Handout for Unit 5

for

Applied Corporate Finance

Unit 5

Dividend Policy

Contents

1. What is Dividend?

2. Dividend Characteristics

3. Dividend – Key Terms

a. Dividend Rate

b. Dividend Payout Ratio

c. Dividend Yield

d. Interim and Final

4. Dividend Payout of BSE100 firms

5. Schools of Thoughts on Dividend Policy

a. Dividends do not Matter

b. Dividends are bad

c. Dividends are good

6. Special Dividend

7. Assessing a company’s dividend policy

a. What did it pay?

b. What could it have paid?

8. Stock Dividend / Bonus

a. Why companies pay bonus

b. Bonus vs Stock Split

c. Why Investors like it

9. Dividend policy - examples

10. Dividend policy – Key Determinants

11. Case – Dividends and Buybacks in India.

What is Dividend?

When a firm makes profits, it can choose to either retain those within the company as source of funds, or

return it to equity holders. When the money is returned to the equity holders, this is known as a Dividend.

Dividend policy is thus a very important part of a company’s corporate finance decision making, 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.

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

Dividend – Common Terms

Dividend 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 Payout – We can calculate what is the payout ratio by dividing the dividend amount

with the profits. This is the percentage of profits being paid out. Subtracting this from 1 will give

us the retention ratio.

Dividend Yield – We can calculate this by dividing the company’s dividend with the market price.

In a way, this is the actual return the investor makes in the form of dividends, and as a shareholder,

you should be most concerned about this in the measures of dividend.

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%

Dividends – Interim and Final

Companies can declare dividend either during the year (known as Interim Dividend) or at the end of the

year (known as Final Dividend). These are combined during the year to understand the total dividend for

the year.

We see in the above figure, how MRF declares both interim and final dividend during the years.

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 20 crore, profits at Rs

400 crore, and a share price of Rs 200. What is the dividend yield, dividend rate, and dividend payout

ratio?

Answer

Dividend Rate = 50% (Rs 5 per share)

Dividend Payout = 25% (Rs 100 crore dividend / Rs 400 crore profits)

Dividend Yield = 2.5% (Rs 5 / Rs 200)

Schools of thoughts on Dividend Policy

There are 3 schools of thought on dividends

Dividends do not matter

Dividends are bad

Dividends are good

Let’s look at them detail

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 be indifferent 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 they can be

considered bad. Also, sometimes dividends show that the company is not finding enough projects that

can make money, and that may result in profits stagnating and share price not performing.

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 payments are generally considered good, sometimes it does not make sense to increase

dividend payments. A couple of such situations are

Company has too much cash, but this is a temporary phenomenon – Since dividends are sticky, it

may make 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

inherently assuming 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

promoters want money. Examples would be Public Sector firms, whose dividend is a source of

income for the government.

Special Dividend

As discussed, sometimes, if the companies have excess cash, they can choose to pay it off to equity holders

as a one-time dividend. This is called a special dividend.

Assessing a company’s dividend policy

In assessing any company’s dividend policy, it is important to understand two things

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 and gauge if they are

creating value by investing that money in good projects.

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 how much buyback

did it do. We have to add the two to get to this value. It may also make sense to view this over a period

of multiple years, since buybacks may not happen every year.

What could the company have paid?

A measure of what the company could have paid as dividend is the Free Cash Flow to Equity. The FCFE is

the measure of how much cash is left in the business after taking care of the non-equity payments

(Debt) and reinvestment needed for future growth – Capex and Working Capital investments.

FCFE = Net Profit

+ Depreciation and Amortization

- Capital Expenditure

- Working Capital Changes

- Debt Repayments

+ Debts Raised

Stock Dividend / Bonus

Sometimes, companies may choose to give a dividend in the form of more stocks to every shareholder.

Thus, if you are holding 1 share, a 1 for 1 stock dividend would give you another share. Stock dividend is

also known as bonus. Let us see what happens to a company before and after the bonus.

We will note that while the Overall value of the company does not change, we have divided the number

of shares, and hence the price per share changes. So does the EPS, and Share Capital. The increase is share

capital is balanced by a similar decrease in reserves and surplus (since bonus is a non-cash transaction).

What is interesting to note is that in a bonus, the new share has the same face value as the existing shares,

and hence the dividend payout and yield increases.

Why does a company give a stock dividend?

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

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 Stock Split

In the case of a stock split, we just divide the existing number of shares. So technically this is nothing more

than a mathematical adjustment.

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%

Stock Bonuses – Why investors like it?

Companies that give stock bonuses are expected to give more bonuses in future. Usually the stock

market expects that.

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%

Once a company gives a stock bonus, it is in a way specifying that it is doing well, and is expected

to do well in the future as well. It can continue to pay the extra dividend.

