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Dividend Policy

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What is Dividend

According to ICAI(Institute of

chartered Accountants of India) ,

A dividend is distribution to share holders out of profits or reserves available for this purpose Divisible profits which are distributed amongst the members of a company in proportion to their shares in a manner as is prescribed by law. Dividend is arrived on the basis of PAT and % of retention of profits








Why companies pay dividend? Investor preference for self control and aversion to regret . Self control theory to check temptations, investors prefer dividend to protect principal from spendthrift tendencies. Aversion to regret Purchase of TV out of dividend income or sale of shares . Which one is preferred?

Why companies pay dividend? Information signaling increased dividends indicates earnings prospects Clientele effect capital gain or dividend income Bird-in-hand policy current income vs future income Temporary surplus cash and No investment opportunities ODI (over seas direct investment) ADRs/GDRs.

Dividend decision It is a complex one. Question is how much to retain and how much to pay. Growth opportunities Vs dividend pay out. It is whether fixed percentage or fixed portion of profits Dividend payment may affect the mood, behaviour and response of existing share holders, prospective investors, stock exchanges , financial institutions etc It creates conflict of interest among lenders, share holders, board of directors etc

Dividend theories Relevant affects over all value of firm. Dividend forms integral part of investing and financing decision Share holders prefer current dividend Bearing on market price Irrelevant Value of firm is impacted by profitability and earnings rather than dividend. Theories Walter model/Gordon model/Miller & Modigliani model (MM)

Miller & Modigliani theory Dividend irrelevance theory- advocates that value of the firm depends solely on its earnings power and not influenced by the ratio between dividends and retained earnings. Formula Po = D1 + P1 1+k Po = value of shares in the beginning or zero period P1 = value of shares in the end of period D1 = dividend per share at the end of the period K = cost of capital

Miller & Modigliani theory A company ahs an outstanding 10,000 shares. Company is contemplating a dividend of Re 5 per share at the of the current year Capitalization rate @ 10% What will be the priceat the end of the year if A) no dividend is declared B) dividend is declared

Miller & Modigliani theory A) When no dividend is declared Po = Rs 100. D1 = 0. k = 10% P1 = Po (1+k) D 1 = 100(1 + .10)-0 = Re 110. B) When dividend is declared Po = Rs 100.D1 =5. k =10% P1 = 100 (1+.10) -5 = 110 5 = 105 Total wealth of share holders incase of A is Rs 110 Total wealth of share holders incase of B is Rs 105 + 5 = 110 So, there is no change in wealth

MM theory -Assumptions

No tax advantage or disadvantage associated with dividends Investment and dividends decisions are independent Firms can issue shares with out floatation or transaction cost If retained earnings is more ,share holders enjoy capital appreciation equal to retained earnings. Dividend payout is more which may equal to capital appreciation. So, value of firm depends on earnings power.

Miller & Modigliani theory - irrlevance Current MV of a company $ 1,00,000 and 2000 shares outstanding. Current share price $50. Company to pay diviend of $ $10 per share. What will be the price after payment of dividend. Dividend payment $10 X 2000 =20000 Company value will be 80000(10000020000) Share price 80000/2000=40 i.e. Ex dividend price

Miller & Modigliani theory - irrlevance If company goes for share repurchase With dividend amount of 20000, company can repurchase 400 shares (20000/50). After share repurchase, 1600 shares outstanding and value will be 80000 (1600 X50) Share repurchase does not alter share price Individuals are indifferent between dividend and share repurchases

MM theory - comments Dividend pay out is information about earnings prospects of the company. Uncertainty and fluctuations - share holders prefer dividend to capital gain. Pricing of shares for additional equity new issues are always priced lower than MP. No fluctuation in cost of capital can be assumed. Transaction, taxation and issue cost exist . Investment and dividend decision are inter connected. When share holders sell their shares, it is subject to capital gains but not dividend. So, Share holders prefer dividend. Equity is not the only source of financing.

Walter Model

Investment decision are inter related. Dividend policy depends upon investment opportunities. If rate of return on investment is greater than cost of capital ,company's retained earnings will go up cost of capital > return, dividend will be distributed.

Walter Model - Implications Growth firm when the rate of return is greater than the cost of capital (r>k). Future earnings expected to go up due to profitable investment opportunities. 0 pay out ratio as entire earnings are retained for future investments. Market value of share move up as share holders expectations also soar. In short, Price will be maximum when Pay out ratio is 0 Bharti Air Tel No dividend between 2003 08.

