Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Lecture 10: Distribution to shareholders Stefan Lyocsa Masaryk University, Faculty of Economics and Administration Brno, Czech Republic. Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary • Level of free cash-flow, depends on company's investment opportunities and operating plans. • Level of debt and interest payments, depends on the capital structure policy. a Level of short term assets depends on the working capital policy (why?). What should we do with the remaining FCF? Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Firm's value depends on its ability to generate free cash flow. Can we influence the value of firm through distribution policy? Distribution policy is a set of rules that determine the: • level of distribution - How much money to distribute among shareholders? • form of distribution - Should we pay dividends or re-purchase stocks? • stability of distribution - Should we change our previous distribution policy? This is a complex decision as different stakeholders prefer different levels and forms of distribution, and our action can influence firm's value as perceived by investors. V J. Stefan Lyocsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Where do we stand? Interest payments Net operating profit after taxes Principal repayments Dividends Stock repurchase Required investments in operating capital Non-oper. invest. FCFj FCF2 Value -(i+WACC)1+(l+WACC)2 + FCF„ (1+WACC) Mix of debt and equity Weighted average cost of capital (WACC) Business risk Cost of debt Cost of equity Market interest rates Market risk aversion Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Recall that we have five good ways how to use FCF. • Pay interest. • Pay principal on debt. • Pay dividends. • Re-purchase stocks. • Invest into non-operating activities, i.e. short-term investments. Which decisions (among the five above) are determined by the: O capital structure of the company and which by the O working capital management strategy? V J. Stefan Lyocsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary mam Company makes an announcement (obligation) (Declaration date) to pay dividends of a given size (annually or quarterly) at a given date (Payment date), while specifying who is going to be recognized as an owner (Holder-of-record) by acknowledging share transfers up-until some date (Ex-dividend date, usually 2 business days prior to HoR date). I-H-1 Declaration Ex-dividend Holder-of-record Payment date date date date https: //www.nasdaq.com/market-activity/stocks/msft/dividend-history Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary S toe ■ | Stock re-purchase is a process when company buys own outstanding shares. Why would a company do that? • Changes in capital structure. • It might buy stocks that it wants to give employees. • Excess cash. When re-purchase tends to occur: i) share price decline, ii) lower interest rates, iii) interest expenses are tax deductible, iv) prevent takeover,... What is the current trend in the world - distributing money through dividends or stock re-purchases? V J. Stefan Lyocsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Dividend irrelevance theory Dividend preference theory Tax effect theory: Capital gains preferred Is distribution policy influencing firm's value? Is there an optimal (value maximizing) distribution policy? Investor's preference for: • Dividends. • Capital gains. Distribution ratio - percentage of net income distributed to shareholders as cash dividends or stock re-purchase. Payout ratio - percentage of net income distributed to shareholder as cash dividends. Dividend yield - annual dividends divided by the share price. Three theories of investor's preference: Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Dividend irrelevance theory Dividend preference theory Tax effect theory: Capital gains preferred o Dividend irrelevance theory of Miller and Modigliani (1961) (see also H. DeAngelo and L. DeAngelo, 2006). Their idea is that under certain assumptions (no taxes and transaction costs), shareholders can construct their own dividend policy (at 'no costs') and therefore dividend policy does not matter. Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Dividend irrelevance theory Dividend preference theory Tax effect theory: Capital gains preferred Scenario 1 Scenario 2 Conditions # stocks at the beginning 100 100 Price at the begining 1 1 Price at the end 1.11 1 Action taken Dividend per stock 0 0.11 Sell stocks 10 0 Wealth Cash earned 11 11 # stocks remained 90 100 Value of stock | 100 100 1 Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Dividend irrelevance theory Dividend preference theory Tax effect theory: Capital gains preferred Summary • Dividend preference theory of Gordon (1963) and Lintner (1962). Their idea is that returns from dividends are more certain than returns from capital gains and therefore paying dividends reduces the risk of holding the shares. Given risk aversion of investors, paying dividends reduces required capital gain (rate of return) on the stock and therefore dividend policy influences capital structure. Similar conclusions are found