FIN3CFI Corporate Finance: Dividend Policy and Repurchase Analysis

This report provides an analysis of corporate dividend policy, focusing on the information signaling hypothesis, free cash flow hypothesis, and clientele effect. It discusses why companies prefer stock repurchases over dividends under a classical tax system, including taxation burdens and greater flexibility. The report also includes an analysis of Australian Vintage Ltd (AVG), examining market returns and excess returns related to dividend announcements. It explores potential reasons for observed trends in excess returns, referencing the impact of dividend changes on investor behavior. Desklib offers a wide range of solved assignments and past papers to assist students in their studies.

CORPORATE FINANCE
DIVIDEND POLICY
STUDENT ID:
[Pick the date]

(a) (i) In accordance with information signalling hypothesis, the dividend policy is an
indicator of the future prospects of the company. This is because an increase in dividends
would highlight that the future performance of the company would be stable and hence the
requisite cash flows generated in the future would be sufficient to meet the business needs.
Further, a decline in the dividends paid might suggest foreseeable issues in the future owing
to which the management might have given a lower dividend pay-out. Also, an assumption
between this hypothesis is that managers tend to use dividends paid as an indicator of present
and future business health (Damodaran, 2015).
(ii) The free cash flow hypothesis is based on the notion that the managers tend to have
tendency to maintain the cash within the company so that the same can be used to serve the
vested interests of the management. This concept can be applied to the dividend theory as if a
high dividend pay-out is announced, it clearly reflects that the managers would hold lesser
amount of cash and hence less likely to serve their vested interests. As a result, higher
dividend payment is associated with higher stock price owing to lesser risk of cash
mismanagement on the part of the managers (Parrino and Kidwell, 2014).
(iii) As per the clientele effect, the stock price of the company tends to move in accordance
with the objectives of investors when there is change in any policy including the dividend
policy. This is derived on the underlying assumption that there are certain investors who
would be attracted to specific policies that the companies have and tend to adjust their
holdings in accordance with the change in company policies. Thus, the decision by the
company to pay higher dividends tends to increase the demand for the shares by the company
as some desire more of the company’s share in their portfolio. Similarly, a lower dividend
pay-out would lead to lower price of the stock as the specific investors who would have held
shares of the company for obtaining higher dividends would sell the same (Brealey, Myers
and Allen, 2014).
(b) The five reasons as to why repurchases are preferred by companies as compared to
dividends under a classical tax system are indicated as follows (Damodaran, 2015).
 One of the reasons would be with regards to the taxation burden since dividends are
taxed twice one at the corporate level and other at the individual level. This is unlike
the case with repurchases where the investor would be taxed only on the capital gains
earned. Also, the rate at which these capital gains are charged would be lower.

 There is higher flexibility with regards to repurchases as compared to dividends. This
is because payment of dividends can be seen as an obligation on the part of the board
and hence when there is a temporary rise in the cash inflow, then instead of dividends,
stock repurchase is a superior choice.
 The stock price tends to be higher in case of share repurchases owing to decrease in
outstanding shares. On the other hand, giving dividends would lead to lower stock
price. The executives of the company are given compensation in the form of options
and hence it is preferable for them that the share prices go higher.
 As the options are exercised by the management and other executives, the number of
outstanding shares tends to increase which leads to dilution. In order to control the
same, the share repurchases are done so that there is no dilution for the existing
shareholders.
 Additionally, share repurchases is a way of signalling to the investors that the
underlying share price is undervalued. This leads to increase in the share price of the
company and hence creates wealth for the shareholders and also the executives who
hold options.
(c) (i) The company chosen is Australian Vintage Ltd (Code: AVG) and the relevant
information is provided below.
(ii) The requisite return on shares is indicated as follows.

(iii) The market returns for the corresponding period is indicated as follows.
(iv) The excess is computed below.
(v) Based on the results obtained by my friend, the excess both for a two day period and three
day period came out to be negative. However, for me the excess for some years came out to
be negative while for the others it came out to be positive.
(vi) One of the possible explanations for the above trend is that the dividend provided by the
company in 2016, 2017 and 2018 was significant lower than the corresponding dividends that
the company paid in the years 2011-2014. As a result, this lower dividend might have
triggered the sell-off in the stock to some extent. The investors would have assumed that
going forward the company would not be performing very well owing to which the excess is
negative in the recent years and positive in the initial years (Parrino and Kidwell, 2014).

References
Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 6th ed. New
York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley,
John & Sons.
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications