Applied Corporate Finance

Unit 5

Dividend Policy

• Measures – Yield, Payout and Dividend Rate• Determinants of Dividend Policy• Various schools of though on Dividend Policy• Managing Changes in Dividend Policy

First Principles

The Investment DecisionInvest in assets that earn a

return greater than the minimum acceptable hurdle

rate

The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and equity to

fund your operations

The Dividend DecisionIf you cannot find investments

that make your minimum acceptable rate, return the cash

to owners of your business

The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used

to fund it.

The return should reflect the magnitude and the timing of the

cashflows as welll as all side effects.

The optimal mix of debt and equity

maximizes firm value

The right kind of debt

matches the tenor of your

assets

How much cash you can

return depends upon

current & potential

investment opportunities

How you choose to return cash to the owners will

depend on whether they

prefer dividends or buybacks

Maximize the value of the business (firm)

Source: Applied Corporate Finance, Aswath Damodaran

What is Dividend

When a firm makes profits, it can choose to either retain those within the company assource of funds, or return it to equity holders. When the money is returned to the equityholders, this is known as a Dividend.

Dividend policy is thus a very important part of a company’s corporate finance decisionmaking, and investor preferences for a company change based on its dividend policy.

Dividend Characteristics

It has been seen that• Dividends tend to be sticky – which means that companies usually would not cut

dividends unless the financial situation is really bad• Dividends tend to follow the earnings, which is logical since from earnings the dividends

will get paid• Dividends get impacted by taxation laws for dividends. Tax laws are important, else the

promoter would take all money out in the form of dividends if there was no tax.• Dividend also depends on the maturity of the country’s economy.

Dividend Yields across countries

Source: http://www.dividend.com/dividend-education/dividend-yields-by-countries/

Dividend – Common Terms

Dividends can be measured in 3 ways• Dividend Rate• Dividend Payout• Dividend Yield

Dividend – Common Terms

Dividends can be measured in 3 ways• Dividend Rate – Companies usually use this method to announce the dividend they are

paying. This dividend is as a percentage of the face value of the company’s stock.

Dividend – Common Terms

• Dividend Payout – We can calculate what is the payout ratio by dividing the dividendamount with the profits. This is the percentage of profits being paid out. Subtracting thisfrom 1 will give us the retention ratio.

Year 2016 2015 2014 2013 2012

Consolidated Profit 1,093.0 977.6 1,005.1 612.6 409.9

Equity Share Dividend 101.8 101.8 37.8 25.2 25.2

Tax On Dividend 28.4 20.7 6.4 4.3 4.1

Total spend on Dividend 130.2 122.5 44.2 29.5 29.3

Divident Payout Ratio 11.91% 12.53% 4.40% 4.81% 7.15%

Divident Payout Ratio (Excluding Dividend Tax) 9.31% 10.41% 3.76% 4.11% 6.15%

Dividend – Common Terms

• Dividend Yield – We can calculate this by dividing the company’s dividend with themarket price. In a way, this is the actual return the investor makes in the form ofdividends, and as a shareholder, you should be most concerned about this in themeasures of dividend.

Dividend – Interim and Final

Companies can declare dividendeither during the year (known asInterim Dividend) or at the end ofthe year (known as FinalDividend). These are combinedduring the year to understand thetotal dividend for the year.

Dividend Payout – BSE 100 companies

Source: http://www.livemint.com/Companies/dfDBLg9PicEj1lTk9ltY4H/Corporate-dividend-payout-ratio-at-highest-in-at-least-11-ye.html

Sample question

• A company has a face value of Rs 10, dividend rate of 50%, shares outstanding at 20crore, profits at Rs 400 crore, and a share price of Rs 200. What is the dividend yield,dividend rate, and dividend payout ratio?

Questions

• What are the key characteristics of dividend?• A company has a face value of Rs 10, dividend rate of 30%, shares outstanding at 10

crore, profits at Rs 200 crore, and a share price of Rs 100. What is the dividend yield,dividend rate, and dividend payout ratio?

Applied Corporate Finance

Unit 5

Schools of thought on Dividend Policy

There are 3 schools of thought on dividends• Dividends do not matter• Dividends are bad• Dividends are good

Dividends do not matter

This is also known as the Miller Modigliani Hypothesis. It makes a few assumptions• There is no cost – direct or indirect of new stock issuance• There is no difference between the tax treatment for capital gains and dividends• The companies do not destroy value of unpaid dividend by investing in bad projects

If there are no tax disadvantages associated with dividends & companies can issue stock,at no issuance cost, to raise equity, whenever needed, then the investor should beindifferent to getting paid in dividends or via capital appreciation.

Dividends are bad

If the dividends create a disadvantage for investors due to taxation treatment, then theycan be considered bad. Also, sometimes dividends show that the company is not findingenough projects that can make money, and that may result in profits stagnating and shareprice not performing.

Dividends are bad

Year 2016 2015 2014 2013 2012

Consolidated Profit 3,080 3,193 1,968 1,011 723

Equity Share Dividend 216 227 133 99 -

Dividends are good

Most of the times though, dividends are good news

• Investors are happy about dividends• Most of the times, it is about the company signaling good future ahead, since companies

are not expected to reduce dividend payouts.• Dividends are a way of transferring wealth from lenders to equity holders.

Some incorrect reasons to pay dividends

While dividend payment are generally considered good, sometimes it does not make sense to increasedividend payments. A couple of such situations are

• Company has too much cash, but this is a temporary phenomenon – Since dividends are sticky, it maymake sense to do a buyback, instead of a dividend. Some companies use this to issue a special dividend.

• Dividends are more certain, and are better than future capital appreciation – Here, we are inherentlyassuming that the company may destroy value with this money in future.

