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Policy
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Introduction
When a firm wants to distribute cash to its
shareholders, it can pay a cash dividend or
it can repurchase shares.
Most companies pay regular, quarterly
dividends. Sometimes firms announce onetime, special dividends.
Firms repurchase shares using an open
market repurchase, a tender offer, a Dutch
auction repurchase, or a targeted
repurchase.
Stock Price
($)
40
Bird-in-Hand
30
MM: Irrelevance
20
Tax Preference
10
0
50%
100%
Payout
[( )( )]
Net
Dividends =
income
Target
equity
ratio
Total
capital
budget
Stock Repurchases
Repurchases: Buying own stock back
from stockholders.
Reasons for repurchases:
As an alternative to distributing cash as
dividends.
To dispose of one-time cash from an asset
sale.
To make a large capital structure change.
Advantages of Repurchases
Stockholders can sell or not. With a cash
dividend, stockholders must accept the payment
and pay the taxes.
Helps avoid setting a high dividend that cannot
be maintained.
Repurchased stock can be used in take-overs or
resold to raise cash as needed.
Income received is capital gains rather than
higher-taxed dividends.
Stockholders may take as a positive signal-management thinks stock is undervalued.
Bird-in-the-Hand Theory
Investors think dividends are less risky
than potential future capital gains, hence
they like dividends.
If so, investors would value high payout
firms more highly, i.e., a high payout
would result in a high P0.
Theory
Irrelevance
Bird in the hand
Implication
Any payout OK
Set high payout
Tax preference
[( )( )]
Net
Dividends =
income
Target
equity
ratio
Total
capital
budget
Stock Repurchases
Repurchases: Buying own stock back
from stockholders.
Reasons for repurchases:
As an alternative to distributing cash as
dividends.
To dispose of one-time cash from an asset
sale.
To make a large capital structure change.
Advantages of Repurchases
Stockholders can sell or not. With a cash
dividend, stockholders must accept the payment
and pay the taxes.
Helps avoid setting a high dividend that cannot
be maintained.
Repurchased stock can be used in take-overs or
resold to raise cash as needed.
Income received is capital gains rather than
higher-taxed dividends.
Stockholders may take as a positive signal-management thinks stock is undervalued.
If a company increases its dividend payout, that raises the numerator of the
stock price equation, D1, and that tends to increase the stock price. However,
raising the dividend will lower the amount of earnings available for
reinvestment, and thus it will lower the growth rate, which will tend to lower
the stock price. (Under certain conditions, g = (1-payout)(ROE). If the
payout were increase to 100%, or 1.0, then g would drop to zero.) Thus,
increasing the dividend payout has two opposing effects on a firm's stock
price. Management must then seek to find the payout policy that balances
these two forces and thereby maximizes the stock price.