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2.7 Dividend

Policy

This Section

Includes : Dividend Decision and Valuation of Firm

Walters Model Gordon Model MM model Residual Model Divident Discount Model Lintner Model

Types of Dividends and Dividend Policies

Factors Affecting Dividend Policies Stability of Divident Share Buyback

INTRODUCTION:

The term dividend refers to that part of profits of a company which isdistributed by the company among its shareholders. It is the reward of theshareholders for investments made by them in the shares of the company. Theinvestors are interested in earning the maximum return on their investments

and to maximize their wealth. A company, on the other hand, needs to providefunds to finance its long-term growth. If a company pays out as dividend mostof what it earns, then for business requirements and further expansion it willhave to depend upon outside resources such as issue of debt or new shares.Dividend policy of a firm, thus affects both the long-term financing and thewealth of shareholders. As a result, the firms decision to pay dividends mustbe reached in such a manner so as to equitably apportion the distributedprofits and retained earnings. Since dividend is a right of shareholders toparticipate in the profits and surplus of the company for their investment in theshare capital of the company, they should receive fair amount of the profits. Thecompany should, therefore, distribute a reasonable amount as dividends (which

should include a normal rate of interest plus a return for the risks assumed) toits members and retain the rest for its growth and survival.

DIVIDEND DECISION AND VALUATION OFFIRM :

The value of the firm can be maximized if the shareholders wealth is maximized. There are conflicting views regarding the impact of dividend decision on thevaluation of the firm. According to one school of thought dividend decision doesnot affect the share-holders wealth and hence the valuation of the firm. Onthe other hand, according to the other school of thought, dividend decision


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Financial Management

34

materially affects the shareholders wealth and also the valuation of the firm.We have discussed below the views of the two schools of thought under twogroups:

a . The Relevance Concept of Dividend or the Theory of Relevance.

b.The Irrelevance Concept of Dividend or the Theory of Irrelevance


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The Relevance Concept of Dividends : According to this school of thought,dividends are relevant and the amount of dividend affects the value of the firm.Walter, Gordon and others propounded that dividend decisions are relevant ininfluencing the value of the firm. Walter argues that the choices of dividendpolicies almost and always affect the value of the enterprise.

The Irrelevance Concept of Dividend : The other school of thoughtpropounded by Modigliani and Miller in 1961. According to MM approach, thedividend policy of a firm is irrelevant and it does not affect the wealth of theshareholders. They argue that the value of the firm depends on the marketprice of the share; the dividend decision is of no use in determining the valueof the firm.

WALTERS MODEL:

Walters model, one of the earlier theoretical models, clearly indicates that

the choice of appropriate dividend policy always affects the value of theenterprise. Professor James E. Walter has very scholarly studied thesignificance of the relationship between the firms internal rate of return, r, (oractual capitalization rate) and its Cost of Capital, Ke (normal capitalization rate)in determining such dividend policy as will maximize the wealth of thestockholders.

Waters model is based on the followingpremises:

(1) The firm finance its entire investments by means of retained earnings.New equity stock or debenture is not issued to raise funds.

(2) Internal rate of return (r) and cost of capital (Ke) of the firm remain

constant. (3) The firms earnings are either distributed as dividends orreinvested internally. (4) Earnings and dividends of the firm neverchange.(5) The firm has long or infinite life.

The formula used by Walter to determine the market price pershare is :

D +r

(ED)P= K

K

Where

,P = Market price per share

D = Dividend per shareE = Earnings per sharer = Internal rate of return (Actualcapitalization rate) K= Cost capital (Externalcapitalization rate)

It may be noted that Walters formula has the same effect as the continuingdividend growthformula. It seeks to measure the effect of dividends on common stock value by


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comparingactual and normal capitalizationrates.

Another feature of Waters formula is that it provides an added or reducedWeight to the retained earnings portion of the capitalization earnings formula.

The factors r and k are placed in front of retained earnings to change itsweighted value under different situations as discussed below:


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1 . Growth FirmsIn growth firms internal rate of return is greater than the normal rate(r > k).

Therefore,r/k factor will greaterthan 1.

Such firms must reinvest retained earnings since existing alternativeinvestments offer a lower return than the firm is able to secure. Eachrupee of retained earnings will have a higher weighting in Watersformula than a comparable rupee of dividends. Thus, large the firmretains, higher the value of the firm. Optimum dividend payout radio forsuch a firm will be zero.

2 . Normal FirmNormal firms comprise those firms whose internal rate of return is equalto normalcapitalization (r=k). These firms earn on their investments rate of return

equal to marketrate of return. For such firms dividend policy will have no effect on themarket valueper share in the Walters model. Accordingly, retained earnings will havethe sameweighted value as dividends. In this case the market value per share isaffected by thepayoutratio.

3 . Declining FirmsFirms which earn on their investments less than the minimum rarerequired byinvestments are designated as declining firms. The management of suchfirms wouldlike to distribute its earnings to the stockholders so that they may eitherspend it orinvest elsewhere to earn higher return than earned by the declining firms.Under sucha situation each rupee of retained earnings will receive lower weight thandividendsand market value of the firm will tend to be maximum when it does not

retain earningsatall.

4 . Evaluation of the Walters ModelProfessor Walter has endeavoured to show in an erudite manner the effectsof dividendpolicy on value of equity shares under different situations of a firm.However, the basicpremises on which edifice of the theory is laid down are unrealistic and


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therefore,conclusions drawn from the Walters model are hardly true for real lifesituations.

Thus, for instance assume that a firm finances its investment opportunities onlyby means of

internal sources and no external financing is resorted to for this purpose.Under such asituation, either the value of the firms investment or dividend or both will besub-optimum.In its attempt to maximize the value of the firm, the management should goon makinginvestments so long as return of investment is equal to the cost of capital. This isthe optimumlevel of investment, the remaining amount should be raised from externalsources. On thecontrary, Walter argues that value of the firm is maximized by retaining all the

profits becausemagnitude of investments financed by retained earnings may be less than theoptimum levelofinvestment.

Further, Professor Walter has assumed that r remains constant under all thesituations. As a matter of fact, r tends to decrease in correspondence withincrease in level of investments. This is why it is suggested that the managementshould make investments upto optimal level where r = k.


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Finally, assumption of constant cost of capital k is incorrect. On the contrary,it varies in tune with change in risk of the firm.

Illustration 1 : The earnings per share of a company is Rs. 8 and the rate ofcapitalisation applicable is 10%. The company has before it an option of

adopting (i) 50%, (ii)75%and(iii)100% dividend payout ratio. Compute the market price of thecompanys quoted shares as per Walters model if it can earn a return of (i)15%, (ii) 10% and (iii) 5% on its retained earnings.

Computation of market price of Companys share by applyingWalters formula

D +R a

(E D)P =

R cR

c

Where P = Market price per shareD = Dividend per share

Ra

= Internal rate of return on investment

Rc

= Cost of capital

E = Earnings pershare

10%or 0.10

Rs. 8

Now, we can calculate the market price per share based on different IRRS anddividend payout rations.

