DISTRIBUTION TO SHAREHOLDERS

• Dividends


  Distribution of income to shareholders
• Stock repurchases


  A transaction in which a firm buys back shares of its own stock, thereby decreasing shares outstanding, increasing EPS, and often, increasing stock price
• Distributing income to shareholders

  1. Reinvest in operating assets

  2. Use to retire debt

  3. Distribute to shareholders
• Distributing income to shareholders

  • How much should be distributed?
  • Should the distribution be in the form of dividends, or should cash be passed on to shareholders by buying back stock?
  • How stable should the distribution be?
• Shareholders prefer stable and dependable funds paid out from year to year, while managers tend to prefer varied distributions depending on the firm's cash flows and investment requirements
• Every peso that management chooses to retain is a peso that shareholders could have received and invested elsewhere
• High growth companies with many good projects/investment opportunities

  Tend to retain a high percentage of their earnings
• Mature companies with a great deal of cash but limited investment opportunities


  Tend to have generous cash distribution policies
• Dividend payout ratio (DPOR)


  The target percentage of net income paid out as cash dividends
• Investors can prefer to receive dividends or have the firm plow the cash back into the business which will produce capital gains
• If the company increases the DPOR

  This will raise expected DPS, which, taken alone, will cause the stock price to rise
• If Expected DPS is raised

  Less money will be available for reinvestment, which will cause expected growth to decline, which tends to lower the stock price
• Any change in the Dividend payout policy will have two opposing effects
• Optimal dividend policy


  The dividend policy that strikes a balance between current dividends and future growth and maximizes the firm's stock price
• Establishing the firm's payout ratio

  1. Determine the optimal capital budget

  2. Determine the amount of equity needed to finance the budget (given its target Capital structure)

  3. Use retained earnings to meet equity requirements to the extent possible

  4. Pay dividends only if more earnings are available that are needed to support the optimal capital budget
• Residual Dividend Model


  A model in which the dividend paid is set equal to net income minus the amount of retained earnings necessary to finance the firm's optimal capital budget
• Under the residual model, dividends and payout ratio would vary with investment opportunities, and dividend variations would also occur if earnings fluctuated
• Stock repurchase


  A transaction in which a firm buys back shares of its own stock, thereby decreasing shares outstanding, increasing EPS, and often, increasing stock price
• Theories about dividend policy

  • Bird-in-the-hand theory
  • Dividend irrelevance theory
  • Tax preference theory
  • Signaling effect theory
  • Clientele effect theory
• Bird-in-the-hand theory


  Implies that the optimal dividend payout ratio is 100%
• Dividend irrelevance theory


  The free cash flow that a firm can produce for its equity shareholders is the basis upon which the common shares are valued, WHETHER OR NOT that cash is paid to the investors in the form of dividends
• Tax preference theory


  Suggests that LOW payout ratios are OPTIMAL
• Signaling effect theory


  Increasing the dividends sends a signal that the Board of Directors is optimistic about the future, which tends to enhance value
• Clientele effect theory


  Different groups of investors prefer DIFFERENT dividend policies, but this probably has NO NET EFFECT on common stock values
• Theories on capital structure

  • Modigliani-Miller (MM) Theorem
  • Static Trade-off Theory
• Modigliani-Miller (MM) Theorem (with taxes)

  The optimum capital structure for a firm is ALL DEBT AND NO EQUITY
• Modigliani-Miller (MM) Theorem (without taxes)

  The value of a firm is INDEPENDENT of its capital structure
• Static Trade-off Theory


  High debt levels impose potential costs on a firm in the form of the RISK OF BANKRUPTCY and THE LOSS OF FINANCIAL FLEXIBILITY, so debt is beneficial INITIALLY, but as more and more debt is added, the cost of debt capital and equity capital rise, and the firm's WACC rises
• • Even though a clientele effect exists, it probably has NO NET EFFECT on common stock values.
• It stated that investors in low tax brackets may prefer higher payout ratios than investors with high tax brackets.
• Dividend irrelevance theory


  This is based upon the concept that the free cash flow that a firm can produce for its equity shareholders is the basis upon which the common shares are valued, WHETHER OR NOT that cash is paid to the investors in the form of dividends.
• If a firm pays taxes it will minimize its WACC by employing ALL DEBT; this will maximize the firm’s value.