Dividend Policy – Some examples

Let us look at a few companies, their dividends and their stock price performance. Looking at the stock

price movement, it seems to indicate that higher dividends are liked by shareholders.

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

Dividend Policy – Key Determinants

The key determinants of dividend policy are thus

Type of Industry

Age of the Company

Shareholder Distribution

Reinvestment Needs

Business Cycles

Government Policies

Case 5 – Unit 5

Dividends and Buybacks

Read the article below and answer the following questions.

“

Govt’s second dividend tax spurs buybacks

Along with three large share buybacks by government-owned companies, Indian companies have

announced buybacks worth over Rs.2,1000 crore so far this year

India’s largest mobile services operator, two of the largest pharmaceutical companies, a top-tier IT services

firm and the second largest tower infrastructure company have chosen the buyback route to return cash

to shareholders this year. This is the first time so many large companies have announced buybacks in quick

succession; fiscal year 2016-17 looks set to break all prior records with regards to share repurchases. Along

with three large buybacks by government-owned companies, Indian companies have announced buybacks

worth over Rs.2,1000 crore so far this year.

Of course, it will be a while before buybacks topple dividends as the preferred means to return cash.

According to data collated by Mint Research, S&P BSE 100 companies alone paid dividends worth Rs.1.51

trillion in FY16. In the same period, the amount spent on buybacks by all listed companies was only Rs.1,800

crore.

But this may well be the beginning of a trend where buybacks are used nearly as much, if not more, as

dividends to return cash. Research by Credit Suisse shows that in the US, S&P 500 companies spent $572

billion on buybacks in 2015, or 1.5 times of what they spent on dividends.

For a number of shareholders, buybacks trump dividends both in terms of tax efficiency and the flexibility

they offer. Ironically, in India, the government seems to have overplayed its hand and magnified the

relative advantages of buybacks. In the 2016-17 Union budget, finance minister Arun Jaitley introduced an

additional tax of 10% on any dividend income of more than Rs.10 lakh. Dividend distribution tax already

amounted to 20.4% of payouts.

For stocks that have been held for over a year, the buyback route entails a tax outgo of only 0.1%, which

is essentially the securities transaction tax (STT) applicable for the transaction. Since 1 July 2015, Securities

and Exchange Board of India (Sebi) has allowed listed companies to make tender buyback offers through

stock exchanges. For such transactions, long-term capital gains tax is exempt.

Earlier, when companies weren’t allowed to make tender buyback offers through stock exchanges,

investors would end up paying a 10% long-term capital gains tax. To be sure, buybacks through tender

offers have picked up since FY16.

For high dividend earners, the tax savings through a buyback issue are substantial. Bharti Airtel Ltd holds

a 71.7% stake in Bharti Infratel Ltd. The latter has announced a buyback of Rs.2,000 crore. If the promoter

tenders shares in proportion to its shareholding, it will take home more than Rs.1,400 crore after

accounting for STT and other costs. If Infratel had chosen the dividend route instead, the net take home

would be only around Rs.1,000 crore.

There is likely to be increasing pressure from shareholders to shift to buybacks, given the tax efficiency.

One likely pushback is that Sebi imposes a restriction on companies buying back shares—i.e. that they

can’t issue fresh equity for a period after the buyback.

From a shareholder’s perspective, buybacks offer the flexibility of foregoing the payout by the company

and staying fully invested with the company. They can do this by simply opting to not tender shares in the

buyback. With dividends, there is no such option. Of course, one can always use dividend proceeds to buy

additional shares, although academic studies show that reinvestment is typically rare and forms a fraction

of all dividends received.

Another peculiarity about buybacks is that while all shareholders are treated the same with dividends, the

pricing of the buyback determines which category of shareholders benefit. Michael J. Mauboussin and Dan

Callahan of Credit Suisse point out in a note titled Disbursing Cash to Shareholders, “Buybacks benefit

ongoing shareholders when management buys stock that is undervalued and benefit outgoing

shareholders when the stock is overvalued. Since management should focus on building value per share

for continuing shareholders, it should always try to buy back shares that are undervalued.”

This shouldn’t normally matter in a tender offer, where investors can participate in the same proportion

as their shareholding. Even so, empirical evidence shows that some shareholders fail to participate, even

when they are incentivized by a substantial premium. Needless to say, investors need to keep a close eye

on the pricing of the offer; but companies, too, would do well to avoid buybacks by paying a large premium.

“

1. Why have buybacks increased in India in the recent past?

2. What is the tax treatment of buybacks?

3. Explain the preference of buybacks to dividends in India and compare this scenario to the US.

4. Explain how buybacks may not distribute benefits evenly, like dividends do.

5. From the shareholders’ perspective, how does a buyback provide a bigger flexibility when

compared to say dividends?