(i) Market price per share when Ra

= 15% When dividendpayout ratio is 50% Dividendpaid = 8 50/100 = Rs. 4

4 +0.15

(8 4)P = 0.10

0.10= Rs. 100

(b) When dividend payout ratio is 75%

Dividend paid = Rs. 875/100 = Rs. 6

6 +

0.15

(8 6)P = 0.100.10

= Rs. 90

(c) When dividend payout ratio is100%

dividend paid = Rs. 8

8 +0.15

(8 8)P = 0.10

0.10= Rs. 80


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(II) Market price per share when Ra

= 10%

(a) When dividend payout ratio is 50% i.e., Rs. 4

4 +0.10

(8 4)

P =

0.10

0.10= Rs. 80

(b) When dividend payout ratio is 75% i.e., Rs. 6

6 +0.10

(8 6)P = 0.10

0.10= Rs. 80

(c) When dividend payout ratio is 100% i.e., Rs. 8

8 +0.10

(8 8)P = 0.10

0.10= Rs. 80

(III) Market price per share when Ra

= 5%

(a) When dividend payout ratio is 50% i.e., Rs. 4

4 +0.05

(8 4)P = 0.10

0.10= Rs. 60

(b) When dividend payout ratio is 75% i.e., Rs. 6

6 +0.05

(8 6)

P =0.10

0.10 = Rs. 70

(c) When dividend payout ratio is 100% i.e., Rs. 8

8 +0.05

(8 8)P = 0.10

0.10= Rs. 80

GORDONS MODEL

:

Myron Gordon has also developed a model on the lines of Prof. Waltersuggesting that dividends are relevant and the dividend decision of the firmaffects its value. His basic valuation model is based on the followingassumptions:

1 . The firm is an all equity firm.2 . No external financing is available or used. Retained earnings represent theonly source

of financing investment programmes.3 . The rate of return on the firms investment r, is constant.


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Fianancia lManagemen t & internationa lfinance38

n

4 . The retention ratio, b, once decided upon is constant. Thus, the growthrate of the firm g = br, is also constant.

5 . The cost of capital for the firm remains constant and it is greater than thegrowth rate, i.e. k > br.

6 . The firm has prepetual life.

7 . Corporate taxes do not exist.

According to Gordon, the market value of a share is equal to the present valueof future stream of dividends. Thus,

P=D1

+(1 + K)

D 2+

(1 + K)2

Dt

(1 + K)t

Dt

= tt= 1 (1 + K )

Gordons basis valuation formula can be simplified as under:

P =E (1 b )

Ke br

or, P=D

Ke g

Where,P = Price of sharesE = Earnings per shareb = Retention Ratioke = Cost of equity capitalbr = g = growth rate in r, i.e., rate of return on investment of an all-equity firmD = Dividend per share

The implications of Gordons basic valuation model may be summarized as below:1 . When the rate of return of firms investment is greater than the requiredrate of return,

i.e. when r > k, the price per share increases as the dividend payout ratiodecreases.

Thus, growth firm should distribute smaller dividends and should retainmaximumearnings.

2 . When the rate of return is equal to the required rate of return, i.e, when r =k, the price


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per share remains unchanged and is not affected by dividend policy.Thus, for anormal firm there is no optimum dividend payout.


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3 . When the rate of return is less than the required rate of return, i.e.,when r


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When a firm pays its earnings as dividends, it will have to approach market forprocuring funds to meet a given investment programme. Acquisition ofadditional capital will dilute the firms share capital which will result in drop inshare values. Thus, what the stockholders gain in cash dividends they lose indecreased share values. The market price before and after payment of dividend

would be identical and hence the stockholders would be indifferent betweendividend and retention of earnings. This suggests that dividend decision isirrelevant.

M-Ms argument of irrelevance of dividend remains unchanged whether externalfunds are obtained by means of share capital or borrowings. This is for thefact that investors are indifferent between debt and equity with respect toleverage and cost of debt is the same as the real cost of equity.Finally, even under conditions of uncertainty, divided decision will be of norelevance because of operation of arbitrage. Market value of share of the twofirms would be the same if they


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identical with respect to business risk, prospective future earnings andinvestment policies. This is because of rational behavior of investor who wouldprefer more wealth to less wealth. Difference in respect of current and futuredividend policies cannot influence share values of the two firms.

M-M approach contains the following mathematical formulations to proveirrelevance of dividend decision.

The market value of a share in the beginning of the year is equal to thepresent value of dividends paid at the year end plus the market price of theshare at the end of the year, this can be expressed as below:

Po

=

D1 +P1 Equation (1)

(1 +K)

Where,P

0= Existing price of a

share k = Cost of capitalD

1= Dividend to be received at the year end

P1

= Market value of a share at the year end

If there is no additional financing from external sources, value of the firm (V) willbe number of share (n) multiplied by the price of each share (Po). Symbolically:

V = nPo

=n(D1 + P1)

(1 + K)

Equation (2)

If the firm issues m number of share to raise funds at the end of year 1 so asto finance investment and at price P

1, value of the firm at time o will be:

nPo =

nD1 + (n m)P1

mP1 Equation (3)

1 +K

Thus, the total of the firm as per equation (3) is equation to the capitalizedvalue of the dividends to be received during the period, plus the value of thenumber of share outstanding at the end of the period, less the value of the newlyissued shares.

A firm can finance its investment programme either by ploughing back ofits earnings or by issue of new share or by both. Thus, total amount of newshare that the firm will issue to finance its investment will be:

mP1

= l1

(X1

- nD1)

= 11

X1

+ nD1 Equation(4)


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Fianancia lManagemen t & internationa lfinance 41

Where,

mP1

= Total amount of funds raised by issue of new share to financeinvestment projects.

11

= Total amount of investment during first periodX

1

= Total amount of net profit during first period

If equation (4) substituted into equation (3), we find the following

equation:

nPo =

(n + m)P1

L1

+X

1

1 + K

Equation 5

On comparison of equation (5) with equation (3) we find that there is no

difference between the two valuation equations although equation (5) hasexpressed the value of firm without dividends. This led M-M to conclude thatdividend policy has no role to play in influencing share value of a firm.

Criticism of MMApproachMM hypothesis has been criticised on account of various unrealisticassumptions as givenbelow.

1 . Perfect capital market does not exist in reality.

2 . Information about the company is not available to all the persons.3 . The firms have to incur flotation costs while issuing securities.4 . Taxes do exit and there is normally different tax treatment for dividendsand capital

gain.5 . The firms do not follow a rigid investment policy.6 . The investors have to pay brokerage, fees etc., while doing anytransaction.7 . Shareholders may prefer current income as compared to further gains.

Illustration. Agile Ltd. belongs to a risk class of which the appropriatecapitalisation rate is10%. It currently has 1,00,000 shares selling at Rs. 100 each. The firm iscontemplatingdeclaration of a dividend of Rs.6 per share at the end of the current fiscal yearwhich has justbegun. Answer the following questions based on Modigliani and Miller Model andassumptionof notaxes:


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(i) What will be the price of the shares at the end of the year if a diviend isnot declared? (ii) What will be the price if dividend is declared?

(iii) Assuming that the firm pays dividend, has net income of Rs. 10 lakhand new investments of Rs. 20 lakhs during the period, how many newshares must be issued?

