Call option holders (managers with many options) prefer a share repurchase to a dividend payout as a means of distributing profits to SH because unlike dividends share repurchases do not lead to the ex- dividend price drop-off. Dividends Share buy-backs Paid by firms with higher permanent operating CFs Used by firms with higher temporary, non- operating CFs Paid by firms with much more constant/persistent CFs Paid by firms with volatile CFs Increase dividends following good performance (only if they can be sustained) Repurchase stock following poor market performance (because stocks are undervalued) Off-market buybacks: preferred when distributing franking credits when the buyback is larger and generates more CFs On-market buybacks: more likely to be used when the firm is overvalued. Bird in the hand fallacy: A theory that postulates that investors prefer dividends from a stock to potential capital gains because of the inherent uncertainty of the latter. Based on the adage that a bird in the hand is worth two in the bush, the bird-in-hand theory states that investors prefer the certainty of dividend payments to the possibility of substantially higher future capital gains. Under the bird-in-hand theory, stocks with high dividend payouts are sought by investors and consequently command a higher market price. The popularity of this fallacy is based on the intuition that investors would rather receive the cash than have managers invest it into negative NPV projects The new dividend payment rules in 2010 replaced the traditional “profits test” with “solvency test”, so dividends can be out of capital as well) (Short-term capital gains are taxed at income tax rates, but long-term capital gains are taxed at 50% of the income rate Excess cash might be a temporary phenomenon. So, the firm has to consider future financing needs. The cost of raising new financing in future years, especially by issuing new equity, can be staggering. In addition, initiating dividends with the cash will create the expectation that the firm will continue to pay those dividends, which might be unsustainable. Stock buybacks provide more flexibility in terms of future actions. Another alternative can be a special dividend.
Lecture 5 • How to evaluate independent and mutually exclusive projects with the equal and unequal lives? Why can applying the standard NPV rule be tricky in the case of mutually exclusive projects with different lives? Perpetuity : a coupon payment every period going on forever. Annuity : a coupon payment every period until T. Independent: 2 projects are independent if acceptance of one has no effect on the acceptance of another. You accept all positive NPV projects. Mutually exclusive : 2 projects are mutually exclusive if acceptance of one project precludes acceptance of the other. This is the decision we are usually faced with – how do we pick one project over another.