how agency costs may affect a company's payout policy.
Agency costs
- Agency costs between shareholders and managers: Managers may prefer to overinvest (empire building), leading to investment in negative NPV projects and reduced shareholder wealth. Increasing payout of free cash flow as dividends reduces the cash available for such overinvestment and therefore reduces agency costs. Growing firms typically retain more earnings to fund positive NPV investments; mature firms in stable industries may return more cash to shareholders.
- Agency costs between shareholders and bondholders: When a firm has risky debt, shareholders may have an incentive to pay large dividends, shrinking the asset base that secures bondholders and transferring wealth to shareholders. Bond indentures typically include covenants to restrict such transfers, for example by limiting dividend payments or requiring maintenance of liquidity and coverage ratios.
LOS 15.e: Explain factors that affect dividend policy in practice.
A company's dividend payout policy determines the amount and timing of dividend payments. Six primary factors affect dividend policy:
- Investment opportunities: Availability of positive NPV investments and the speed required to exploit them determine the cash a firm must retain. Firms with many profitable rapid-response opportunities tend to have lower payout ratios.
- Expected volatility of future earnings: Firms tie target payout ratios to long-run sustainable earnings and are reluctant to change dividends when earnings are volatile.
- Financial flexibility: Firms that value flexibility may prefer stock repurchases to dividends because repurchases are not viewed as sticky commitments. Retaining cash preserves flexibility for unforeseen needs and investment opportunities, especially in crises when credit markets tighten.
- Tax considerations: Investors care about after-tax returns. When capital gains are taxed more favourably than dividends, high-tax-bracket individual investors prefer low dividend payouts while tax-exempt or low-tax investors (such as pension funds and corporations) prefer higher dividends.
Additional practical considerations related to tax:
- Taxes on dividends are paid when dividends are received, while taxes on capital gains are paid only when shares are sold.
- The cost basis of shares may receive a step-up at a shareholder's death, potentially avoiding capital gains taxes entirely for estates.
- Tax-exempt institutions (pension funds, endowments) are indifferent between dividends and capital gains.
- Flotation costs: Issuing new equity incurs flotation costs (typically 3%-7%), making new equity more expensive than retained earnings. Higher flotation costs lower expected dividend payouts because firms prefer to retain earnings rather than issue costly new shares for positive NPV projects.
- Contractual and legal restrictions: Legal and contractual limits can restrict dividend payments. Examples include:
Common restrictions:
- The impairment of capital rule: in some jurisdictions dividends cannot exceed retained earnings.
- Debt covenants: bond agreements may require minimum liquidity or coverage ratios before permitting dividends.
LOS 15.f: Calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation, dividend imputation, and split-rate tax systems.
Double taxation system: Earnings are taxed at the corporate level and dividends are taxed again at the shareholder level. The effective tax rate on a dollar of earnings distributed as dividends is:
effective tax rate = corporate tax rate + (1 - corporate tax rate) × individual tax rate
EXAMPLE - Effective tax rate under double taxation
A U.S. company's annual earnings are $300, corporate tax rate = 35%. The company pays out 100% of earnings as dividends. Individual tax rate on dividend income = 15%. Calculate effective tax rate on a dollar paid as dividends.
Answer:
Effective (double) tax rate calculation shown as both an arithmetic result and as application of formula:
0.35 + (1 - 0.35)(0.15) = 0.4475 or 44.75%
Alternatively expressed as:
Effective (double) tax rate = (300 - 165.75) / 300 = 44.75%
Split-rate system: Corporate tax on distributed earnings is lower than on retained earnings, offsetting part of the double taxation effect. The effective tax rate uses the corporate tax rate applicable to distributed income in the double taxation formula.
EXAMPLE - Effective tax rate under a split-rate system
A company has pretax earnings €300. Corporate tax rate on retained earnings = 35%; corporate tax rate on distributed earnings = 20%. The company pays out 50% of earnings as dividends. Individual tax rate on dividends = 30%. Effective tax rate on one euro of earnings distributed as dividends:
Answer:
effective tax rate on income distributed as dividends = 20% + [(1 - 20%) × 30%] = 44%
Note: Distributed earnings are still taxed twice but the corporate portion uses the lower distributed-income corporate rate.