Modigliani and Miller - DividendIrrelevancy Model

=P

1 +D1Po 1 +Ke


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Where,

D1

= Contemplated dividend per

share

Rs. 6

P1

= Market price of share at the year end (to be determined)

Po

= Existing market price of

share

Rs. 100

Ke

= Cost of equity capital or rate of

capitalisation

10% or 0.10

(i) If dividend is not declared

P1 +D1

P 0 = 1+ Ke

100 =

P1

+0

1+0.10

P1 100=

1.10

100 1.10 = P1

P1

= Rs. 110

(ii) If dividend isdeclared :

P1 + D1 P0

= 1+ Ke

100=

P1

+6

1+0.10

P1 +6 100 = 1.10

100 1.10 = P1

+6

110 = P1

+ 6

P1

= 110 - 6

P1

= Rs. 104


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(ii) Calculation of No. of Shares to be issued

Particular

sDividen

d

Dividend

not

Net Income

Less : Dividends

paid Retained

earnings New

investments

Amount to be raised by issue of new shres (A)

Market pice per share (B)

New shares to be issued (A)/(B) (C)

10,00,00

0

10,00,000

4,00,000

10,00,000

20,00,000

16,00,000 10,00,000

Rs. 104 Rs. 110

15,385 9,091

Alternatively, the number of new shares to be issued is calculated as follows :

N =I (E

nD1)

P1

Where,

n = Number of Shares outstanding at the beginning of the periodi.e., 1,00,000 shares

N = Change in the number of Shares outstanding during the

period (to be ascertained)

I = Total investment required for capital budget i.e., Rs. 20,00,000

E = Earning of the firm during the period after payment of dividend.If dividend declared =10,00,000 - 6,00,000 = Rs.4,00,000If no dividend declared = 10,00,000

Now we can calculate the number of new shares to be issued:

(I)If dividend declared:

N =20,00,000

4,00,000

Rs.104

(II) If no dividend

declared:

= 15385 Shares

N =20,00,000

10,00,000

110

= 9091 Shares


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Verification of M.M. Dividend Irrelevancy Theory

Existing

shares

New sharesissued

Total No. of shares at the end (i)

Market price per share (ii)

1,00,00

0

1,00,000

9,091

1,15,38 1,09,091

Rs. 104 Rs. 110

Rs. 120 Rs. 120 lacs

Therefore, whether dividends are paid or not, value of the firm remains the

same as perM.M.

approach.

RESIDUAL MODEL:

If a firm wishes to avoid issue of shares, then it will have to rely on internallygenerated funds to finance new positive NPV projects. Dividends can only bepaid out of what is left over. This leftover is called a residual and such adividend policy is cllaed residual dividend approach.

When we treat dividend policy as strictly a financing decision, the payment ofcash dividends is a passive residual. The amount of dividend payount willfluctuate from period to period in keeping with fluctuations in the number of

acceptable investment opportunities available to the firm. If these oportunitiesabound, the percentage of dividend payout is likely to be zero. On the other handif the firm is unable to find pofitable investment opportunities, dividend payoutwill be 100%.

With a residual dividend policy, the firms objective is to meet itsinvestment needs and mostly to maintain its desired debt equity ratiobefore paying dividends. To illustrate imagine that a firm has Rs. 1000 inearnings and a debt equity ratio of 0.5. Thus the firm has0.5 of debt for every 1.5 of the total value. The firms capital structure is 1/3 ofdebt and 2/3 of equity.

The first stpe in implementing a residual dividend policy is to deermine theamount of funds that can be generated without selling new equity. If the firmreinvests the entire Rs. 1000 and pays no dividend, then equity will increase byRs. 1000. To keep the debt equity ratio constant, the firm must borrow Rs. 500.

The second stpe is to decide whether or not the dividend will be paid. If fundsneeded are less than the funds generated then a dividend will be paid. Theamount of dividend will be the residual after meeting investment needs.Suppose we require Rs. 900 for a project. Then 1/3 will be contributed by debt(i.e. Rs. 300) and the balance by equity/retained earnings. Thus the firm wouldborrow Rs. 300 and fund Rs. 600 from the retained earnings. The residual i.e. Rs.


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1000 Rs. 600 = Rs. 400 would be distributed as dividend.

More clarity can be had from the data givnebelow :


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PAT NewInvst.

Debt portion RetainedEarnings

Additional

Dividends

1000 3000 1000 1000 100 0

1000 2000 6 6 1000 3 3 0

1000 1500 5 0 1000 0 0

1000 1000 3 3 6 6 7 0 3 3

1000 5 0 1 6 3 3 3 0 6 6

1000 0 0 0 0 1000

DIVIDEND DISCOUNT MODEL :

The dividend disocunt model is a more conservative variation of discounted cashflows, that

says a share of stock is worth the present value ofits future

This model was popularized by John Burr Williamsin

rather than itsearnings.

.

... a stock is worth the present value of all the dividends ever to be paid upon it,no more, no less... Present earnings, outlook, financial condition, andcapitalization should bear upon the price of a stock only as they assist buyersand sellers in estimating future dividends.

The dividend discount model can be applied effectively only when a companyis already distributing a significant amount of earnings as dividends. But intheory it applies to all cases, since even retained earnings should eventuallyturn into dividends. Thats because once a company reaches its maturestage it wont need to reinvest in its growth, so management can begindistributing cash to the shareholders. As Williams puts it.

If earnings not paid out in dividends are all successfully reinvested... thenthese earnings should produce dividends later; if not, then they are moneylost... In short, a stock is worthonly .

The Dividend Discount Model (DDM) is a widely accepted stock valuation toolfound in most introdutory finance and invesment taxtbooks. The model

calculates the present value of the future dividends that a company is expectedto apply to its shareholders. It is particularly useful because it allows investors todetermine an absolute or intrinsic value of a particular comapny that is notinfluenced by current stock market conditions. The DDM is also useful becausethe measurement of future dividends (as opposied to earnings for example)facilitates an apples-to-apples comparison of companies across differentindustries by focusing on the actual cash investors can expect to receive.

There are three alternative dividend discount models used to


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determine the intrinsic value of a share of stock

a . the constant (or no-growth) dividend model;b. the constant growth dividend model; andc. the two-stage (or two-phase) dividend growth model.


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Constant dividends :

where :

= intrinsic value= expected dividend

= appropriate discont factor for the investment

This method is useful for analyzing preferred shares where the dividend is fixed.However, the constant dividend model is limited in that it does not allow forfuture growth in the dividend payments for growth industries. As a result theconstant growth dividend model may be more useful in examining a firm.

Constant dividend

growth :

where :

= intrinsic value= expected dividend

= appropriate discont factor for the investment

= constant dividend growth rate

The constand dividend growth model is useful for mature industries, where thedividend growth is likely to be steady. Most mature blue chip stocks may beanalyzed quickly with the constant dividend growth model. This model has itslimitations when considering a firm which is in its growth phase and will moveinto a mature phase at some time the future. A two stage growth dividendmodel may be utilized in such situations. This model allows for adjustment tothe assumptions of timing and magnitude of the growth of the firm.

For initial dividend growth & then steady

growth :n

D

(1 + g )t

D (1 + g

P = 0 1

+0 2

t =1

(1 + Ke ) k e g

2

where:

= instrinsic value = PV of dividends + PV of price

= expected dividend

= appropriate discount factor for the investment

= initial dividend growth rate

= steady dividend growth rate

LINTNER MODEL :

John Lintner surveyed dividend behavior of several corporate andshowed that a . Firms set long run target payout ratios.

b. Managers are concerned more about change in the dividend than the

absolute level c. Dividends tend to follow earnings, but dividends follow a

smoother path than earnings


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d. Dividends are sticky in nature because managers have a reluctance toeffect dividend changes that may have to be reversed.


