Session 22 Dividend Policy

Financial Management

Session -22

Dividend Policy

Different Types of Dividends

• Many companies pay a regular cash dividend.– Public companies often pay quarterly.– Sometimes firms will pay an extra cash dividend.– The extreme case would be a liquidating dividend.

• Liquidating dividend is paid as return of capital when some or all of the business has been liquidated. While regular, extra and special dividends are income in the hands of shareholders, liquidating dividend is not income but receipt of capital.

• Companies will often declare stock dividends.– No cash leaves the firm.– The firm increases the number of shares outstanding.

• Some companies declare a dividend in kind.

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Dividend Payout Ratio

Dividend payout ratio = DPS / EPS

Dividend payout ratio indicates theproportion of earnings per share paid out toordinary shareholders as dividend.

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Dividend Yield

Dividend yield = DPS / Market Price per Share

Dividend yield measures the return receivedby the investors of ordinary shares by way ofdividend in relation to an ordinary share’smarket price.

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Are Dividends Relevant?- MM Theory

Modigliani and Miller (MM) advanced a theory that dividend policy has no effect on the market value of a company and hence dividends are irrelevant.

It does not matter how a company divides its earnings between dividend payment to its shareholders and retained earnings.

Standard Method of Cash Dividend

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Record Date – Date on which company determines existing shareholders.

Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock immediately before this date is entitled to a dividend.

Declaration Date – Date of the announcement of dividend.

Procedure for Cash Dividend

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25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec.

Declaration Date

Cum-dividend

Date

Ex-dividend

Date

Record Date

Payment Date

…

Declaration Date: The Board of Directors declares a payment of dividends.Cum-Dividend Date: Buyer of stock still receives the dividend.Ex-Dividend Date: Seller of the stock retains the dividend.Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 5 November.

Price Behavior

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• In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.

$P

$P - divEx-

dividend Date

The price drops by the amount of the cash dividend.

-t … -2 -1 0 +1 +2 …

Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

The Irrelevance of Dividend Policy

• A compelling case can be made that dividend policyis irrelevant. (Proposed by Miller and Modigliani)

• Since investors do not need dividends to convert shares to cash; they will not pay higher prices for firms with higher dividends.

• In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends.

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Homemade Dividends

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• XY Inc. is a $42 stock about to pay a $2 cash dividend.• An investor owns 80 shares and prefers a $3 dividend.• Investor’s homemade dividend strategy:

– Sell 2 shares ex-dividend

$3 Dividend$240

$0$240

$39 × 80 =$3,120

Dividend Policy is Irrelevant

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• In the above example, Bob Investor began with a total wealth of $3,360:

share42$shares 80360,3$

240$share

39$shares 80360,3$

80$160$share

40$shares 78360,3$

After a $3 dividend, his total wealth is still $3,360:

After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360:

Dividends and Investment Policy

• Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time).

• Recall that one of the assumptions underlying the dividend-irrelevance argument is: “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.”

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Repurchase of Stock

• Instead of declaring cash dividends, firms can rid themselves of excess cash through buying shares of their own stock.

• Recently, share repurchase has become an important way of distributing earnings to shareholders.

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Stock Repurchase versus Dividend

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$10=/100,000$1,000,000=Price per share100,000=outstandingShares

1,000,000Value of Firm1,000,000Value of Firm1,000,000Equity850,000AssetsOther

0Debt$150,000CashsheetbalanceOriginalA.

Equity&LiabilitiesAssets

Consider a firm that wishes to distribute $100,000 to its shareholders.

Stock Repurchase versus Dividend

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$9=00,000$900,000/1=shareper Price100,000=goutstandinShares

900,000FirmofValue900,000FirmofValue900,000Equity850,000AssetsOther

0Debt$50,000Cash

dividendcash shareper $1After B.Equity&sLiabilitieAssets

If they distribute the $100,000 as a cash dividend, the balance sheet will look like this:

Stock Repurchase versus Dividend

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Assets Liabilities & EquityC. After stock repurchaseCash $50,000 Debt 0Other Assets 850,000 Equity 900,000Value of Firm 900,000 Value of Firm 900,000Shares outstanding= 90,000Price per share = $900,000 / 90,000 = $10

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

Share Repurchase Why?• Flexibility for shareholders

– Firms view dividend as a commitment• Keeps stock price higher

– Good for insiders who hold stock options• Offset to dilution

– The exercise of stock option reduce # shares• As an investment of the firm (undervaluation)• Tax benefits

– Capital gain tax and dividends tax may be different

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Factors Driving Share Repurchase

• Unused Cash

• Tax Gains

• Market Perceptions

• Show Rosier Financials– ROA and ROE increases

• Increase Control

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Firms without Sufficient Cash

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In a world of personal taxes, firms should not issue stock to pay a dividend.

Firm Stock Holders

Cash: stock issue

Cash: dividends

Gov.

