6 dividend decision
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Dividend Decisions
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Dividend Decisions
Dividend Policy determines the proportion of totalearnings is to be paid as dividends and the
proportion to be retained in the business for
reinvestment purposes.
Dividend decision links the Investment decisionwith the Financing Decision.
Higher dividends means lower Retained
earnings, which in turn means more reliance on
external funds.
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Forms of Dividends
Cash Dividend: Companies mostly pay dividends in
cash. ± Regular, special, and interim dividends
± Have liquidity issues.
Stock Dividend (Bonus Shares): Issue of shares free of cost to the existing shareholders of the company.
± Represents the capitalisation of reserves.
± Proportionate shareholding remains the same, while
shareholding of each shareholder increases.
± In India, bonus shares cannot be issued in lieu of cash
dividends.
RIL recently declared a cash dividend of Rs. 13 per shareand a 1:1 bonus.
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Forms of Dividends
Why Bonus shares:
Brings the market price within a popular price range. A share of Rs 1000/- is less affordable than Rs 100/- share.
Increases the no.of shares, hence the liquidity of thestock.
Indicates bright future prospects.
Stock Splits: The par value of the shares is reduced, thereby
increasing the no. of shares outstanding. (Not a form of Dividend)
Bonus Debentures: HLL issued (1:1) debentures onbonus (free) basis (2001).
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Forms of Dividends
Share Repurchase: Purchase by the company of its own
equity shares. ± rewarding the shareholders as the repurchase is at a
price higher than the current market price, besidesmode of capital restructuring.
Modes of Share Repurchase:
± Open Market Repurchase (India)
± Tender Offer (India)
± Dutch Auction
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Procedural Aspects of Dividends
Board Resolution: Board of Directors at their board
meeting adopt a resolution to pay dividends. Shareholders¶ approval: Board¶s resolution has to be
approved by the shareholders at the Annual GeneralMeeting.
Record date: Upon approval of the resolution, theCompany fixes a ³Record date´ ± to freeze theshareholders to whom dividends has to be paid.
Dividend payment: Once the dividend is declared,dividend warrants must be posted within 30 days.
Stock has to be bought
by this date for investor
to receive dividends
Announcement
date
Ex-Dividend Record
Date
Payment
date
Company approves
DividendCompany closes books and
records owners of stockDividend is paid
to shareholders
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7
Dividend Decisions - Overview of Theories
Dividends are ³Bad´
Middle-of
-the-road
(MM Theory)
Dividend
Policy
Dividends are ³Good´
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Dividends are ³bad´
Dividends create tax disadvantage for investors who
receive them as dividends are taxed heavily than capitalgains.
Accordingly, dividends should reduce the returns to
shareholders after personal taxes.
Shareholders would respond by reducing the stock pricesof firms of such firms relative to firms that do not pay
dividends.
Consequently, firms would be better off by either retain
the money they would have paid as dividends or repurchasing stock.
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Measuring the Dividend Tax disadvantage
Tax rates on dividends are generally greater than on
capital gains.
Measure the price change on the ex-dividend date and
compare it with the actual dividend paid.
B B B cgCF P (P P)t! A A A cg oCF P (P P)t D(1 t )!
B B cg A A cg oP (P P)t P (P P)t D(1 t ) !
oB A
cg
(1 t )P P
D (1 t )
!
Price drop on the ex-dividend date should reflect the tax differential
between tax on dividends and capital gains.
If PB-P A = D, investor is indifferent between dividends and Capital Gains
If PB-P A < D, investor is taxed more heavily on dividends
If PB-P A > D, investor is taxed more heavily on Capital Gains
Sell before Ex-dividend Sell after Ex-dividend
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Implications of Dividend Tax disadvantage
Firms with an investor base composed primarily of
individuals should typically have lower dividends ascompared to firms with tax-exempt institutional investors.
Higher the income level (and hence the tax rate) of
investors, lower should be the dividend payout by the
firm.
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Dividends are ³Good´
Despite the tax disadvantage of dividends, firms continue
to pay dividends.
Some dubious reasons for paying dividends are:
o Bird-in-hand fallacy: C ertain dividends are better than
uncertain capital gains.
The choice is, however, between dividends today andan almost equal amount in price appreciation today.
o Temporary excess cash: Return excess cash arising
due to extra-ordinary year or sale of assets might appear
reasonable. But if the firm expects shortfall in the near future, it is
better to retain the excess cash now than to return it
now and raise funds later, as there is cost of issuing
bonds/ equity.
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Some good reasons for paying dividends
Although the dividends have tax disadvantages, esp. for
individuals, they are preferred due to:
1. Investors like dividends:
Self-Control: Individuals lack self-control. They rely on
external regulations to control their actions. Hence in order
to conserve their savings, investors would like to limit theamount at their disposal in the form of Dividend such that
the principal amount is left untouched.
