Chapter 16: Distributions

to shareholders dividends
and share repurchases
Amad, Diana Rose Q. Estrera, Jannibee L.
Bautista, Joanne S Roca, Ralph Laurence
A. 1. What is meant by the term dividend
policy?
A dividend policy is a
company's approach to
distributing profits back to its
owners or stockholders.
2. Explain briefly the dividend irrelevance theory that was put forward
by Modigliana and Miller. What are the key assumptions underlying
their theory?

Modigliani and Miller (MM) are known for their capital

structure theories, advanced the dividend irrelevance
theory. This theory suggested that in a perfect world
with no taxes or bankruptcy cost, the dividend policy
is irrelevant. They proposed that the dividend policy
of a company has no effect on the stock price of a
company or the company’s capital structure
3) Discuss why some investors may prefer high-dividend-paying stocks,
while other investors prefer stocks that pay low or nonexistent dividends.

Investors might prefer high

dividends paying because they may
regard dividends as less risky.
Investors might prefer low-payout
firms or capital gains to dividends
because they may want to avoid
transactions costs.
 B. Discuss:
(1) the information content, or signaling, hypothesis;
• Miller and Modigliani argued that dividend an
nouncements are signals through which man
agement conveys information to investors.
• Managers tend to raise dividends only when
they believe that future earnings can comfort
ably keep up a higher dividend level, and the
y will cut dividends only when all else has fail
ed.
• Positive Signal - Larger than normal dividend
• Negative Signal - Dividend cut
• Neutral Signal - Dividends are increased by
normal amount
B. Discuss:
(2) the clientele effect;
 Different clienteles most likely prefer on
different dividend payout policies.
 When it is in a low tax bracket and they
have a need for a cash income, this
group might prefer high payout stocks.
 These investors could sell some of their
stock, but this would be difficult because
transaction costs would be incurred and
the sale might have to be in a down
market.
 When it is in a high tax brackets and they
do not even need a cash income, this
group prefer low payout stocks.
B. Discuss:
(3) catering theory
 This suggests that the preference of dividends by the
investors varies overtime and corporate firms adapt their
dividend policy in order to provide the desires of the
investorts.
The theory also suggests that corporate managers should
accommodate the shifting preferences of investors.
By each measure, investors initiate dividends when
demand for payers is high.
By some measures, investors tend to neglect dividends
when demand is low.
B. Discuss:
(4) their effects on dividend policy.

 These group of clients is one of the consideration upon

changing the dividend policy of the firm.
 Through different sides of clientele, it would affect what a
change in its dividend policy would do to the demand for
the firms stock considering that there were also cost upon
switching from one stock to another.
 Miller and Modigliani argued that the existence of
clienteles does not imply that one dividend policy is better
than another.
 Dividend policy should be changed slowly in order to give
stockholders time to adjust.
C. Problem 1. Assume that SSC has an
$800,000 capital budget planned for
the coming year. You have
determined that its present capital
structure (60% equity and 40% debt)
is optimal, and its net income is
forecasted at $600,000. Use the
residual dividend model to determine
SSC's total dollar dividend and
payout ratio. In the process, explain
how the residual dividend model
works. Then explain what would
happen if expected net income was
$400,000 or $800,000?
 You can simply impress your audience and
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 The Optimal capital budget and the target capital structure is
already part of the given.
Get a modern PowerPoint
We
Presentation that ismust determine the amount of Equity needed to finance the
beautifully designed.
projects.
Equity $480,000 60% ($800,000)
Debt $320,000 40% ($800,000)
If a residual exists which is, if net income exceeds the amount of
the equity that the company needs. The residual amount should be
pay out in dividends.
eautifully designed.
 The projected net income is at $600,000
$600,000 - $480,000 = $120,000 which is the
amount that should be paid out as dividends. Thus,
the Payout Ratio would be:
$120,000 / $600,000 = .20 or 20%
 If the firm's earnings would be at $400,000, the
firm would still need $480,000 of equity.
 It should then retain all of its earnings and sell
$80,000 of new stock to suffice the equity that is
lacking.
 The residual would call for a zero dividend
payment.
If the firm's earnings would be $800,000, the
dividend would be increase to
$800,000 - $480,000 = $320,000
•the project payout would be
$320,000 / $800,000 = 40%
C. 2.) In general terms, how would a change in investment
opportunities affect the payout ratio under the residual
dividend model?
It will lead to an increase or
decrease in the amount of
equity needed. The residual
amount would be smaller if
investment opportunities
were good.
C. 3.) What are the advantages and disadavantages of the
residual policy?
Advantages Disadvantages
.

Minimizes new stock Variable dividends send

issues, hence flotation costs conflicting signals, increase
and neg-ative signals risk, and do not appeal to any
associated with new stock. specific clientele. Results in
higher required return.
D. Describe the series of steps that most firms take in
setting dividend policy in practice

The steps in setting policy are:

1. Identify target capital structure.
2.Forecast capital needs over planning horizon
, often 5 years.
3. Estimate annual debt and equity needs.
4. Set long-run target payout ratio based on
the residual model.
5. Generally, some growth rate emerges. Aim
for growth at target rate if possible, varying
capital structure as necessary.
E. What is a devidend reinvestment plan (DRIP), and how does
it work?
What it is:
A dividend reinvestment plan (DRIP) is an
arrangement offered by companies to investors
wishing to receive additional shares of
company stock in lieu of cash dividend payments.

 How it works:
In many cases, optimistic investors, rather
than receiving cash from a declared dividend,
participating investors receive shares and fractional
shares of company stock of equivalent value.
 F. What are stock Dividends and stock splits?

Stock Dividends Stock Splits

it is a form of dividend it is a corporate action in

payment where the which a company divides
companies return a its existing shares into
profit to their investors multiple shares to boost
by giving them the liquidity of the shares
additional shares of the
company instead of a
cash dividend.
 What are the advantages and disadvantages of
stock dividends and stock split?

Advantages Disadvantages
If the company is If a company does not
expected to grow, then perform according to
having more of the investor expectations, an
company's stock is investor will have a larger
worthwhile because amount of his portfolio tied
an investor can sell up in an investment that
the stock in the future will not make as much
and make a larger money as expected, or
profit. might even lose money
G. What are stock repurchases

.
A share repurchase is a
transaction whereby a
company buys back its
own shares from the
marketplace .
 Discuss the advantages and disadvantages of a firm's
repurchasing its own shares
Advantages Disadvantages

1. Enhanced dividends and 1. High price

E.P.S.

2. Enhanced Share Price 2. Market Signaling

3. Capital structure 3. Loss of

investment income
4. Employee incentive
schemes

5. Reduced take over threat

Thank You