Chapter 14 Mini Case

Chapter 14 Mini Case

What is meant by the term “distribution policy”?

Distribution policy refers to the mechanisms that an organization uses to distribute earnings (Brigham & Ehrhardt, 2020). Organizations must determine the portion of the earnings to be distributed. In addition, distribution may be in several forms. Dividends may be paid in cash or stock repurchases. The policy also determines whether an organization maintains the same dividend growth rate.

How has the mix of dividend payouts and stock repurchases changed over time?

Over time, organizations have been developing methods of achieving the optimal distribution policy that fulfills shareholder requirements and maintains organizational value. Investors are ordinarily concerned with dividend yield and capital gains (Hail et al., 2014). Organizations, therefore, optimize to strike a balance between target distribution ratio and target payout ratio.

The terms “irrelevance,” “dividend preference” (or “bird-in-the-hand”), and “tax effect” have been used to describe three major theories regarding the way dividend payouts affect a firm’s value. Explain these terms and briefly describe each theory

The dividend irrelevance theory suggests that a firm’s value depends on the ability of its assets to produce shareholder value rather than the balance between dividends and retained earnings (Brigham & Ehrhardt, 2020). The dividend irrelevance theory states that investors can create a dividend policy that is not dependent on an organization’s dividend policy. For example, supposing an organization decided not to pay dividends and keep all net income as retained earnings, an investor who wants an 8% return may create such a return by selling the 8% of their investment portfolio. Assuming the organization pays the 8% dividend where an investor desires a 5% return can use the additional 3% to buy additional shares. However, an investor would have to incur brokerage costs and pay taxes. The theory, therefore, states that if investors would create their dividend policy without incurring additional costs, then an organization’s dividend policy could be irrelevant.

Dividend Preference (bird in hand theory)

This theory advocates that the risks of a stock decline with an increase in dividends. This theory suggests that an investor prefers to be paid dividends which is a better guarantee than the guarantee that a stock will increase in value and return capital gains (Brigham & Ehrhardt, 2020). As such, even if an organization pays a lower dividend than the ideal investor would like, it is still a preferred option compared to capital gains. An investor would prefer an organization that pays higher dividends because it reduces risks (Brigham & Ehrhardt, 2020). If the company’s management knows that the organization pays a higher dividend, it is likely to engage in malpractices that squander cash. In addition, an organization that pays high dividends is under more scrutiny and requires more avenues to raise cash and meet its high payout demands.

Tax Effect Theory

Tax effect theory suggests that investors prefer capital gains due to the tax effect. Capital gains are realized when the value of a stock appreciates. However, an investor does not pay taxes until they sell their stock. In contrast, the tax levied on dividends is paid immediately after issuing the dividend. Because of the time value of money, an investor would prefer to benefit from capital gains and pay taxes later when they sell their share because they’d ideally pay less tax in dollar value (Brigham & Ehrhardt, 2020). If a stockholder dies, then no capital gains tax is paid because the beneficiary receives the stock as valued. In scenarios where the dividend tax rate is higher than the capital gains tax rate, investors would require a rate of return that incorporates the difference between the 2 taxes, referred to as dividend tax penalty, and their required rate of return. As such, under this theory, investors would prefer a low-paying company.

What do the three theories indicate regarding the actions management should take with respect to dividend payouts

Dividend Irreverence

This theory suggests that management’s actions are irrelevant and do not affect the dividend payouts because investors can create their own.

Bird in Hand Theory

This theory suggests that managers maintain high payouts because they reduce the risks. An organization with a high payout requires prudent management of financial resources and faces higher scrutiny, and is, therefore, more likely to have reduced risks than low payouts organizations.

Tax Effect

This theory suggests that managers should maintain low payouts since less taxes are paid. A high payout dividend means the investor pays more tax. If the company pays no dividend and the investor only benefits from capital gains, this is preferred since the capital gains tax is paid when the stock is sold at a future date, which could be a less dollar value due to the time value of money.

What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend payouts?

The empirical results suggest that organizations with high payouts ordinarily require a higher rate of returns. Investors require to be compensated significant amounts of pretax before buying the stock (Brigham & Ehrhardt, 2020). In economies where the dividend tax is low, most organizations prefer high payouts, and where dividend tax is high, organizations prefer stock repurchases. Investors also avoid agency costs and prefer organizations where dividends grow with stability (Brigham & Ehrhardt, 2020).

Discuss the effects on distribution policy consistent with: the signaling hypothesis (also called the information content hypothesis)

The signaling hypothesis refers to the way investors interpret payouts. If an organization increases its payout, investors could interpret this as a signal that the organization projects better future performance. A reduced payout could mean that future projections indicate poor performance. The stock price increment that follows a high payout does not indicate a preference for dividends over retained earnings; rather, it shows that the payout policy conveys information.

Clientele Effect

The type of investors who hold an organization’s stock (clientele) determines the nature of its payout. For instance, an organization with retirees and investors in pension funds requires large payouts since they are in the lower tax brackets and have a higher demand for current income (Brigham & Ehrhardt, 2020). Investors in their prime earning years require reinvestments and would ideally purchase additional shares with their dividends. If an organization invests more and reduces its payout, investors with higher demand for current income are disadvantaged.