Imputation tax system: Corporate taxes are attributed to shareholders as credits, so taxes are effectively paid at the shareholder's marginal rate. Shareholders receive a tax credit for corporate taxes paid. If the shareholder's tax bracket is lower than the corporate rate, the shareholder receives a refund or credit; if higher, the shareholder pays the difference.
EXAMPLE - Effective tax rate under an imputation system
Phil Cornelius and Ian Todd each own 100 shares in a British corporation making £1.00 per share pretax. The corporation pays out all income as dividends. Cornelius's individual tax rate = 20%; Todd's = 40%. Corporate tax rate = 30%. Calculate effective tax rate on the dividend for each shareholder.
Answer:
Under an imputation system, the effective tax rate on the dividend equals the shareholder's marginal tax rate. Thus, Cornelius: 20%; Todd: 40%.
MODULE QUIZ 15.1
Use the following information to answer Questions 1 through 4.
Klaatu is a country that taxes dividends based on a double-taxation system. The corporate tax rate on company profits is 35%. Barada is a country that taxes dividends based on a split-rate tax system. The corporate tax rate applied to retained earnings is 36%, while the corporate tax rate applied to earnings paid out as dividends is 20%. Nikto is a country that taxes dividends based on an imputation tax system. The corporate tax rate on earnings is 38%.
1. An investor living in Klaatu holds 100 shares of stock in the Lucas Corporation. Lucas's pretax earnings for the current year are $2.00 per share, and the company has a payout ratio of 100%. The investor's individual tax rate on dividends is 30%. The effective tax rate on a dollar of funds to be paid out as dividends is closest to:
- A. 35.0%.
- B. 54.5%.
- C. 62.3%.
2. An investor living in Barada holds 100 shares of Prowse, Inc. Prowse's pretax earnings in the current year are $1.00 per share, and Prowse pays dividends based on a target payout ratio of 40%. The individual tax rate that applies to dividends is 28%, and the individual tax rate that applies to capital gains is 15%. The effective tax rate on earnings distributed as dividends is:
- A. 20.0%.
- B. 42.4%.
- C. 53.9%.
3. Jenni White and Janet Langhals are each shareholders that live in Nikto, and each owns 100 shares of OCP, Inc., which has €1.00 per share in net income. OCP pays out 100% of its earnings as dividends. White is in the 25% tax bracket, while Langhals is in the 42% tax bracket. The effective tax rate on earnings paid out as dividends is:
- A. 28.0% for White and 42.0% for Langhals.
- B. 53.5% for White and 64.0% for Langhals.
- C. 25.0% for White and 42.0% for Langhals.
4. The bird-in-hand argument for dividend policy is based on the idea that:
- A. rs = D1 / P0 + g is constant for any dividend policy.
- B. a decrease in current dividends signals that future earnings will fall.
- C. because of perceived differences in risk, investors value a dollar of dividends more highly than a dollar of expected capital gains.
MODULE 15.2: STOCK BUYBACKS
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LOS 15.g: Compare stable dividend with constant dividend payout ratio, and calculate the dividend under each policy.
Stable dividend policy
A stable dividend policy focuses on a steady dividend payout even when earnings are volatile. Firms that adopt a stable dividend typically forecast long-run earnings to determine an appropriate stable dividend level, aligning dividend growth with long-term earnings growth. A firm may gradually move toward a target payout ratio using a target payout adjustment model.
Target payout adjustment model
If earnings are expected to increase and the current payout ratio is below the target, an investor can estimate future dividends using the target payout adjustment approach.
EXAMPLE - Expected dividend based on a target payout adjustment approach
Last year, Buckeye, Inc., had earnings of $3.50 per share and paid a dividend of $0.70. In the current year, the company expects earnings of $4.50 per share. The company has a 35% target payout ratio and plans to reach it over a 5-year period. Calculate the expected dividend for the current year using the target payout adjustment model.
Answer:
expected increase in dividends
= [(expected earnings × target payout ratio) - previous dividend] × adjustment factor
= [($4.50 × 35%) - $0.70] × 0.2 = $0.175
expected dividend for the current year
= previous dividend + expected increase in dividends
= $0.70 + $0.175 = $0.875
PROFESSOR'S NOTE: The payout ratio may appear to fall in a single year under the adjustment model even though the firm is moving toward its target payout ratio over the long term. Year-to-year inconsistencies can occur, but the approach is designed to work over the long run.
