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liberal and conservative dividend policies and theories of dividend policies for valuation of shares
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Chapter XDividend Policies
Dividend
The return given to the shareholders on their investment
First Stage in Dividend Policy: Conservative
Second Stage: Liberal Third Stage: No Dividend Policy India is in the second stage right now
Factors Determining Dividend Policy
Company Policy Stability in Earnings Liquidity of the Co. Past Dividend Rates Projects under
Consideration Market Expectation Taxation Legal restriction
Independent Opportunities
Restrictions of FIs Nature of Business Cost of Capital Phase of Trade
Cycle Accumulated
Reserves Co’s Growth Needs Bonus Issue
Types of Dividend Policies
Conservative Dividend Policy
Liberal Dividend Policy
Conservative Dividend Policy: Merits
Good Treasury Mgt.
Stability in Dividend
Provision for Contingency
Organic Growth
Inorganic Growth
Modest Expectation
Taxation
Higher Book Value
Value Unlocking
Research Oriented Companies
Demerits of Conservative Dividend Policy
Lesser Image as a Creator of value for the Shareholders
Book Value will be far more than Market Value of the Shares
Accessing Capital Market becomes Difficult in the Future
Lesser Liquidity for the Shares
Liberal Dividend Policy
Handsome Dividend A Number of Interim Dividends
within a Year Regular Issue of Bonus Shares Special dividends on Important
Occasions Taking Care of Enhancing
Shareholder Value as much as maximising Profits of the Company
Merits of Liberal Dividend Policy
Good Image Shareholder Satisfaction Liquidity of the Scrip High Market Price Growth Driven Policy Accessing the Market Raising Finance Globally Constant Innovation
Demerits of Liberal Dividend Policy Difficult Treasury Management
Lack of Stability in Dividend Payment
Affecting Growth Prospects
Insatiable Appetite of Shareholders
High Dividend Tax
Bonus Shares
Stock Dividend
Capitalising the Reserves
Given as a ratio 1:2
Conserves Cash
For the Shareholder, tax liability is less as stock dividend is not treated as income
Benefits of Bonus Shares to the Company
No cash Outflow Higher Liquidity Good Image Higher Market Capitalisation Reduction in Rate of Dividend No Dividend Tax Undercapitalisation
Benefits of Bonus Shares to the Shareholders
Higher Holding
Partial Liquidation
Taxability
Higher Liquidity
Higher Future Dividend
Impact of Bonus Shares
On Balance Sheet: Asset side not affected, Reserves come down and Share Capital goes up-Net worth does not change
On Share Price: Immediate high, subsequent lower and higher in the long term
On EPS: Gets reduced- Suggestible when the operating profit is expected to go up
Bonus Shares & SEBI Guidelines Provision in Articles of Association Increasing Authorised Capital Out of Free Reserves/Share Premium Not Out of revaluation Reserve Only on Fully Paid Shares Not in Lieu of Dividend Implementation within six months No Default on Financial Obligations Not in one year of Public Issue/Rights
Issue Applicable to Listed Companies
Dividend Models
Walter’s Model
Gordon’s Model
Modigliani-Miller Model
Walter’s Model
James Walter & his Article, ”Dividend Policy: Its Influence on the value of the Firm”
Growth Firm: ROI > k-optimal dividend is 0%
Normal Firm: ROI =k, Any rate of dividend
Declining Firm: ROI < k , 100% Pay-Out Ratio
Assumptions of Walter’s Model
Only Two Sources of Finance: Equity Shares and Retained Earnings
ROI is constant from one year to another
K is constant from one year to another
Firm has an infinite life
Computation of Market Value of Shares
Where
P=Market Price of Equity
R=Rate of Return
K=cost of capital
E=Earnings per Share
D=Dividend per Share
kkDE
RDP
)(
Problem No. 1
The National Sports Company with an EPS of Rs.11 and a cost of capital at 13%, achieved a Return on Investment at 18%. As per Walter’s Model, what would be the optimum pay-out ratio? What would be the share price at this ratio?
Problem No.2
The earning per share of a company are Rs.8.It has an internal rate of return of 14% and the capitalisation of its risk class is 12%. If Walter’s Model is used,
(i) What should be the optimum pay-out ratio of the firm?
(ii) What would be the price of its share at this pay-out ratio?
(iii)How shall the price of the share be affected, if 20% pay-out ratio was employed?
Percentage of Dividend & Dividend Pay-Out Ratio
If Dividend is given as a percentage, it should be calculated on the face value.
If it is given as a pay-out ratio, it should be calculated on the EPS
Problem No.3
Company A has achieved an EPS of Rs.8 for the year2007-08. What is the Dividend per Share if,
(a) 25% dividend is declared on the share of Rs.10 face value
(b) dividend pay-out ratio is 25%
Problem No.4
Fairever Cosmetics achieved an EPS of Rs.9 per share on its equity share of Rs.10 each., for the year 2006-07.It achieved a Return on Investment @ 14% with a cost of capital @ 16%. What is the ideal pay-out ratio?
At that ratio, calculate the market value of share of the firm.
If Board of Directors recommend a Dividend of Rs.4, what would be the market price of share of the firm?
Problem No.5
For the year 2006-07, Sellwell Ltd., achieved an EPS of Rs.9. Its cost of capital is 11% and Rate of Return is 14%.
Determine its market price when
the dividend pay-out ratio is (a) o% (b) 25% © 50% (d) 100%
Problem No. 6
Trywell Ltd., achieved an EPS of Rs.12 on its equity shares of Rs.10. The cost of capital of the company was 7% while the rate of return was 4%.
