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Level 140

Dividends & Share Repurchases

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Three Theories of Investor Preference
-MM's dividend irrelevance theory holds that in a no…
Clientele Effect
Clientele effect refers to the varying preferences for dividends of different groups of investors. Companies structure their dividend policies consistent with preferences of their clienteles. M&M, however, note that once all the clienteles are satisf…
Shareholder/Manager Agency Conflict
Agency conflict between shareholders and managers can be reduced by paying out a higher proportion of the firm's free cash flow to equity so as to discourage investment in negative NPV projects.
Shareholder/Bondholder Agency Conflict
Agency conflict between shareholders and bondholders occurs when shareholders can expropriate bondholder wealth by paying themselves a large dividend (and leaving a lower asset base for outstanding bonds as collateral). Agency conflict between bondholders…
Double Taxation System
When dividends are taxed at the corporate level and at the investor level.
Split-rate Tax System
A split-rate system has different corporate tax rates on retained earnings and earnings that are paid out in dividends (distributed income). Under split-rate system, effective tax rate is computed the same way as double taxa…
Tax Imputation System
Under a tax imputation system, taxes are paid at the corporate level but are used as credits by the stockholders. Hence all taxes are effectively paid at the shareholder's effective tax rate.
Stable Dividend Policy
A company tries to align its dividend growth rate with the company's long-term earnings growth rate to provide a steady dividend. A firm with a stable dividend policy could use a target payout adjustment m…
Constant Payout Ratio
Company defines a proportion of earnings that it plans to pay out to shareholders regardless of volatility in earnings (and consequently in dividends)
Residual Dividend Approach
Dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget
Longer-term residual dividend
Company forecasts its capital budget over a longer time frame and attempts to pay out the residual in steady dividend payments.
Rationale for Share Repurchases
There are five common rationales for share repurchases (versus dividends):
Dividend Coverage Ratio
Dividend Coverage Ratio = Net Income / Dividends
FCFE Coverage Ratio
FCFE / (dividends + share repurchases)
Dividend Sustainability
For both dividend and FCFE coverage, ratios that are below industry averages or trending downwards over time indicate problems for dividend sustainability.