Constant dividend payout ratio policy
A constant payout ratio means paying a fixed percentage of earnings each year as dividends. Dividends vary directly with earnings. A strict constant payout ratio is rarely used because it causes dividend volatility when earnings fluctuate.
LOS 15.h: Describe broad trends in corporate payout policies.
General global trends:
- In developed markets, the proportion of companies paying cash dividends has trended downwards over long periods.
- The percentage of companies repurchasing shares has risen in the United States since the 1980s and in the United Kingdom and continental Europe since the 1990s. Major companies in Asia (particularly China and Japan) have engaged in substantial repurchases since the 2010s.
LOS 15.i: Compare share repurchase methods.
Four common methods of buybacks (market rules may restrict choices):
- Open market transactions: The company repurchases shares in the open market. This is the most flexible approach; the company is not obligated to complete an announced program. Outside the United States and Canada, open market transactions (method 1) are used almost exclusively.
- Fixed-price tender offer: The firm offers to buy a specified number of shares at a fixed price, typically at a premium to market. The firm can complete purchases quickly. If more shares are tendered than desired, purchases are typically prorated across tendering shareholders.
- Dutch auction: The company specifies a range of acceptable prices rather than a single price. Shareholders submit bids indicating price and number of shares. Bids are accepted starting from the lowest price until the desired quantity is filled; all accepted bids receive the highest accepted price (the clearing price).
- Repurchase by direct negotiation: The company purchases shares directly from a major shareholder, often at a premium. This can be used to remove a large overhang (or in greenmail situations). Negotiated purchases sometimes occur at a discount when sellers face urgent liquidity needs.
LOS 15.j: Calculate and compare the effect of a share repurchase on earnings per share when 1) the repurchase is financed with the company's surplus cash and 2) the company uses debt to finance the repurchase.
Repurchases funded with surplus cash reduce cash and shareholders' equity, increasing leverage and usually reducing liquidity ratios. Fewer shares outstanding can increase EPS. When repurchases are financed by new debt, the after-tax interest expense reduces net income and must be included when assessing the effect on EPS.
EXAMPLE - Methods of financing a stock repurchase and their effect on EPS
JetFun, Inc., has 10 million shares outstanding and net income of $50 million. The company has $100 million excess cash earning no return and is considering repurchasing 2 million shares at a 25% premium over current market price of $40. Compare effects on EPS when the repurchase is:
(1) financed using surplus cash; (2) financed using new debt borrowed at an after-tax interest rate of 3%.
Answer:
Current EPS = $50 million / 10 million shares = $5
Repurchase price = $40 × (1 + 0.25) = $50 per share
Total cost of repurchase = $50 × 2 million = $100 million
Shares outstanding after buyback = 10 million - 2 million = 8 million
Using surplus cash:
foregone income = $0
new EPS = $50 million / 8 million = $6.25
Using new debt:
after-tax cost of funds = 3% × $100 million = $3 million
earnings after deducting cost of funds = $50 million - $3 million = $47 million
new EPS = $47 million / 8 million = $5.875
Note: EPS increases in both scenarios because the earnings yield before repurchase (EPS / price paid per share = 5 / 50 = 10%) is greater than the after-tax cost of debt (3%) used to finance the repurchase. When earnings yield exceeds after-tax cost of debt, repurchases increase EPS. However, higher leverage may raise cost of capital; an increase in EPS does not automatically imply an increase in shareholder wealth.
LOS 15.k: Calculate the effect of a share repurchase on book value per share.
After a repurchase, outstanding shares fall and book value per share (BVPS) changes. If the price paid per share is greater than pre-repurchase BVPS, BVPS will fall; if the price paid is less than pre-repurchase BVPS, BVPS will rise.
EXAMPLE - Impact of share repurchase on book value per share
Consider two companies, Alpha and Beta, each planning to repurchase $5 million of shares. The provided result (data in original problem) shows:
Alpha's BVPS decreased from $15.00 to $13.33 after the buyback because the repurchase price ($20.00) exceeded the pre-repurchase BVPS of $15.00.
Beta's BVPS increased from $25.00 to $26.67 after the buyback because the repurchase price ($20.00) was less than the pre-repurchase BVPS of $25.00.
LOS 15.l: Explain the choice between paying cash dividends and repurchasing shares.
Five common rationales for repurchases over dividends:
- Potential tax advantages: When tax rates on capital gains are lower than rates on dividends, repurchases can be more tax-efficient for many investors.
