2024 – WEEK 8 DISCUSSIONS Distributions to Shareholders and Capital Structure Decisions Examine the financial statements

WEEK 8 DISCUSSIONS

Distributions to Shareholders and Capital Structure Decisions

 Examine the financial statements for the company that you selected for the Financial Research Project.

 A.  Capital Structure

 1. Refer to the Balance Sheet –

 a. What is the capital structure of the company (i.e., dollar amounts of Retained Earnings, Capital Stock, Preferred Stock).

b. What is the Debt to Assets ratio?

 2. Using the data from the previous questions, explain which theory of capital structure seems to best explain how the company that you selected for the Financial Research Project maintains its capital structure? 

 Note: The traditional capital structure theories that are examined in your textbook include: (1) Static Tradeoff Theory, (2) Signaling Theory, (3) Reserve Borrowing Capacity, (4) Pecking Order Theory, (5) Using Debt to Constrain Managers, and (6) Windows of Opportunity.

  

B. Distributions to Shareholders:

 1.  Refer to the Statement of Cash Flows –

 (a) How much did the company pay out in dividends last year (i.e., the last year for which financial statements were prepared)? 

(b) How much stock did the company repurchase last year (i.e., the last year for which financial statements were prepared)?

 2.  Explain why the company did, or did not pay dividends or repurchase stock?

 3. Should the company increase or decrease the amount of dividends paid and stock repurchased?  Why or why not?

 4. What theory best describes the way the company handles its distributions to shareholders?  (Note: The main dividend theories are discussed below.)

  

Note: The traditional Dividend Theories are:

 Remember the key question – Does dividend policy affect stock price?

 Dividend Irrelevance (Miller and Modigliani)

1.  Investors are concerned about total return, and therefore don’t care if returns come from dividends or stock price appreciation.

2.  Investors have the choice of “Homemade Dividends” or cash from selling shares; or, the investor could reinvest a dividend in more shares.  Either strategy confounds the dividend decisions. 

Dividend Relevance

 Bird-In-Hand Theory (Gordon and Lintner) –

1.  Presumes that investors believe that dividends are more certain than capital gains – management can control dividends, but can’t directly control a stock’s price.

2.  Assumes that investors value a dollar of dividends more highly than a dollar of capital gains since discount rate for stock paying dividends is lower (less risky).

  Tax Differential Theory –

1.  The after-tax return to investors is what matters and this is maximized if tax payments can be lowered or deferred.

2.  The tax changes in 2003 reduced the tax rate for dividends through 2010 (extended for two more years), so that advantage is nullified as it is the same as the long-term capital gains rate, 15%.

 Other Perspectives

Residual Dividend Theory –

1.  Flotation costs eliminate the indifference between financing new projects with internally generated funds compared to new external financing (that has flotation costs).

2.  Suggests that dividends are paid only if profits are not used entirely for investment purposes – that is, when there are “residual earnings” after financing new projects.

 Clientele Effect –

1.  Due to transaction costs, investors may not want to create “homemade dividends” or buy additional stock.

2.  Investors sort themselves out by their preferences for dividends or capital gains.

3.  That is, firms draw a clientele which has a preference for the firm’s existing or stated dividend policy.

 Information Effect –

1.  Investors may use a change in dividend policy as a “signal” about the firm’s financial condition.

2.  A larger than expected dividend could signal the likelihood of improved earnings; a lower than expected dividend may be a signal that earnings may decline.

 Agency Costs –

1.  Stock price of a firm controlled by investors who are separate from management may be lower than the stock price of a closely-held firm; this difference in price is the result of agency costs.

2.  Dividend policy may be a tool to reduce agency costs; if dividends are paid, management has to replace the capital with new equity, which will result in closer monitoring by financial markets, auditors, regulators, etc.

 Expectations Theory –

1.  Investors form expectations about the amount of forthcoming dividend payments.

 

2.  Then, investors compare actual dividend to their expected dividend; if there is a difference, investors will use the difference as a clue about future earnings and there will be either an increase, or decrease, in the stock price.

 

The company is Google