pay dividends and repurchase stock(8524)
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PAY DIVIDENDS AND REPURCHASE STOCK
A companys dividend is set by the board of directors. The announcement of the dividend states
the payment will be made to all stockholders who are registered on a particular record date. Then a
week or so later dividend checks are mailed to stockholders. Stocks are normally bought or sold with
dividend (or cum- dividend) until two business days before the record date, and then they trade ex-
dividend. If you buy stock on the ex-dividend date, your purchase will not be entered on the
companys books before the record date and you will not be entitled to the dividend.
The company is not free to declare whatever dividend it chooses. In some countries, such as
Brazil and Chile, companies are obliged by law to pay out a minimum proportion of their earnings.
Some restrictions may be imposed by lenders, who are concerned that excessive dividend payments
would not leave enough in the kitty to repay their loans. In the United States, state law also helps to
protect the firms creditors against excessive dividend out of legal capital, which is generally defined
as the par value of outstanding shares.
Most U.S companies pay a regular cash dividend each quarter, but occasionally this is
supplemented by a one-off extra or special dividend. Many companies offer shareholders automatic
dividend reinvestment plans (DRIPs). Often the new shares are issued at a 5% discount from the
market price. Sometimes 10% or more of total dividends will be reinvested under such plans.
Dividends are not always in the form of cash. Frequently companies also declare stock
dividends. For example, if the firm pays a stock dividend of 5%, it sends each shareholder 5 extra
shares for every 100 shares currently owned. A stock dividend is essentially the same as a stock split.
Both increase the number of shares but do not affect the companys assets, profits, or total value.
So, both reduce value per share.
The Dividend Decision is a decision made by the directors of a company. It relates to the amount and
timing of any cash payments made to the company's stockholders. The decision is an important one
for the firm as it may influence its capital structure and stock price. In addition, the decision may
determine the amount of taxation that stockholders pay.
There are three main factors that may influence a firm's dividend decision:
Free-cash flow
Dividend clienteles
Information signaling
The free cash flow theory of dividends
Under this theory, the dividend decision is very simple. The firm simply pays out, as dividends, any
cash that is surplus after it invests in all available positive net present value projects.
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A key criticism of this theory is that it does not explain the observed dividend policies of real-world
companies. Most companies pay relatively consistent dividends from one year to the next and
managers tend to prefer to pay a steadily increasing dividend rather than paying a dividend that
fluctuates dramatically from one year to the next. These criticisms have led to the development of
other models that seek to explain the dividend decision.
Dividend clienteles
A particular pattern of dividend payments may suit one type of stock holder more than another; this
is sometimes called the clientele effect. A retiree may prefer to invest in a firm that provides a
consistently high dividend yield, whereas a person with a high income from employment may prefer
to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particularpatterns of dividend payments, a firm may be able to maximise its stock price and minimise its cost
of capital by catering to a particular clientele. This model may help to explain the relatively
consistent dividend policies followed by most listed companies.'
A key criticism of the idea of dividend clienteles is that investors do not need to rely upon the firm to
provide the pattern of cash flows that they desire. An investor who would like to receive some cash
from their investment always has the option of selling a portion of their holding. This argument is
even more cogent in recent times, with the advent of very low-cost discount stockbrokers. It remainspossible that there are taxation-based clienteles for certain types of dividend policies.
Information signaling
A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcementsconvey information to investors regarding the firm's future prospects. Many earlier studies had
shown that stock prices tend to increase when an increase in dividends is announced and tend to
decrease when a decrease or omission is announced. Miller and Rock pointed out that this is likely
due to the information content of dividends.
When investors have incomplete information about the firm (perhaps due to opaque accounting
practices) they will look for other information that may provide a clue as to the firm's future
prospects. Managers have more information than investors about the firm, and such information
may inform their dividend decisions. When managers lack confidence in the firm's ability to generate
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cash flows in the future they may keep dividends constant, or possibly even reduce the amount of
dividends paid out. Conversely, managers that have access to information that indicates very good
future prospects for the firm (e.g. a full order book) are more likely to increase dividends. According
to Grullon (2002) the information value lies in the fact that a dividend increase signals a decrease in
systematic risk (a decrease in discount rate), the correlation between dividend changes and earnings
changes has not been proved.
Investors can use this knowledge about managers' behaviour to inform their decision to buy or sell
the firm's stock, bidding the price up in the case of a positive dividend surprise, or selling it down
when dividends do not meet expectations. This, in turn, may influence the dividend decision as
managers know that stock holders closely watch dividend announcements looking for good or bad
news. As managers tend to avoid sending a negative signal to the market about the future prospects
of their firm, this also tends to lead to a dividend policy of a steady, gradually increasing payment.
In a fully informed, efficient market with no taxes and no transaction costs, the free cash flow model
of the dividend decision would prevail and firms would simply pay as a dividend any excess cash
available. The observed behaviours of firm differs markedly from such a pattern. Most firms pay a
dividend that is relatively constant over time. This pattern of behavior is likely explained by the
existence of clienteles for certain dividend policies and the information effects of announcements of
changes to dividends.
REPURCHASE STOCK
A program by which a company buys back its own shares from the marketplace, reducing the
number of outstanding shares. Share repurchase is usually an indication that the company's
management thinks the shares are undervalued. The company can buy shares directly from the
market or offer its shareholder the option to tender their shares directly to the company at a fixedprice.
Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases
earnings per share and tends to elevate the market value of the remaining shares. When a company
does repurchase shares, it will usually say something along the lines of, "We find no better
investment than our own company."
Instead of paying a dividend to its stockholders, the firm can use the cash to repurchase stock.
The reacquired shares may be kept in the companys treasury and resold if the company needs
money. There are four main ways to repurchase stock. By far the most common method is for the
firm to announce that it plans to buy its stock in the open market, just like any other investor.
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However, companies sometimes use a tender offer where they offer to buy back a stated number of
shares at a fixed price, which is typically set at about 20% above the current market level.
Shareholders can then choose whether to accept this offer. A third procedure is to employ a Dutch
auction. In this case the firm states a series of prices at which it is prepared to repurchase stock.
Shareholders submit offers declaring how many shares they wish to sell at each price and the
company calculates the lowest price at which it can buy the desired number of shares. Finally,
repurchase may take place by direct negotiation with a major shareholder. The most notorious
instances are greenmail transactions, in which the target of an attempted takeover buys off the
hostile bidder by repurchasing any shares that it has acquired. Greenmail means that these shares
are repurchased at a price that makes the bidder happy to leave the target alone. This price does not
always make the targets shareholders happy.
Stock repurchases, like dividends, are a way to hand cash back to shareholders. But unlike
dividends, share repurchases are frequently a one-off event. So a company that announces a
repurchase program is not making a long-term commitment to earn and distribute more cash. The
information in the announcement of a share repurchase program is therefore likely to be different
from the information in a dividend payment.
Companies repurchase shares when they have accumulated more cash than they can invest
profitably or when they wish to increase their debt levels. Neither circumstance is good news in
itself, but shareholders are frequently relieved to see companies paying out the excess cash rather
than frittering it away on unprofitable investments. Shareholders also know that firms with large
quantities of debt to service are less likely to squander cash.
Stock repurchases may also be used to signal a managers confidence in the future. When companies
offer to repurchase their stock at a premium, senior management and directors usually commit to
hold on to their stock. So it is not surprising that researchers have found that announcements of
offers to buy back shares above the market price have prompted a larger rise in the stock price.