Presentation
Financial Management
Chapter 15:
Distributions to Shareholders:
Dividends and Share Repurchases
Group Members
i. Sheikh Shubha Nesargo - 16
ii. Kazi Shaika Sharmin - 18
iii. Md Shakil Ahmed - 28
iv. Kawsar Nahid - 56
INTEGRATED CASE
Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous casting process. SSC’s
founders, Donald Brown and Margo Valencia, had been employed in the research department of a major
integrated-steel company, but when that company decided against using the new process (which Brown and
Valencia had developed), they decided to strike out on their own. One advantage of the new process was that it
required relatively little capital compared to the typical steel company, so Brown and Valencia have been able
to avoid issuing new stock and thus own all of the shares. However, SSC has now reached the stage in which
outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital
structure of 60% equity and 40% debt. Therefore, Brown and Valencia have decided to take the company
public. Until now, Brown and Valencia have paid themselves reasonable salaries but routinely reinvested all
after-tax earnings in the firm, so the firm’s dividend policy has not been an issue. However, before talking with
potential outside investors, they must decide on a dividend policy.
Assume that you were recently hired by Arthur Adamson & Company (AA), a national
consulting firm, which has been asked to help SSC prepare for its public offering.
Martha Millon, the senior AA consultant in your group, has asked you to make a
presentation to Brown and Valencia in which you review the theory of dividend policy
and discuss the following questions:
(a)
1. What is meant by the term dividend policy?
Answer
A dividend policy is a strategy that a company's board of directors uses to
distribute its earnings to shareholders as dividends. In other word, a dividend
policy is a policy a company uses to structure its dividend payout.
2. Explain briefly the dividend irrelevance theory that was put
forward by Modigliani and Miller. What were the key assumptions
underlying their theory?
Answer
The dividend irrelevance theory that was put forward by Modigliani and Miller is
that a firm’s value is determined only by its basic earning power and its business
risk meaning that, the value of the firm depends only on the income produced
by its assets, not on how that income is split between dividends and retained
earnings. The key assumptions underlying this theory are:
• No tax is charged on dividend,
• No transaction cost in buying and selling stocks,
• Investors and managers have the same information regarding future earning.
3. Why do some investors prefer high-dividend-paying stocks, while
other investors prefer stocks that pay low or nonexistent dividends?
Answer
Some investors prefer high-dividend- paying stocks because the high-dividend-
paying stocks has steady income and they are less volatile and more stable due
to their regular payout. Moreover, some investors believe that high-dividend
stocks outperform over the long term.
Other investors prefer stocks that pay low or nonexistent dividend because of
some reasons like future growth potentiality, risk appetite, portfolio
diversification benefits etc.
(b)
Discuss (1) the information content, or signaling hypothesis, (2) the
clientele effect, (3)catering theory, and (4) their effects on dividend
policy.
Answer
1. The information content or Signaling hypothesis:
The theory that investors regard dividend changes as signals of
management’s earnings forecasts. It is an idea that states that dividend
policy communicates information about a company's financial health and
future prospects to investors.
2. The clientele effect:
Clienteles means different groups of stockholders prefer different
dividend payout policies. The clientele effect is the tendency of a firm to
attract a set of investors who like its dividend policy.
Answer
3. The catering theory:
It is a theory that suggests investors’ preferences for dividends vary over
time and that corporations adapt their dividend policies to cater to the
current desires of investors
4. Effect on dividend policy:
These theories paint a combined picture of how dividend choices are
shaped by two key forces: management's desire to send signals and
investors' preferences for income or growth. This interplay ultimately
affects how investors perceive the company and, consequently, the stock
price.
(c)
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.
Answer
Here,
Equity required for budget = (800000 × 0.60) = 480000
Income Available for dividend payout = (600000 – 480000) = 120000
𝟏𝟐𝟎𝟎𝟎𝟎
So, dividend payout ratio = ( × 𝟏𝟎𝟎) = 20%.
𝟔𝟎𝟎𝟎𝟎𝟎
Answer
In the residual dividend model, first the amount of equity to be used in the new
project is determined and financed from net income. The remaining net income
is available for dividend payment. Then the dividend payout ratio is calculated
by the amount of income available as dividend divided by the total net income.