with the 'agency cost' problem. How dividends influence manager's behavior? The higher the debt, the higher are interest expenses and therefore: i) less cash to 'play' with, ii) more overseeing from debtors. Just like in the dividend preference theory, owners might prefer dividends as opposed to capital gains. V J. Stefan Lyocsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Dividend irrelevance theory Dividend preference theory Tax effect theory: Capital gains preferred • Tax effect theory. If taxes on dividends and capital gains are equal, capital gains tend to be preferred because of time value of money. You never pay taxes from capital gains sooner than taxes from dividends. Why? Usually you received dividends net of taxes. Capital gains are paid only in the next calendar (accounting) year! In certain countries (e.g. Slovakia) you are not required to pay capital gain tax if you own the stock for more than 1 year! Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Which theory is supported by empirical data? Different investors prefer different distribution policies - clientele effect. Why? Someone might prefer current cash income and someone who is in no need of cash might prefer to reinvest or save. • If your stock does not pay dividends and you would prefer current cash income you would need to sell stocks, which is not for free. • If you would prefer to save or reinvest you would need to re-invest after-tax dividends if your stock pays dividends, which is also not free. Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Therefore investors tend to seek firms that meet their preference. This has implications for distribution policy. Whatever your distribution policy, stability of the policy matters! Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Which theory is supported by empirical data? Different stockholders and potential investors have different views on the current and future financial condition (cash flows and risks). However, it is safe to assume that, managers are better informed. Research suggests that an 'asymmetric' effect exists. If dividends are cut (decreased), value tends to decline (stock prices decline). If dividends are increased, value tends not to decline. This has distribution policy implications. You should not be overly optimistic with the amount of dividends as cut backs in the future are 'expensive'. Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary How much should we distribute? Assume: • We know the optimal capital budget for the next year. 9 We know the target capital structure. Net Income —Target Equity Ratio x Optimal Capital Budget Firms should use the residual distribution model to advice them on the long-run target distribution ratios. Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Assume a company has net income of 100, and target equity ratio of 0.70. Now given three scenarios, what are the target distribution levels?" • Lack of investment opportunities lead to a planned 70 in capital budget. • Moderate investment opportunities lead to a planned 110 in capital budget. • Excellent investment opportunities lead to a planned 200 in capital budget. V J. Stefan Lyocsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary • Re-purchase announcements are viewed positively and increase the market value of firm. Cash dividends might increase the market value even more. • 'Clientele' can decide whether to sell their stock or to keep it - dividends must be accepted. • Re-purchase is not perceived as a long-term commitment as opposed to a dividend payment. • Re-purchase can be used to change capital structure (drastically and fast). • Re-purchase might be viewed as very expensive (why?). • Re-purchase has tax advantage over dividends (deferred capital gain tax). • Dividend policy should be stable (signaling theory). V J. Stefan Lyocsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution prefe Clientele Signaling hyp< Residual distribution Dividends vs. stock re-pu Sui Dividend Yield [%] Argentina India Japan Mexico United States Indonesia Germany South Africa Canada Turkey France China Italy European Union United Kingdom Saudi Arabia Brazil Russia Australia 0 Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Co n St rai tits Of i dividend 1 policy Although distribution policy theory might be useful, there are several practical constraints. • Debtors might limit the firm to pay dividends. • Obligations from preferred stocks need to be met first. • Maximum amount of dividend payments might exists. Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Financial management - Lecture 10 Summary • Distribution policy: dividend payments vs. stock re-purchase • Theories of distribution policies • What are the pros and cons of dividends and stock re-purchase Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13 Theories of investor's distribution preferences Clientele effect Signaling hypothesis Residual distribution model Dividends vs. stock re-purchase Summary Lecture 10: Distribution to shareholders Stefan Lyocsa Masaryk University, Faculty of Economics and Administration Brno, Czech Republic. Štefan Lyócsa Brigham - Ehrhardt, Financial Management 13