Clientele Effect - Over a period, shareholders tend to invest
in firms whose dividend policies match their preferences.
High tax investors prefer companies which pay low or nodividends, while low tax investors prefer high dividend
paying firms. Pettit (1977) regressed dividend yields on characteristics of investor base ± age, income,
diff tax rates etc.
Safer companies had older and poor investors paid more dividends than companies with
rich and younger investors.
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Some good reasons for paying dividends
2. Dividends as Information Signal: H ow do firms convey
information credibly to financial markets?
Signaling theory suggests that firms need to take actions that
cannot be easily imitated by firms without good projects. ±
say by increasing dividends
Increasing dividends sends positive signal as it indicatesimproved capacity to generate higher cash flows in the future
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Some good reasons for paying dividends
3. Dividends reduce managerial discretion:
Accumulated cash left to the discretion of managers may
be wasted in poor projects.
Forcing firms to pay dividends is a way to discipline
managers in project selection and to reduce the cash
available for discretionary use.
Firms with separation of ownership and management,
should pay larger dividends than firms with substantial
insider ownership.
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Modigliani & Miller (MM) Theory
Assume an unlevered firm which has:
± post-tax EBIT of Rs 100 Mn that grows @5%pa
± Shares outstanding:105 Mn shares
± cost of capital : 10%.
± Reinvestment requirement: Rs. 50 Mn (grows @ 5%. pa)
Value of Firm = Cash flow / k-g
(100-50)*(1.05)/(10%-5%) = Rs.1050 Mn
Price per share = Rs 1050 Mn /105 Mn = Rs 10/-
Based on its cash flow, firm could pay dividend of Rs 50 Mn
Dividend per share = Rs 50 Mn/ 105 Mn = 0.476
Total value per Share = Rs 10 + Rs 0.476 = Rs 10.476.
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MM Theory
Scenario ± I : Company doubles the dividend:
± Dividend to be paid is Rs 100 Mn instead of Rs 50Mn. ± Firm would have to raise additional Rs 50 Mn for dividend pay out.
± Assume the firm issues new shares (at no floatation costs)
Value of Firm = (50)*(1.05)/(10%-5%) = Rs1050 Mn
Existing shareholders will receive a much larger dividendDividend per share = Rs 100 Mn/ 105 Mn = Rs 0.953
After issue of new shares, old shareholders are owningRs.1000 Mn, out of the total firm value of Rs. 1050 Mn.
Price per share = Rs 1000 Mn /105 Mn = Rs 9.523 Total value per Share = Rs 9.523 + Rs 0.953 = Rs 10.476.
Firm value remains unaffected by the dividend policy.
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MM Theory
Scenario ± II : Company stops paying the dividend:
± The firms decides not to pay dividend and retain the residual cash of Rs 50 Mn.
Value of Firm = Cash flow/k-g + Cash Balance
(50)*(1.05)/(10%-5%) + 50 = Rs1100 Mn
Value per share = Rs 1100 Mn /105 Mn = Rs 10.476
Increase in stock price is offset by the loss of cash flowfrom dividends. When the firm pays more, the pricedecreases but is exactly offset by the increase in dividends
per share.
Firm value remains unaffected by the dividend policy.
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MM Theory
Value of the firm depends upon the earning power of the
firm¶s assets or its Investment policy. The manner in which the earnings are split between
dividends & Retained earnings does not effect the value of the firm.
Assumptions of MM Hypothesis:
± Perfect Capital Markets ± Investors are rational.
± No flotation costs
± No taxes
± No change in the given Investment policy
Crux of the MM hypothesis: The effect of dividendspayments on shareholders¶ wealth is offset exactly by theimpact of other means of financing. Hence, Dividenddecision is a residual decision.
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Dividend policy when dividends are irrelevant
The assumptions needed to arrive at the dividend
irrelevance proposition are too restrictive and we may betempted to reject it.
But the theory does contain valuable message.
± A firm that has invested in bad project, cannot hope to
increase its value by paying higher dividends. ± A firm with great investments may be able to sustain its
value even if it does not pay any dividends.
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Quantum vs. Stability
Two aspects of Dividend Policy are: ±Quantum of Dividends
±Stability or Fluctuating Dividends
Dividend payout may be ³ H igh´ or ³Low´ and the
payout be ³Stable´ or ³Fluctuating´ .
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Factors affecting ³Quantum of Dividend´
1.Funds Requirements: Payout depends upon funds
requirements in the foreseeable future, assessed thru¶
financial forecasts.
± Firms with large investment projects, hence huge
requirements of funds, keep D/P low.
± On the other hand, firms with limited investment
avenues, have high D/P ratio. E.g. Bombay Dyeing.
