Why Companies Choose Repurchases rather than Dividends - Assignment Example

Name Tutor Title: Finance Institution Date Information Content or Signaling hypothesis There exist a strong relationship between dividends and share price. Research studies have demonstrated that market usually reacts positively to the increases in dividends and vice versa. The signaling hypothesis is one of the hypotheses that have received the strongest support in explaining this relationship. This hypothesis puts forward that the announcement of a special dividend transmits new information to a market marked by asymmetric information (Balachandran and Nguyen 2004). The signaling hypothesis is founded on the idea that managers of companies have better information about the company’s earnings prospective than do analyst and shareholders. Hence, to maximize investors’ wealth, managers have to disclose this information to the market by performing certain observable company achievement, for example paying special dividends. Consequently, the market uses such information to update prospects about the company’s earnings potential. A new stock price is determined as an effect of this process (Woolridge 1982). Announcement of special dividends is associated with positive period returns as these announcements convey positive information about the firm’s expectations to a less informed market (DeAngelo et al. 2000). The relative size of the special dividends is associated with the announcement period returns. The larger the relative size of a special dividend, the greater the content of the information transmitted (Gombola and Liu 1999). The announcements of initial special dividends have a greater positive abnormal price reaction than announcement of subsequent special dividends. This is because the market will have already incorporated the initial innovation signaled in the initial special dividends into prospects. Hence, the next special dividend will not be a greater surprise with a consequent diminution of the price reaction (Grullon and Michaely 2002). There is a greater market reaction to those special dividends announcements with a choice to participate in dividend reinvestment plans. The explanation behind this prediction has it root in the fact that these announcements offer shareholders an option to reinvest all or part of their cash dividends in buying extra shares. Consequently, investors can still get imputation credits and take part in dividend reinvestment plans to get new shares if they do not need cash. On the other hand, shareholders with a cash preference will select to receive cash. The firm’s operating performance will be better than that recorded before the announcement if the manager’s primary incentive for announcing special dividends is to signal progress in future prospects. In addition, the announcement period abnormal returns should be positively associated with abnormal performance immediately after announcing special dividend (Grullon and Michaely 2003) Agency cost hypothesis Modern firms are increasingly exercising separation of ownership from control where owners delegate part of their control and use rights to the managers. The Agent may not always act in a way that caters for the interest of the principal resulting to agent costs. Agency costs refer to the sum of all costs that arise from the ineffectiveness of a relationship between the agent and the principal (Easterbrook 1984). As a result, firms’ dividend policy is designed to reduce the sum of agency costs. The agent-cost hypothesis suggests that dividend payout is inversely associated with institutional ownership. Dividend payouts have an impact to minimize agency cost by compelling the corporation to be exposed to the discipline of the capital market. If institutional owners are efficient in monitoring management, corporations with high degree of institutional ownership will not need to worry about agency cost and therefore would pay fewer dividends. Therefore, payment of dividends is one of the means accessible to manager for controlling agency problem (Graham and Harvey 2002). An increase in dividends will lead to a reduction in agency costs. Paying higher dividends decreases the internal cash flow subject to management prudence and compels the company to search for more external funding. Increasing prices outside capital subjects the company to the analysis of the capital market for more finances and decreases the opportunity of sub-optional investment. Moreover, monitoring by outside suppliers of capital guarantee that managers work in the best interest of outsiders’ investors. Hence, dividend payouts may act as a method of monitoring or bonding management performance (Asquith and Mullins 1983). Most research studies have provided support for the agency-cost hypothesis explanation for dividends. Dividends play a significant role in resolving agency costs in minority-manager-controlled companies. There is a negative association between dividends payment and the percentage of insiders. There is no need to pay dividends to reduce agency costs if there are a lower percentage of outsiders (Rozeff 1982). We therefore conclude that managers make financial policy tradeoff such as paying dividends to manage agency costs. Clientele Effect A corporation’s stock moves according to the demands and goals of shareholders in response to a tax, dividend or other policy change influencing the corporation. The clientele effect presumes that shareholders are attracted to different corporation policies and consequently the shareholders will alter their stock possessions accordingly if the corporation changes its policy. In effect of this adjustment, the stock price will change. A company that pays higher dividends will attract clientele whose investment objective is to gain stock with a high dividend disbursement. Shareholders are more likely to sell their stock and move to another firm that pays a higher dividend if the firm decides to reduce its dividend. Consequently, the share price of the firm will reduce. However, this may imply that the investors may incur costs of adjustment. It is recommendable for firms to adapt an easily identifiable dividend pattern to avoid such expenses to the investor. On the other hand, the firm may incur significant expenses in the form of missed investment prospects or expenses of raising finance owing to shortage of free cash flow (Bajaj and