- Share price support and signalling: Management may repurchase shares to signal that it considers the shares undervalued. Repurchases can convey confidence about the company's future in the presence of information asymmetry.
- Added flexibility: Repurchases are not perceived as sticky commitments like dividends. Companies can pay a small regular dividend and use repurchases to return additional cash when desirable, timing purchases opportunistically.
- Offsetting dilution: Repurchases can offset EPS dilution from employee stock option exercises.
- Increasing financial leverage: When funded by debt, repurchases lower equity and increase leverage, allowing management to adjust capital structure toward a desired target.
EXAMPLE - Impact of share repurchase and cash dividend of equal amounts
Spencer Pharmaceuticals, Inc. (SPI) has 20,000,000 shares outstanding with a market value of $50 per share. SPI earned $100 million this quarter; directors will reinvest 70% and distribute the remaining 30% ($30,000,000). Two alternatives:
(1) Pay a cash dividend of $30,000,000 / 20,000,000 = $1.50 per share.
(2) Repurchase $30,000,000 of common stock at $50 per share.
Assume dividends are received when shares go ex-dividend, the repurchase can be executed at $50 per share, and tax treatment is the same under both alternatives. How is a shareholder's wealth affected?
Answer:
Cash dividend:
After ex-dividend, one share is worth $50 - $1.50 = $48.50 plus $1.50 in cash = $50 total wealth.
Share repurchase:
With $30,000,000 the firm can repurchase $30,000,000 / $50 = 600,000 shares.
After the repurchase the value per remaining share is the market value of equity after repurchase divided by remaining shares; the total wealth for one shareholder remains $50.
This demonstrates that, assuming identical tax treatment, repurchases and dividends of equal amounts have the same economic effect on shareholder wealth.
What if the company borrows to repurchase shares?
EXAMPLE - Share repurchase when after-tax cost of debt is less than earnings yield
Using SPI data: share price = $50; shares outstanding = 20,000,000; EPS before buyback = $5.00; earnings yield = 5 / 50 = 10%; after-tax cost of borrowing = 8%; planned buyback = 600,000 shares. Calculate EPS after buyback.
Answer:
total earnings = $5.00 × 20,000,000 = $100,000,000
Because after-tax cost of borrowing (8%) < earnings yield (10%), repurchase increases EPS.
EXAMPLE - Share repurchase with borrowed funds when after-tax cost of debt exceeds earnings yield
Using the same SPI data but with after-tax borrowing cost = 15% (creditors perceive higher risk). Calculate EPS after buyback.
Answer:
Because after-tax cost of borrowing (15%) > earnings yield (10%), added interest reduces earnings and EPS after buyback is less than the original $5.00.
Conclusion: A repurchase financed by debt increases EPS if the after-tax cost of debt < earnings yield; decreases EPS if cost > earnings yield; and leaves EPS unchanged if cost = earnings yield.
LOS 15.m: Calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow.
LOS 15.n: Identify characteristics of companies that may not be able to sustain their cash dividend.
Dividend safety measures the probability that dividends will continue at current levels. Traditional ratios include the dividend payout ratio (dividends / net income) and its inverse, the dividend coverage ratio (net income / dividends). A high payout ratio (and low coverage ratio) signals a greater risk of a dividend cut. These ratios should be compared with industry and market averages. Stable or increasing dividends are viewed favourably; past dividend cuts are viewed unfavourably.
Free cash flow to equity (FCFE) coverage is also important. FCFE is the cash flow available for distribution to shareholders after capital expenditures and working capital needs. The FCFE coverage ratio is defined as FCFE / (dividends + share repurchases). A FCFE coverage significantly below one is considered unsustainable because the company is drawing down cash reserves to meet payouts.
EXAMPLE - Dividend sustainability analysis (Chevron Corp.)
Selected financial data for years ending 31 December 2008 and 2009 are provided in the exercise. Using the information given, calculate dividend payout ratio, dividend coverage ratio, and FCFE coverage ratio, and discuss trends.
