Learning Module 1 Analysis of Dividends and Share Repurchases

Learning Module 1 Analysis of Dividends and Share Repurchases EXAMPLE 2 Globus Maritime Announces a Reverse Split In May 2018, Globus Maritime Lid, a Greek dry bulk shipping company providing worldwide maritime transportation services, was warned by NASDAQ that it no longer met the continuing listing requirements once its share price had traded below the USSI a share minimum price requirement for 30 consecutive business days. Globus was given until the end of October 2018 to regain compliance. Globus announced a 1 for 10 reverse split to occur on 15 October. On 12 October, shares were trading at US$4.25 before the reverse split had taken place. 1. If the reverse split were to take place when the share price was US$4.25, find the expected stock price after a 1-for-10 reverse split, assuming no other factors affect the split Solution: If the price was US$4.25 before the reverse split, for every 10 shares, a shareholder would have i share priced at 10x US$4.25 = US$42.50 2. Comment on the following statement: "Shareholder wealth is negatively affected by a reverse stock split" Solution: The statement is not generally correct. Considering the reverse split on its own, the market capitalization of the common equity would be unchanged. If the reverse split was interpreted as a good decision (eg, because the company will be able to retain the advantages of being listed on the NASDAQ its price and thus market capitalization might increase. But other factors such as continued limited growth of its operations or continued small share float and turnover, could drive down the stock's value. EXAMPLE 3 Historical Examples: Information on Dividend Initiations Following are two examples of the information content of dividend initiations following the 2008 global financial crisis. A. Oracle Corporation, a leading business software maker, initiated a USS0.05 quarterly dividend in May 2009. Oracle's annual US$0.20 dividend amounts to about US$1 billion, a relatively small amount compared with operating cash flow of USS8 billion and another USS9 billion in cash and cash-equivalent assets on its balance sheet at the end of fiscal year 2009. An analyst who follows Oracle for institutional investors saw the Oracle announcement as a signal that the company was well positioned to ride out the downturn and also gain market share. B. In mid-2009, Paris-based Groupe Eurotunnel announced its first-ever dividend after it completed a debt restructuring and received insurance proceeds resulting from a fire that had closed the Channel Tunnel. In a 2 June 2009 press release, Eurotunnel's CEO said that this "marked a turning point for the company as its business has returned to the realm of normality"; the company anticipated a return to profitability. EXAMPLE 4 Signaling with Dividends and the Costs of Mimicking Suppose that the management of a company with poor future prospects recommends to the board of directors an increase in its dividend. Management explains to the board that investors may then believe that the company has positive future prospects, leading to an increase in share value and shareholder wealth. 1. State whether such imitation is likely to achieve the stated objective over the long term. Solution: No, such dividend increases are not likely to achieve the stated objective over the long term for the company described. 2. Justify your answer to Question 1. Solution: Dividend increases are costly to mimic because a company that does not expect its cash flows to increase will not be able to maintain the increased dividend. The company will have to either cut the dividend in the future or go to the market to obtain new equity or debt funding to pay the dividend. Both these alternatives are costly for the company because they result in downward revisions to the stock price, on average. EXAMPLE 5 Dividend Reductions and Price Increases In November 2018, BT Group Plc, one of the world's largest providers of communication services and solutions operating in over 170 countries, announced it would cut its interim dividend from 4.85 pence a share to 4.62 pence a share. The company also revealed that net cash flow from operating activities had plunged 71% to £754 million and that revenue had fallen 2% to £11.6 billion. With declines across all divisions. All this despite the fact that in the first six months of the year, the company reported a pretax profit increase to £1.3 billion from £1.1 billion a year prior and a 2% increase in adjusted earnings (EBITDA) to £3.7 billion from £3.6 billion as the telecoms giant cut costs as part of its restructuring. One analyst commented that while the dividend decrease was an "unwelcome surprise, it was also a "prudent move" given the 71% decline in net cash and thus "should not take too much sheen on a dividend yield, which previously stood at an attractive 6.4%. It was also noted that BT Group was replacing its chief executive in February 2019, thus, future dividends would depend on decisions made by the new leadership As the market digested this information, the telecoms company's share price rose 6.9% to 257 