Vijh, 1990). Hence, it is important for firms to follow a constant dividend policy that will confidently attract the appropriate clientele and reduce both adjustment costs for the shareholders and the firm’s costs of raising finance. Shareholders who prefer regular cash income will more likely be attracted to firms that pay higher dividends, for example utilities firms. On the other hand, companies that pay lower dividends and reinvest more of their free cash flow in new projects and development will attract shareholders that have no pressing need for cash. Shareholders are also attracted to a company’s dividend policy that is both free and universally available as it signals information to the market. As a result, managers are unwilling to cut dividends since a reduction in dividend is frequently read as bad information by the clientele. Hence, they usually increase dividends only if are certain that future free cash flows will allow them to maintain the set up pattern (Balachandran, Cadle and Theobald 1996). Discuss four reasons for companies to choose repurchases rather dividends under a classical tax system There are basically five main methods that corporations cab use to distribute excess capital to their investors: general cash dividends, specially designated dividends, self-tender offers, open-market stock repurchases, and targeted stock repurchases. However, the most commonly used methods include regular cash dividends and open market repurchases. Whilst open market repurchases and regular dividends continue to be the most used methods, repurchases seem to be growing more quickly than dividends. As a result, researchers in the last two decades have focused on the reasons why corporations change payout policy. There are four reasons why a corporation may decide to use repurchases as opposed to dividends when distributing excess capital to investors: signaling of equity under valuation, wealth expropriation from debt holders, capital structure adjustment and excess cash distribution (Balachandran Cadle and Theobald 1999). Equity Under valuation: Managers know more regarding the corporation’s projections than other shareholders and hence, if they believe that the corporation is undervalued, they may boost the long-term value of shares of their corporation by repurchasing stock at bargain prices. Shares are ‘cheap’ compared to their long-term prospects of cash flows. There is a positive stock market reaction to repurchase programs announcements. Repurchase announcement dates are associated with upward revisions of earnings forecast. Furthermore, there is a positive association between these forecasts revisions and repurchase announcement returns. A study conducted it showed that announcement of open market repurchase resulted in an increase in average returns of the companies by 12%. We can therefore conclude that managers of corporations that repurchase their own shares can purchase shares at bargain prices leading to more benefits to their long-term shareholders. To be correct, Announcement of dividends increases is also associated with increases in stock price. However, this increase accumulates to all present investors (insiders and outsiders shareholders) in equal share. By contrast, stock repurchases all shareholders who sell benefit proportionately from future share price appreciation. This discrepancy in outcome on long-term share proposes that apparent equity under valuation is a central concern for management when deciding between dividend increases and open-market repurchase. Capital structure adjustment: Most firms use stock options and stock appreciation rights as part of their payment packages for key staff. Stock option grants are a significant concern for management when deciding between dividends and stock repurchases. Higher dividends reduce option values while repurchase do not. Therefore, managers of firms are more likely to distribute cash to investors through open-market stock repurchase rather than through an increase in cash dividends if they own more stock options or stock appreciation rights (Bartov, Krinsky and Lee 1998) Income-tax consequences: Most prominent shareholders have notably expressed a preference for open-market repurchases as opposed to cash dividends. Income-tax concern is one reason behind this preference. For individual shareholders, selling shares instead of collecting dividends has positive tax results. A study conducted showed that there is three reasons that support a preference for stock repurchase. First, the marginal tax rate on dividends surpassed that on appreciated capital gains. Second, whereas only a fraction of the stock sale profits that constitutes a realized capital gain is taxed, the full amount dividend income is taxed as ordinary income. Finally, taxes on capital gains are postponed until the stock is sold while the dividends are taxable when allocated. Therefore, stockholders aspiring to make the most of the after-tax flows from their stock holdings will choose to receive cash allocation in the form of stock repurchases as opposed to dividend increases (De Jonga Ronald and Chris 2003). Cash flow: The possibility that manager will over invest is determined by cash allocated in dividends or stock repurchases. Generally, stock repurchases are much more unstable and more open method of cash payout while dividends is permanent obligations to allocate cash to investors (Balachandran 1996). This does not mean that dividends are better methods for monitoring managers since stock repurchases are on average much larger payouts and as such provide a better method to reduce excess funds available to managers. There is a firmer empirical support for cash flow in case of stock repurchases than in dividends increase (Grullon and Michaely 2003). Bibliography Asquith, P., and D.W. Mullins, 1983. "The Impact of initiating Dividend Payments on Shareholder Wealth," Journal of Business. 56, no. 1, pp. 77-96. Bajaj, M., and A. Vijh, 1990. "Dividend Clienteles and the Information Content of Dividend Changes," Journal of Financial Economics, 26, no. 2, pp. 193-219. Balachandran, B. 1996. Dividend Policy and Convertible stocks in the UK. European Financial management, Vol. 2, No.3, pp 369-370. Balachandran, B., Cadle, J and Theobald, M. 1996, Interim dividend cuts and omissions in the UK, European Financial Management 2, 23–38. 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