Answer:
a. Dividend payout ratio = dividend / net income
2008: 5,261 / 23,931 = 0.22 or 22%
2009: 5,373 / 10,483 = 0.51 or 51%
b. Dividend coverage ratio = net income / dividend
2008: 23,931 / 5,261 = 4.55
2009: 10,483 / 5,373 = 1.95
FCFE = cash flow from operations - FCInv + net borrowings
2008: FCFE = 29,632 - 19,666 + 1,682 = 11,648
2009: FCFE = 19,373 - 19,843 + 1,659 = 1,189
FCFE coverage ratio = FCFE / (dividends + share repurchases)
2008: FCFE coverage = 11,648 / (5,261 + 6,821) = 11,648 / 12,082 = 0.96
2009: FCFE coverage = 1,189 / [5,373 + (-168)] = 1,189 / 5,205 = 0.23
Discussion:
The dividend coverage ratio declined markedly from 4.55 in 2008 to 1.95 in 2009. The FCFE coverage ratio fell from 0.96 to 0.23. The FCFE coverage < 1="" in="" both="" years="" indicates="" payouts="" (dividends="" plus="" repurchases)="" exceeded="" fcfe="" in="" 2008="" and="" especially="" in="" 2009,="" drawing="" down="" cash="" reserves.="" the="" fall="" in="" coverage="" ratios="" suggests="" lower="" dividend="" sustainability="" in="" 2009="" than="" in="">
Conclusion regarding sustainability: Although Chevron's dividend coverage was still nearly 2 times in 2009 by net income, the FCFE coverage ratio indicates payouts exceeded sustainable free cash flow, and the drop in FCFE coverage implies the payout policy may not be sustainable without changes (for example, resumption of repurchases or reduction in dividend if poor earnings persist).
PROFESSOR'S NOTE: FCFE is discussed extensively in the Equity Valuation portion of the curriculum.
MODULE QUIZ 15.2
1. Over the past 25 years, in the developed markets including the United States, the United Kingdom, and the European Union, the fraction of companies that:
- A. pay out cash dividends has decreased.
- B. repurchase shares has decreased.
- C. use particular dividend policies has been consistent over time and across countries.
2. Which of the following is most likely to be sustainable?
- A. A FCFE coverage ratio of 0.5.
- B. A dividend payout ratio of 0.5.
- C. A dividend coverage ratio of 0.5.
3. Nick Adams is recommending to the board of directors that they share the profits from an excellent year (totaling $56 million) with shareholders by either declaring a special cash dividend of $20 million, or using the $20 million to repurchase shares of Volksberger common stock in the open market. Selected financial information about the firm is shown in the following: (data as provided in original problem)
Adams drafts a memo to the board detailing the financial impact of a special cash dividend versus repurchasing shares. His memo includes two statements (as in the original problem). Which of Adams's statements are correct?
- A. Both statements are correct.
- B. Only one of the statements is correct.
- C. Neither statement is correct.
4. Which of the following would not be a good reason for a company to repurchase shares of its own stock? Management:
- A. believes a stable cash dividend is in the best interests of shareholders.
- B. believes its stock is overvalued.
- C. wants to increase the amount of leverage in its capital structure.
5. Last year, Wolverine Shoes and Boots had earnings of $4.00 per share and paid a dividend of $0.20. In the current year, the company expects earnings of $4.40 per share. The company has a 30% target payout ratio and plans to bring its dividend up to the target payout ratio over an 8-year period. Next year's expected dividend is closest to:
- A. $0.14.
- B. $0.24.
- C. $0.34.
KEY CONCEPTS
LOS 15.a
Cash dividend payments reduce cash and stockholders' equity, lowering current and quick ratios and raising leverage ratios (for example, debt-to-equity and debt-to-asset). Stock dividends and stock splits leave capital structure unchanged. In a stock dividend, retained earnings decline by the value of the dividend while contributed capital increases by the same amount; total equity is unchanged.
LOS 15.b
Three main investor preference theories:
- MM dividend irrelevance: In a no-tax/no-cost world, dividend policy is irrelevant because investors can create homemade dividends.
- Dividend preference (bird-in-the-hand): Investors prefer certain current cash (dividends) over uncertain future capital gains.
- Tax aversion: When dividends are taxed more heavily than capital gains, investors prefer firms to buy back shares rather than pay dividends.
LOS 15.c
Dividends convey signals about future earnings because they are costly and sticky. Unexpected increases are generally interpreted as good news; unexpected decreases are generally interpreted as bad news in many markets.
LOS 15.d
Two types of agency conflicts affect payout policy:
- Shareholders vs managers: Paying out more free cash flow reduces overinvestment in negative NPV projects.