Walter Model - Implications Normal firm when the rate of return is equal to cost of capital (r= k). Do not have unlimited profitable opportunities. Once profitable opportunities are exhausted, return (r) from investment equals to cost of capital (k) Returns on reinvestment will just equal to dividend income Price per share does not vary with changes in dividend pay out ratio as the share holders are indifferent to dividend ratio.

Walter Model - Implications Declining firm when the rate of return is lesser than cost of capital (r < k). profitable investment opportunities are less. Dividend pay out ratio may be 100% Market price may go up due to higher dividends. E.g. Hindustan Lever

Valuation formula P = D + r/k ( E D ) k P - Market price per share D dividend per share E earnings per share (E-D) retained earnings per share r - rate of return on investments k cost of capital

Walter Model

Walter model EPS Re 10 Market capitalization rate 10% Pay out option 50%,75% & 100% Rate of return -it it is 15%,10% & 8 % Compute market value of share

Pay out ratio

a) R =15% (r > k ) Growth firm

b) R =10% ( r = k) Normal firm r/k .10/.10=1.0

c) R = 8% (r < k) Declining firm

r/k .15/.10=1.5 a) Pay out @ 50% D =5 b) Pay out 75% D = 7.5 c) Pay out @ 100% D = 10P = 5+1.5(10-5) .10 = Rs 125

r/k .08/.10=.8P=5+0.8(10-5) .10 = Rs 90

P=P = 5+1.0(10-5) .10 = Rs 100

P=7.5+1.5(10-7.5) .10 = Rs 112.50 P = 10+ 1.5 (10 -10) .10 = Rs 100

P=7.5+1.0(10-7.5) .10 = Rs 100

P=7.5+0.8(10-7.5) .10 = Rs 95

P=10+1.0(10-10.0) .10 = Rs 100

P=10.0+0.8(10-10.0) .10 = Rs 100

Walter Model ABC co EPS Re per share 5. Cost of equity 10%. Rate of return 18%. According to Walters formula What is the share price if dividend pay out ratio is 25%

Walter Model P = 1.25 + 18/10(5-1.25) 0.10 = Re 80

Gordons Model It is similar to Walter's model. Dividend is relevant to the value of the firm and dividend policy certainly affects the value of the firm i.e. market price Assumptions It is all equity company Retained earnings represent only source for financing the firm. Rate of return and cost of capital remain constant Retention ratio is constant Investor values current dividend more highly than expected future dividends (capital gain) because future is full of risks. MP represents discounted value of future dividends. Corporate tax does not exist

Gordons Model Formula - E (1-b) Ke br Dividend = E(1-b) E is earning per share and 1-b is proportion of dividend distributed. E earnings per share 1-b = pay out ratio Ke = cost of capital br = growth rate

Gordons Model Formula - E (1-b) Ke br R=30%,k-20%,EPS Re 5 & b = 25% Price of the share will be Dividend is 20% i.e.(5*25%) Re1.25.Retention is 5- 1.25 = 3.75 5(1-0.25)/0.20-25*0.30 br - .25 X .30 =0.075 3.75/0.20 - 25*30% 3.75/.20 0.075 3.75/0.125 = Re 30

Dividends and tax impact Taxation dividend and capital gains Usually tax rate is higher for dividends than capital gains Companies can pay less cash dividend which will result low payout. Company will go for share buy back which will in turn increase the share price. It will reduce the impact of tax on dividends for investors

Dividend Policy Dividend policy determines what proportion of earnings is paid to share holders by way of dividend and retention of earnings for reinvestment Capital budgeting decision is impacted by dividend policy, since it has a bearing on EPS. Continuous trade off between retained earnings versus dividend pay out. Dividend and market price

Factors impacting Dividend Policy Funds requirement Pay out ratio is lower when investment prospects are bright. E.g. RIL low pay out ratio due to rapid expansion. Hindustan Lever has higher pay out ratio is 90 % (dividend @ 500% for Dec 2004) Access to External sources of financing. Share holders preference current dividend or capital gain. Composition of share holders such as MF /corporates etc. Cost factor Equity versus retained earnings. Control aspect regulatory /lenders covenants

Factors impacting Dividend Policy Tax implications Legal constraints Magnitude and stability of earni