If the net income was 400000, there would be no income available for dividend
payout and if the net income was 800000, the dividend payout ratio would be,
𝟖𝟎𝟎𝟎𝟎𝟎−𝟒𝟖𝟎𝟎𝟎𝟎
× 𝟏𝟎𝟎 = 40%.
𝟖𝟎𝟎𝟎𝟎𝟎
2. In general terms, how would a change in investment
opportunities affect the payout ratio under the residual
dividend model?
Answer
A change in investment opportunities would lead to an increase (if investment
opportunities were good) or a decrease (if investment opportunities were not good) in
the amount of equity needed, hence in the residual dividend payout.
3. What are the advantages and disadvantages of the residual policy?
(Hint: Don’t neglect signaling and clientele effects.)
Answer
The advantages of the residual policy are:
• Maximum use of lower cost retained earnings,
• It reduces to the issues of new stocks and flotation costs,
• Helps to set a target payout.
The disadvantages of the residual policy are:
• Such a policy does not have any specific target clients,
• Signals conflicting with firm’s interests may be sent across,
• The amount payable as dividend fluctuates heavily if this policy is practiced
(d)
Describe the series of steps that most firms take in setting
dividend policy in practice.
Answer
The series of steps that most firms take in setting dividend policy in practice are:
• Forecasting annual capital budget and annual sales along with its working capital
needs.
• Setting the target capital structure which minimizes the WACC while retaining
sufficient reserve borrowing capacity to provide financing flexibility.
• Estimating the approximate amount of debt and equity financing required.
• Determining a long-term target payout ratio, based on the residual model concept.
• Deciding an actual dollar dividend. This dividend will reflect the long-run target payout
ratio and the probability that the dividend once set will have to be lowered or worse yet
omitted.
(e)
What is a dividend reinvestment plan (DRIP), and how does it work?
Answer
Dividend Reinvestment Plans (DRIPs) are plans that enable stockholders to
automatically reinvest dividends received back into the stocks of the paying firms.
There are two types of DRIPs: (1) plans that involve only old, already outstanding
stock and (2) plans that involve newly issued stock.
Under an “old stock” plan, the company gives the money that stockholders who
elect to use the DRIP would have received to a bank, which acts as a trustee. The
bank then uses the money to purchase the corporation’s stock on the open market
and allocates the shares purchased to the participating stockholders’ accounts on a
pro rata basis.
(e)
What is a dividend reinvestment plan (DRIP), and how does it work?
Answer
Dividend Reinvestment Plans (DRIPs) are plans that enable stockholders to
automatically reinvest dividends received back into the stocks of the paying firms.
There are two types of DRIPs: (1) plans that involve only old, already outstanding
stock and (2) plans that involve newly issued stock. Under an “old stock” plan, the
company gives the money that stockholders who elect to use the DRIP would have
received to a bank, which acts as a trustee. The bank then uses the money to purchase
the corporation’s stock on the open market and allocates the shares purchased to the
participating stockholders’ accounts on a pro rata basis. A “new stock” DRIP invests
the dividends in newly issued stock; hence, these plans raise new capital for the firm.
(f)
What are stock dividends and stock splits?
Answer
Stock dividends means the issue of new shares in lieu of paying a cash dividend.
Stock Split is an action taken by a firm to increase the number of shares outstanding,
such as doubling the number of shares outstanding by giving each stockholder two
new shares for each one formerly held.
(g)
What are stock repurchases? Discuss the advantages and
disadvantages of a firm repurchasing its own shares.
Answer
Stock Repurchases means transactions in which a firm buys back shares of its own
stock, thereby decreasing shares outstanding, increasing EPS, and, often, increasing
the stock price.
The advantages of stock repurchases are:
• Viewed positively by an investor,
• Shareholders have flexibility in receiving cash, avoiding forced dividend
acceptance and taxes,
• Can remove a large block of stock that is “overhanging” in the market and keep the
price per share down.
Answer
• Can be used to produce large-scale changes in capital structure,
• can be reissued for employee stock options.
The disadvantages of stock repurchases are:
• Stockholders may not be indifferent between dividends and capital gains, and the
stock price might benefit more from cash dividends than from repurchases,
• The selling stockholders may not be fully aware of all the implications of a
repurchase, or they may not have all the pertinent information about the
corporation’s present and future activities,
• The corporation may pay too high a price for the repurchased stock, to the
disadvantage of remaining stockholders.
Thank you