pence per share. EXAMPLE 6 Agency Issues and Dividends 1. Two dividend-paying companies A and B directly compete with each other. Both companies are all-equity financed and have recent dividend payout ratios averaging 35%. The corporate governance practices at Company Bare weaker than at Company A. For example, at B but not A. the chief executive officer is also chair of the board of directors. Recently, profitable investment opportunities for B have become fewer, although operating cash flow for both A and B is strong Based only on the information given, investors who own shares in both A and B are most likely to press for a dividend increase at: A. Company A, because it has better growth prospects than Company B B. Company 8, because a dividend increase may mitigate potential over-investment agency problems C. Company B, because a dividend increase may mitigate potential underinvestment agency problems. Solution: B is correct. Company B's strong operating cash flow in an environment of fewer profitable growth opportunities may tempt Company B's management to overinvest. The concern is increased because of Company B's relatively weak corporate governance. EXAMPLE 7 Electric Utilities, Agency Costs, and Dividends Electric utilities often have above-average dividend yields. A distinctive characteristic of many utility companies is that they pay a high percentage of earnings as dividends while periodically issuing new equity to invest in the many projects necessitated by the capital-intensive nature of their business. This practice of financing dividends with new equity appears unwise because new equity is expensive. Researchers examining a set of US-based electric utilities, however, have demonstrated that there may be a good reason for paying dividends and then issuing equity: the mitigation of the agency problems between managers and shareholders and between atility regulators and utility shareholders. Because electric utilities are typically monopolies in the sense that they are usually the only providers of electricity in a given area, they are regulated so they are not able to set electricity rates at monopolistically high levels. The regulators are expected to set rates such that the company's operating expenses are met and investors are provided with a fair return. The regulators, however, are usually elected or are political appointees and view ratepayers as potential voters. Thus, utility shareholders, in addition to facing potential manager-shareholder agency issues because managers have incentives to consume perquisites or to overinvest, also face a regulator-shareholder conflict in which regulators set rates low to attract the votes of individuals being served by the utility. In the utility industry, therefore, dividends and the subsequent equity issue are used as mechanisms to monitor managers and regulators. The company pays high dividends and then goes to the capital markets to issue new equity. If the market does not think that shareholders are getting a fair return because regu lators are setting rates too low, or because managers are consuming too many perks, the price at which new equity can be sold will fall until the shareholder expectations for returns are met. As a result, the company may not be able to raise sufficient funds to expand its plant to meet increasing electricity demand-the electric utility industry is very capital intensive- and, in the extreme, customer needs may not be met. Faced with this possibility and potentially angry voters, regulators have incentives to set rates at a fair level. Thus, the equity market serves to monitor and arbitrate conflicts between shareholders and both managers and regulators. EXAMPLE 8 A Company That Needs to Reinvest All Internally Generated Funds 1. Boar's Head Spirits Ltd., based in the United Kingdom, currently does not pay a dividend on its common shares. Boar's Head has an estimated operating cash flow of £500 million. The company's financial analyst has calculated its cost of capital as 12%. The same analyst has evaluated modernization and expansion projects with a positive NPV that would require £800 million. The cost of positive NPV projects exceeds estimated operating cash flow by £300 million (£800 million £500 million). Having an above-average debt ratio for its industry, Boar's Head is reluctant to increase its long-term debt in the next year. Discuss whether you would expect Boar's Head to initiate a dividend based on the above facts. Solution: One would expect Boar's Head would not initiate a dividend. As things stand, internally generated funds, as represented by operating cash flow, are not sufficient to fund positive NPV projects. So, payment of a dividend would be at the expense of rejecting positive NPV projects unless the balance of such projects and the dividend were both financed by debt. Given its concern about debt levels, the company would not be expected to pay a dividend that needs to be financed by debt. Because the company has unfunded positive NPV projects, it could consider issuing new shares to fund those projects. The company, however, would not be expected to issue shares solely for the