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Chapter 18 provides knowledge of distributions to shareholders: Dividends and repurchases. This chapter presents the following content: Theories of investor preferences, signaling effects, residual model, stock repurchases, stock dividends and stock splits, dividend reinvestment plans. | CHAPTER 18 Distributions to Shareholders: Dividends and Repurchases Topics in Chapter Theories of investor preferences Signaling effects Residual model Stock repurchases Stock dividends and stock splits Dividend reinvestment plans What is “distribution policy”? The distribution policy defines: The level of cash distributions to shareholders The form of the distribution (dividend vs. stock repurchase) The stability of the distribution Do investors prefer high or low payouts? There are three theories: Dividends are irrelevant: Investors don’t care about payout. Bird-in-the-hand: Investors prefer a high payout. Tax preference: Investors prefer a low payout, hence growth. Dividend Irrelevance Theory Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. Modigliani-Miller support irrelevance. Theory is based on unrealistic assumptions (no taxes or . | CHAPTER 18 Distributions to Shareholders: Dividends and Repurchases Topics in Chapter Theories of investor preferences Signaling effects Residual model Stock repurchases Stock dividends and stock splits Dividend reinvestment plans What is “distribution policy”? The distribution policy defines: The level of cash distributions to shareholders The form of the distribution (dividend vs. stock repurchase) The stability of the distribution Do investors prefer high or low payouts? There are three theories: Dividends are irrelevant: Investors don’t care about payout. Bird-in-the-hand: Investors prefer a high payout. Tax preference: Investors prefer a low payout, hence growth. Dividend Irrelevance Theory Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. Modigliani-Miller support irrelevance. Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test. 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 stock price. Tax Preference Theory Low payouts mean higher capital gains. Capital gains taxes are deferred. This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low stock price. Implications of 3 Theories for Managers Theory Implication Irrelevance Any payout OK Bird-in-the-hand Set high payout Tax preference Set low payout Which theory is most correct? Empirical testing has not been able to determine which theory, if any, is correct. Thus, managers use judgment when setting policy. Analysis is used, but it must be applied with judgment. What’s the “clientele effect”? Different groups of investors, or clienteles, prefer different dividend