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Lintner expressed corporate dividend behavior in the form of afollowing model :D

t= cr EPS

t+

(1-c)Dt1

D t=

DPS foryear t

c = Adjustment rate or Speed or Adjustment

r = Target Payout RateEPS

1= EPS for year t

Dt1

= DPS for year t1

The Lintner model shows that the current dividend depends partly on curentearnings and partly on previous years dividend. Likewise the dividend for theprevious year depends on the earnings of that year and the dividend for theyear preceding that year, so on and so forth. Thus as per the Lintner Model,

dividends can be described in terms of a weighted average of past earnings.DividendDates

What is a Declaration, Record, Ex-Dividend &Payment dates?

Decleration date : The date on which board of directors declare dividendis called a declaration date.

Record date : Record date, is that date when the company closes itsstock transfer books and makes up a list of the shareholdersfor payment of dividends.

Ex-dividend date : It is that date notified by the stock exchange, as adate which will entail a buyer of shares, the dividend, ifbought before the ex-dividend date. This date sets up theconvention of declaring that the right to the dividendremains with the stock until x days prior to the Recorddate. Thus whoever buys share on or beyond the ex-dividend date are not entitled to dividend.

Payment date : The date on which the company mails the cheques to therecorded holders.

Example :

Let us say, settlement of stocks follows T+3, which means that, when youbuy a stock, it takes three days from the transaction date (T) for the change tobe entered into the comanys record books. As mentioned, if you are not in thecompanys record books on the date of record, you wont receive the dividendpayment. To ensure that you are in the record books, you need to buy stock atleast three days before the date of record, which also happens to be the daybefore the ex-dividend date.

Ex-Dividend Date Date ofRecord


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Monday Tuesday Wednedsda Thursday Friday

5th 6th 7th 8th 9th


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As you can see by the diagram above, if you buy on the ex-dividend date, whichis only two days before the date of record, you will not recive the dividendbecause your name will not appear in the companys record books until Friday. Ifyou want to buy the stock and receive the dividend, you need to buy it on theMonday the 5th. (When the stock is trading with the dividend the term cum

dividend is used). If you want to sell the stock and still receive the dividend, youneed to sell on or after Tuesday the 6th.

TYPES OF DIVIDENDPOLICY :

The various types of dividend policies are discussed asfollows:

1 . Regular DividendPolicyPayment of dividend at the usual rate is termed as regular dividend. The

investors such asretired persons, widows and other economically weaker persons prefer to getregular dividends.A regular dividend policy offers the followingadvantages.

a . It establishes a profitable record of the company.

b. It creates confidence amongst the shareholders.

c. It aids in long-term financing and renders financing

easier. d. It stabilizes the market value of shares.

e. The ordinary shareholders view dividends as a source of funds to meettheir day-to- day living expenses.

f. If profits are not distributed regularly and are retained, the shareholdersmay have to pay a higher rate of tax in the year when accumulatedprofits are distributed.

However, it must be remembered that regular dividends can be maintained onlyby companies of long standing and stable earnings. A company should establishthe regular dividend at a lower rate as compared to the average earnings of thecompany.

2 . Stable DividendPolicy

The term stability of dividends means consistency or lack of variability in thestream ofdividend payments. In more precise terms, it means payment of certainminimum amountof dividend regularly. A stable dividend policy may be established in any of thefollowingthreeforms.


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(a) Constant dividend per share: Some companies follow a policy of payingfixed dividend per share irrespective of the level of earnings year afteryear. Such firms, usually, create a Reserve for Dividend Equalisation toenable them to pay the fixed dividend even in the year when theearnings are not sufficient or when there are losses. A policy of constant

dividend per share is most suitable to concerns whose earnings areexpected to remain stable over a number of years. Figure given belowshows the behavior of dividend in such policy.


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EPS

Earnings and

Dividend DPS

Time Years

(b) Constant pay out ratio: Constant pay-out ratio means payment of a fixedpercentage of net earnings as dividends every year. The amount ofdividend in such a policy fluctuates in direct proportion to the earnings ofthe company. The policy of constant pay-out is preferred by the firmsbecause it is related to their ability to pay dividends. Figure given belowshows the behavior of dividends when such a policy is followed.

EPS

Earnings and

Dividend DPS

Time Years

(c) Stable rupee dividend plus extra dividend: Some companies follow a policyof paying constant low dividend per share plus an extra dividend in theyears of high profits. Such a policy is most suitable to the firm havingfluctuating earnings from year to year.


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Advantages of Stable Dividend Policy

A stable dividend policy is advantageous to both the investors and the companyon account of the following;

a) It is sign of continued normal operations of the

company. b) It stabilizes the market value of shares.c) It creates confidence among the investors.d) It provides a source of livelihood to those investors who view dividends as asource of

funds to meet day-to-day expenses.e) It meets the requirements of institutional investors who prefer companieswith stable

dividends.f) It improves the credit standing and makes financing easier.g) It results in a continuous flow to the national income stream and thushelps in the

stabilization of national economy.

Dangers of Stable Dividend PolicyInspite of many advantages, the stable dividend policy suffers from certainlimitations. Oncea stable dividend policy is followed by a company, it is not easier to change it. Ifthe stabledividends are not paid to the shareholders on any account including insufficientprofits, thefinancial standing of the company in the minds of the investors is damaged andthey may

like to dispose off their holdings. It adversely affects the market price of shares ofthe company.And if the company pays stable dividends in spite of its incapacity, it will besuicidal in thelong-run.3 . Irregular Dividend PolicySome companies follow irregular dividend payments on account of the following:

a . Uncertainty of earnings.b. Unsuccessful business operations.c. Lack of liquid resources.d.Fear of adverse effects of regular dividends on the financial standing of thecompany.

4 . No Dividend PolicyA company may follow a policy of paying no dividends presently because of itsunfavourableworking capital position or on account of requirements of funds for futureexpansion andgrowth.

5 . Residual Dividend Policy


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When new equity is raised floatation costs are involved. This makes new equitycostlier thanretained earnings. Under the Residual approach, dividends are paid out ofprofits aftermaking provision for money required to meet upcoming capital expenditure

commitments.

TYPES OF DIVIDENDS:

Dividends may be declared in the form of cash, stock, scrips, bonds andproperty. We shall discuss each of these forms.


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1 . CashDividendsCash dividend is, by far, the most important form of dividend. In cashdividends stockholders receive cheques for the amounts due to them. Cash generated by

business earningsis used to pay cash dividends. Sometimes the firm may issue additional stock touse proceedsso derived to pay cash dividends or approach bank for the purpose. Generally,stockholdershave strong preference for cashdividends.

2 . Stock DividendsStock dividends rank next to cash dividends in respect of their popularity. In

this form ofdividends, the firm issues additional shares of its own stock to the stockholders inproportionto the number of shares held in lieu of cash dividends. The payment of stockdividendsneither affects cash and earnings position of the firm nor is ownership ofstockholders changed.Indeed there will be transfer of the amount of dividend from surplus account tothe capitalstock account which tantamount to capitalization of retained earnings. The neteffect of this

would be an increase in number of shares of the current stockholders. Butthere will be nochange in their equity. With payment of stock dividends the stockholders havesimply moreshares of stock to represent the same interest as it was before issuing stockdividends. Thus,there will be merely an adjustment in the firms capital structure in terms of bothbook valueand market price of the commonstock.