purpose of paying dividends. EXAMPLE 9 Makinasi Appliances Company Cuts Its Dividend 1. In September 2018, Makinasi Appliances Company, a hypothetical global home appliances manufacturer, announced it would cut its dividend for the first time in its history. The company, which pays quarterly dividends, said the dividend would be reduced to US$0.70 a share from the US$1.60 paid a year earlier. The 2017 total dividend was US$6.50 a share. The dividend cut ends a 400% cumulative increase in the dividend over 10 years. Faced with plunging global demand for appliances (Makinasi's sales were forecasted to fall 19%) and ongoing competition in the white goods industry, Makinasi was expecting a loss as high as US$32.5 million (operating loss of US$46 million) for the fiscal year ending March 2019, compared with the analyst forecasted loss of US$18.3 million for the same period. The company already had a loss of US$28.6 million in fiscal year 2018 (the operating loss was US$30.4 million). Makinasi's plans are to aggressively cut costs: It plans to cut production-related costs by US$18 million and fixed costs by US$21 mil lion. The company has said that the lower dividend is because of the difficulty in maintaining the dividend at its previous level. Board member bonuses have been eliminated, and manager bonuses have been reduced by 40%. Capital spending will be cat by 30% to US$27 million, and R&D spending will be cut by 13.5% to US$24million. The company announced plans to raise capital via a bond issue for up to US$50 million. The national credit rating agency has cut Makinasi's bond rating from A to A- Discuss Makinasi's decision to cut its dividend in light of the factors affecting dividend policy covered in this section. Solution: Of the six factors discussed in this section, the volatility of future earnings and preservation of financial flexibility are the major factors influencing Makinası's decision to cut its dividend. Paying the full dividend would have lowered Makinasi's liquidity ratios and forced it to raise even more external capital. In addition, paying the full dividend probably would likely have resulted in a more severe downgrade in its bond rating and an increase in the cost of debt financing. Paying the full dividend when faced with huge, larger-than-expected operating losses also might have sent a signal to investors that Makinasi was not serious about cutting costs and curtailing losses. Flotation costs could also play a role in Makinasi's case, Flotation cost on new equity are typically higher than those on new debt, it is possible that if it paid a dividend of more than US$0.70 a share, it would have to issue new equity in addition to the US$50 million in debt. EXAMPLE 10 Determining Dividends by Using a Target Payout Adjustment Model 1. Last year Luna Inc. had earnings of US$2.00 a share and paid a regular div- idend of US$0.40. For the current year, the company anticipates earnings of US$2.80. It has a 30% target payout ratio and uses a 4-year period to adjust the dividend. Compute the expected dividend for the current year. Solution: Expected dividend - Previous dividend + [(Expected earnings Target payout ratio - Previous dividend) × Adjustment factor)] = US$0.40+ [(US$2.80 x 0.3-USS0.40)×(1/4)] - US$0.40+ [(US$0.84 US$0.40) × (1/4)] US$0.51 dividend, an US$0.11 increase Thus, although earnings are expected to increase by 40%, the increase in the dividend would be 27.5%. Despite the adjustment process, the payout ratio would fall from 20% (US$0.40/US$2.00) to 18.2% (US$0.51/US$2.80). The firm would move toward its target payout ratio if earnings growth were slower and the adjustment time period were shorter (i.e., the adjustment factor higher). EXAMPLE 12 BCII Considers Alternative Methods of Share Repurchase The board of directors of British Columbia Industries, Inc. (BCII) is considering a 5 million common share repurchase program. BCII has a sizable cash and marketable securities portfolio. BCII's current stock price is C$37. The company's chief financial officer wants to accomplish the share repurchases in a cost-effective manner. Some board members want repurchases accomplished as quickly as possible, whereas other board members mention the importance of flexibility. Discuss the relative advantages of each of the following methods with respect to cost, flexibility, and speed: 1. Open market share repurchases. Solution: Open market share repurchases give the company the most flexibility. BCII can time repurchases, making repurchases when the market prices its stock below its perceived intrinsic value. BCII can also change amounts repurchased or even not execute the repurchase program. Open market repurchases are typically made opportunistically, with cost a more important consideration than speed. Because open market repurchases can be conducted so as to minimize any effects on price and can be timed to exploit prices that are perceived to be below intrinsic value, this method is also relatively cost-effective. 2. A fixed-price tender offer. Solution: A fixed-price tender offer can be accomplished quickly, but the company usually has to offer a premium. Obviously, this raises the cost of the buy- back; however, the premium may provide a positive signal to investors regarding management's view of the value of the stock. 