Question

Case study Rockboro Machine Tools Corporation

Synopsis:

In September 2015, Sara Larson, the chief financial officer (CFO) of a large computer-aided design and computer-aided manufacturing equipment manufacturer needed to decide whether to pay out dividends to the firm’s shareholders, or to repurchase stock.

If she chose to pay dividends, she would have to decide upon the magnitude of the payout. A subsidiary question is whether the firm should embark on a corporate-image campaign, changing its corporate name to reflect its new outlook.

Objectives:

Review many practical aspects of dividend and share buyback decisions, including signaling and clientele effects, and the finance and investment implications of increasing dividend payouts and share repurchase decisions.

Prepare an analysis demonstrating the impact on cash-flows of the dividend versus the stock repurchase scenarios.

Indicate the impacts on the balance sheet for either decision

Prepare a summary indicating the practical considerations when setting a firm’s dividend policy.

Prepare a summary recommendation of a dividend versus stock repurchase

Answer 1

Dividends are a share of profits that a company pays at regular intervals to its shareholders.

A share buyback refers to the purchase by a company of its shares from the marketplace.

Impact on Cash Flows:

The main difference between dividends and buybacks is that a dividend payment represents a definite return in the current timeframe that will be taxed by the taxman, whereas a buyback represents an uncertain future return on which tax is deferred until the shares are sold. Thus, the shareholder is liable to pay taxes on dividend immediately whereas in Stock Repurchase, taxes are paid when the shares are sold.

buybacks provide greater flexibility for the company and its investors. A company is under no obligation to complete a stated repurchase program in the specified timeframe, so if the going gets rough, it can slow down the pace of buybacks to conserve cash. With a buyback, investors can choose the timing of their share sale and consequent tax payment. This flexibility is not available in the case of dividends, as an investor has to pay taxes on them when filing tax returns for that year. For a dividend-paying company, although dividend payments are discretionary, reducing or eliminating dividends is generally not an option as disgruntled shareholders may sell their shareholdings en masse if the dividend is reduced, suspended or eliminated.

Dividends return cash to all shareholders while a share buyback returns cash to self-selected shareholders only. So when a company pays a dividend, everyone receives cash according to the proportion of their shareholding whether they need cash or not. However, in case of a share buyback, investors decide whether they want to take part in the process or not. This also gives them the option of changing their shareholding pattern.

Financial Impact of Dividend Payment:

The cash dividend affects two areas on the balance sheet: the cash and shareholders' equity accounts. After the dividend declaration and before the actual payment, the company records a liability to its shareholders in the dividend payable account. When the dividends are paid, the effect on the balance sheet is a decrease in the company's retained earnings and its cash balance. In other words, retained earnings and cash are reduced by the total value of the dividend.

Stock dividends have no impact on the cash position of a company and only impact the shareholders' equity section of the balance sheet. Stock dividends do not result in asset changes of the balance sheet but rather affect only the equity side by reallocating part of the retained earnings to the common stock account.

Financial Impact of Stock Repurchase:

A stock repurchase effect on a company’s income statement is evident in per-share measures of profitability and cash flow such as earnings per share (EPS) and cash flow per share (CFPS). Assuming that the price-earnings (P/E) multiple at which the stock trades is unchanged, the buyback should eventually result in a higher share price.

On the balance sheet, a stock repurchase will reduce the company’s cash holdings, and consequently its total assets base, by the amount of the cash expended in the buyback. The buyback will simultaneously also shrink shareholders' equity on the liabilities side by the same amount. As a result, performance metrics such as return on assets (ROA) and return on equity (ROE) typically improve subsequent to a share buyback.

Practical consideration when setting a firms dividend policy:

1. Legal requirements

There is no legal compulsion on the part of a company to distribute dividend. However, there certain conditions imposed by law regarding the way dividend is distributed. Basically there are three rules relating to dividend payments. They are the net profit rule, the capital impairment rule and insolvency rule.

2. Firm's liquidity position

Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.

3. Repayment need

A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity reduces.

4. Expected rate of return

If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividend.

5. Stability of earning

If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.

6. Desire of control

If the management of the firm doesnot not prefer to issue additional common stock because of the fear of dilution in control on management, a firm prefers to retain more earnings to satisfy additional financing need and thereby it reduces its dividend payment capacity.

7. Access to the capital market

Easy access to capital markets in raising additional financing, does not require more retained earnings. Thus, the firm's dividend payment capacity becomes high.

8. Shareholder's individual tax situation

Stockholders prefer relatively lower cash dividend because of higher tax to be paid on dividend income. The stockholders in higher personal tax bracket prefer capital gain rather than dividend gains.

Recoomendation of a dividend Vs Stock repurchase

Cash dividend provides a regular stream of cash for investors. It allows the shareholder to remain invested in the company and still receive regular cash flows. Cash dividend can be a big incentive for investors who rely heavily on their investments to meet their living expenses, especially retired investors who may not have another source of income.

Since the size of a dividend payout is smaller compared to a buyback, it allows the company to maintain a conservative capitalization structure every quarter rather than just hold large piles of cash.

A major advantage of dividend payments is that they are highly visible. Information on dividend payments is easily available through financial websites and corporate investor relations sites. Information on buybacks, however, is not as easy to find and generally requires poring through corporate news releases.