3 . Stock Splits

Closely related to a stock dividend is a stock split. From a purely economicpoint of view a stock split is nothing but a gaint stock dividend. A stock split isa change in the number of outstanding shares of stock achieved through aproportional reduction of increase in the par value of the stock. Themanagement employs this device to make a major adjustment in the marketprice of the firms stock and consequently in its earnings and dividends pershare. In stock split only the par value and number of outstanding shares are


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affected. The amounts in the common stock, premium and retained earningsremain unchanged. This is exhibited in the table. It may be noted from thetable that although number of shares was doubled, capital account of the firmdid not change because of proportional reduction in par value of the stock.

EFFECT OF A 2-FOR-1 STOCK SPLIT ON A FIRMSEQUITY

Before the Stock After the Stock Split

Common Stock (Re. 1 par, 40,000

shares)0.50 par, 8,00,000PremiumRetained earnings

4,00,00

0

3,00,000

4,00,000

3,00,000

Except in accounting treatment, the stock dividend and stock split are very

similar. Stock split is recorded as a doubling of the number of the sharesoutstanding and having of the par value per share. For a stock dividend,however, the account increases by the par value of


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shares issued, increases the capital-surplus account by the difference betweenthe market value of the shares issued and the par value, and reduces theretained earnings account by an amount needed to leave networth unchanged.For both stock splits and stock dividends, therefore, networth is unaffected. Thedifference in accounting procedure may be illustrated.

A company has the followingnetworth: Capital Stock:

Common Shares, Rs. 10 par, 2,00,000

20,00,000Retained earnings

45,00,00065,00,000

After a 2-for-1 split, this would appear asfollows: Capital Stock:

Common Shares, Rs. 5 par, 4,00,000


45,00,000

65,00,000

After a 100 per cent stock dividend the networth would show as follows (usingpar value as a basis for the transfer):

Capital Stock:Common Shares, Rs. 10 par, 4,00,000


25,00,00065,00,000

Owing to differences in accounting procedure the balance sheet will differ ineach case, thenet effect is thesame.

A . Reasons for stocksplitsA number of reasons may be offered for splitting of the firms common stock.


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These are:i) Broader Marketability of thestock

The basic reason of stock split is to provide broader and more stable market forthe stock. It

is agreed that when stock prices of a company tend to rise sharply due toeconomic prosperityof the company and its improved profitability and it is believed that the price ofthe sock hasmoved out of the price range of any investors narrowing the market of stock, themanagementmay, in a bid to promote wider distribution of shares, resort to stock split.Stock split willresult in lowering price of stock and the stocks will be within easy reach ofcommon investors.

ii) Need for Garnering ExternalResourcesA company contemplating to garner funds from the market may use stock splitto prepareground for new issues. In times of rising stock prices, market price of shares ofprofitable andprosperous companies rises beyond the reach of a large number of investors.In view oflimited saleability of shares, companies may experience a great problem inacquiring desired


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amount of capital. Thus, to increase the marketability of new issues, stock splitis very often used.iii) Merger or Acquisition of

CompaniesA firm contemplating merger or acquisition through exchange of stock willoften split itsstock to make the transactions more attractive to stockholders of the firm it istaking over.Suppose, for example, Globe Company offers to acquire assets of AlfredCompany throughan exchange of stock. The management of Globe Company decides that anexchange ratioof 1 to 10 (1 share of Globe Company for 10 shares of Alfred Company) wouldbe fair tostockholders of both companies. However, 1:10 exchange ratio may not appeal tostockholdersof Alfred company and the offer may be rejected. In such a situation stocksplit may beemployed to make the offer attractive. Thus, the management of Globe Companyby splitting1 share in 5 shares, may put the exchange ratio at 1:2 which may be readilyaccepted bystockholders of AlfredCompany.

B. ReverseSplitSometimes, a company may think of reducing the number of shares so as toenhance itsshare price. This can be accomplished by means of reverse split which meansreduction innumber of outstanding shares. To illustrate, assume a company has 4,00,000outstandingshares of Re. 1 share. If the management declares 1-for-2 reverse split, thecompany willhave 2,00,000 shares of Rs. 2 per share. Under this arrangement stockholdersreceive fewer

shares with higher parvalue.

The basic purpose of reverse split is to increase the market value of each share.Companies experiencing financial trouble usually find their share pricesdeclining in the market. Such companies follows the policy of reverse split so asto check further price decline and raise it. The announcement of a reverse split isan indication that the company is in financial jeopardy. Reverse stock splits arenot as common as stock split ups.


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Stock splits must be approved by a majority in number, representing three-fourths in value of members of the firm and approved by a Court of Law. Thefirm is required to give notice of this alternation to the Registrar of Joint StockCompanies within 30 days of doing so (Section 391, Indian Companies Act,1956).

4 . ScripDividendScrip dividend means payment of dividend in scrip of promissory notes.Sometimes companyneeds cash generated by business earnings to meet business requirementsbecause of temporaryshortage of cash. In such cases the company may issue scrip or notespromising to paydividend at a future date. The scrip usually bears a definite date of maturity orsometimes

maturity date is not stipulated and its payment is left to the discretion of theBoard of Directors.

Scrips may be interest-bearing or non-interest bearing. Such dividends arerelatively scarce. The issue of scrip dividends is justified in the followingcircumstances:

1 . When a company has plentitude of earnings to distribute dividends butcash position is temporarily meager because bulk of the sale proceedswhich are tied in receivable


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for time being will be released very shortly, the management in such asituation may issue certificates to the stockholders promising them to paydividend in the near future.

2 . When a company wants to maintain an established dividend recordwithout paying out cash immediately, it may take recourse to scrip

dividend.3 . When the management believes that stock dividends will not be useful

because further earnings of the company will not increase sufficiently tomaintain dividend rate on increased shareholding, issue of promissorynotes to pay dividends in future would be a wise step.

4 . When the company does not wish to borrow to cover its dividendrequirements the danger lies in their use as a sop to stockholders whenbusiness earnings are inadequate to make dividend payments.

Such a form of dividend is non-existent inIndia.

5 . BondDividendAs in scrip dividends, dividends are not paid immediately in bond dividends.Instead thecompany promises to pay dividends at a future date and to that effect bondsare issued tostock holders in place of cash. The purpose of both the bond and scrip dividendsis alike, i.e.,postponement of dividend payments. Difference between the two is in respect ofthe date ofpayment and their effect is the same. Both result in lessening of surplus andaddition to theliability of the firm. The only difference between bond and scrip dividends is thatthe formercarries longer maturity than the latter. Thus, while issue of bond dividendincreases long-term obligation of the company, current liability of the company would rise as aconsequenceof the issuance of the scrip-dividends. In bond dividends stockholders havestronger claimagainst the company as compared to

dividends.

Bond used to pay dividends carry interest. This means that the companyassumes fixed obligation of interest payments annually and principal amount ofbond at maturity date. It should be remembered that the company is assumingthis obligation in return for nothing except credit for declaring dividends.How far the company will be able to satisfy this obligation in future, is alsodifficult to predict at the time of issue of bonds. The management should,therefore, balance cost of issuing bond dividends against benefits resulting fromthem before deciding about distribution of dividends in the form of bonds. Bond


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dividends are not popular in India.