Assume that IWT has completed its IPO and has a $112.5 million capital budget planned for the coming year. You have determined that its present capital structure (80% equity and 20% debt) is optimal, and its net income is forecasted at $140 million. Use the residual distribution approach to determine IWT’s total dollar distribution. Assume for now that the distribution is in the form of a dividend. Suppose IWT has 100 million shares of stock outstanding. What is the forecasted dividend payout ratio? What is the forecasted dividend per share? What would happen to the payout ratio and DPS if net income were forecasted to decrease to $90 million? To increase to $160 million

The forecasted dividend per share with the current capital budget is $0.5. If net income increases, all factors held constant, the dividend payout would increase. IWT would have more funds to support its capital budget and increase its payout to shareholders.  

In general terms, how would a change in investment opportunities affect the payout ratio under the residual distribution policy?

Following the above table, a change in investment opportunities affects the organization’s distribution policy. When the net income is $ 90 million, the organization uses all its equity to finance the capital budget in line with its capital structure. An increase in investment opportunities would result in a higher capital budget, meaning that the organization would have to retain more earnings to support the investment. This would leave less funds available for investors, and the payout ratio would reduce.

What are the advantages and disadvantages of the residual policy?

Organizations use this model to maintain their capital structure. This model allows organizations to predict with accuracy how much equity is needed to support capital budgets without selling new stock that would interfere with an organization’s optimal range (Hackbarth & Mauer, 2013). In this sense, organizations get the flexibility they need to maintain their optimal range. The residual policy allows organizations to prioritize growth and fulfill their commitment to shareholders.

The disadvantage is that the organization becomes prone to the signaling hypothesis where investors interpret a change in dividends to forecast the organization’s future performance. It may not attract investors who like a certain type of dividend payout policy.

Describe the procedures a company follows when it makes a distribution through dividend payments.

First, an organization declares dividends on a dividend declaration date and the dividend to be paid becomes a liability. The declaration date also announces a payment date and a holder of record date (Brigham & Ehrhardt, 2020). On the holder of record date, the organization prepares a list of shareholders to be paid at the holder of record date. There could be trading of stocks between the declaration and holder of record date. To avoid confusion, the right to dividend remains with the stock until 2 working days before the holder of the record date. Any trade that occurs within the two days prior to the holder of the record date does not attract any dividend. After the lapse of the second day before the holder of the record date, the right to dividend leaves the stock. This date is referred to as the ex-dividend date. The organization then pays the shareholders listed on the holder of record roll on the payment date set in the dividend declaration date.

What is stock repurchasing?

Stock repurchase is an action by an organization that decides to purchase part of its shares. This is normally done to increase leverage. It may use the proceeds to recapitalize. Secondly, organizations that offer stock options to employees may repurchase the stick when employees exercise their right to sell (Brigham & Ehrhardt, 2020). If an organization has idle cash, maybe proceeds from the sale of an asset, it may use some of the cash to purchase its shares.

Describe the company’s procedures when it makes a distribution through a stock repurchase.

A firm may repurchase its stock by using a broker in the free market. This is the most popular route that organizations follow. The organization may offer existing shareholders a tender to exchange their shares at a certain agreed price. The offer usually includes the number of shares the organization would like to purchase. Thirdly, the organization can purchase the shares from one of the major shareholders (Brigham & Ehrhardt, 2020). This process can be negotiated to suit the needs of all parties.

Discuss the advantages and disadvantages of a firm repurchasing its shares

Stock repurchases allow an organization to maintain ownership and control (Houcine & Boubakar, 2013). It may reduce the organization’s cost of capital. Supposing an organization uses debt leverage to finance stock repurchase, the organization would enjoy a tax benefit hence reducing the cost. The organization may enjoy capital gains from the temporary undervaluation of its stock.

The major disadvantage of stock repurchases is market signaling. Other investors may interpret stock repurchases as an admission that the company lacks profitable investment opportunities. Secondly, a company that buys its stock through debt could become overleveraged, increasing risk. The company’s stock could be overvalued, and buying the shares could mean that the organization foregoes another potentially profitable business venture.  

References

Brigham, E. F., & Ehrhardt, M. C. (2020). Financial management: Theory and practice [with MindTap] (16th ed.). Mason, OH: South-Western. ISBN-13: 9781337902601.

Hackbarth, D., & Mauer, D. C. (2011). Optimal Priority Structure, Capital Structure, and Investment. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.1424107

Hail, L., Sikes, S. A., & Wang, C. (2014). Cross-Country Evidence on the Relation between Capital Gains Taxes, Risk, and Expected Returns. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.2404044

Houcine, R., & Boubaker, A. (2013). The Relation Between Stock Repurchase And Ownership Structure In France. International Journal of Accounting and Financial Reporting, 3(2), 149. https://doi.org/10.5296/ijafr.v3i2.4007