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Corporate Financial Strategy
4th edition
Dr Ruth Bender
Chapter 13
Dividends and buy-backs
Corporate Financial Strategy
Dividends and buy-backs: contents
 Learning objectives
 Dividend strategy and the life cycle model
 Some factors that might affect dividend policy
 Signalling effect of a change in dividends
 Reasons for companies to buy back their own shares
 Lintner: target dividend pay-out ratio
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Learning objectives
1. Set out the main arguments in favour of and against companies
paying dividends.
2. Identify different types of dividend policy.
3. Explain why companies might prefer to undertake periodic share
purchases rather than pay dividends.
4. Understand why different types of investor might have a preference for
either dividends or buyouts.
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Dividend strategy and the life cycle model
Cash availability
Launch
Growth
Maturity
Decline
Corporate Financial Strategy
Profit
availability
No spare cash available. All
cash is needed for investment
in developing the business.
Cash is needed for
development and investment
in growing market share.
Dividend policy
None. Probably
making losses.
Nil dividend pay-out.
May be profitable.
Nil dividend pay-out is
preferable. However,
new shareholders
might prefer a
nominal pay-out.
A medium to high
dividend pay-out is
preferred.
The company is now cash
Profitable.
positive and has fewer
opportunities to invest in
profitable growth.
The company is cash positive, May be profitable; has Full pay-out of
with no reinvestment potential. retained profits.
available cash as
dividend, even in
excess of current
profits.
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Some factors that might affect dividend policy
 Tax regime
 To avoid agency issues of holding too much spare cash
 Signalling mechanism to the market
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Signalling effect of a change in dividends
Increase the dividend
level
Decrease the dividend
level
Good news
The company is prospering,
and we can afford to pay out
more of our profits without
damaging our prospects.
The company has changed its
strategy and the directors see
these very profitable investment
opportunities, which will provide
more shareholder value than will
mere payment of dividends.
Bad news
The directors have run out of
ideas for profitable growth.
Profits and cash flow are falling,
and the company is facing
trouble in the foreseeable future.
Increasing the dividend level
could be seen as a signal of
advancing one stage in the life
cycle.
Decreasing the dividend level
could be seen as a signal of
moving back one stage in the
life cycle.
Interpretation
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Reasons for companies to buy back their own shares
 To increase eps
 To increase management’s percentage holding
 More flexible than paying a dividend
 To buy out weaker shareholders
 To give shareholder a choice of how they get their return
 To offset eps dilution from share option exercise
Apply to buy-backs but not dividends
Apply to buy-backs and to dividends
 To improve management’s business focus by gearing up
 To reduce the cost of capital
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Lintner: target dividend pay-out ratio
Research by Lintner indicated that companies have a target dividend payout ratio, but that they never actually pay that full amount. He suggested
that companies determine their annual dividend based on the following
formula:
DIV1 – DIV0 = a × {(r × eps1) – DIV0}
DIV0 is the dividend paid last year
DIV1 is the dividend to be paid this year
eps1 is the earnings per share this year
r is the target dividend pay-out ratio
a is an adjustment factor.
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