6 . PropertyDividendsIn property dividend the company pays dividends in the form of assets otherthan cash.Generally, asses which are superfluous for the company are distributed asdividends to thestockholders. Sometimes the company may use its products to pay dividends.Securities ofthe subsidiary companies owned by the company may also take the form ofproperty dividends.

This kind of dividend payment is not in vogue inIndia.

FACTORS AFFECTING DIVIDENDPOLICY :

There is a controversy amongst financial analysts regarding impact of dividendson market price of a companys shares. Some argue that dividends do nothave any impact on such


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price while others hold a different opinion. However, preponderance ofevidence suggests that dividend policies do have a significant effect on thevalue of the firms equity shares in the stock exchange. Having accepted thispremise, it will now be appropriate to consider those factors which affect thedividend policy of a firm.

The factors affecting the dividend policy are both external as wellas internal.

Following are the external factors which affect the dividend policy

of a firm:1 . General state of economy - The general state of economy affects to agreat extent the

managements decision to retain or distribute earnings of the firm. In case

of uncertaineconomic and business conditions, the management may like to retain thewhole or apart of the firms earnings to build up reserves to absorb shocks in thefuture. Similarlyin periods of depression, the management may also withhold-dividendspayment toretain a large part of its earnings to preserve the firms liquidity position. Inperiods ofprosperity the management may not be liberal in dividend paymentsthough the

earning power of a company warrants it because of availability of largerprofitableinvestment opportunities.

Similarly in periods of inflation, the management may withhold dividendpayments in order to retain larger proportion of the earnings forreplacement of worn-out assets.

2 . Legal restrictions - A firm may also be legally restricted from declaringand paying dividends. For example, in India, the companies Act, 1956 hasput several restrictions regarding payments and declaration of dividends.

Some of these restrictions are as follows:

(i) Dividends can only be paid out of (a) the current profits of thecompany, (b) the past accumulated profits or (c) money providedby the Central or State Governments for the payment ofdividends in pursuance of the guarantee given by theGovernment. Payment of dividend out of capital is illegal.

(ii) A company is not entitled to pay dividends unless (a) it has providedfor present as well as all arrears of depreciation, (b) a certain


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percentage of net profits of that year as prescribed by the CentralGovernment not exceeding 10%, has been transferred to thereserves of the company.

(iii) Past accumulated profits can be used for declaration of dividendsonly as per the rules framed by the Central Government in this

behalf.

Similarly, the Indian Income Tax Act also lays down certain restrictions onpayment of dividends. The management has to take into consideration all thelegal restrictions before taking the dividend decision otherwise it may bedeclared as ultra vires.


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The following are the internal factors which affect the dividend policy of a firm:1 . Desire of the shareholders - Of course, the directors haveconsiderable liberty

regarding the disposal of the firms earnings, but the shareholders are

technically theowners of the company and, therefore, their desire cannot beoverlooked by thedirectors while deciding about the dividendpolicy.

Shareholders of a firm expect two forms of return from their investmentin a firm:(i) Capital gains - The shareholders expect an increase in the marketvalue of the

equity shares held by them over a period of time. Capital gain

refers to theprofit resulting from the sale of capital investment i.e., the equityshares incase of shareholders. For example, if a shareholder purchases ashare for Rs.40 and later on sells it for Rs.60 the amount of capital gain is a sumof Rs. 20.

(ii) Dividends - The shareholders also expect a regular return on theirinvestment

from the firm. In most cases the shareholders desire to getdividends takespriority over the desire to earn capital gains because of the followingreasons:(a) Reduction of uncertainty - Capital gains or a futuredistribution of earningsinvolves more uncertainty than a distribution of current earnings.(b) Indication of strength - The declaration and payment ofcash dividendcarries an information content that the firm is reasonably strong andhealthy.(c) Need for current income - Many shareholders require

income from theinvestment to pay for their current living expenses. Suchshareholders aregenerally reluctant to sell their shares to earn capital gain.

2 . Financial needs of the company - The financial needs of thecompany are to be considered by the management while taking thedividend decision. Of course, the financial needs of the company maybe in direct conflict with the desire of the shareholders to receive largedividends. However, a prudent management should give more weightage


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to the financial needs of the company rather than the desire of theshareholders. In order to maximize the shareholders wealth, it isadvisable to retain earnings in the business only when company hasbetter profitable investment opportunities as compared to theshareholders. However, the directors must retain some earnings, whether

or not profitable investment opportunity exists, to maintain the companyas a sound and solvent enterprise.

3 . Desire of control - Dividend policy is also influenced by the desire ofshareholders or the management to retain control over the company.

The issue of additional equity shares for procuring funds dilutes controlto the detriment of the existing equity shareholders who have adominating voice in the company. At the same time, recourse to long-termloans may entail financial risks and may prove disastrous to the interests ofthe shareholders in times of financial difficulties.

In case of a strong desire for control, the management may bereluctant to pay substantial dividends and prefer a smaller dividend payout ratio. This is particularly true in case of companies which needfunds for financing profitable investment


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opportunities and an outside group is seeking to gain control over thecompany. However, where the management is strongly in control of thecompany either because of substantial shareholdings or because of theshares being widely held, the firm can afford to have a high dividend payout ratio.

4 . Liquidity position - The payment of dividends results in cash outflowfrom the firm. A firm may have adequate earnings but it may not have sufficientcash to pay dividends. It is, therefore, important for the management to takeinto account the cash position and the overall liquidity position of the firmbefore and after payment of dividends while taking the dividend decision. A firmmay not, therefore, be in a position to pay dividends in cash or at a higher ratebecause of insufficient cash resources. Such a problem is generally faced bygrowing firms which need constant funds for financing their expansionactivities.

STABILITY OF DIVIDEND:

Another important diemention of a dividend policy is the stability of dividendsi.e. how stable, regular or steady should the dividend stream be, over time? Itis generally said that the shareholders favour stable dividends and thosedividends, which have prospects of steady upward growth. If a firm developssuch a pattern of paying stable and steady dividends, then theinvestors/shareholders may be willing to pay a higher price for the shares. Sowhile designing a dividend policy for the firm, it is also to be considered as towhether the firm will have a consistency in dividend payments or the dividendswill fluctuate from one year to another. In the long run, every firm will like tohave a consistent dividend policy, yet fluctuations from one year to anothermay be unfavourable.

Rationale for stability ordividend

Most of the firms follow stable dividends or gradually increasing dividends due tofollowing reasons

a . Many investors consider dividends as a part of regular income to meet theirexpenses.

Hence, they prefer a predictable pattern of dividends rather thanfluctuating pattern.

A fall in the dividend inocme may lead to sale of some shares. On theother handwhen the dividend income increases, an investor may invest some of theproceeds asreinvestment in shares. Both the cases involve transaction cost andinconvenience forinvestor. Hence, they prefer regulardividends.

b. The dividend policy of firms conveys a lot to the investors. Increasing


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dividends means better prospects of the company. On the contrary,decreasing dividends suggest bad earnings expectations. In addition,stable dividends are sings of stable earnings of the company. On the otherhand, varying dividends lead to uncertainty in the mind of shareholders.

c. Certain investors mainly institutional, consider the stability of

dividends as an important criterion before they decide on the investmentin that particular firm.