Calculate the market price of the share if the Dividend Pay-out ratio was (a) 0% (b) 20% © 40% (d) 80% (e) 100%
Problem No.7
Consider the following data: Growth Normal
Declining Firm Firm
FirmROI 17% 18%
19%K 15% 18%
20%EPS (Rs) 6 6
6Calculate the market price of shares of
thefirms if the pay-out ratio is 20%, 45%
or 70%.Also comment on it.
Criticisms of Walter’s Model
Only zero debt companies have equity and retained earnings as the only two sources of finance
ROI will not be constant
K also will not remain constant
Dividend Capitalisation Model
Myron J. Gordon concurred with Walter in Dividend being relevant to Market price of Share
He differed in advocating growth as the driver of the market price
Growth is the product of retention ratio (b) and Rate of Return (R)
Assumptions of Gordon’s Model
Only Equity and Retained Earnings are the only sources of finance
R is constant from one year to another
Taxes do not exist
K is also constant
The Firm has a perpetual life
Computation of Market Price
bRK
bEP
e
)1(
Miller-Modigliani Dividend Model
Merton Miller & Franco Modigliani presented a paper in 1958 and argued that Dividend
was irrelevant in determining the price of the share
- It was the Investment policy and earnings of the firm that determined the share price
- In 1961, an Article was published by them, which came to be known as Irrelevance Theory
Arbitrage Process
Price may go up post declaration of dividend
After the payment of dividend, the firm may have to access the capital market for the future requirement
This will bring down the price of the shares to the previous levels
The Theory impacted the capital market so much that nearly 70% of American Corporations became ‘No Dividend’ Corporations
Assumptions
1. Perfect Capital Markets: - all the investors are rational -price sensitive information is available
to all the investors simultaneously -securities are infinitely divisible - no single investor is big enough to influence the price2. Non-Existence of Taxes3. Constant Investment Policy4. Forecasting Ability
Computation of Share Price
Where Po = Price at the beginning P1 = Price at the end ke = Cost of Equity D = Dividend per Share
101 )1( DkPP e
Exercise-page No.289
17. The share price of TVS Electronics Ltd. was ruling at Rs. 57.60. The Board of Directors declared a dividend of Re. 0.70 per share of Rs. 10. If cost of equity is 3%, calculate the share price after declaration of dividend using Miller Modigliani Dividend Model.
Exercise-Page No.289
16. Cost of Equity of VIP Industries Ltd. was 5% and the price of equity share was Rs. 122.60. The company declared a dividend at 20% on its equity shares having the face value at Rs. 10. What will be the share price after the declaration of dividend?
18. Triumph Engineering Ltd had 5,000 equity shares of Rs. 100 each. During a financial year, its cost of equity was 17%%. Using Miller - Modigliani model, decide what will be the price of the share, if no dividend is declared? If a dividend of Rs. 23 per share is declared, what will be the share price?
Exercise-Page No.289
19. United Pharma Ltd. had 3,00,000 outstanding equity shares of Rs.10 each on Jan 1,2007. The company now intends to pay Rs.6 per share for the current year. It belongs to a risk class whose appropriate capitalisation rate is 9%. Determine the price of the company’s share using Modigliani-Miller model,
(i) when dividend is declared (ii) when no dividend is declared.
19. United Pharma Ltd. had 3,00,000 outstanding equity shares of Rs.10 each on Jan 1,2007. The company now intends to pay Rs.6 per share for the current year. It belongs to a risk class whose appropriate capitalisation rate is 9%. Determine the price of the company’s share using Modigliani-Miller model, (i) when dividend is declared (ii) when no dividend is declared.
19. United Pharma Ltd. had 3,00,000 outstanding equity shares of Rs.10 each on Jan 1,2007. The company now intends to pay Rs.6 per share for the current year. It belongs to a risk class whose appropriate capitalisation rate is 9%. Determine the price of the company’s share using Modigliani-Miller model, (i) when dividend is declared (ii) when no dividend is declared.
Exercise-Page No.292
17. Two chemical companies A Ltd. and B Ltd. had equity shares priced at Rs. 300 each. During the financial year 2006-07, each one made a net profit of Rs. 430 crores. Cost of equity is the same for both the companies at 16%. A Ltd. decided to declare a dividend at Rs. 7 per share and B Ltd. decided not to declare any dividend.
Using Miller-Modigliani hypothesis, a) Calculate the share price of A Ltd. after dividend
declaration b) Calculate the share price of BLtd. after the results c) Is there any difference in the total shareholder
wealth between the two companies?
Exercise-Page No 292 16. The following seven engineering companies
undertake turn-key projects in India. Their financials for 2004-05 are given below. All the companies have Rs. 10 as the Face value of share of a Company
P0 D ke (%)
ABG Heavy Industries Ltd 264 1.504.4 Engineers India Ltd 8237.502.4 Hindustan Dorr-Oliver Ltd 813 1.202.2 MC. Nally Bharath Ltd 1300.302.3 Petronet Engineering Ltd 168 1.005.9 PSL Ltd 251 4.504.14 Sanghvi Motors Ltd. 8405.002.1 Using Modigliani - Miller hypothesis, calculate the
market price of shares after the declaration of dividend.
Exercise-page No.292
18. Apply Modigliani - Miller hypothesis and determine the share prices of the following companies after the declaration of dividend.
Problem No. 19
THANK YOU