Discussion Issues and Derivations
- Dividends versus Stock Buybacks: The Determinants
In a general framework, firms will consider the following in deciding how to return cash to stockholders.
1. how much of a signal they want to send with their decision; dividends tend to send a stronger signal because they imply a commitment for future periods.
2. how much the firm values flexibility; the greater the value of flexibility to a firm, the more inclined it will be to buy back stock.
3. how much of a tax burden dividends will create for stockholders; this will depend upon the type of stockholders that the firm, and how they are taxed on dividends and capital gains.
Based upon the above discussion, for instance, we can make the following assumptions:
1. Firms that want to derive the maximum signaling benefit from the return of the cash, and whose stockholders like or are indifferent to cash dividends, will likely increase regular dividends. Firms that want to derive the signaling benefit but whose stockholders are more resistant to dividends might have to enter into forward contracts to repurchase equity.
2. Firms that are unsure about their capacity to keep generating excess cash in future periods are more inclined to use special dividends, if their stockholder base likes dividends, or equity repurchases, if it does not.
- Spin-offs, Split-offs and Divestitures: The Determinants
Firms may choose to divest or spin off assets for a number of reasons and may choose one approach over the others:
1. Source of Undervaluation: The initial rationale for divestitures, spin offs, split offs, and split ups is the perceived undervaluation of some or all of the firm’s components. The firm may be undervalued for a number of different reasons, each of which lends itself to a different response.
a. If the poor quality of incumbent management is one of the reasons for the low value assigned to a business, the firm will probably gain the most by selling the business, severing its connection to incumbent management. If on the other hand, the problems lies in the quality of the management at the corporate level, a spin off may be all that is needed.
b. If there is a broad perception that sections of the business are undervalued because of the pall created by other sections of the business, the appropriate response would be a spin off, if only one business line is involved or a split up, if multiple business lines are involved. As an example of a spin off, consider the pressure brought to bear on the tobacco firms, such as Philip Morris and RJR Nabisco, to spin off their food businesses, because of the perception that the lawsuits overhanging the tobacco businesses were weighing down the values of their food businesses as well. An example of a split up comes from AT & T and its proposed split up into three business lines, each trading separate shares.
c. If there is a perception on the part of some stockholders that a section of the firm is undervalued, a split off may make more sense because it allows these stockholders the option to exchange their shares for the new shares, maximizing the value increment to the firm.
In the case of spin offs, split offs, and split ups, the division or assets can continue to operate relatively smoothly. A sale or break up of the assets might have a disruptive influence, however, which, in turn, might lower their value.
2. Tax and Regulatory Concerns: One or another of these options may provide a tax benefit, making it more favorable. For instance, Marriott spun off its real estate operations into a REIT in the late 1980s. One reason for the spin off might have been the perception of undervaluation. An even stronger reason might have been the tax advantages accruing from the REIT status, since REITs do not pay taxes at the entity level. A second concern is that the spun off entity might be under less regulatory constraints than the parent company. For instance, AT & T may have decided to spin off its non-phone businesses in part because the regulatory burden under which the phone business operated was constraining its other business pursuits as well.
3. Expropriation of Bondholder Wealth: Some divestitures or spin offs are motivated by the desire to transfer wealth from bondholders to stockholders. In a divestiture, the sale of an existing asset and the payment of a liquidating dividend clearly leave bondholders worse off. In a spin off or split up, the results are more ambiguous, since the spun off entities often take a share of the debt with them.
- Stock Dividends and Stock Splits
By itself, a stock dividend or stock split is a purely cosmetic act, with no effect on the overall value of the firm or its equity. Every stockholder in the firm owns more stock in the firm, but each unit of stock is now worth proportionately less.
There is evidence, however, that stock prices rise on the announcement of stock splits. It has been suggested by some that this may be because of the signal that stock splits send to the market. Only firms that believe that their stock price will keep rising or feel that they can increase their dividends in future periods on a larger number of shares will split their stock, it is argued.
There is no evidence of another claim that is often made about stock splits, i.e., that they increase the potential market for the stock by making it more affordable to small investors. In fact, the evidence that does exist suggests that stock splits increase transactions costs (especially if the bid-ask spread is considered one such cost) to investors.