• Sometimes, companies may be making losses but still paying dividends. This could be because promoterswant money. Examples would be Public Sector firms, whose dividend is a source of income for thegovernment.

Special Dividend

Special Dividend

Questions

• Explain the assumptions inherent in the Dividends do not matter school.• What is a special dividend?

Applied Corporate Finance

Unit 5

Assessing the company’s dividend policy

In assessing any company’s dividend policy, it is important to understand two things1. We should find out how much dividend the company paid, and how much it could have

paid. If we find they are paying less as compared to what they should, then we try andgauge if they are creating value by investing that money in good projects.

2. We should find if the company is paying enough when compared to its peers.

What did the company pay?

To understand this, we need to find out how much dividend the company paid, and howmuch buyback did it do. We have to add the two to get to this value. It may also makesense to view this over a period of multiple years, since buybacks may not happen everyyear.

What could they have paid – the FCFE

A measure of what the company could have paid as dividend is the Free Cash Flow toEquity. The FCFE is the measure of how much cash is left in the business after taking care ofthe non-equity payments (Debt) and reinvestment needed for future growth – Capex andWorking Capital investments.

What could they have paid – the FCFE

A measure of what the company could have paid as dividend is the Free Cash Flow toEquity. The FCFE is the measure of how much cash is left in the business after taking care ofthe non-equity payments (Debt) and reinvestment needed for future growth – Capex andWorking Capital investments.

FCFE = Net Profit+ Depreciation and Amortization- Capital Expenditure- Working Capital Changes- Debt Repayments+ Debts Raised

Apollo Tyres – Dividend Analysis

Let’s now check this for Apollo Tyres

ROE vs Cost of Equity

Let us also try and calculate the Return on Equity vs the Cost of Equity for Apollo Tyres, which will giveus an idea if they have indeed created value from the money they did not pay to investors.

Similar test for Your Company

Try and do the same for your company under the project1. Calculate FCFE for the last few years2. Calculate the Dividend Paid and Buybacks over those years3. Compare ROE vs Cost of Equity for the period under consideration, to see if the company has

created value with undistributed dividends, if any

Questions

• What number tells us about the potential of a firm to pay dividend? How do we calculate it?• Should buybacks be also considered as a dividend payment? Why?

Applied Corporate Finance

Unit 5

Assessing the company’s dividend policy

In assessing any company’s dividend policy, it is important to understand two things1. We should find out how much dividend the company paid, and how much it could have

paid. If we find they are paying less as compared to what they should, then we try andgauge if they are creating value by investing that money in good projects.

2. We should find if the company is paying enough when compared to its peers.

What about peers?

Let us also look at MRF and Ceat Tyres over the last year. Let us calculate FCFE for them over the lastyear, and try and check what dividend they have paid.

Questions

• What would your views be about the Dividend Policy of Apollo Tyres vs its peers?

Applied Corporate Finance

Unit 5

Stock Dividend / BonusAssume that the company gives a stock dividend of 1 share for every 1 share held

After Bonus

20,00,000

5

1,00,00,000

100

20,00,00,000

10

2,00,00,000

4,00,00,000

20

30%

3

3%

Now

Shares Outstanding 10,00,000

EPS 10

Net Profit 1,00,00,000

Stock Price 200

Market Cap 20,00,00,000

Face Value 10

Share Capital 1,00,00,000

Reserves and Surplus 5,00,00,000

P/E 20

Dividend 30%

Dividend per share 3

Dividend Yield 1.5%

Why Stock Dividend?

In general, this increases the investor base over a period of time

So why would companies give stock dividends?

All else being equal, lower share price results in attracting more investors

It is a cashless transaction, but dividend payout increases

Stock dividend does not disturb leverage ratios or solvency ratios

Bonus vs Split

Now

Shares Outstanding 10,00,000

EPS 10

Net Profit 1,00,00,000

Stock Price 200

Market Cap 20,00,00,000

Face Value 10

Share Capital 1,00,00,000

Reserves and Surplus 5,00,00,000

P/E 20

Dividend 30%

Dividend per share 3

Dividend Yield 1.5%

After Split

20,00,000

5

1,00,00,000

100

20,00,00,000

5

1,00,00,000

5,00,00,000

20

30%

1.5

1.5%

After Bonus

20,00,000

5

1,00,00,000

100

20,00,00,000

10

2,00,00,000

4,00,00,000

20

30%

3

3%

Stock Bonuses – Why investors like it?

Companies that give stock bonuses are expected to give more bonuses in future. Usuallythe stock market expects that.

Stock Bonuses – Why investors like it?

Once a company gives a stock bonus, it is in a way specifying that it is doing well, and isexpected to do well in the future as well. It can continue to pay the extra dividend.

Buybacks in India

Off late, buybacks have increased in India. The reason is that the government has applieda new tax on any dividends in excess of Rs 10 lakhs. This has resulted in companies goingfor a buyback instead of paying dividends.

Dividend Policy – Some Examples

2010 2011 2012 2013 2014 2015 2016

ITC 4.5 4.5 4.5 5.3 6.0 6.3 8.3

Axis Bank 12.0 14.0 16.0 18.0 20.0 23.0 25.0

BHEL 4.7 6.2 6.4 5.4 2.8 1.2 0.4

ITC

Axis Bank

BHEL

Dividend Policy - Summarizing

The key determinants of dividend policy are thus• Type of Industry• Age of the Company• Shareholder Distribution• Reinvestment Needs• Business Cycles• Government Policies

Project work

Try and look at your firm, and find out about the dividend policy of your firm in detail, justlike we have done for Apollo Tyres

Questions

• Write down the key determinants of the dividend policy• What is your expectation from a company’s stock price, when the company has

consistently increased dividend in the past, but has recently cut it down.