Taxes

Investment Bankers The direct costs of stock issuance will add to this effect.

Firms with Sufficient Cash

• The above argument does not necessarily apply to firms with excess cash.

• Consider a firm that has $1 million in cashafter selecting all available positive NPV projects.– Select additional capital budgeting projects (by

assumption, these are negative NPV).– Acquire other companies– Purchase financial assets– Repurchase shares

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Taxes and Dividends

• In the presence of personal taxes:1. A firm should not issue stock to pay a dividend.2. Managers have an incentive to seek alternative

uses for funds to reduce dividends.3. Though personal taxes mitigate against the

payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends.

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Real-World Factors Favoring High Dividends

• Desire for Current Income• Behavioral Finance

– It forces investors to be disciplined.• Tax Arbitrage

– Investors can create positions in high dividend yield securities that avoid tax liabilities.

• Agency Costs– High dividends reduce free cash flow.

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The Clientele Effect

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• Clienteles for various dividend payout policies are likely to form in the following way:

Group Stock Type

High Tax Bracket IndividualsLow Tax Bracket IndividualsTax-Free InstitutionsCorporations

Low-to-Medium payout

Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.

Usual Practices

• Corporations “smooth” dividends. (Lintner theory)

• Dividend Change = Div(1) – Div(0) • = s.(t*EPS(1) –Div(0))

• s- speed of adjustment• t-payout ratio

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Smooth Dividend

• Suppose VIL has a target payout ratio of 0.30. last year EPS were Rs 10 and accordingly VIL paid Rs 3 as dividend. However, earnings have jumped to Rs. 20 this year what would be the dividend next year if speed of adjustment is 0.5

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Usual Practices

• Dividends provide information to the market.– Dividend Signaling

• Cash Flow = Capital Expenditure + Dividend• Increase in dividends raise stock price

• Firms should follow a sensible policy:– Do not forgo positive NPV projects just to pay a

dividend.– Avoid issuing stock to pay dividends.– Consider share repurchase when there are few

better uses for the cash.

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Stock Dividends

• Pay additional shares of stock instead of cash• Increases the number of outstanding shares• Small stock dividend

– Less than 20 to 25%– If you own 100 shares and the company declared a

10% stock dividend, you would receive an additional 10 shares.

• Large stock dividend – more than 20 to 25%

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Stock Splits

• Stock splits – essentially the same as a stock dividend except it is expressed as a ratio– For example, a 2 for 1 stock split is the same as a

100% stock dividend.• Stock price is reduced when the stock splits.• Common explanation for split is to return price

to a “more desirable trading range.”

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Multiple Choice Question-1

What should be the target dividend payout ratio ofa company, that has high cash flow liquidity but notenough good investment projects? It also has unused borrowing capacity.a) High to Mediumb) Medium to lowc) Lowd) Need more information

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Multiple Choice Question-1 (Ans.)

Ans. (a)

Explanation: The company has cash left and access to further borrowings. So, cash flow is not a problem. Also, it cannot use available cash in new investments. So,based on residual dividend approach, it should paymedium to high level of dividends.

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Multiple Choice Question-2A company has expected earnings of Rs.5 million.It is planning a total investment outlay of Rs.3.5 million this year. Historically, the company has hada dividend payout ratio of 25 percent. Calculate theamount of dividends that the company will distribute.a) Rs.1.5 millionb) Rs.1.25 millionc) Rs.1.00 million

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Multiple Choice Question-2 (Ans.)

Ans. (b)

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Multiple Choice Question-3

A company has made a profit of Rs.300, 000. It has plans to invest Rs.600, 000 in new projects. Its targeted debt-equity ratio is2:1. How much dividend could be paid?a) Rs.300,000b) Rs.100,000c) Rs.200,000d) Nil

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Multiple Choice Question-3 (Ans.)

Ans. (b)Explanation:Investment = Rs.600, 000Debt-equity ratio = 2:1Own equity in new investment =600,000/3 = Rs.200, 000Dividend = Rs.300, 000 - Rs.200, 000 = Rs.100, 000

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Multiple Choice Question-4A company expects this year’s EPS to be Rs.2 andprojects EPS of Rs.1.80, Rs.2.30, Rs.2.80 and Rs.2.60 over the next four years. It has long-termtarget dividend payout ratio of 50 percent. Which of the following dividend patterns would you recommend?a) Rs.1.00, Rs.1.00, Rs.1.00, Rs.1.40, Rs.1.30b) Rs.1.00, Rs.0.90, Rs.1.15, Rs.1.40, Rs.1.30c) Rs.1.00, Rs.1.00, Rs.1.10, Rs.1.20, Rs.1.30d) Rs.1.00, Rs.0.90, Rs.1.10, Rs.1.30, Rs.1.30

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Multiple Choice Question-4 (Ans.)

Ans. (c)

Thank You!

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