2. Liquidity: For paying dividends, firm needs Cash
(Liquidity). Hence, liquidity status has an impact on the D/Pdecision. A ³profitable´ & ³rapidly expanding´ firm may not
have the necessary funds to pay dividends due to liquidity
constraints.
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3. Access to External Funds: Firms which has access to
external sources, may feel less constrained in its dividend
decision. Dividend decisions would be independent of the
Investment decision & Liquidity position. Such firms may
pay liberal dividends.
4. Shareholder Preference: Preference of shareholders
may influence the D/P. If Shareholders prefer dividends
instead of Capital Gains, Co. may be inclined to pay liberaldividends and vice versa. The ³clientele effect´ appears to
work in such cases.
Factors affecting ³Quantum of Dividend´
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Factors affecting ³Quantum of Dividend´
5. Control: External equity (except for Rights Issue) dilutes
the control over the company. Internal financing helps in
maintaining the control. Management & Shareholders are
averse to external financing & hence firms rely on retained
earnings.
6. Difference in Cost of External Equity & Retained
Earnings: Cost of External Equity is higher than the cost
of Internal Equity (Retained earnings) ± due to Issue Cost
& Under pricing. Magnitude of the differential has abearing on the proportion of external Equity & Retained
Earnings. And therefore on the D/P.
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Factors affecting ³Stability of Dividends´
Stability of dividends is considered a desirable policy by the
Management.
Stable Dividend Payout Ratio Policy: % age of
Dividend paid out remains constant. Dividends ,therefore,
fluctuate with the Earnings. Such policy transfer the
variability of earnings to dividends. Not very popular.
Earnings
/Dividends
Time
Earnings
Dividends
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B. Factors affecting ³Stability of Dividends´
Stable Dividend Policy: Rupee level of dividends
remains stable or gradually increases (generally).Generally this policy is followed.
Dividend
Earnings
/Dividends
Time
Earnings
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Why firms follow Stable Dividend Policy?
Firms tend to follow a Stable or gradually rising
Dividend Policy.
1. For many investors, dividend income is utilised to
meet a portion of their living expenses. As these
expenses are stable or gradually increasing,investors prefer stable or gradually increasing
dividend inflow. If dividends are fluctuating widely,
investors may be forced to either sell their
investments or reinvest the surplus funds. Bothinvolve transaction costs & inconvenience.
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Why firms follow Stable Dividend Policy?
2.Dividend decision provides a Signal to the investors
regarding the future prospects of the Company.
Increasing dividends means improved earnings prospects,
and so on.
Dividends, therefore, resolves uncertainty in the minds of
the investors. If the firm varies the Dividends frequently
based on short term influences, its dividend decision shall
lack the ³uncertainty ± resolution power ́.
Hence, firms maintain a stable dividends and change only
gradually corresponding to long-term changes inprospects.
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Corporate Dividend Behaviour
Do firms follow a pattern regarding Dividends?
Lintner provided an answer, based on a survey of
Corporate Dividend Behaviour. Findings of the survey
suggests:
1. Firms set long-run target payout ratios;
2. Management is more concerned with the ³changes´ in
dividends rather than ³absolute´ dividends;
3. Dividends tend to follow earnings, but dividends follow
a smoother path than earnings;
4. Dividends are sticky as managers are reluctant tochange Dividends which may have to be reversed
later.
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Lintner¶s Model
Lintner expressed Corporate Dividend Behaviour in the
form of a Model:Dt = cr EPSt +(1-c)Dt-1
where,
Dt = Dividend per Share for year ³t´
c = adjustment rater = target payout rate
EPSt = Earnings per Share for year t
Dt-1= Dividend per Share for year ³t-1´
Lintner¶s Model shows that current Dividend dependsupon: (a) Current earnings, and (b) Previous year¶sdividends
Lintner¶s Model is supported by empirical researchconducted in India also.
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Lintner¶s Model
Calculate the DPStfrom the following data for XYZ
Ltd :
EPSt = Rs 25/- ; Dt-1= Rs 14/- ; c = 0.45 & r = 60%.
Dt = (0.45 * 0.6*Rs 25 ) + ((1-0.45)*Rs14)= 6.75 + 7.70 = Rs 14.45
³c´
the adjustment factor shall be small for conservative companies and large for
aggressive companies.
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Empirical evidence of Dividend Policy
Dividends tend to follow earnings
± As dividends are paid out of earnings.
Dividends are sticky
± Reluctance of firms to raise dividends until they feel confident of
maintaining it and to cut dividends unless absolutely required.
Dividends follow a smoother path than earnings A firms dividend policy tends to follows the life cycle of
the firm
± Firms in high growth stage pay low / no dividends, while stable
firms with large cash balances and fewer projects pay out higher
dividends.
Dividend policy varies across countries ± Difference in stage of growth
± Difference in tax treatment
± Difference in corporate control