SHARE BUYBACK(REPURCHASE) :

When companies have sufficient liquid assets they resort to share buy back orshare repurchase, wherein they cancel or retire a part of its outstanding sharesby purchasing from the market or directly from the shareholders. This isparticularly relevant when the shares are available


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in the market much below its book value. When the shares are repurchased, theunderlying motive is to distribute the excess cash to the shareholders. Thecancellation of shares means the shareholders will receive cash for their shares,reduced outstanding number of shares in the books of the coampany, earningsper share increase and also market price of the share increases.

There are three methods of shares repurchase :

a. Repurchase Tender Offer : Here the firm specifies the number ofshares it proposes to buy back, the price it would pay and the time periodfor which the offer would be open for the shareholders to tender theirshares. The firm may retain the flexibility to withdraw the offer ifinsufficient number of shares are submitted for repurchase.

b. Open Market Repurchase : Here the firm buys from the market atthe prevailing price. The time period is generally longer than that isadopted for Tender Offers. In terms of flexibility, the open maketrepurchase provides the firm more fredom in deciding when to

repurchase and how many shares to be repurchased.c. Negotiated Repurchase : In this case the firm may buy shares from a

large shareholder at a negotiated pice. This is adopted only when alarge shareholder groups viz. promoters, are willing to sell their stake.

Let S denote the number of outstanding shares. Po be the current market priceand le N be the number of shares that would be bought back by the companythen

=S

P0Theoretical post Buy Back price (P

1) is

given asSN

. As it can be seen the price after

buy

back would increase, as the number of shares outstanding gets reduced.

Advantages of Shares Repurchase over Dividends

1 . Cash dividend implies a commitment on the part of a company tocontinue payments in future, as investors keep expectivng them.However, share repurchase is an one time affair.

2 . The decision to repurchase the shares offers a company more flexibilityas to number of shares, the period etc.

3 . Share repurchase are more focused in terms of paying out cash

only to those shareholders who need it. However, dividends are paid toall.

4 . Share buy back provide a way of increasing insiders control in the firm. Ifonly outsiders tender their shares, automatically insiders controlincreases.

When Share buyback is adopted by the companies?

a . If excess cash flows are temoporary, share repurchase can be adopted.If cash flows are stable, then the firm may prefer to give dividends.

b. Firms uncertain about their future investment opportunities in thebusiness are more likely to use share repurchase as a means of returning


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cash to shareholders.

c. The share repurchase is relevant especially when the shares of the firm areundervalued. d. When the promoters want to increase their control in thefirm they use share buyback

to the maximum effect.


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Clienteleeffect

Investors have diverse preferences. Some want more dividend income; otherswant more capital gains; still others want a balanced mix of dividend incomeand capital gains. Over a period of time, investors naturally migrate to firmswhich have a dividend policy that matches their preferences. The concentrationof investors in comapanies with dividend policies that are matched to theirpreferences is called the clientele effect. The existence of a clientele effectimplies that (a) firms get investors they deserve and (b) it will be difficult for afirm to change and established dividend policy.

PROBLEMS AND

SOLUTIONS: Illustration 1

A company has following

capital:

7% Preference Shares of Rs.100 6,00,00

Ordinary Shares of Rs.10 each 16,00,00

22,00,0

The following information are available relating to its financial year ending 31-12-84:

i) Profit, after taxation @ 40%,

Rs.5,42,000 ii) Ordinary dividend paid

20%.iii) Depreciation Rs.1,20,000

iv) Market price of Ordinary SharesRs.40 v) Capital CommitmentRs.2,40,000.

You are required to calculate the following:

a) The dividend yield on the Ordinary Shares.

b) The cover for the preference and Ordinarydividends. c) The earnings yield,d) The price-Earning

ratio, e) The Net CashFlow,

f) The reason for the comparison of net cash flow with capitalcommitment.

Solution :

a) Dividend yield on ordinary shares (or) dividend yield ratio

= (DPS / market price) x 100


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= (10 x 20% / 40) x 100

= 5%

[Market price = Capitalized value ofdividend]


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b) Dividend coverage ratio: preference = (PAT / Preferencedividend)

= 542000 /

42000= 12.9times

=> Equity = (PAT Preference dividend) / equity dividend

= 500000 /320000

= 1.5625times

c) Earnings yield ratio = (EPS / market price ) x 100

= (3.125 / 40) x

100

= 7.8125%

[EPS = 500000 / 160000 = Rs 3.125]

d) Price Earning Ratio = [(40 / 3.125)] = 12.8 times

(Market price / EPS)

e) Net cash flow

PAT

Rs

54200

(+) depreciation 12000

66200

(-) preference dividend 4200

(-) equity dividend 32000

Net cash flow 30000

f) Since the cash flow position shows the firms ability to meet the capitalexpenditure

/ capital commitment.

Illustration 2

ABC Ltd. has a capital of Rs.10 lakhs in equity shares of Rs.100 each. Theshares currently quoted at par. The company proposes declaration of a dividendof Rs.10 per share at the end of the current financial year. The capitalisationrate for the risk class to which the company belongs is 12%.

What will be the market price of the share at the end of

the year, if i) A dividend is not declared?

ii) A dividend is declared?

iii) Assuming that the company pays the dividend and has net profits of


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Rs.5,00,000 and makes new investments of Rs.10 lakhs during theperiod, how many new shares must be issued? Use the M.M. model.


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1

P1

Solution :

Modigliani Miller Approach

n = no of shares = 10000

P0 = market price = Rs100D

1= Expected dividend = Rs10

Ke

= cost of capital = 12%

i. Market price of share ( P1) if dividend not declared

Given D1

= 0

We know,

P0

= (D1+P

1)/ (1+K

e) = 112

ii. P1

if dividend declared

D1

= Rs10

P0

= (D1+P

1) / (1+

Ke

) P1

= Rs.102

iii. No of shares to be issued:n = (I E + nD

)/ P1

Illustration

3

= (1000000 500000 + 100000) / 102

= 5882 shares

A textile company belongs to a risk-class for which the appropriate PE ratio is 10.It currently has 50,000 outstanding shares selling at Rs.100 each. The firm iscontemplating the declaration of Rs.8 dividend at the end of the current fiscalyear which has just started. Given the assumption of MM, answer thefollowing questions.

i) What will be the price of the share at the end of the year: (a) if adividend is not declared, (b) if its is declared?

ii) Assuming that the firm pays the dividend and has a net income ofRs.5,00,000 and makes new investments of Rs.10,00,000 during theperiod, how many new shares must be issued?

iii) What would be the current value of the firm: (a) if a dividend isdeclared, (b) if a dividend is not declared?


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1

1

Solution :

Given,

P/E ratio = 10

n = 50,000sharesP

0= Rs. 100

D1

= Rs. 8

E = Rs. 5,00,000

I = Rs. 10,00,000

Ke = 1 / (P/E ratio)

1. Calculation of P1

1 . if dividend not declared:

P0

= (D1+ P

1) /

(1+Ke) P1

= Rs110

2 . if dividend

declared: P0

=

(D1+ P

1) / (1+Ke)

P1

= Rs.102

3 . If the company pay dividend:

P1 = Rs. 102n = (I E +nD ) / P1 1

No of new shares, n = 900000 / 102 = 8823.5294 shares

4 . Value of the firm:

a) If the company pay dividend:

V = (n + n)P

= (58823.5294) 102

= Rs. 6000000

b) If the company does not pay dividend:

V = (n+ n)P

= 54545.4545 x 110

= Rs. 6000000

Working notes:n = (1000000 - 500000) / 110 = 4545.4545


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Illustratio

n 4

(i) From the following information supplied to you, ascertain whether the firmsD/P ratio is optimal according to Walter. The firm was started a year ago with an

equity capital of Rs. 20 lakh.Earnings of the firm Rs. 2,00,000.00

Dividend paid 1,50,000.00

P/E ratio 12.50

Number of shares outstanding, 20,000 @ Rs.100 each. The firm is expected tomaintain its current rate of earnings on investment.

ii) What should be the P/E ratio at which the dividend payout ratio will have noeffect on the value of the share?

iii) Will your decision change if the P/E ratio is 8, instead of 12.5?