3. Dutch auction tender offer. Solution: Dutch auctions generally enable a company to do the buyback at a lower price than with a fixed-price tender offer. For example, a fixed price tender offer for 5 million shares at C$40 would cost BCII C$200 million. If the Dutch auction were successful at C$38, the cost would be C$190 million, a savings of C$10 million. Dutch auctions can be accomplished quickly, though usually not as quickly as fixed-price tender offers EXAMPLE 13 Share Repurchase Using Surplus Cash 1. Takemiya Industries, a Japanese company, has been accumulating cash in recent years with a plan to expand in emerging Asian markets. Takemiya's management and directors believe that such expansion is no longer practical, and they are considering a share repurchase using surplus cash. Take- miya has 10 million shares outstanding, and its net income is ¥100 million. Takemiya's share price is ¥120. Cash not needed for operations totals ¥240 million and is invested in Japanese government short-term securities that earn close to zero interest. For a share repurchase program of the contemplated size, Takemiya's investment bankers think the stock could be bought in the open market at a ¥20 premium to the current market price, or ¥140 a share. Calculate the impact on EPS if Takemiya uses the surplus cash to repurchase shares at ¥140 per share. Solution: First, note that current EPS = (¥100 million net income)/(10 million shares) = ¥10.00. If Takemiya repurchases shares, net income is unchanged at ¥100 million. A share repurchase at ¥140 a share reduces share count by approximately 1.7 million shares (¥240,000,000/Y140) so that 8.3 million shares remain outstanding. Thus, after the share repurchase, EPS should be (¥100 million)/(8.3 million shares) = ¥12.00, approximately. EPS would increase by 20% as a result of the share repurchase. Note that EPS would increase even more if the open market purchases were accomplished at the prevailing market price without the premium. EXAMPLE 14 Share Repurchases Using Borrowed Funds Selamat Plantations, Inc., plans to borrow Malaysian ringgit (MYR)12 million, which it will use to repurchase shares. The following information is given. Share price at time of share repurchase MYR60 • Earnings after tax = MYR6.6 million EPS before share repurchase MYR3 • Price/Earnings (P/E) = MYR60/MYR3 = 20 Earnings yield (E/P) = MYR3/MYR60 = 5% • Shares outstanding = 2.2 million Planned share repurchase 200,000 shares 1. Calculate the EPS after the share repurchase, assuming the after-tax cost of borrowing is 5% Solution: EPS after buyback (Earnings-After-tax cost of funds)/Shares outstanding after buyback [MYR6.6 million (MYR12 million 0.05)]/2 million shares [MYR6.6 million (MYR0.6 million)]/2 million shares MYR6.0 million/2 million shares =MYR3.00 With the after-tax cost of borrowing at 5%, the share repurchase has no effect on the company's EPS. Note that the stock's earnings yield, the ratio of earnings per share to share price or E/P, was MYR3/MYR60 = 0.05 or 5%. equal to the after-tax cost of debt. 2. Calculate the EPS after the share repurchase, assuming the company's borrowing rate increases to 6% because of the increased financial risk of borrowing the MYR12 million. Solution: EPS after buyback (Earnings-After-tax cost of funds)/Shares outstanding after buyback [MYR6.6 million (MYR12 million 0.06)]/2 million shares [MYR6.6 million (MYR0.72 million)]/2 million shares MYR5.88 million 2 million shares =MYR2.94 Note that in this case, the after-tax cost of debt, 6%, is greater than the 5% earnings yield, thus, a reduction in EPS resulted. EXAMPLE 15 The Effect of a Share Repurchase on Book Value per Share The market price of both Company A's and Company B's common stock is US$20 a share, and each company has 10 million shares outstanding. Both companies have announced a US$5 million buyback. The only difference is that Company A has a market price per share greater than its book value per share, whereas Company B has a market price per share less than its book value per share: • Company A has a book value of equity of US$100 million and BVPS of US$100 million/10 million shares = US$10. The market price per share of US$20 is greater than BVPS of US$10. • Company B has a book value of equity of US$300 million and BVPS of US$300 million/10 million shares US$30. The market price per share of US$20 is less than BVPS of US$30. Both companies: buy back 250,000 shares at the market price per share (US$5 million buyback/US$20 per share 250,000 shares) and . are left with 9.75 million shares outstanding (10 million pre-buyback shares 0.25 million repurchased shares = 9.75 million shares). After the share repurchase: . Company A's shareholders' equity at book value falls to US$95 million (US$100 million US$5 million), and its book value per share decreases from US$10 to US$9.74 (shareholders' equity/shares out-standing = US$95 million/9.75 million shares US$9.74). • Company B's shareholders' equity at book value falls to US$295 