- Shareholders vs bondholders: Shareholders may expropriate bondholders by paying large dividends; bond indentures and covenants limit such transfers.
LOS 15.e
Six primary factors affecting dividend policy: investment opportunities, expected earnings volatility, financial flexibility, tax considerations, flotation costs, and contractual/legal restrictions (for example, impairment of capital rules and debt covenants).
LOS 15.f
Effective tax rate under double taxation:
effective rate = corporate tax rate + (1 - corporate tax rate) × individual tax rate
A split-rate system uses the corporate rate applicable to distributed income in the same formula. Under an imputation system, taxes are credited to shareholders so the effective tax rate on dividends equals the shareholder's marginal tax rate.
LOS 15.g
Stable dividend policy: Align dividend growth with long-term earnings growth; use target payout adjustment to move toward a target payout ratio gradually.
Constant payout ratio: Pay a fixed proportion of earnings each year; dividends vary directly with earnings and are seldom used strictly because they produce volatile dividends.
LOS 15.h
Global trends: proportion paying cash dividends has fallen; share repurchases have increased in many developed markets since the 1980s and have grown in Asia in the 2010s.
LOS 15.i
Common repurchase methods: open market transactions; fixed-price tender offers; Dutch auctions; repurchase by direct negotiation.
LOS 15.j
Repurchases using surplus cash reduce cash and equity and increase leverage; fewer shares outstanding can raise EPS. When financed with debt, EPS increases only if after-tax cost of debt < earnings yield; otherwise EPS falls. Increased EPS from leverage must be weighed against higher cost of capital and risk.
LOS 15.k
After a repurchase, BVPS changes: BVPS falls if purchase price > pre-repurchase BVPS; BVPS rises if purchase price < pre-repurchase BVPS.
LOS 15.l
Rationales for repurchases vs dividends: tax advantages; share price support/signalling; flexibility; offsetting option dilution; changing capital structure (increasing leverage).
LOS 15.m
Dividend coverage ratio = net income / dividends
FCFE coverage ratio = FCFE / (dividends + share repurchases)
LOS 15.n
For both dividend and FCFE coverage, ratios below industry averages or trending downward indicate potential problems with dividend sustainability.
ANSWER KEY FOR MODULE QUIZZES
Module Quiz 15.1
1. B The effective tax rate on earnings distributed as dividends is 0.35 + (1 - 0.35)(0.30) = 0.545 = 54.5%. (LOS 15.f)
2. B The effective tax rate on earnings distributed as dividends is 0.20 + (1 - 0.20)(0.28) = 0.424 = 42.4%. (LOS 15.f)
3. C Under an imputation tax system, the effective tax rate on earnings distributed as dividends is the tax rate of the shareholder receiving the dividends. (LOS 15.f)
4. C The bird-in-the-hand argument is based on the fact that a dividend payment is more certain than future capital gains. (LOS 15.b)
Module Quiz 15.2
1. A Over the past decades, the percentage of companies engaging in share repurchases has increased over time while the fraction paying cash dividends has decreased. Dividend policies also differ across countries. (LOS 15.h)
2. B An FCFE coverage ratio or dividend coverage ratio much less than one is not sustainable because the company is drawing on cash and securities to make payments. A dividend payout ratio less than one indicates the company is paying out less in dividends than it earns, which is normally sustainable. (LOS 15.n)
3. C Adams is incorrect with respect to Statement 1. If the firm pays a special dividend of $20 million, both assets and equity drop by $20 million. The total wealth per share remains $28, matching the repurchase alternative. Adams is also incorrect with respect to Statement 2. With the current EPS $56 million / 40 million = $1.40 and price $28, the buyback of $20 million / $28 = 714,286 shares leaves price unchanged at $28 and EPS increases to $56 million / 39,285,714 = $1.43. Since price stays the same and EPS rises, the P/E ratio falls slightly after the repurchase. (LOS 15.j)
4. B Management would repurchase shares if it believed the shares were undervalued, not overvalued. (LOS 15.l)
5. C
expected increase in dividends
= [(expected earnings × target payout ratio) - previous dividend] × adjustment factor
= [($4.40 × 30%) - $0.20] × (1 / 8)
= $0.14
expected dividend for the current year
= previous dividend + expected increase in dividends
= $0.20 + $0.14 = $0.34
(LOS 15.g)