Solution :

i. Ke = (EPS / market price) = 1 /(12.5) = 8 %

r = (200000 / 2000000) x 100 = 10 %

Payout ratio = (150000/200000) x 100 = 75%

It is the growth firm (r > Ke), as per WALTERs model the optimum payout

ratio is Zero. So in the given case pay out ratio is not optimum.

Proof:

a). Market price at 75% payout ratio

EPS =Rs10

DPS =Rs7.5r = 10 % & Ke = 8%

DPS +

r

(EPS DPS)Market Price = KeKe

7.5+0.1

(2.5)Market Price = 0.08 =Rs. 132.81

0.08

b). Market price at zero


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payout:EPS = Rs10DPS = Rs0

r = 10 % & Ke = 8 %

DPS +

r

(EPS DPS)Market Price = Ke = 156.25

Ke


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Therefore Zero Payout is optimum.i. The payment of dividend in case of normal firms(r = Ke) has no effect on

the market value of the share.

Ke = r = 10%

P/E ratio = 10times i.e [ 1 / Ke]ii. If P/E ratio = 8 , Ke= 12.5 %

r = 10%

When r < Ke the firm is Decline firm as per WALTER and its Optimum payoutratio is100%.

So in the given case it is 75% payout only, it is not optimum payout.

Proof:

Market price at 75% payout:

DPS +r

(EPS

Market Price = KeKe

At 100% payout.

DPS +r

(EPS

Market Price = KeKe

Illustration 5

Excellence Ltd registered earnings of Rs. 800,000 for the year ended 31st March. They finance all investments from out of retained earnings. The opportunitiesfor investments are many. If such opportunities are not availed their earningswill stay perpetually at Rs. 800,000. Following figures are relevant.

Policy Retention Growth Cost of equity on all

A 0 0 1 4

B 2 5 1 5

C 4 7 1 6

The returns to shareholders are expected to rise if the earnings are retainedbecause of the risk attached to new investments. As for the current year,dividend payments will be made with or without retained earnings. Whataccording to you, should be retained ?


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Solution :

GORDANModel:

D (1 g) Market Price =0

K0 g

Evaluation of different dividend policies:

Policy A Policy B Policy C

Retention ratio 0 % 25 % 40%

Payout ratio 100% 75% 60%

g 0% 5 % 7 %

Dividend (D0) 800000 600000 480000

D1

800000 630000 513600

Ke

14 % 15% 16%

Value of firm [(D1)/ (K

e-g)] 5714286 6300000 5706667

(Add) dividend 800000 630000 513600

Cum dividend Value of firm 6514286 6930000 6220267

From the above policies, policy B gives more value to the share holders. Hence it

is advisableto adopt the policy B.

Illustration 6

X Ltd. has 1000 shares of Rs 10 each raised at a premium of Rs. 15 per share.The companys retained earnings are Rs. 552500. The Companys stock sellsfor Rs. 20 per share.

a . If a 10% stock dividend is declared how may new shares would be issued?

b. What would be the market price after the stock dividend?

c. How would the equity account change?

d. If a 25% stock dividend is declared what changes will take place?

e. If the company instead declares a 5:1 stock split, how many shares will beoutstanding?

What would be the new part value? What would be the new market price?

f. If the company declares a 1:4 reverse split, how many shares will beoutstanding? What would be the new par value? What would be the newmarket price?

g. If the company declares a dividend of Rs. 2 per share and the stock goesex dividend tomorrow, what will be the price at which it will sell?


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Equity Share Capital (1,00,000 shares of Rs. 10 10,00,0

Share premium 15,00,0

Reserves & Surpluses 5,00,0

Net worth 30,00,0

Solution :

a) If 10% stock dividend declared:

No of new shares issued as bonus = 100b) Market price after bonus issue = [(1000 x 20) + (100 x 0 )] / 1100

=Rs.18.18

c) Change in equity accountEquity share capital increased by Rs1000Reserves decreased by Rs1000.Hence, there is no change in the Net Equity

d) If 25% stock dividend declared1) No new shares issued = 1000 @ 25 % = 250 shares2) Market price after stock dividend = [(1000 x 20) + (250 x 0)] / 1250

=Rs.16

3) Change in EQUITYaccount: Capital increasedby Rs. 2500Reserve decreased Rs.2500

There is no change in Net Equity.

e) If the company declares 5 : 1 stock split i.e. 5 shares issued inexchange of 1 share each.

No of shares outstanding = 5000New face value of share = 10/ 5 = Rs.2New market price = 20 / 5 = Rs.4

f) If the company declares 1: 4 reverse split i.e 1 share issued inexchange of every 4 shares.

No of shares outstanding = 250New face value = 4 x 10 = Rs.40Market price = 20 x 4 = Rs.80

g) Cum dividend market price =Rs. 20 (-) dividend = 2

Ex-dividend market price Rs. 18

Illustration 7Following is the capital structure of Progressive Co. Ltd. as on 31st March, 2003.

Rs.


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On 1st April, 2001, the company made a bonus issue of two shares for everyfive held. The market price at the time of bonus issue was Rs. 40 per share.X holds 100 shares of the Progressive Co. Ltd. purchased on 1st April, 1997 amarket price of Rs. 30. He sold these shares on 31st March, 2003 at Rs. 50 pershare. The income tax rate for X is 20% and capital gain tax is 15% for him.

If the company pays a regular dividend of 10% on par before transferringearnings to reserves and surpluses, state whether X was able to earn his re-quired rate of return of 10% on his investment? (The PV at 10% 1 st year 0.91;2nd year 0.83;3rd year 0.75; 4th year 0.68; 5th year 0.62 and 6th

year 0.56).

Solution:

Appraisal of Investment decision: [NPVmethod ]

1) Initial Investment (outflow):

100 shares @ 30 each = 3000

2) Present value recurring cash

inflows

Year Dividend Tax Net

cash

Pvfactor

Presentvalue

1 1 0 2 8 0.91 72.8

2 1 0 2 8 0.83 66.4

3 1 0 2 8 0.75 60.0

4 1 4 2 1 1 0.68 76.1

5 1 4 2 1 1 0.62 69.4

6 1 4 2 1 1 0.56 62.7

386.00

3) Present value of terminal cash inflow:

Sale proceeds 140shares@ 50 each =

7000 (-) capital gain tax4000@ 15% =600

6400

Its present value = 6400 x 0.56 = 3584

4) NET PRESENT VALUE:


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Present value of cash inflow (386+3584) =3970 (-) outflow

3000

Net present value 970

The investment yields more than 10 % return to theinvestor.

dici conceps

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