million (US$300 million US$5 million), and its book value per share increases from US$30 to US$30.26 (shareholders' equity/shares out- standing US$295 million/9.75 million = US$30.26). EXAMPLE 16 The Equivalence of Share Repurchases and Cash Dividends 1. Rohit Chemical Industries, Inc. (RCII) has 10 million shares outstanding with a current market value of Rs200 per share. WCII's board of directors is considering two ways of distributing RCII's current Rs500 million free cash flow to equity. The first method involves paying an irregular or special cash dividend of Rs500 million/10 million = Rs50 per share. The second method involves repurchasing Rs500 million worth of shares. For simplicity, we make the assumption that dividends are received when the shares are ex-divided and that any quantity of shares can be bought at the market price of Rs200 per share. We also assume that the taxation and information content of cash dividends and share repurchases, if any, do not differ. How would the wealth of a shareholder be affected by RCII's choice of method in distributing the Rs500 million? Solution: Cash Dividend After the shares are ex-divided, a shareholder of a single share would have Rs50 in cash (the dividend) and a share worth Rs200-Rs50 = Rs150. The ex-dividend value of Rs150 can be demonstrated as the market value of equity after the distribution of Rs500 million divided by the (unchanged) number of shares outstanding after the dividend payment, or [(10 million) (Rs200) Rs500 million)/10 million = Rs1,500 million/10 million = Rs150. Total wealth from ownership of one share is, therefore, Rs50 + Rs150 = R$200. Share Repurchase With Rs500 million, RCII could repurchase Rs500 million/Rs2002.5 million shares. The post-repurchase share price would be unchanged at Rs200, which can be calculated as the market value of equity after the Rs500 million share repurchase divided by the shares outstanding after the share repurchase, or [(10 million) (Rs200) Rs500 million]/(10 million-2.5 million) = Rs1,500 million/7.5 million Rs200. Total wealth from ownership of one share is, therefore, Rs200, exactly the same as in the case of a cash dividend. Whether the shareholder actually sold the share back to RCII in the share repurchase is irrelevant for a shareholder's wealth: If the share was sold, Rs200 in cash would be realized; if the share was not sold, its market value of Rs200 would count equally toward the shareholder's wealth. EXAMPLE 17 Direct Negotiation: A Share Repurchase That Transfers Wealth 1. AfriCitrus (AC) common shares sell at South African rand (ZAR)200, and there are 10 million shares outstanding. Management became aware that Kirk Mzazi recently purchased a major position in its outstanding shares with the intention of influencing the business operations of AC in ways the current board does not approve. An adviser to the board has suggested approaching Mzazi privately with an offer to buy back ZAR500 million worth of shares from him at ZAR250 per share, which is a ZAR50 premium over the current market price. The board of AC declines to do so because of the effect of such a repurchase on AC's other shareholders. Determine the effect of the proposed share repurchase on the wealth of shareholders other than Mzazi. Solution: With ZAR500 million, AC could repurchase ZAR500 million/ZAR250 = 2 million shares from Mzazi. The post-repurchase share price would be ZAR187.50, which can be calculated as the market value of equity after the ZAR500 million share repurchase divided by the shares outstanding after the share repurchase, or [(10 million)(ZAR200) - ZAR500 million]/(10 million - 2 million) = ZAR1,500 million/8 million = ZAR1875.50. Shareholders other than Mzazi would lose ZAR200-ZAR187.50 ZAR12.50 for each share owned. Although this share repurchase would conserve total wealth (including Mzazi's), it effectively transfers wealth to Mzazi from the other shareholders. EXAMPLE 19 ITOCHU Corporation Announces Share Buyback to Improve ROE 1. In October 2018, ITOCHU Corporation, a leading Japanese sogo shosha (general trading company), reported that in order to improve its return on equity (ROE) it would repurchase shares by fiscal year-end March 2019 to achieve a target medium-to-long-term ROE of 13% or higher. Accordingly, ITOCHU said it could repurchase shares in the amount up to ¥30 billion. In February 2019, ITOCHU announced it was increasing its share repurchase target up to ¥100 billion. ITOCHU repurchases in these first two tranches are shown in Exhibit 10. Exhibit 10: Share Buyback Activities, October 2018 to March 2019 Period Shares Repurchased Average Price (V) December 15,097,200 1.987 Total Value (V) 30 billion 2018 January 2019 Period Shares Repurchased Average Price (Ұ) Total Value (¥) February - March 2019 19,024,200 1.997 38 billion Sum 34,121,400 1,993 68 billion ITOCHU was followed by many other large Japanese companies, including SoftBank, Sony, Haseko, Tokyo Tatemono, and Toppan Printing. Also in February 2019, these companies announced large share buyback programs to improve ROE in response to shareholder activist pressure to improve shareholder returns and governance.