Page 29 - FINAL CFA II SLIDES JUNE 2019 DAY 6

Advantages of the residual dividend model: READING 22: DIVIDENDS AND SHARE REPURCHASES: ANALYSIS
• Simplicity: Use the funds necessary to invest in profitable projects and
then gives what is left over to the shareholders.
• Flexibility: Allows management to pursue profitable investment MODULE 22.2: STOCK BUYBACKS
opportunities without being constrained by dividend considerations.

Disadvantages of the residual dividend model:
• Dividend payments may be unstable as investment opportunities and earnings often vary from year to year.

Long-term residual dividend: Some companies try to mitigate the disadvantages of the residual dividend approach by forecasting their capital budget over
a longer time frame. The leftover earnings over this longer time frame are allocated as dividends and are paid out in relatively equal amounts each year. Any
excess cash flows are distributed through share repurchases. Because shares are bought using a company’s own cash, a share repurchase can be
considered an alternative to a cash dividend.

LOS 22.h: Compare share repurchase methods – 4 Methods!

1. Open market transactions -allowing a company to buy back its shares in the open market at the most favorable terms. There is no obligation to
complete an announced buyback program. Unlike in European, American companies do not need shareholder approval for open market transactions.

2. Fixed price tender offer : firm buys a predetermined number of shares at a fixed price, typically at a premium over the current market price. Although
the company forgoes flexibility (the firm cannot execute its purchases at an exact opportune time), it allows a company to buy back its shares rather
quickly. If more than the desired number of shares are tendered in response to the offer, the company will typically buy back a prorated number of
shares from each shareholder responding to the offer.

3. Dutch auction is a tender offer in which the company specifies not a single fixed price but rather a range of prices. Dutch auctions identify the minimum
clearing price for the desired number of shares that need to be repurchased. Each participating shareholder indicates the price and the number of
shares tendered. Bids are accepted based on lowest price first until the desired quantity is filled. The price of the last offer accepted (i.e., the highest
accepted bid price) will however be the price paid for all shares tendered. Hence, a shareholder can increase the chance of having their tender
accepted by offering shares at a low price. Dutch auctions also can be accomplished rather quickly, though not as quickly as tender offers.
4. Repurchase by direct negotiation entails purchasing shares from a major shareholder, often at a premium over market price. This method is often
used in a greenmail scenario (where a hostile bidder is offered a premium to go away) to the detriment of the remaining shareholders. A negotiated
purchase can also occur when a company wants to remove a large overhang in the market that is dampening the share price. Surprisingly, many
negotiated transactions occur at a discount to market price, indicating that urgent liquidity needs of the seller motivated the transaction.