Introductory Corporate Finance: Dividend Policy - Stock Repurchases, Open Market Fixed-Price Tender Dutch Auction Target Repurchase Compare to Dividends Tax Signaling Control Implications

What This Is

Stock repurchases are a way for companies to return value to shareholders by buying back their own shares. This can be done through various methods, including open market repurchases, fixed price tender offers, Dutch auctions, and target repurchases. Stock repurchases can be compared to dividends in terms of tax implications, signaling, and control implications. For example, let's consider Tesla, which has a market capitalization of $1 trillion and a share price of $1,000. If Tesla repurchases 10% of its outstanding shares, it would spend $100 billion to buy back 100 million shares.

Key Formulas & Models

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: proportion of debt in capital structure
  • rd: cost of debt
  • T: corporate tax rate
  • wps: proportion of preferred stock in capital structure
  • rps: cost of preferred stock
  • we: proportion of equity in capital structure
  • re: cost of equity
• DOL = Q(P?V) / (Q(P?V)?F) – degree of operating leverage; measures EBIT sensitivity to sales.
  • Q: quantity sold
  • P: price per unit
  • V: variable costs per unit
  • F: fixed costs
• Tobin's Q = (MVE + D) / E – market value of assets; measures market value of assets relative to book value.
  • MVE: market value of equity
  • D: market value of debt
  • E: book value of equity
• Payout Ratio = DPS / EPS – payout ratio; measures proportion of earnings paid out as dividends.
  • DPS: dividend per share
  • EPS: earnings per share
• Retention Ratio = 1 - Payout Ratio – retention ratio; measures proportion of earnings retained in the firm.
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – sustainable growth rate; measures maximum rate of growth a firm can sustain.
  • ROE: return on equity
• Dividend Irrelevance Theorem = DPS = Earnings – dividend irrelevance theorem; states that dividend policy is irrelevant to firm value.
• Signaling Theory = DPS > Earnings – signaling theory; states that dividend payments can signal to investors that a firm has excess cash and is undervalued.

Step-by-Step Calculation

1. Calculate the weighted average cost of capital (WACC) using the formula WACC = wd × rd(1?T) + wps × rps + we × re.
2. Determine the degree of operating leverage (DOL) using the formula DOL = Q(P?V) / (Q(P?V)?F).
3. Calculate the market value of assets (Tobin's Q) using the formula Tobin's Q = (MVE + D) / E.
4. Calculate the payout ratio using the formula Payout Ratio = DPS / EPS.
5. Calculate the retention ratio using the formula Retention Ratio = 1 - Payout Ratio.
6. Calculate the sustainable growth rate using the formula Sustainable Growth Rate = ROE × (1 - Retention Ratio).

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
   • Correction: Use market value of debt and equity to calculate WACC.
   • Counterexample: If a company has a market value of debt of $100 million and a book value of debt of $50 million, using book value would result in an incorrect WACC.
2. Mistake: Ignoring flotation costs when calculating WACC.
   • Correction: Include flotation costs in the cost of equity.
   • Counterexample: If a company has a cost of equity of 10% and flotation costs of 5%, ignoring flotation costs would result in an incorrect WACC.
3. Mistake: Confusing sunk cost with opportunity cost.
   • Correction: Use opportunity cost to calculate WACC.
   • Counterexample: If a company has a sunk cost of $100 million, using it as an opportunity cost would result in an incorrect WACC.

Exam / CFA Tips

1. Tip: Be able to distinguish between dividend irrelevance and signaling theory.
2. Tip: Understand the difference between open market repurchases and fixed price tender offers.
3. Tip: Be able to calculate the sustainable growth rate using the formula Sustainable Growth Rate = ROE × (1 - Retention Ratio).

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and tax of 25%. Calculate the degree of operating leverage (DOL) using the formula DOL = Q(P?V) / (Q(P?V)?F).

Answer: DOL = 2.5

Explanation: Assuming a quantity sold of 100,000 units, price per unit of $100, variable costs per unit of $50, and fixed costs of $500,000, the DOL can be calculated as 2.5.

Last-Minute Cram Sheet

1. WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital.
2. DOL = Q(P?V) / (Q(P?V)?F) – degree of operating leverage.
3. Tobin's Q = (MVE + D) / E – market value of assets.
4. Payout Ratio = DPS / EPS – payout ratio.
5. Retention Ratio = 1 - Payout Ratio – retention ratio.
6. Sustainable Growth Rate = ROE × (1 - Retention Ratio) – sustainable growth rate.
7. Dividend Irrelevance Theorem = DPS = Earnings – dividend irrelevance theorem.
8. Signaling Theory = DPS > Earnings – signaling theory.
9. In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
10. Dividend payments can signal to investors that a firm has excess cash and is undervalued.